WCM 2003

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Working Capital Management

Introduction

Working capital management is the management of funds required for

running the day-to-day operations of the organisation. There are two

concepts of working capital:

(a) Gross working capital, and

(b) Net working capital.

Gross working capital is the total of all current assets. Net working capital

is the difference between current assets and current liabilities.

Management of working capital refers to the management of current assets

as well as current liabilities.

Constituents of Current Assets and Current Liabilities

A. Current Assets

• Inventories: (a) raw materials (RM)

(b) work-in-progress (WIP)

(c) finished goods (FG)

(d) others.

• Trade (sundry) debtors

• Loans & advances

• Advance payments

• Cash and bank balance



B. Current Liabilities

• Trade (sundry) creditors

• Trade advances received

• Borrowings (short-term) from commercial banks and others

• Provisions

Characteristics of Current Assets

Two characteristics of current assets should be borne in mind:

(i) Short life span, and

(ii) Swift transformation into other asset forms

The life span of current assets depends upon the time required in the

activities of procurement, production, sales and collection, and the degree

of synchronisation of these activities. Efficient management of one

component cannot be undertaken without simultaneous consideration of

the other components.



Working Capital Cycle

Finished goods

Accountreceivables(sales)

Work-in-progress

Raw materials

CashSuppliers

(purchase)

Admn.Selling

& Dist.O/H

wages,

salaries &

factory

overhead



Factors influencing working capital requirement

The working capital needs of an organisation are influenced by the

following factors:

(a) Nature of business

(b) Seasonality of operations

(c) Production policy

(d) Market conditions

(e) Conditions of supply of raw materials etc.

Level

An important working capital policy decision is concerned with the level of

investment in current assets. Under a ‘flexible policy’ (also called

‘conservative policy’) the investment of current assets is high. The firm

maintains a huge balance of cash, inventories, sundry debtors etc.

Under a ‘restrictive policy’ (also called ‘aggressive policy’) the investment in

current assets is low. The firm keeps a small balance of cash, inventories,

sundry debtors etc.

Determining the optimum level of current assets involves a trade off

between costs that rise with current assets and costs that fall with current

assets. The former are referred to as carrying costs and the latter as

shortage costs.



Exhibit 1 shows how these costs behave in relation to the level of current

assets.

Carrying Cost

& Total Cost

Shortage Cost

Carrying Cost

Shortage Cost

Level of current assets

Current Assets Financing Strategy / Policy

Broadly the assets are divided into two classes, viz.

a) Fixed assets

b) Current assets

The investment in current assets may be broken into two parts:

i. Permanent current assets

ii. Temporary current assets

Exhibit 2 shows capital requirements and their financing under various

strategies.



Fluctuating or

Temporary CA

Capital Requirement

Requirement A

C

B Permanent CA

Requirement

FA Requirement

Time

Strategy A

Long term financing is used to meet fixed asset requirement and peak

working capital requirement. When the working capital requirement is lessthan its peak level, the surplus is invested in liquid assets say, cash and

marketable securities.

Strategy B

Long term financing is used to meet fixed asset requirement and

permanent working capital requirement. Here short term financing is used

to meet fluctuating or temporary working capital requirement.

Strategy C

Long term financing is used to meet fixed asset requirement and

permanent working capital requirement as well as a portion of fluctuating



working capital requirement. During seasonal upswing, short term financing

is used. During seasonal downswing, surplus is invested in liquid assets.

Operating Cycle

The operating cycle of an organisation begins with the acquisition of raw

materials and ends with the collection of receivables. It may be divided into

4 (four) stages:

(i) Purchase of raw materials and storage stage

(ii) Work-in-process(WIP) stage

(iii) Finished goods inventory stage

(iv) Sales and debtors collection stage.

Information about the operating cycle is helpful in (a) forecasting working

capital, and (b) control of working capital.

Inventory Period

The time lag between the purchase of raw material and the sale of finished

goods is called the inventory period.

Accounts Receivable Period

The period that elapses between the date of sales and the date of

collection of receivables is called accounts receivable period.

Accounts Payable Period

The period that elapses between the date of purchase of raw material and

the date of payment for purchase is called accounts payable period.



Cash Cycle

The period that elapses between the payment for purchase of raw material

and the collection of cash for sales is called cash cycle.

Therefore, the operating cycle is the sum of the inventory period and the

accounts receivable period. Cash cycle is equal to the operating cycle

minus accounts payable period.

Formula:

Inventory period = Average inventory

Annual cost of goods sold / 365

Accounts receivable period = Average accounts receivable

Annual sales / 365

Accounts payable period = Average accounts payable

Annual cost of goods sold / 365



Exhibit 3 shows operating cycle and cash cycle.

.

Order placed Stock Recd Cash Recd.

Inventory Period A/c Receivable Period

A/cs Payable Period

Receipt of Inv. Cash paid

Operating Cycle

Cash Cycle

Example

Horizon Ltd. furnishes the following data from the financial statements:

Sales Rs. 800000Cost of goods sold Rs. 720000

Inventory as on 1/1/2005 Rs. 96000


Accounts receivable as on 1/1/2005 Rs. 86000


Accounts payable as on 1/1/2005 Rs. 56000


Assume 365 days a year.

Find out:



i. Inventory period

ii. Accounts receivable period

iii. Accounts payable period

iv. Operating cycle

v. Cash cycle?



Answer

i. Inventory period = (96000 + 102000) / 2

720 / 365 = 50.1 days

ii. Accounts receivable period = (86000 + 90000) / 2

800 / 365 = 40.2 days

iii. Accounts payable period = (56000 + 60000) / 2

720 / 365 = 29.4 days

iv. Operating cycle = Inventory period + Accounts receivable period

= 50.1 days + 40.2 days 90.3 days

v. Cash cycle = Operating cycle - Accounts payable period

= 90.3 days – 29.4 days = 60.9 days

Example

The relevant financial information for X Ltd. for the year ended 31 /12 2010

is given below:

Sales Rs. 80000

Cost of goods sold Rs. 56000









Assume 365 days a year.

Find out:

i. Inventory period

ii. Accounts receivable period

iii. Accounts payable period

iv. Operating cycle

v. Cash cycle?



Answer

i. Inventory period = (9 +12) / 2

56 / 365 = 68.4 days

ii. Accounts receivable period = (12 + 16) / 2

80 / 365 = 63.9 days

iii. Accounts payable period = (7 + 10) / 2

56 / 365 = 55.4 days

iv. Operating cycle = 68.4 days + 63.9 days = 132.3 days

v. Cash cycle = 132.3 days - 55.4 days = 76.9 days

Example

From the following information extracted from the books of a manufacturing

co., compute the operating cycle in days:

Period covered = 365 days

Average period of credit allowed by suppliers = 16 days

Average sundry debtors (outstanding) = Rs. 480000

Raw material consumption = Rs. 4400000

Total production cost = Rs. 10000000

Total cost of sales = Rs. 10500000

Sales for the year = Rs. 16000000Value of average stock maintained:

(a) Raw material = Rs. 320000

(b) Work-in-progress = Rs. 350000

(c) Finished goods = Rs. 260000



Answer

Days

(i) Raw material holding period = (320000 x 365)4400000 = 27

Less credit allowed by the suppliers = 16

11

(ii) W-I-P holding period = (350000 x 365)

10000000 = 13

(iii) Finished goods holding period = (260000 x 365)

10500000 = 9

(iv) Sundry debtors collection period = (480000 x 365)

16000000 = 11

Duration of operating cycle = 44

Management of Working Capital

The management of working capital involves the management of:

• Cash and liquidity management

• Credit management:

(i) Management of receivables (debtors), and

(ii) Management of payables (creditors)

• Inventory management.



Cash and Liquidity Management

Cash, the most liquid asset, is of vital importance to the daily operations of

business firms. It is crucial for the solvency of the business. Cash is

referred to as the “life blood” of an organisation.

As John Maynard Keynes puts it, there are three motives for holding cash

as follows:

(i) Transaction motive i.e. needing cash for meeting the transaction needs.

(ii) Precautionary motive i.e. protecting firms against uncertainties about

magnitude and timing of cash inflows and outflows.

(iii) Speculative motive i.e. tapping profit making opportunities by way of

speculative activities.

Cash has an opportunity cost. The idle cash resource is at the expense of

profit sacrificed by foregoing alternative investment opportunities. Hence, a

finance manager should:

• Establish a reliable cash forecasting and reporting system

• Improve cash collection and disbursements

• Achieve optimal conservation and utilisation of funds.

Profit vs. Cash

There are sharp differences between profit and cash mentioned below:

I. Cash refers to the cash as well as bank balances of a company at the

end of the accounting period, as reflected in the balance sheet. But the



profit reflects the earning capacity of a company, whereas cash reflects its

liquidity position.

II. There may be situation where a company may reveal the profits in its

profit & loss a/c at the end of the accounting period but in fact, it may be

cash starved.

III. Profit can be said to be the excess of income over expenditure of the

company for a particular accounting period. They include both cash income

(viz. cash sales, interest on investments etc.) and non-cash income (viz.

credit sales, discount received, excess provision for depreciation, doubtful

debts etc.). Similarly both expenses in cash / cheque (viz. payment of

salaries, wages, interest on term loan etc.) and non-cash expenses (viz.

preliminary expenses written off, outstanding expenses like unpaid salary,

rent, insurance etc.) where there is no actual cash outflow at the time of

accounting, are included.

Sources and Applications of Cash in Business

Sources

Existing cash / bank balance or reserves

Cash sales

Collection from sundry debtors

Interest and dividend receipts

Increase in loans / deposits

Issue of shares / securities

Sale of assets

Bank overdraft or lines of credit.



Applications

• Cash purchase

• Payment to suppliers against credit purchase

• Wages and salaries

• Manufacturing expenses

• General administration and selling expenses

• Capital equipment purchase

• Repayment of loans

•

Retirement of securities• Share buy back.

Cash forecasting – short-term and long-term

The cash budget is prepared for short-term cash forecasting which shows

the timing and magnitude of expected cash receipts & payments over the

forecast period, not usually exceeding 1 year.

Items of cash receipts and payments and the basis of their estimation are

mentioned hereunder:

Items Basis of estimation

(a) Cash sales Sales budget and its division into

cash and credit sales

(b) Collection of accounts Sales budget and its division into

receivables cash and credit sales as well as

collection pattern

(c) Interest and dividend receipts Firm’s portfolio securities and

returns expected of them



(d) Increase in loans / deposits

and issue of securities Financial plan

(e) Sale of assets Proposed disposal of assets

(f) Cash purchase Purchase budget and its division into

cash and credit purchases

(g) Payment for purchases Purchase budget and its division into

cash and credit purchase terms

(h) Wages & salaries Manpower employed and Wages &

salaries structure

(i) Manufacturing expenses Production budget(j) General, Admn. & Selling Administration and sales personnel

expenses and proposed sales promotion and

distribution expenses budget

(k) Capital equipment purchases Capital expenditure budget, and

payment term associated with

capital equipment purchases

(l) Repayment of loans &

retirement of securities Financing plan

Example

From the following information, prepare a monthly cash budget for three

months ending 31st December, 2008.

Month Sales Materials Wages Prodn.o/h Admn.s&d.o/h

(Rs) (Rs) (Rs) (Rs) (Rs)

-------- ---------- ----------- ---------- ----------- ---------------

June 6000 3600 1300 450 320

July 6500 4000 1500 450 320



Aug 7000 4800 1500 500 350

Sept 7500 4500 1500 600 350

Oct 8000 4600 1600 600 400

Nov 8500 5000 1800 700 400

Dec 9000 5200 2000 700 450

Credit terms are:

Sales --- 3 months to s/ debtors.

--- 10% of sales are on cash. On average, 50% credit sales are

paid on due date and the other 50% are paid in the month

following.Creditors (materials) --- 2 months.

Lag in payment --- wages: ¼ month, overheads: ½ month.

Cash and bank balances on 1st October is expected to be Rs 3000.

Other relevant information are:

(i) Plant & machinery to be installed in August at a cost of Rs 48000 will be

paid by monthly installment of Rs 1000 from October 1st.

(ii) Pref. share dividend of 5% on capital of Rs 100000, are to be paid on 1st

December.

(iii) Calls on 500 equity shares @ Rs 2 per share are expected on 1 st

November.

(iv) Dividends from investment amounting to Rs 500 are expected on 31st

December.

(v) Income tax are to be paid in December Rs 1000.



Answer

Cash Budget

Budget Period ending 31/12/2008

Details October(Rs) November(Rs) December(Rs)

Balance b/d 3000 1075 700

Receipts:

Sales 6425 6925 7425

Capital - 1000 -

Dividends - - 500

--------- ----------- ------------Total (a) 9425 9000 8625

--------- ----------- ------------

Payments

Creditors 4800 4500 4600

Wages 1575 1750 1950

Production o/h 600 650 700

Admn.,selling&dist. o/h 375 400 425

Pref. dividend - - 5000

Income tax - - 1000Plant & machinery 1000 1000 1000

---------- ------------ ------------Total (b) 8350 8300 14675

---------- ------------ -----------Balance (a) – (b) 1075 700 (-) 6050



====== ====== ======

Workings:

1. Receipts from sales (Rs)

Months Sales October November December

June 6000 2700

July 6500 2925 2925

August 7000 - 3150 3150

September 7500 - - 3375

October 8000 800

November 8500 - 850

December 9000 - - 900

TOTAL 6425 6925 7425

2. Calculation of wages

October : ¼ th of September + ¾ th of October wages

November : ¼ th of October + ¾ th of November wages

December : ¼ th of November + ¾ th of December wages.

Evaluation of Receipts & Payment Method

Advantages

• It provides a complete picture of expected cash flows.



• It is a sound vehicle for exercising control over day to day

transactions.

Drawbacks

• Its reliability is impaired by delays in collection or sudden demand for

large payments.

• It fails to provide a clear picture of important changes in the working

capital movements, relating to inventories and receivables.

Long – term cash forecasts are generally prepared for a period ranging

from 2 to 5 years and serve to provide a broad picture of a firm’s financing

needs and availability of investible surplus in future. Such forecasts are

helpful in planning capital investment outlays and long-term financing. The

method used for this purpose is the adjusted net income method. A format

of the same is given below:

Adjusted Net Income Method

Years 2005 2006 2007 2008 2009

Sources

Net Income(after tax)

Non-cash charges(depreciation etc.)

Increase in borrowing

Sale of equity sharesMiscellaneous

Uses

Capital expenditure



Increase in current assets

Repayment of borrowings

Dividend payment

Miscellaneous

Surplus / Deficit

Opening cash balance

Closing cash balance

This method for long-term forecasting of cash resembles the fund flow

statement.

Cash reports for Control

Cash reports provide a comparison of actual developments with forecast

figures. These are helpful in controlling and revising cash forecasts on a

continuous basis. The important cash reports are:

(i) Daily cash reports

(ii) Daily treasury report

(iii) Monthly cash report

Cash Collection and Disbursement

Float

The cash collection shown by a firm in its books is called ‘book or ledger

balance’, whereas the balance shown in its bank account is called

‘available or collected balance’. The difference between the available

balance and the ledger balance is called ‘float’.



The net float is the sum of disbursement float and collection float. It is

simply the difference between the firm’s available balance and its book

balance. If the net flow is positive, it means that the available balance is

greater than the book balance, and vice versa. Therefore, a finance

manager should try to speed up collections and delay disbursements in

order to maximise the net float.

Speeding up collections

Lock boxes system

Under this system customers are advised to mail their payments to the post

office boxes called lock boxes, instead of sending them to corporate office.

The local banker collects the cheques from the lock box once a day or

more, and deposits the cheques directly into the local bank account of the

firm. This system cuts down the mailing time and processing time.

Concentration banking system

In this system the firm asks its customers in a particular area to send

payments to a local branch office rather than to the corporate office. The

cheques received by the local branch office are deposited for collection into

a local bank account. Surplus funds from various local bank accounts are

transferred regularly to a concentration account at one of the firm’s

principal banks.

Delaying payments

Like speeding collection, the firm can also slow down its disbursements. To

enhance the efficiency of management of cash, collection and

disbursements must be closely monitored.



Following courses of action may be taken:

• Prompt billing

• Expeditious collection of cheques through

(a) Lock box system

(b) Concentration banking

• Control of payables from H.O

• Maintaining the float through

(a) Disbursement float

(b) Collection float

(c) Net float

Optimal Cash Balance

If a company maintains a small cash balance, it has to sell its marketable

securities more frequently than if it holds a large cash balance. Hence, the

transaction costs will tend to diminish if cash balance becomes larger.

However, the opportunity costs of maintaining large cash increase as the

cash balance increases, and vice versa. This behaviour can be graphically

represented to show the optimum cash balance, as follows:

Total Costs

Costs

Opportunity

Cost

Transaction

Cost



Cash balance

Cash Management Models

Out of many cash management models, two models deserve mention, as

follows:

(i) Baumol model

(ii) Millar and Orr model

Baumol model

William J. Baumol has proposed a model which applies the economic order

quantity (EOQ) concept, commonly used in inventory management. This

model determines the cash conversion size which influences the average

cash holding of the firm.

Formula:

TC = I (C / 2) + b (T / C)

Where C = Amount of marketable securities converted into cash per

order

I = Interest rate earned (per planning period) on investment

marketable securities

T = Projected cash requirements during the planning period

TC = Sum of conversion and holding costsI (C / 2) = Interest income foregone or holding costs

b (T / C) = Conversion costs

b = Fixed cost of conversion of marketable securities



The value of C which minimises TC can be found from the following

equation:

C = √ 2 b T

I

Example

ABC Ltd. estimates its total cash requirement as Rs. 2 crores next year.

The company’s opportunity cost of funds is 15% per annum. The company

will have to incur Rs. 150 per transaction when it converts its short term

securities to cash.

Determine the optimum cash balance. How much is the total annual cost

for the optimum cash balance? How many times the conversion of

marketable securities into cash takes place?



Answer

We know C = √ 2 b T = √ 2 x 150 x 20000000

I 0.15 = Rs. 200000

The annual cost TC = I (C / 2) + b (T / C)

= 0.15 (200000 / 2) + 150 (20000000 / 200000)

= Rs. 30000.

The number of conversion = T / C = 20000000 / 200000 = 100.

Millar and Orr model

Expanding on the Baumol model, Millar and Orr considered a stochastic

(random) generating process for periodic changes in cash balance. The

model assumes that the changes in cash balance over a given period are

random in size as well as direction. The upward changes in cash balance

are allowed till the cash balance reaches an “upper control limit (UL)’.

When this level is attained, the cash balance is reduced to a “return point

(RP)” by investing UL – RP in marketable securities. On the other hand,

downward changes are allowed only till the cash balance touches a “lower

control limit (LL)”. Once this level is reached, enough marketable securities

are disposed of in order to restore the cash balance to its “return point(RP)”. This can be shown in diagram below.

Cash UL

RP



LL

Time

Formula:

RP = 3 3 b σ2 + LL

4 x I

UL = 3 RP – 2LL

Where RP = Return point

B = Fixed cost per order for conversion of marketable

securities

I = Daily interest rate earned on marketable securities

σ2 = Variance of daily changes in the expected cash balance

LL = Lower control limit

UL = Upper control limit

Example

B Ltd. provides the following information:

(a) The annual yield available on marketable securities is 12%. On a daily

basis, the yield, using a 360 day year, works out to 12/360 = 0.0333%.

(b) The fixed cost of conversion = Rs. 160

(c) The standard deviation of the change in daily cash balance is Rs.

5000.



(d) The company wants to maintain a minimum cash balance of Rs.

50000.

Find out RP and UL?

Answer

We know RP = 3 3 b σ2 + LL

4 x I

= 3 3 (160) (5000)2

+ 500004 x 0.00033

= Rs. 94962.50

UL = 3 RP – 2LL

= (3 X RP) – (2 X 50000) = Rs. 184887.50

As long as the cash balance lies between the above two limits (UL – RP),

no conversion of marketable securities to cash will take place. Such a

course of action will minimise the total costs of transaction cost and holding

cost or opportunity cost.

Signals of insufficient working capital

• Pressure on existing cash

• Desperate cash generating activities, e.g. offering higher discount for

early cash payment

• Bank overdraft exceeding limit

• Seeking more overdrafts or lines of credit from banks

• Part-payment to raw material suppliers and other creditors



• Constant effort by the management for ‘survival’ rather than ‘growth’.

• Failure in honoring commitments.

Efficiency and control of cash management

(a) Collection and disbursement of cash must be properly monitored e.g.

prompt billing, expeditious collection of cheques, control of payables etc.

(b) Reporting on cash collection and payment on periodical basis e.g. daily

cash report, monthly cash report.

Short-term investment of surplus fund

• Short-term deposits in banks

• Purchase of treasury bills

• Purchase of commercial papers

• Inter-corporate deposits

• Bill discounting.



Inventory Management

Inventories represent the second largest asset category for manufacturing

companies next only to plant & equipment. Inventories are nearly 60% of

current assets. So, the importance of inventory management cannot be

over emphasised.

Types of Inventories

Three types of inventories exist:

1) Raw materials (i.e. basic inputs)

2) Work-in- progress (i.e. intermediate stages of production)

3) Finished goods (i.e. final products ready for sale)

Need to hold Inventories

There are three general motives for holding inventories:

I. Transaction motive

II. Precautionary motive

III. Speculative motive



Transaction motive emphasises the need to maintain inventories to

facilitate smooth production and sales operations.

Precautionary motive emphasises the need to hold inventories to guard

against the risk of unpredictable changes in demand and supply forces.

Speculative motive influences the decision to change the inventory levels to

take advantage of price fluctuations.

Objectives of Inventory Management

There are two conflicting needs:

a) To maintain a large size of inventory for efficient and smooth

production and sales operations.

b) To maintain a minimum investment in inventories to maximise

profitability.

Both excessive and inadequate inventories are two extremes and danger

points. Therefore, the objective of inventory management should be to

determine and maintain optimum level of inventory which will lie between

the excessive and inadequate inventories.

Dangers of Over-investment in Inventory

i. Unnecessary tie-up of funds and loss of profit

ii. Excessive carrying costs

iii. Risk of liquidity



iv. Physical deterioration of inventories in stores due to passage of time,

mishandling and improper storage.

Dangers of Under-investment in Inventory

i. Production hold-ups

ii. Failure to meet delivery commitments – a permanent loss of customers.

GOLDEN RULE

Place an order at the RIGHT TIME with RIGHT SOURCE to get the RIGHT

QUANTITY at the RIGHT PRICE and RIGHT QUALITY.

Costs related to Inventory Management

(a) Ordering costs

(b) Carrying costs

(c) Shortage costs

Ordering costs

• Requisitioning

• Order placing

• Expediting

• Transportation

• Receiving, inspecting and storing

• Clerical and staff



Carrying costs

• Warehousing

• Handling

• Insurance

• Deterioration and obsolescence

• Interest on capital locked up

• Clerical and staff

Shortage costs

• High costs due to ‘crash’ procurement

• Less efficient and uneconomic production schedules

• Customer dissatisfaction

• Loss of sales

Cause and Effect

Cause Effect

(a) Increase in the number of orders i) Ordering costs increase

ii) Carrying costs decrease

(b) Increase in order size i) Ordering costs decrease

ii) Carrying costs increase

(c) Increase in safety stock i) Shortage costs decrease



ii) Carrying costs increase

Therefore, the economic size of inventory to minimise overall costs of

inventory would depend on trade-off between carrying costs and ordering

costs.

Inventory Management Techniques

In order to maximise wealth the firm should determine the optimum level of

inventory which is commonly called ‘economic order quantity’ (EOQ). It is

that order size at which annual total costs of ordering and holding

(carrying) are the minimum.

Basic Questions relating to Inventory Management

• What should be the size of the order?

• At what level should the order be placed?

Three Approaches to determine EOQ

I. Trial and error approach

II. EOQ formula approach

III. Graphical approach

Trial and Error Approach

The trial and error approach to find out EOQ can be explained with an

example, given below:

Estimated annual requirement (A) = 1200 units

Purchase cost per unit (P) = Rs. 50

Ordering cost per order (O) = Rs. 37.50



Carrying cost per unit (C) = Re. 1

Total costs of various orders

Order size (Q): 1200 600 400 300 240 200 150 120 100

Average inventory (Q/2): 600 300 200 150 120 100 75 60 50

No. of orders (A/Q): 1 2 3 4 5 6 8 10 12

Annual carrying cost Rs.

(C X Q/2): 600 300 200 150 120 100 75 60 50

Annual ordering cost Rs.

(O X A/Q): 37.5 75 112.5 150 187.5 225 300 375 450Total annual costs Rs.: 637.5 375 312.5 300 307.5 325 375 435 500

Minimum annual cost = Rs. 300

EOQ = 300 units.

EOQ Formula Approach

The basic EOQ model is based on the following assumptions:

i) The forecast usage / demand for a given period (say 1 year) is known.

ii) The usage / demand is constant throughout the period.

iii) Inventory orders can be replenished easily i.e. no delay in placing and

receiving orders.

iv) Two distinguishable costs associated with inventories are:

a) ordering costs, and b) carrying costs.

v) Ordering cost per order is constant regardless of the order size.

vi) Carrying cost is expressed either as a fixed percentage of the inventory

value or as carrying cost per unit.



Formula:

EOQ = 2AO Where: A = Annual usage / demand

C O = Ordering cost per order

C = Carrying cost per unit or as

percentage of the inventory value.

Taking previous example, we can find out EOQ by applying the formula.

EOQ = 2 x 1200 x 37.50

1 = 300 units.

Let us take another example.

Following information is available from a company:Annual requirements = 20000 units

Ordering cost per order = Rs. 2000

Purchase cost per unit = Rs. 12.

Carrying cost = 25% of inventory value.

Find out the EOQ of the company?

Answer

EOQ = 2 x AO = 2 x 20000 x 2000

C 0.25 x 12 = 5164 units.

Graphical Approach

Minimum Total Costs

Costs

Carrying

Cost

Ordering

Cost



Q

Order Size

EOQ = Q.

Note

(i) Total carrying costs increase as the order size increases as a large

inventory level will be maintained.

(ii) Total ordering costs decline with increase in order size as large order

size means less no. of orders.

(iii) Total costs decline initially, but they start rising when the decrease in

average ordering costs is more than offset by the increase in carrying

costs.

(iv) EOQ occurs at the point Q where the total cost is minimum.

Optimum Production Range

The same EOQ model can be applied to determine the optimum size of

manufacture or economic lot size (ELS).

Here two types of costs are involved viz:

a) Set up costs

b) Carrying costs.

Set up costs

1) Cost of preparing and processing of stock orders

2) Cost of preparation of drawings and specifications



3) Cost of tooling machine set up

4) Cost of handling machines, tools, equipments and materials etc.

Note

a) Set up costs will decrease with bulk production runs.

b) Carrying costs will increase with bulk production runs as large stocks

of finished inventories will be held.

c) Economic production (or lot) size will be the one where the total cost

(i.e. both set up and carrying costs) is minimum.

Formula:

ELS = 2 AS Where: ELS = Economic lot size

C A = Total estimated production

S = Set up cost per production run

C = Carrying cost per unit or as % of the

inventory value.

Example

A company furnishes the following information:

Estimated production for the year = 90000 units

Set up cost per production run = Rs. 50

Carrying cost per unit = Re. 1

Find out the ELS?

Answer

ELS = 2 AS = 2 x 90000 x 50

C 1 = 3000 units per production run.



Quantity Discount and Order Quantity

The standard EOQ model is based upon the assumption that the price per

unit remains constant irrespective of the order size. When the quantity

discounts are available, the price per unit fluctuates by the order quantity.

The firm has to increase its order size more than the EOQ level to avail the

quantity discount.

Cause and Effect of availing Quantity Discount

Cause Effect

Availing quantity discount i) Order size increases

ii) No. of order reduces

iii) Average inventory holding increases

iv) Purchase price per unit decreases

v) Ordering cost decreases

vi) Carrying cost increases

vii) Net profitability (Return) increases.

Note

The net return is the difference between the resultant savings and

additional carrying cost. If the net return is positive, the firm’s order size

should equal the quantity necessary to avail quantity discount. If negative,

its order size should equal EOQ level.

Procedure to determine Optimul Order Size when Quantity Discount

available

I. Determine the order quantity (Q) using the standard EOQ formula

assuming no discount available.



II. If Q enables the firm to get quantity discount then it represents the

optimal order size.

III. If Q is less than the minimum order size (Q1) required for quantity

discount, then compute the change in profit due to increase in the

order quantity from Q to Q1.

IV. If the change in profit is positive, Q1 represents the optimum order

quantity. If the change in profit is negative, Q represents the optimum

order quantity.

Formula:

= AD + [A/Q – A/Q1] O – [ Q1 (P – D) C – Q (PC)]2 2

Where = Change in profit

A = Annual usage / demand

D = Discount per unit when quantity discount available

Q = Economic order quantity (EOQ) assuming no quantity

discount

Q1 = Minimum order quantity required to avail quantity

discount

O = Ordering cost per order

P = Purchase price per unit without discount

C = Carrying cost as percentage of inventory value.

ExampleABC Ltd. furnishes the following data:

Annual usage = 10000 units

Ordering cost per order = Rs. 150

Purchase price per unit = Rs. 20



Carrying cost = 25% of inventory value

Minimum order quantity to avail quantity discount = 1000 units

Discount per unit = Re. 1

Find out the net return?

Answer

Q = EOQ = 2 AO 2 x 10000 x 150C = 0.25 x 20 = 775 units.

Applying the previous formula we can find out the change in profit.

= AD + [A/Q – A/Q1] O – [ Q1 (P – D) C – Q (PC)]2 2

= 10000 x 1 + [10000/775 – 10000/1000] x 150 –

[1000 (20 – 1) 0.25 - 775 (20 x 0.25)]2 2



= 10000 + 435 – (2375 - 1938) = Rs. 9998 (positive).

Since net return is positive, Q1 = 1000 units represents the optimal order

quantity.

Re-order Point

The second question of inventory management “when to order” is solved by

determination of re-order point. It is that inventory level at which an order

should be placed to replenish the inventory.

Three aspects of re-order point under ‘certainty’ are:

a) Lead time i.e. time normally taken in replenishing inventory after the

order is placed

b) Average daily usage

c) Economic order quantity

Formulae:

(i) Re-order point (under certainty) = Lead time in days x Average daily

usage

(ii) Re-order point (under uncertainty) = Normal consumption + Safety stock

(iii) Re-order point (under stock-out factor) = S (L) + F S.R.L

Where S = Average daily usage

L = Lead time in days

F = Stock-out acceptance factor

R = Average quantity ordered.

Example

XYZ & Co. Ltd. furnishes the following data:

Average daily usage = 20 units per day

Lead time in days = 60 days



Stock-out acceptance factor = 1.2

Average quantity ordered = 500 units

What will be the re-order level of the company?

Answer

Re-order point = S (L) + F S.R.L

= (20 x 60) + 1.2 20 x 500 x 60 = 2130 units.

Safety Stock

It is defined as the minimum or buffer inventory maintained by the firm ascushion against expected increased usage and / or increased delay in

delivery (lead) time in order to prevent the stock-out situation.

Formulae:

Safety stock (when usage rate variable) = (Maximum daily usage rate –

Average daily usage rate) x Lead time in days

Safety stock (when both lead time & usage rate vary) = (Maximum possible

usage – Normal usage)

= (Maximum daily usage x Maximum lead time in days) – (Average daily

usage x Average lead time in days)

Example

If a company’s inventory lead time varies between 60 days and 180 days

with an average lead time of 90 days and the usage rate varies between 75

units and 125 units per day with an average usage rate of 100 units per

day, what is the quantity of safety stock required to be maintained by the

company for complete protection against stock-out?

Answer



Safety stock = (Maximum daily usage x Maximum lead time in days) –

(Average daily usage x Average lead time in days)

= (125 x 180) – (100 x 90) = 13500 units.

Factors for consideration in Inventory Management

In reality, some additional considerations must be taken into account in

inventory management, as mentioned below:

(a) Anticipated scarcity of inventory

(b) Expected price change of inventory

(c) Obsolescence risk of inventory

(d) Government restrictions on the level of inventory

(e) Marketing considerations.

Pricing of Raw materials and Valuation of Stock

Following methods are generally used for pricing of materials:

(i) FIFO method

(ii) LIFO method

(iii) Weighted Average method

FIFO Method

The material which is issued to production first is priced on the basis of the

cost of raw material received earliest, and so on.

LIFO MethodIn this method the material issues to production are priced on the basis of

the cost of most recent purchases.

Weighted Average Method



Under this method material issues to production are priced at the weighted

average cost of materials in stock.

Monitoring and Control of Inventories

Following methods are generally used by the management:

(a) ABC analysis

(b) JIT analysis

(c) Ratio analysis

(d) FSN analysis

ABC Analysis

A firm should be selective in its approach to control investment in various

types of inventories. It should pay maximum attention to those items whose

value is the highest and classify inventories to identify which items should

receive the most attention in controlling. This analytical approach is called

the ABC analysis and tends to measure the significance of each item of

inventories in terms of its values.The high value items are classified as ‘A’ items and would be under the

tightest control. ‘B’ items represent value of moderate importance and

require reasonable attention of management. ‘C’ items represent relatively

least value and would be under simple control.

ABC analysis is also known as “control by importance and exception

(CIE)”, and as “proportional value analysis (PVA)”.

Steps in ABC Analysis

I. Classify the items of inventories, and determine the expected use in

units, and the expected price per unit for each item.



II. Find out the total value of each item by multiplying the expected units

by its unit price.

III. Rank the items as per the total value, giving 1st rank to the item with

the highest total value and so on.

IV. Compute the percentage of no. of units of each item to the total units

of all items and the percentage of total value of each item to the total

value of all items.

V. Combine or cumulate percentage of nos. on the basis of cumulative

percentage of their relative values to form three categories viz. A, B,

and C.

Example

XYZ & Co. Ltd. discloses the following information on expected usage and

price of 7 items used by the Co. for production:

Item Annual usage (units) Price per unit (Rs.)

1 10000 0.65

2 10000 30.40

3 15000 1.50

4 5000 51.20

5 30000 1.70

6 16000 5.50

7 14000 5.14

Suggest selective inventory control measure by applying ABC analysis?

ABC Analysis

Item Rank Units % of total Cumul Unit price Total cost % of total Cumul% (Rs.) (Rs.) %



2 1 10000 10% 30.40 304000 38%

4 2 5000 5% 51.20 256000 32%------ -------15% 15% 70% 70%

------ -------6 3 16000 16% 5.50 88000 11%

7 4 14000 14% 5.14 72000 9%------- --------30% 45% 20% 90%------- --------

5 5 30000 30% 1.17 51000 6%

3 6 15000 15% 1.50 22500 3%

1 7 10000 10% 0.65 6500 1%---------- -------- ---------- -------

Total 100000 55% 100% 800000 10% 100%----------- ------- ----------- -------

Graphical Presentation of ABC Analysis

100

80Cumulative

60 percentageof cost

40 A B C

2

20 40 60 80 100Cumulative percentage of units

Conclusion:

i. Item nos. 2 &4, representing 15% of the total inventory items with 70% of

the total inventory value are ‘A’ items.

ii. Item nos. 6 & 7, representing 30% of the total inventory items with 20%

of the total inventory value are ‘B’ items.

iii. Items A & B jointly represent 45% of the total inventory items with 90%

of the total inventory value.



iv. Item nos. 5, 3 & 1, representing 55% of the total inventory items with

only 10% of the total inventory value are ‘C’ items.

v. A tight control should be exercised on item ‘A’ in order to maximise

profitability on its investment. Simple control on item ‘C’ will be sufficient.

Just-in-Time Inventory Control (JIT)

This system has been originally developed by Taichi Okno of Japan. The

JIT inventory control system implies that the firm should maintain a

minimum level of inventory and rely on suppliers to provide parts and

components just-in-time to meet its assembly requirements.

Pre-requisites of JIT Inventory Control

• A significant change in the total production and inventory

management system

• A strong and dependable relationship with suppliers who are located

nearby from the manufacturing facility

• A reliable transportation system

• An easy physical access in the form of enough ‘entries’ andconveniently located ‘docks and storage areas’ to dovetail incoming

supplies to the needs of assembly line.

Under this system a concerted effort is made to reduce the costs and also

the safety stock by establishing a strong long term relationship with the

suppliers.

Ratio Analysis (Measure of Effectiveness)Following ratios and indexes may be helpful for inventory management and

control:

Overall inventory turnover ratio = Cost of goods sold / Average totalinventories at cost



R.M. inventory turnover ratio = Annual consumption of raw material /Average raw material inventory

WIP inventory turnover ratio = Cost of manufacture / Average WIPinventory at cost

F.G. inventory turnover ratio = Cost of goods sold / Average F.G. inventoryat cost

Average age of R.M. in inventory = Average R.M. inventory at cost /Average daily purchase of R.M.

Average age of F.G. in inventory = Average F.G. inventory at cost /Average cost of goods produced per

day

Out of stock index = No. of times out of stock / No. of times requisitioned

Spare parts index = Value of spare parts inventory / Value of capitalequipment

Essentials for Inventory Monitoring and Control System

Exercise of vigilance against imbalance of raw materials and WIP

which tends to limit the utility of stocks

Vigorous efforts to expedite completion of unfinished production jobs

to get them into saleable condition

Active / quick disposal of goods that are surplus, obsolete or

unsaleable

Shortening of the production cycle

Change in design to maximise the use of standard parts and

components which are available off-the-shelf

Strict adherence to production schedule

Discounted pricing to dispose of unusually slow moving items

Easing out of seasonal sales fluctuations to the extent possible



Criteria for Judging the Inventory System

1. Comprehensibility

2. Flexibility and adoptability

3. Timeliness.

Areas of Improvement

1. Effective computerisation in the system of inventory management

2. Review of classification of inventories, e.g. ABC, FSN classification of

inventories

3. Improved coordination amongst purchase, production, marketing and

finance departments

4. Development of long term relationship with the suppliers and vendors

5. Disposal of obsolete / surplus inventories in expeditious manner

6. Adoption of challenging norms for inventory management like JIT.

Problems

Question 1

Following information have been provided by PQR & Co.:

The carrying cost per unit of inventory is 31% of inventory value.

The fixed cost per order is Rs. 20.

The no. of units required per year is 30000 units.

The variable cost per unit ordered is Rs. 2.



The purchase cost (excluding variable cost) per unit is Rs. 30.

Find out :

a) EOQ

b) Total no. of orders in a year

c) Time gap between two orders?

Answer

a) EOQ

Annual usage (A) = 30000 units

Ordering cost per order (O) = Rs. 20

Carrying cost per unit (C) = 31% of inventory value i.e. 31% of

(purchase cost + variable cost) = 31% of (30 +2) = Rs. 10.

EOQ = 2 A O = 2 x 30000 x 20C 10 = 346 units.

b)Total no. of orders in a year = A / EOQ = 30000 / 346 = 87.

c) Time gap between two orders = 365 / 87 = 4 days.

Question 2

ABC Corporation Ltd. require 2000 units of a certain items per year. The

purchase price per unit is Rs. 30. The carrying cost of inventory is 25% of

the inventory value. The fixed cost per order is Rs. 1000.

Find out:

a) EOQ



b) What will be the total cost of carrying and ordering inventories when 4

orders of equal size are placed?

Answer

a) EOQ = 2 A O = 2 x 2000 x 1000C 0.25 x 30 = 730 units.

b) 4 orders of equal size means:

Per order size = 2000 / 4 = 500 units.

The total cost of carrying as well as ordering = (C x Q/2) + (O x A/Q)

= [ (0.25 x 30) x 500/2] + [1000 x 2000/500]

= [7.50 x 250] + [1000 x 4] = 1875 + 4000 = Rs. 5875.

Question 3

A customer orders 5000 units @ 1000 units per order during last year. the

production cost is Rs. 12 per unit – Rs. 8 for raw material & labour andRs.

4 for overhead cost. It costs Rs. 1500 to set up for one production run of

1000 units. The inventory carrying cost is 20% of the production cost.

Since this customer may buy at least 5000 units this year also, the

company wants to avoid making 5 different production runs.

Determine the most economic production run?

Answer

Economic production run or ELS = 2 A S = 2 x 5000 x 1500C 0.20 x 12

= 2500 units.

Question 4



ABC Co. Ltd. wants to find out the reorder level for one of its major raw

materials. The following data are available:

Usage = 40 units per day

Lead time = 30 days

Average quantity ordered = 900 units

Stock-out acceptance factor = 2

What should be the reorder point of the company?

Answer

Re-order point = S (L) + F S.R.L

= (40 x 30) + 2 40 x 900 x 30

= 1200 + 2 1080000

= 3278 units.

Question 5

A company’s requirements for next one month are 6300 units. The ordering

cost per order is Rs. 10. The carrying cost per unit is Re. 0.26. The Co.

wants to avail the discount facility offered to it as follows:

Lot size (units) Discount per unit (Rs.)

1 – 999 0.000



1000 – 1499 0.010

1500 – 2499 0.015

2500 – 4999 0.030

5000 and above 0.050

Find out:

(i) EOQ

(II) What should be the order size and how many orders should be placed

at minimum cost?

Answer

(i) EOQ = 2 A O = 2 x 6300 x 10 = 700 units.

C 0.26

(ii) No. of orders 1 2 3 4 5 6 7 9 10

Order size: 6300 3150 2100 1575 1260 1050 900 700 630

Average inventory: 3150 1575 1050 787.5 630 525 450 350 315

Carrying cost (Rs.): 819 410 273 205 164 137 117 91 82



Ordering cost (Rs.): 10 20 30 40 50 60 70 90 100

Total costs (Rs.): 829 430 303 245 214 197 187 181 182

Less: Discount (Rs.): 315 189 95 95 63 63

Total cost after Discount (Rs.): 514 241 208 150 151 134 187 181 182

Therefore, the company should place 6 nos. orders of 1050 units each, as

the total cost is minimum at Rs. 134.

Question 6

ABC & Co. Ltd. has an expected usage of 50000 units during the next year.

The cost of processing an order is Rs. 20. The carrying cost per unit is Re.

0.50. Lead time on an order is 5 days and the company will keep a reserve

supply of 2 days usage. Assume 250 days working in a year.

Calculate:

(i) EOQ

(ii) Reorder point?

Answer

(i) EOQ = 2 A O = 2 x 50000 x 20 = 2000 units.C 0.50

(ii) Average daily usage = 50000 / 250 = 200 units.

Reorder point = (Lead time x Average daily usage) + Safety stock



= (5 x 200) + (2 x 200) = 1000 + 400 = 1400 units.

------

Credit Management – Management of Debtors

Introduction

A business firm’s investment in accounts receivable depends on how much

it sells on credit and how long it takes to collect receivables. Accounts

receivables (or Sundry Debtors) constitute the third most important asset

category for business firms, after plant & equipment and inventories.



Various Aspects of Credit Management

• Terms of payment

• Credit policy variables

• Credit evaluation

• Credit granting decision

• Control of accounts receivables

• Credit management in India

Let us discuss all these aspects in seriatim.

Terms of payment

Terms of payment vary widely in practice. The major terms of payment are:

i. Cash terms

ii. Open account

iii. Consignment

iv. Bill of exchange / Draft

v. Letter of credit (L/C)

Cash terms

When goods are sold in cash terms, the payment is received either before

the goods are shipped (cash in advance) or when the goods are delivered

(cash on delivery).

Open account

Credit sales are generally on open account. The seller first ships the goods

and then sends the invoice or bill. The credit terms (viz. credit period, cash

discount, trade discount, period of discount etc.) are stated in the invoice.

Consignment



When goods are sent on consignment, they are merely shipped but not

sold to the consignee. The consignee acts as the agent of the seller

(consignor).

Bill of exchange / Draft

It represents an unconditional order issued by the seller asking the buyer to

pay on demand (Demand draft) or at certain future date (Time draft), the

amount specified on it.

Letter of credit (L/C)

A L/C is issued by a bank on behalf of its customer (buyer) to the seller.

The bank agrees to honour drafts drawn on it for the supplies made to the

customer provided the seller fulfils the conditions laid down in the L/C.

Credit policy variables

The important dimensions of a firm’s credit policy are as follows:

i. Credit standards

ii. Credit period

iii. Cash discount

iv. Collection effort

Credit standards

The effects of liberal credit standards are:

Push up sales by attracting more customers

Higher incidence of bad debt loss

A large investment in receivables

A higher cost of collection.

Stiff credit standards have opposite effects.



The effect of relaxing the credit standards on residual income (i.e. income

left after providing for the cost of capital) are estimated by the following

formula:

R I = [ S (1 – V) - S bn ] (1 – t) – K I

Where R I = Change in residual income

S = Increase in sales

V = Ratio of variable cost to sales

bn = Bad debt loss ratio on new sales

t = Corporate tax rate

K = Cost of capital

I = Increase in receivables investment.

I = ( S / 360) x ACP x V

Where S / 360 = Average daily increase in sales

ACP = Average collection period.

Note to remember

If the impact of change in credit standards on net profit is positive, the

proposed change is desirable.

Example

ABC Ltd. classifies its customers into five categories. Presently, it extends

unlimited credit to customers in categories 1, 2, and 3, limited credit to

customers in category 4, and no credit to customers in category 5.



Due to this credit policy, the Co. is foregoing sales of Rs. 3 million to

customers in category 4 and Rs. 6 million to customers in category 5.

ABC is now considering the adoption of a more liberal credit policy under

which the customers in category 4 would be extended unlimited credit and

customers in category 5 would be extended limited credit. Such relaxation

would increase sales by Rs. 9000000 on which bad debt losses would be

10%. The contribution-margin ratio (1 – V) for ABC is 20%. The average

collection period is 50 days and the cost of funds is 12%. The tax rate for

ABC is 40%.

What will be the effect of relaxing the credit policy on residual income?

Answer

R I = [ S (1 – V) - S bn ] (1 – t) – K I

I = ( S / 360) x ACP x V

= (9000000 / 360) x 50 x 0.8

= 1000000

R I = [9000000 x 0.20 – 9000000 x 0.10] (1 – 0.4) – 0.12 x 1000000

= Rs. 420000 (positive)

Credit period

The credit period refers to the length of time, customers are allowed to pay

for their purchases. It generally varies from 15 to 60 days.

Effects of lengthening credit period are:



Push up sales

Larger investment in receivables

Higher incidence of bad debt loss

Shortening of the credit period has the opposite effects.

The effects of lengthening the credit period on residual income are

estimated by the same formula:

R I = [ S (1 – V) - S bn ] (1 – t) – K I

Formula

I = (ACPn - ACPO) [ So / 360] + V (ACPn) S / 360

Where I = Increase in receivable investment

ACPn = New average collection period after lengthening the credit

period

ACPo = Old average collection period

SO / 360 = Average daily sales



S/360 = Average daily increase in sales.

Example



PQR Ltd. currently provides 45 days credit to its customers. Its present

sales are Rs. 80 million. The company’s cost of capital is 13% and the ratio

of variable cost to sales is 0.75.

PQR is now considering to extend credit period to 60 days. Such an

extension is likely to push up sales by Rs. 20000000. The bad debt

proportion on additional sales would be 10%. The tax rate is 35%.

What will be the effect of lengthening credit period on residual income of

the company?

Answer

R I = [ S (1 – V) - S bn ] (1 – t) – K I

I = (ACPn - ACPO) [ So / 360] + V (ACPn) S / 360

= (60 – 45) x 80000000 + 0.75 x 60 x 20000000360 360

= 5833333

R I = [20000000 x 0.25 – 20000000 x 0.10] (0.65) – 0.13 x 5833333

= 1950000 – 758333


Cash discount



Generally the firms offer cash discounts to induce customers to make

prompt payments. Example, 2/10, net 30.

Effects of liberalising cash discounts are:

Enhancement of sales

Reduction of average collection period

Increase in the cost of discount.

Tightening the cash discount policy has the opposite effects.

The effects of liberalising the cash discount on residual income are

estimated by the following formula:

R I = [ S (1 – V) - DIS ] (1 – t) + K I

Where S = Increase in sales


DIS = Increase in discount cost


K = Cost of capital

I = Increase in receivable investment

Formula

DIS = Pn (So + S) dn – PO So do

Where Pn = Proportion of discount sales after liberalising the discounting

terms

So = Sales before liberalising the discounting terms


dn = New discount %

PO = Proportion of discount sales before liberalising the discounting

terms



do = Old discount %

Formula

I = So / 360 (ACPo - ACPn) – V. ( S / 360). ACPn

Where So = Sales before liberalising the discounting terms

ACPo = Average collection period before liberalising the discounting

terms

ACPn = Average collection period after liberalising the discounting

terms

S = Increase in sales.

Example



The present credit terms of XYZ Co. Ltd. are 2/15, net 45. Its sales are

Rs. 200 million. Its average collection period is 30 days. Its variable cost to

sales ratio is 0.80 and its cost of capital is 12%. The proportion of sales on

which the customers currently take discount is 0.5.

XYZ is now considering to relax its discount terms to 3/15, net 45. Such a

relaxation is expected to increase sales by Rs. 10 million, reduce the

average collection period to 27 days, and increase the proportion of

discount sales to 0.6. The tax rate is 40%.

What will be the effect of liberalising the cash discount on residual income

of the company?

Answer

R I = [ S (1 – V) - DIS ] (1 – t) + K I

DIS = Pn (So + S) dn – PO So do

= 0.60 (200000000 + 10000000) 0.03 – 0.50 x 200000000 x 0.02

= 1780000

I = So / 360 (ACPo - ACPn) – V. ( S / 360). ACPn

= 200000000 (30 – 27) – 0.80 x 10000000 x 27360 360

= 1066667

R I = [10000000 (0.2) – 1780000] (0.6) + 0.12 x1066667


Collection effort

Effects of rigorous collection programme are:



Decrease in sales

Shorten the average collection period

Reduction of bad debt %

Increase in collection expenses.

A lax collection programme has the opposite effects.

The effects of lax collection programme on residual income are estimated

by the following formula:

R I = [ S (1 – V) - B D] (1 – t) – K I

Where R I = Change in residual income


V = Variable cost to sales ratio

B D = Increase in bad debt cost


K = Cost of capital

I = Increase in receivable investment

Formula

B D = bn (So + S) – bo so

Where bn = New bad debt ratio

So = Old sales


bo = Old bad debt ratio

Formula

I = So / 360 (ACPn – ACPo) + ( S / 360). ACPn . V

Example



ABC Ltd. is considering relaxation in its collection effort. Its sales currently

are Rs. 100 million, its average collection period is 30 days, Its variable

cost to sales ratio is 0.75, its cost of capital is 14%, and its bad debt ratio is

0.04. The tax rate is 30%.

Such relaxation is expected to push up sales by Rs. 10 million, increase the

average collection period to 40 days, and raise the bad debt ratio to 0.05.

What will be the effect of relaxing the collection effort on residual income?

Answer

R I = [ S (1 – V) - B D] (1 – t) – K I

B D = bn (So + S) – bo so

= 0.05 (100000000 + 10000000) – 0.04 x 100000000

= 1500000

I = So / 360 (ACPn – ACPo) + ( S / 360). ACPn . V

= 2777778 + 833333

= 3611111

R I = [10000000 (0.25) – 1500000] (0.7) – 0.14 x 3611111




Credit evaluation

Proper assessment of credit risks is an important element of credit

management. In assessing credit risks, two types of errors occur

mentioned below:

Type I error: A good customer may be misclassified as a poor credit risk.

Type II error: A bad customer may be misclassified as a good credit risk.

There are three broad approaches to credit evaluation, as mentioned

below:

I. Traditional credit analysis

II. Numerical credit scoring

III. Discriminant analysis

Traditional credit analysis

The traditional approach to credit analysis calls for assessing a prospective

customer in terms of ‘5 Cs’ of credit viz.

• Character

• Capacity

• Capital

• Collateral

• Conditions

To get information on the 5 Cs, a firm may rely on the following:

(a) Financial statements

(b) Bank references

(c) Experience of the firm

(d) Prices and yields on securities.



Numerical credit scoring

This system involves the following steps:

(i) Identify factors relevant to credit evaluation.

(ii) Assign weights to these factors as per their relative importance.

(iii) Rate the customer on various factors using a suitable rating scale (say

5 point scale).

(iv) For each factor, multiply the factor rating with the factor weight to get

the factor score.

(v) Add all factor scores to get the overall customer rating index.

(vi) Classify the customer based on the rating index.

Discriminant analysis

This technique may be employed to construct a better risk index. It

considers the financial ratios of its customers as the basic determinants of

creditworthiness, viz.

(a) Current ratio

(b) Return on net worth

A graph of these two variables is drawn to plot the customers and then a

straight line is drawn to find out the creditworthiness of the customers.

The equation for this straight line is:

Z function = 1 Current ratio + 0.1 Return on equity

Based on the information and analysis, the customers may be classified

into various risk categories.

Credit granting decision

Once the creditworthiness of a customer has been assessed, the next

questions arise: Should the credit be offered ?



If the expected profit of the course of action “offer credit” is positive, it is

desirable to extend credit, otherwise not.

Control of accounts receivables

Traditionally there are two methods for monitoring accounts receivables.

They are:

• Days’ sales outstanding (DSO)

• Ageing schedule (AS)

Days’ sales outstanding (DSO)

The DSO at a given time ‘t’ may be defined as the ratio of accounts

receivable outstanding at that time to average daily sales during the

preceding 30 days, 60 days, 90 days and so on.

Formula: DSOt = Accounts receivable at time ‘t’Average daily sales

In this method accounts receivables are deemed to be in control if the DSO

is equal to or less than a certain norm.

Ageing schedule (AS)

The AS classifies outstanding accounts receivables at a given point of time

into different age brackets. The actual AS of the firm is compared with

some standard AS to determine whether the accounts receivables are in

control.

Credit management in India

How is trade credit managed in India?

The analysis can be drawn into three broad areas:

(i) Credit policy in India

(ii) Credit analysis in India



(iii) Control of receivables in India.

Credit policy in India

• Very few companies attempted a systematic approach towards

formalisation of their credit policy.

• Credit philosophy is too general and there are no direct guidelines in

credit decision.

• Firms manufacturing consumer products offer no credit whereas firms

manufacturing capital goods offer long credit.

• The practice of offering cash discount is not common.

Credit analysis in India

• Prospective customers are to furnish trade references and bank

references.

• Financial statements are not analysed in detail.

• There is absence of independent credit rating agencies to assess

credit standing of the customers.

• Large business firms classify their customers into several credit

categories.

Control of receivables in India

• Inadequate and ill-defined system for monitoring and controlling

accounts receivables persist.

• The measures commonly employed for judging the status of accounts

receivables are:

(a) Bad debt losses



(b) Average collection period

(c) Ageing schedule.

Areas of Improvement

Credit management in practice needs to be strengthened along several

lines, viz.

i) Explicit articulation of credit policy

ii) Better coordination between sales, production, and finance departments

iii) A well-defined collection programme.



Problem

Question 1

XYZ Ltd. sells on terms 2/10, net 45. Its annual sales are Rs. 90 million.

30% of its customers pay on the 10th day and take the discount.

If accounts receivable average of the company is Rs. 12 million, what is the

average collection period on non-discount sales?

Answer

Accounts receivable = [ ACP on discount sales] x (Discount sales / 360) +

[ ACP on non-discount sales] x (Non-discount sales / 360)

12000000 = (10) x 27000000 + (ACP on non-discount sales) x 63000000360 360

So, ACP on non-discount sales = 12000000 – (10) 27000000 / 360

63000000 / 360

= 64.3 days.

-------



Credit Management – Management of Payables (Creditors)

Creditors are a vital part of effective cash management and should be

managed carefully to enhance the cash position.

Purchasing initiates cash outflows and an aggressive purchase function

can create liquidity problems.

The following points to be noted are:

The level of management authorising / approving purchase in the

company – it should be tightly managed.

The quantities to be purchased should be geared to demand

forecasts.

Cost of carrying stock to the company

Finding out the alternative source of supply, and get quotations frommajor suppliers

Obtain the best discount and price without compromising the quality

and best credit terms.

Reduce dependence on a single supplier

Ascertain the possibility of passing on cost increase quickly through

price increase to the customers

Arrange to have delivery of supplies staggered or on a just-in-time

(JIT) basis



Short Term (Working Capital) Financing

Introduction

Current assets of a firm are supported by a combination of long term and

short term sources of finance. Short term sources of finance support the

current assets exclusively.

Sources of Short term Financing

Various sources of short term financing are mentioned below:

(a) Accruals

(b) Trade credit

(c) Working capital advance by commercial banks

(d) Public deposits

(e) Inter corporate deposits

(f) Short term loans from financial institutions(g) Rights debentures

(h) Commercial paper

(i) Factoring.

Let us discuss each of these sources individually.

Accruals

The major accrual items are salary & wages and taxes. These are simply

what the firm owes to its employees and to the governments. Accruals vary

with the level of activity of the firm i.e. when the business activity level

expands, accruals increase and vice versa. As they respond automatically

to changes in the level of activity, accruals are treated as ‘spontaneous



financing’. They are also regarded as ‘free’ source of financing as no

interest is paid by the firm on its accruals.

Trade credit

Trade credit represents the credit extended by the suppliers of goods and

services. It is an important source of finance representing 25% to 50% of

short term financing available to the creditworthy firms.

Preconditions for obtaining trade credit

(a) Confidence of suppliers on the firm

(b) Earning record of the firm over a period of time

(c) Liquidity position of the firm

(d) Track record of payment and honoring commitments

(e) Sound suppliers’ relationships.

Cost of trade credit

The cost of trade credit depends on the terms of credit offered by the

supplier. When the supplier offers discount for prompt payment, trade credit

availed by the firm beyond the discount period is quite costly. The cost of

trade credit during the discount period is nil, whereas the cost during the

non-discount period is calculated as follows:

Cost of trade credit (COTC) = Discount % x 3601 – Discount % Credit period – Discount period

Example

What is the cost of trade credit when the credit term is 2/10, net 30?

Answer

COTC = 0.02 x 360 x 1001 – 0.02 30 – 10

= 36.7%.



In general, the cost of trade credit is very high beyond the discount period.

Unless the firm is hard pressed financially, it should not forego the discount

for prompt payment, failing which it should delay the payment till the last

day of the net period and even beyond, if possible.

Working capital advance by commercial banks

Working capital advance by commercial banks represents the most

important source for financing current assets.

Procedures

(a) Application by the firm in the prescribed forms containing:

(i) the name and address of the firm

(ii) the details of the firm’s business

(iii) the nature and amount of security offered

(iv) financial statements and financial projections of the firm.

(b) Processing of applications by the bank

(c) Sanction of advance by the bank specifying the following terms and

conditions:(i) the amount of maximum limit of advance

(ii) the nature of advance

(iii) period of validity

(iv) the rate of interest

(v) the primary security to be charged e.g. hypothecation, pledge

(vi) the insurance of the security

(vii) the details of collateral security

(viii) the margin money to be maintained

(ix) other restrictions.

Forms of bank finance



Cash credit / Overdraft [Fund based]

Under this arrangement the borrowing firm can draw credit / take overdraft

upto a predetermined limit specified by the bank. The firm also enjoys the

facility of repaying the amount partially or fully as and when desired.

Interest is charged by the bank only on the running balance, not on the

sanctioned limit.

Working Capital Demand Loan (WCDL) [Fund based]

Under this arrangement, the loans are paid by the bank either on demand

or in periodical installments on submission of demand promissory note

(D P Note) executed by the firm. The interest is charged on the entire loan

amount.

Purchase / Discounting of Bills by the Bank [Fund based]

Under this system, the bill is accepted by the purchaser and thereafter the

seller (firm) offers it to its bank for discounting / purchase. When the bank

discounts / purchases the bill, it releases the fund to the selling firm. The

bank presents the bill to the purchaser (acceptor) on the due date and getspayment. There is also a system of rediscounting the bills by other banks /

RBI upto a certain limit.

Letter of Credit (L / C) [Non-fund based]

Letter of Credit is issued by the Bank on behalf of its customer to the seller.

Two kinds of Letter of Credit are:

• Sight L/C

• Usance L/C

• Revolving L/C.

Bank Guarantee [Non-fund based]



In this arrangement the bank gives the guarantee to the seller on behalf of

its client (purchaser) that it will honour the payment to the seller in case of

failure on the part of its client to pay for the goods received.

Regulation of bank finance

The RBI issues guidelines and directives from time to time to the banks

towards regulation of bank finance, based on the recommendations of

various committees, viz. the Tandon Committee, the Chore Committee etc.

Norms for Inventory and Receivables

As suggested by the Tandon Committee in mid 70s, RBI laid down the

norms for inventory and receivables to be followed by the industries.

However, these norms are indicative and the banks have discretion to

deviate from the norms.

Maximum Permissible Bank Finance (MPBF)

The Tandon Committee suggested three methods for determining the

maximum permissible bank finance. These are as follows:

(a) Method no. I: MPBF = 0.75 (CA – CL)

(b) Method no. II: MPBF = [0.75 (CA)] – CL)

(c) Method no. III: MPBF = 0.75 (CA – CCA)] – CL

Where CA = Current Assets

CL = Current Liabilities

CCA = Core current assets (i.e. permanent component of working

capital).

Example

From the following extracts of a balance sheet of a company, find out the

MPBF available to the company under three methods suggested by the

Tandon Committee.



Balance Sheet (extract)

Current Liabilities Amount Current Assets Amount(Rs./lacs) (Rs./lacs)

Trade creditors 120 Raw materials 180

Other current liabilities 30 Work in progress 50

Bank borrowings 250 Finished goods 100

Receivables 150

Other current assets 20-------- --------400 500

-------- --------

Assume CCA = Rs. 200 lacs.

Answer

The MPBF for the company under three methods:

(a) Method no. I: MPBF = 0.75 (CA – CL)

= 0.75 (500 – 150) = Rs. 262.50 lacs.

(b) Method no. II: MPBF = [0.75 (CA)] – CL)

= [0.75 x 500] – 150 = Rs. 225 lacs.

(c) Method no. III: MPBF = 0.75 (CA – CCA)] – CL

= [0.75 (500 – 200)] – 150

= [0.75 x 300] – 150 = Rs. 75 lacs.

The bank generally adopts the second method. Under this method, the

current ratio = CA / CL = 500/ (150 +225) = 500/375 = 1.33.

For better utilisation of the bank credit, RBI introduced MPBF in two parts:

(a) Cash credit limit upto 25% of MPBF and

(b) Working capital demand loan (WCDL) limit upto 75% of MPBF.



Information and reporting system

As recommended by the Chore Committee, the reporting system as

required by the banks from the borrowing firms is as follows:

QIS – Form I

The contents required to be filled in this form are:

• The estimates of production, sales for the current year and the

ensuing quarter

• The estimates of current assets and liabilities for the ensuing quarter

QIS – Form II

The contents required to be filled in this form are:

• The actual production, sales of the current year and latest completed

year

• The actual current assets and liabilities for the latest completed year

QIS – Form III

Half-yearly operating statements

QIS – Form III B

Half-yearly fund flow statements

Public deposits

Many firms have solicited unsecured deposits from the public in the recent

years to finance their working capital requirements. The rate of interest

ranges between 9% and 14%.

Regulation for public deposits

The Companies (Acceptance of Deposits) Amendment Rules, 1978

provides the following regulations for public deposits:



(a) Limit: Upto 25% (maximum) of share capital and free reserves of the

company

(b) Maturity period: Minimum for a period of 6 months and maximum upto

3 years for manufacturing companies and 5 years for

NBFCs.

Evaluation

Advantages of public deposits

(i) Simple procedure

(ii) No restrictive covenants(iii) No security to be offered

(iv) Post-tax cost reasonable

Disadvantages of public deposits

(i) Quantum of fund limited

(ii) Short maturity period.

Intercorporate deposits

A deposit made by one company with another, normally for a period upto 6

months, is referred to as an intercorporate deposit. Such deposits are of

three types:

i) Call deposits

ii) Three-months deposits

iii) Six-months deposits.

Features of intercorporate deposit

• Lack of regulation

• Secrecy



• Importance of personal contacts.

Short term loan from financial institutions

The LIC of India, GIC, UTI etc. provide short term loans to manufacturing

companies having excellent track records.

Preconditions / Eligibility

1. The company should have declared an annual dividend of not less

than 6% for the past 5 years or at least 10% for the past 3 years.

2. The debt-equity ratio of the company should not exceed 1.5 : 1.

3. The current ratio should be at least 1.33.

4. The average interest cover ratio for the past 3 years should be at

least 2 : 1.

Features

a. This loan is totally unsecured and is given on the strength of a

demand promissory note (DP note).

b. The loan is given for a period of 1 year and can be renewed for

another two consecutive years.

c. After the loan is repaid, the company will have to wait for at least 6

months before availing another such loan.

d. The loan carries an interest @ 18% per annum.

Rights debentures for working capital

Public limited companies can issue ‘rights debentures’ to their

shareholders for working capital requirements.

Guidelines / Regulations



(a) The amount of debenture issue should not exceed:

(i) 20% of the gross current assets, loans and advances minus the long

term funds presently available for working capital, or

(ii) 20% of the paid up share capital and free reserves, whichever is

Lower.

(b) The debt-equity ratio of the company should not exceed 1 : 1.

(c) The debentures shall be first offered to the existing shareholders on a

pro-rata basis.

Commercial paper (CP)

Commercial papers represent short term unsecured promissory notes

issued by the large companies which enjoy a very high credit rating and

considerable financial strength.

Features

(a) The maturity period of CP ranges from 90 days to 180 days.

(b) It is sold at a discount from its face value and redeemed at face value.

(c) It is either placed with the investors directly or sold thro: dealers.

(d) There is no well developed secondary market for CP.

Regulations / Preconditions set by RBI

1. The company must have a net worth of at least Rs. 4 crores.

2. Its MPBF is at least Rs. 4 crores.

3. The face value of CP shall not exceed 75% of the company’s working

capital limit.

4. The minimum rating of CP should be P2 from CRISIL.



5. The minimum size of CP issue should be Rs. 10 lacs and the

denomination of each CP note should be Rs. 5 lacs or multiples

thereof.

6. If a company issues CP, then its working capital limit will be lowered

to that extent.

The effective cost of CP is calculated as follows:

Cost of CP(%) = Face value – Net amount realised x 360 x 100Net amount realised Maturity

period

Example

Following data are available from a company:

Face value of a CP = Rs. 500000

Maturity period of the CP= 180 days

Net amount realised by the company from the CP = Rs. 475000.

Find out the effective cost of CP to the company?

Answer

Cost of CP(%) = Face value – Net amount realised x 360 x 100Net amount realised Maturity

period

= 500000 – 475000 x 360 x 100475000 180

= 10.53%.



Factoring

A ‘factor’ is a financial institution which offers services relating to

management and financing of debts arising from credit sale. It involves sale

of accounts receivables to a factor that charges a commission and may or

may not bear the credit risks associated with the accounts receivables,

purchased by the factor.

Features

(i) The factor selects the accounts of the client to be handled by it and

establishes the credit limits applicable to the selected accounts.

(ii) The factor assumes responsibility to collect debts of the accounts and

pays to its client at the end of the credit period.

(iii) The factor advances to its client to the extent of 70% to 80% of the debt

against not-yet-collected / due debts against interest payment to the factor.

(iv) Factoring is done on ‘recourse’ basis (i.e. credit risk borne by the client)

or ‘non-recourse’ basis (i.e. credit risk borne by the factor).

(v) The factoring commission may be charged @ 1% to 2% of the face

value of the debt factored.

Evaluation

Advantages of factoring

(a) It ensures a definite pattern of cash inflows from credit sales.

(b) It eliminates the need for credit and collection department in the firm.

Disadvantages of factoring

(a) The cost of factoring is higher than the cost of other forms of short term

financing.



Key Working Capital Ratios

Overall Inventory-turnover Ratio = Cost of goods soldAverage total inventories cost

Raw material Inventory-turnover Ratio = Annual consumption of R.M

Average R.M. inv. Cost

WIP Inventory-turnover Ratio = Cost of manufacture

Average WIP Inv. Cost

F.G. Inventory-turnover Ratio = Cost of goods sold

Average F.G. Inv. Cost

Average age of R.M. in Inventory = Average R.M. inv. Cost

Average daily purchase of R.M.

Average age of F.G. in Inventory = Average F.G. inv. Cost

Average cost of goods mfd. per day

Out of stock Index = Number of times out of stock

Number of times requisitioned

Receivables Ratio

(or Debtors Velocity) = Debtors x 365

Credit sales

Payables Ratio

(or Creditors Velocity) = Creditors x 365

Credit purchase

Current Ratio = Current Assets

(2:1) Current Liabilities



(or) = cash + bank + debtors + inventories + B/R + adv. payments

creditors + B/P + bank O/D + provisions

Acid-test Ratio

(or Quick Ratio) = Quick or liquid assets

(1:1) Current liabilities – Bank O/D

= Current Assets - Inventories

Current Liabilities - Bank O/D

Cash Ratio = Cash + Bank + Current investments

Current liabilities

Example

The following are the financial statements of ABC Ltd. for the year 2007

and 2008:

2007 2008(Rs.) (Rs.)

Stock 80000 120000S/Debtors 60000 80000

S/Creditors 80000 100000

Proposed dividend 20000 40000

Cash and Bank 40000 60000

Prepaid expenses 20000 40000

Calculate the following ratios:

a) Current ratio

b) Acid test ratio

c) Cash ratio?



Answer


Current Liabilities

= cash + bank + debtors + inventories + B/R + adv. payments

creditors + B/P + bank O/D + provisions

Current Ratio (2007) = 80000 + 60000 + 40000 + 2000080000 + 20000

= 200000 = 2:1100000

Current Ratio (2008) = 120000 + 80000 + 60000 + 40000

100000 + 40000

= 300000 = 2.14:1140000

Acid-test Ratio

(or Quick Ratio) = Quick or liquid assets

Current liabilities – Bank O/D

= Current Assets - Inventories


Acid-test Ratio (2007) = 200000 – 80000 = 120000 = 1.2:1

100000 – NIL 100000

Acid-test Ratio (2008) = 300000 – 120000 = 180000 = 1.29:1140000 140000

Cash Ratio = Cash + Bank + Current investments

Current liabilities

Cash Ratio (2007) = 40000 / 100000 = 0.4:1

Cash Ratio (2008) = 60000 / 140000 = 0.43:1



Example

The following are the financial statements of XYZ Ltd. for the year ended

31 / 12 / 2009. Consider 360 days = 1 Year.

Rs.

Stock (closing) 500000

S/Debtors 700000

S/Creditors 500000

Bank O/D 200000

B/Receivables 160000

Cash and Bank balance 40000

Stock (opening) 600000

Purchases 2400000

Sales 4000000

Calculate:

a) Current ratio

b) Quick ratio

c) Stock turnover ratio

d) Debtors velocity

e) Creditors velocity?



Answer


Current Liabilities

Current Ratio (2009) = 500000 + 700000 + 160000 + 40000

500000 + 200000

= 1400000 / 700000 = 2:1

Quick Ratio = Current Assets - Inventories


Quick Ratio (2009) = 1400000 – 500000

700000 – 200000

= 900000 / 500000 = 1.8:1

Stock-turnover Ratio = Cost of goods sold

Average total Inv. Cost

= Opening stock + Purchase – Closing stock

Opening stock + Closing stock

2

= 600000 + 2400000 – 500000

600000 + 500000

2

= 2500000 / 550000 = 4.5 times

Debtors Velocity = Debtors x 360

Credit sales

Debtors Velocity (2009) = 700000 x 360 = 63 days.4000000

Creditors Velocity = Creditors x 360

Credit purchase

Creditors Velocity (2009) = 500000 x 360 / 2400000 = 75 days.



Example

From the following particulars, find out:

a) Current assets

b) Closing stock

c) Debtors

Current ratio = 2:1

Acid test ratio = 1:1

Current liabilities = Rs. 360000

Cash in hand = Rs. 15000.



Answer

Current ratio = 2:1= CA / CL = CA / 360000

CA = 2 x 360000 = Rs. 720000.

Acid test ratio = 1:1= CA – Inventory

CL – Bank O/D

= 720000 – Inventory

360000

360000 = 720000 – Inventory

Or, Inventory = 720000 – 360000 = Rs. 360000.

CA = Inventory + Cash + Debtors

720000 = 360000 + 15000 + Debtors

Or, Debtors = 720000 – 375000 = Rs. 345000.

Example

XYZ Ltd. is engaged in large scale consumer retail business. From the

following information, prepare a forecast of their working capital

requirement:

Projected annual sales = Rs 65 lakhs

Percentage of net profit on cost of sales = 25%

Average credit period allowed to debtors = 10 weeks

Average credit period allowed by creditors = 4 weeksAverage stock carrying (in terms of sales requirement) = 8 weeks

Add 10% to computed figures to allow for contingencies.



Answer Rs.

Projected annual sales 6500000

Projected sales per week = 6500000 = 125000

52

Less: net profit (25% on cost means 20% on sales)

i.e. 20% of Rs 125000 = 25000

Projected cost of goods per week = 100000

Working Capital Requirement Forecast

Current Assets ------ Rs. Rs.

Stock (100000 x 8) = 800000

Debtors (125000 x 10) = 1250000 2050000

Less: Current Liabilities -------

Creditors (100000 x 4) = 400000 400000

Working Capital = 1650000

Add: Contingency (10%) = 165000

Total requirement of working capital = 1815000



Example

Prepare a statement showing working capital needed to finance a level of

activity of 60000 units of output for the year. The expected ratios of cost to

selling price are:

Raw material = 60%, Wages = 10%, Overheads = 20%, and Profit = 10%.

Raw materials are expected to remain in stores for an average of 2 months

before issue to production. Each unit of production is expected to be in

process for 1 month. Finished goods will remain in warehouse awaiting

dispatch to customers for nearly 3 months.

Credit allowed by creditors is 2 months from the date of delivery of raw

materials. Credit given to debtors is 3 months from the dispatch.

Selling price is Rs 5 per unit. Cash and bank balance should be kept at Rs

12500 for contingency purpose.



Answer

Workings

Total activity per month = 60000 units = 5000 units12

Total sales value per month = Rs 5 x 5000 = Rs 25000

Amount to be blocked per month:

In raw material = 60% of Rs 25000 = Rs 15000

In wages = 10% of Rs 25000 = Rs 2500

In overheads = 20% of Rs 25000 = Rs 5000

In debtors (profit) = 10% of Rs 25000 = Rs 2500


Particulars Period Total R.Mat WIP F.G Debtors Creditors

(Rs) (Rs) (Rs) (Rs) (Rs) (Rs)

Materials = Rs 15000

In stock = 2 months 30000

In WIP = 1 month 15000

In F.G. = 3 months 45000

In debtors = 3 months 45000

9 months



credit from

creditors = 2 months 30000

7 months 105000

Wages = Rs 2500



In debtors = 3 months 75007 months 17500

Overheads = Rs 5000



In debtors = 3 months 15000

7 months 35000

Profit = Rs 2500

In debtors = 3 months 7500 7500

165000 30000 22500 67500 75000 30000



Total requirement of working capital = Rs 165000 (as per statement)

Plus cash contingency = Rs 12500 (cash + bank)

Total requirement = Rs 177500

Example

From the following information, prepare a statement showing the

requirement of working capital :

Inventory holding period(with reference to cost of goods sold)= 90 days

Average collection period = 60 days

Average payment period = 75 days

Cash and bank balance = 2.5% of sales

Sales = Rs 2000000

Gross profit = 25%

The company expects 50% sales increase during the year.

Credit purchase is one-third of cost of goods sold.

Assume 1 year = 360 days.



Answer

Cost of goods sold = Rs2000000–G.P.Rs 500000 (25%)= Rs 1500000

Expected sales = 150 x 2000000 = Rs 3000000100

Less expected G.P. = 25 X 3000000 = Rs 750000

100 --------------------

Expected cost of goods sold = Rs 2250000

Expected credit purchase = 1/3 x 2250000 = Rs 750000.


Rs Rs.

Current Assets

Stock (2250000 x 90 days) = 562500

360

Debtors (3000000 x 60 days) = 500000 1062500

360

Cash & Bank balance (2.5% of Rs 3000000) (+) 75000

1137500

Less Current Liabilities

Creditors (750000 x 75 days) 156250360

Total working capital required = 981250

-------------



INTERNAL TEST EXAMINATION

Class: MBA – 4 BBS. September 2011.

Subject: Working Capital Management

Total Marks: 25

Q 1. Section A: Compulsory (5 x 2 = 10)

(a) Operating cycle

(b) Core current assets

(c) ABC system of inventory control

(d) Collection and Distribution float

(e) Marketable securities

Section B

Attempt any 3 questions from Section B: (3 X 5 = 15)

Q 2. What are the five traditional C’s, a finance manager might

consider in evaluating creditworthiness of a potential customer?

Q 3. Explain the recommendations of Tandon Committee on

banking policy?

Q 4. What are the marketable securities? Explain how do they

help a business firm in managing cash immediately?

Q 5. What do you mean by Inventory Control? Explain the

techniques available for monitoring and control of inventories?

Q 6. Explain how credit control policy variables affect or influence

the level of (a) Turnover, (b) Bad debt loss, (c) Investment in

accounts receivables, and (d) Cost of collection of a

business firm?

--------



Subject: Working Capital Management

Suggestions for September 2011.

MBA – 4 BBS

Q 1. Section A: Compulsory (15 x 2 = 30)

(a) Factoring

(b) Concentration banking

(c) Re-order level

(d) Operating cycle

(e) Spontaneous finance(f) Motives for holding cash

(g) Core current assets

(h) ABC system of inventory control

(i) Working capital cycle

(j) Current ratio

(k) Short term borrowings

(l) Hedging

(m) Collection and Distribution float

(n) Liquid ratio

(o) Marketable securities

Section B

Attempt any nine questions from Section B: (9 X 5 = 45)

Q 2. What are the five traditional C’s, a finance manager might

consider in evaluating creditworthiness of a potential customer?

Q 3. How will you determine optimum level of working capital?



Q 4. Explain the objectives of a finance manager in cash

management?

Q 5. Explain the recommendations of Tandon Committee on

banking policy?

Q 6. What are the various short term loans available from the

banks and other financial institutions?

Q 7. What are the marketable securities? Explain how do they

help a business firm in managing cash immediately?

Q 8. Is there any need for holding cash? Is it advisable to have

surplus cash in the business?Q 9. What do you mean by Inventory Control? Explain the

techniques available for monitoring and control of inventories?

Q 10. Explain the various factors which influence the volume of

working capital?

Q 11. What is a bill of exchange? How a business firm can finance

its immediate needs from bill of exchange?

Q 12. What is Economic Order Quantity (EOQ)? How do we

calculate EOQ?

Q 13. Explain how credit control policy variables affect or

influence the level of (a) Turnover, (b) Bad debt loss, (c)

Investment in accounts receivables, and (d) Cost of

collection of a business firm?

--------



Documents

WCM 2003