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Note On WCM & FP
Note On WCM & FP
Operating Cycle
In general, operating activities in a firm includes (a) Procurement of Raw Materials (b)
Conversion of RMs to Finished Goods ready for sale (c) Finished Goods are sold against
cash or credit (Let’s assume ‘Cash sales’ means ‘Zero-days credit’) (d) Collection of
receivables (pending dues). Time and capital, both are involved in each activity. This cycle of
operating activities (of time) is termed as Operating Cycle or Gross Operating Cycle.
Purchases (RMs) => Processing & Sales => Collection of sales
Furthermore, capital required to support these activities are “Working Capital”. Please note
cash and cash equivalents is also required for smooth and uninterrupted operations.
A firm must make a trade-off between Cash and Marketable securities, though, Marketable
securities are highly liquid, but it involves conversion cost. Further, access cash means loss of
opportunity to earn benefits (opportunity cost).
1
In the Table 1, RM is getting converted to WIP and then to Finished Goods available for
sales. Thus, each activity involves a processing time. Time period collectively taken by all
the inventories (RM, WIP, FG) from purchases to sales is termed as Days Inventories
Outstanding (DIO) or Inventory Days.
The time period from sales to collection of receivables is termed as ‘Days Sales Outstanding’
(DSO) or Receivable Days. Similarly, from purchases to making payment is termed as ‘Days
Payable Outstanding’ (DPO) or Payable Days.
Operating Cycle = DIO + DSO
Cash Conversion Cycle = DIO + DSO - DPO
Turnover Ratio(s)
These ratios are helpful to observe an operating activity and see how many times such
activities can be performed in a year. If conversion from RM to WIP is one month, it shows
12 such cycles may be completed in a year. So, RM Turnover Ratio equals to ‘1 Year divided
by one month’.
RM Turnover = 365 days/RM conversion period
Or
Cost of RM consumed in a year/Avg. RM
* Avg. RM = 0.5 * (Opening RM + Closing RM)
Note: Kindly refer to Table 1 and observe the changes in numerator and denominator.
RM Turnover = Cost of RM consumed /Avg. RM
WIP Turnover = Cost of Goods Manufactured/Avg. WIP
FG Turnover = COGS/Avg. FG
Inventory Turnover = COGS/Avg. Inventory
2
DuPont Analysis
Return on Assets (ROA): Measures how efficiently a firm generates income using its assets.
ROA = Net Income / Total assets (NI/TA)
¿ ∗Sales
Sales
ROA= =Profit Margin ( PM )∗Assets Turnover Ratio( ATR)
TA
Return on Equity (ROE): Measures how efficiently a firm generates income using its
equity. It includes leverage aspects as well.
ROE = Net Income / Equity Capital
¿ ∗Assets
Assets
ROE= =ROA∗Equity Multiplier
Equity
ROE=PM∗ATR∗Equity Multiplier
DuPont Corporation first analysed ROE by breaking it into three parts.
Thus, return for equity holders can be maximized by enhancing any one or combination of
profit margin, assets turnover, and leverage. However, these factors can’t be increased
beyond a point. Profit margin can be increased till revenue is maximised. Financial leverage
enhances return only if cost of capital is lowered. Assets turnover is a function of plant
capacity and can’t be increased beyond a point.
Q. Now, what if all the three parameters are already optimized and firm plans to increase
sales.
The firm will have to install new units.
Let’s assume, a firm wants to see next year growth in sales (g) by 50%.
Investment Required = g * TA
Sources of Capital:
a) Projected Profit Retained = Projected Profit * retention ratio (b)
= Profit Margin * Projected Sales * Retention = PM * Sales * (1 + g) * b
3
*Assuming no capital is used from reserves and surplus fund
b) Additional credit extended by suppliers as purchases increase = g * spontaneous
liabilities (a/c Payable)
c) External Fund
External Fund Needed (EFN) = g * TA – [ PM * sales * (1+g) * b + (g * SL)]
EFN =g∗( TA−SL )−b∗PM∗sales∗(1+ g)
g=b∗¿/(TA −SL−b∗¿)
Dividing numerator and denominator by Total Assets
g=b∗ROA /(1−b∗ROA)
[(TA-SL)/TA ≈ 1; SL/TA ≈ 0]
IGR=b∗ROA /( 1−b∗ROA)
Sustainable Growth Rate (SGR): This is the sales growth rate a firm can have when
financial leverage is maintained. It suggests that firm can raise additional debt against
additional equity capital (projected earnings retained). Thus, making no change in the
financial leverage.
SGR=b∗ROE/(1−b∗ROE)