PAN African e-Network Project

MFM
Working Capital Management
Semester - 3
Session - 2

Ms. Kanika Arora

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

•Working Capital refers to that part of the firm’s

capital, which is required for financing short-
term or current assets such a cash,
marketable securities, debtors and inventories.
 Cash Conversion Cycle
Purchase Sell Inventory
Inventory on Credit

Pay for Collect

Inventory Receivables

Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle
 Receivables Management
• Receivables is defined as ‘debt owed to
the BUSINESS by customers arising
from sale of goods or services in the
ordinary course of business’.

• Receivables management is also called

trade credit management.
 Receivables Management
• When a business makes an ordinary sale
of goods or services and does not receive
payment, it grants trade credit and creates
accounts receivable to be collected in the
future.

• It incurs Cost in managing the receivables

 Receivables Management
Objective

• Maintain Receivables at a level at which

there is a trade-off between Profitability
& Cost
 Receivables Management
Objective
• Here Cost means-
– Receivables collection cost, like
administration etc
– Financial cost like interest, bank charges etc
– Cost of defaults or delinquency

So, OPTIMUM level of Receivables is where

cost is less then the profitability.
Optimum Level of Receivables

Profitability

Costs &
Profitability Optimum Level

Liquidity

Stringent Control Liberal

 Receivables Management -
Tools & Techniques
DSO (Days of Sales Outstanding) – This
represents average number of days until a
company is paid by its customers.

Formula to get this value is as below-

(Average Receivables ÷ Cumulative Sales)

× 365
 Receivables Management -
Tools & Techniques
Aging Schedule – Aging schedule highlights the
receivables according to the age or length of time of their
outstanding. It is typically represented as shown below:
Period / Age Amount (USD) Percentage of
Total
Not Due 800000 40
0 – 30 days 400000 20
31 – 0 days 300000 15
61 – 90 days 200000 10
91 - 180 days 100000 5
Over 180 days 200000 10
Total 2000000 100
 Receivables Management -
Tools & Techniques
CEI (Collection Efficiency Indicator) –
CEI measures efficiency of collection process performance over time.

Closer to 100 is better

 Inventory Management

• What is Inventory ?

An Inventory is the raw materials,

component parts, work-in-process, or
finished products that are held at any
location in the supply chain in the course of
business operations
 Inventory Management

• What is Inventory Management?

Inventory management is all about

knowing what is on hand, where it is in
use, and how much finished product
results
 Inventory Management
• Why do we need Inventory
Management?

Managing inventory is a juggling act.

Excessive inventory can place a heavy
burden on the cash resources whereas
Insufficient inventory can result in lost
sales, delays for customers etc.
 Inventory Management
• Factors Influencing Inventory
Management

oLead Time

oCost of Inventory holding

oMaterial Costs
oOrdering Costs
oCarrying Costs
 Inventory Management
oStock Levels
oReorder Level
oMaximum Level
oMinimum Level
oSafety Level / Danger Level

oSales Forecast & Material Requirement

Planning
 Inventory Management

oService Levels

oObsolete Inventory and Scrap

oQuantity Discounts
 Inventory Management
Inventory Management Techniques

It deals with mainly :

1. How much should be ordered ?

Economic Order Quantity (EOQ)

2. When it should be ordered ?

Re-Order Level
 Inventory Management

Economic Order Quantity (EOQ)

• The EOQ is optimum level of Inventory

Order Lot Size where ordering and
carrying costs are minimum.
 Inventory Management
• It considers following two costs:

– Ordering Cost: for example order placing

cost, transportation, C&F cost, inspection
cost and other admin cost etc
– Carrying Cost: for example warehousing
cost, insurance cost, wastage cost and
other admin cost etc
EOQ – GRAPHICAL APPROACH
Minimum Total Costs

Ordering Cost

EOQ Order Size Q

 Inventory Management
• How to calculate EOQ
To calculate EOQ, following variables are used

C = Consumption /Annual Usage / Demand

Q = Quantity Ordered
O = Ordering Cost per Order
I = Inventory Carrying Cost (as a % on P )
P = Price per Unit
TC = Total Cost of Ordering & Carrying

2 CO / PI
 Inventory Management -
Tools & Techniques
DIO (Days of Inventory Outstanding) –
This represents average number of days
that inventory is held.

Formula to get this value is as below-

(Average inventories ÷ Cumulative cost
of sales) × 365
 Inventory Management
Few other important measurement
 Inventory Management
Inventory Classification Methods
This technique is based on the assumption that not all type of
inventory need equal amount of attention. It should be based on
some classification like-
Classification of Inventory Basis of classification
ABC – Always Better Control Valuation of inventory (Qty*Price)

VED -- Vital, Essential, Desirable The importance or criticality

FSN - Fast-moving, Slow-moving, The pace at which the material moves
Non-moving
HML - High, Medium, Low Unit price of materials
SDE - Scarce, Difficult, Easy Procurement Difficulties
 Exercise 1
From the following Information, you are required to calculate the length of
Operating Cycle of XYZ Ltd. for the year ended 31st March 2013. Assume
365 days in a year.

Balances as at 31st March

P/L Data 2013 Balance Sheet Data 2012 2013

Sales 80,000 Inventory 9,000 12,000

Cost of Goods Sold 56,000 Debtors 12,000 16,000
Creditors 7,000 10,000
 Exercise 1 - Solution
Operating Cycle : Av Inventory Period + Av Accounts Receivable Period

Inventory Period Receivable Period

Average Inventory Average Receivables
-------------------------- x 365 -------------------------- x 365
Cost of Goods Sold Annual Sales

(9000+12000) / 2 (12000 + 16000) / 2

-------------------------- X 365 ---------------------------- X 365
56000 80000
Inv Period = 68.4 days Receivable Period = 63.9
days

Operating Cycle : 68.4 + 63.9 = 132.3 days

 Exercise 2
From the following Information, you are required to calculate the length of
Cash Cycle of XYZ Ltd. for the year ended 31st March 2013. Assume 365
days in a year.

Balances as at 31st March

P/L Data 2013 Balance Sheet Data 2012 2013

Sales 80,000 Inventory 9,000 12,000

Cost of Goods Sold 56,000 Debtors 12,000 16,000
Creditors 7,000 10,000
 Exercise 2 - Solution
Cash Cycle :

Av Inventory Period + Av Accounts Receivable Period - Av Payables Period

Inventory Period Receivable Period Payable Period

Average Inventory Average Receivables Average Payable

-------------------------- x 365 -------------------------- x 365 -------------------------- x 365
Cost of Goods Sold Annual Sales Cost of Goods Sold

(9000+12000) / 2 (12000 + 16000) / 2 (7000 + 10000) / 2

-------------------------- X 365 ---------------------------- X 365 ---------------------------- X 365
56000 80000 56000

Inv Period = 68.4 days Receivable Period = 63.9 Receivable Period = 55.4
days days

Cash Cycle : 68.4 + 63.9 – 55.4 = 76.9 days

 Cash Management
• What is Cash ?

• In financial world, Cash includes

o Currency in Hand
o Bank Balances
o Cash in Transit
o Foreign Exchange
o Marketable Securities
 What is Cash Management

• Idle Cash is unproductive

• Cash Management is effective planning,

monitoring and management of liquid /
near liquid resources.
 What is Cash Management
• Cash Management includes:
• Day-to-day cash control
• Money at the bank
• Receipts
• Payments
• Short Term investments and borrowings
• Foreign Exchange
• Pooling and netting
 Benefits of Effective Cash
Management
• Control of financial risk
• Opportunity for profit / cost saving
• Strengthened balance sheet
• Increased customer, supplier, and
shareholder confidence
 Concept of Liquidity

• Having sufficient funds to meet all

foreseen and unforeseen obligations
• Liquidity has costs
• Spread between borrowing and deposit
rates and between long and short term
rates
 Reason for holding Cash
• Transactional motive
– To take care of day-to-day operational needs
• Speculative motive
– To take advantage of unexpected
opportunities
• Contingency / Precautionary motive
– To manage emergencies
 Reason for holding Cash
1. Transaction motive: Firms maintain
cash balances to conduct normal
business transactions. For example,
• Payroll must be met
• Supplies and inventory purchases must be
paid
• Trade discounts should be taken if financially
attractive
• Other day-to-day expenses of being in
business must be met
 Reason for holding Cash
2. Precautionary motive: Firms maintain
cash balances to meet precautionary
liquidity needs.

• Two major categories of liquidity needs:

1. To bridge the gaps between cash inflow
and cash outflow
2. To meet unexpected emergencies
 Reason for holding Cash
3. Speculative motive: Firms maintain
cash balances in order to “speculate” –
that is, to take advantage of
unanticipated business opportunities
that may come along from time to time.

• The nature of these opportunities may

vary.
 Optimizing Cash Balance

• Having too much cash means high

holding cost

– Lost opportunity (Interest Earned)

 Optimizing Cash Balance

• Having too less cash means high trading

cost
– Cost of short term securities / loans

• Optimum Cash Balance is trade off

between holding cost and trading cost of
Cash
 Understanding Float

Float is the difference between

– balance recorded in the company

ledger account
– balance recorded at the bank ledger
account
 Understanding Float

• Disbursement float

– Generates when a firm issues cheques

to suppliers
– Available balance at bank > book
balance
 Understanding Float
• Collection Float
– Generates when a firm receives
cheques from customers
– Available balance at bank > book
balance
• Net Float = Disbursement Float +
Collection Float
 How to control Float

• Own Actions

– Efficient Information systems

– Educate customers
– Include costs in prices
– Negotiate with bank
 How to control Float

• Bank Services
– Lockbox
– Remote disbursement
– Controlled disbursement
– Direct collections
– Efficient collections structure
 What is Credit Monitoring

• Credit in Banking refers to

– Short Term Loans & Advances

– Medium / Long Term Loans
 What is Credit Monitoring

• Credit Monitoring in Banking refers to

– Pre-sanction appraisal
– Documentation & Negotiation
– Disbursement and Disbursal
– Post-lending supervision and control
 Why Credit Monitoring ?

• Giving loans is the principal function of

banks
• loans account for about two-thirds of
Bank's assets / source of revenues
• Risk in banking tends to be concentrated
in the loan portfolio
 Why Credit Monitoring ?
• Uncollectable loans or non performing
assets (NPA) can cause serious financial
problems for banks
• Effective credit monitoring is answer to
– Basis on which lending decision is
taken
– Type and quantum of loan
– Terms and conditions of the loan
 Types of Credits
• Long Term Loans
• Medium Term Loans
• Short Term or Working Capital Loans
– Fund Based
• Cash Credit
• Overdraft
• Bill Financing
 Types of Credits
• Short Term or Working Capital Loans
– Non Fund Based
• Bank Guarantee
• Letter of Credit
• Deferred Payment Guarantee
– Structured Credits
• Commercial Paper
• Factoring
• Buyer / Supplier Credits
 Sources of Short-term
Financing
• Three major sources of short-term
financing:

1. Trade credit (accounts payable)

2. Commercial bank loans
3. Commercial paper
 Sources of Short-term
Financing
1. Trade credit (“spontaneous financing”): form
of “free” financing in the sense that no explicit
interest rate is charged on outstanding
accounts payable
– Accounts payable arise spontaneously during
normal course of business
– Commercial firms buy inventory and supplies in
open account from their suppliers on whatever
credit terms are available rather than cash
payments.
 Sources of Short-term
Financing
– Two costs associated with trade
credit:
1. Cost of missed discounts
2. Cost of financing outstanding
accounts receivable (firm offers trade
credit) increases cost of doing
business over what it would be if firm
sold on cash terms only.
 Sources of Short-term
Financing
2. Commercial bank loans
– Employed to finance inventory and
accounts receivable
– Used as source of funds to enable firm
to take discounts on accounts payable
when cost of missed discounts exceeds
interest cost of bank debt
 Sources of Short-term
Financing
2. Commercial bank loans (continued)
– Two possible structures:
1. Note for a fixed period of time
– At end of note term (maturity date), face amount of note must be
repaid or note must be renewed (“rolled over”).
– Bank and borrower may enter into formal/informal agreement to
renew note at maturity at specified rate, which is tied to prime
interest rate (rate charged to bank’s best corporate customers).
o Ex. Interest rate at prime plus some percentage over prime:
“prime plus 2%”
– Size of premium above interest rate is determined by bank’s
assessment of risk involved in making loan
o Higher risk, higher premium
– As prime rate changes, bank’s cost of obtaining funds changes, so
requiring firm to roll over its notes allows bank to change interest rate
on note.
 Sources of Short-term
Financing
2. Commercial bank loans (continued)
– Two possible structures
2. Line of credit (“revolver”)
– Bank establishes upper limit on amount firm may
borrow and firm draws whatever money it needs
against credit line up to maximum.
– Interest rate may be fixed or float with prime or LIBOR
rate.
– Interest is charged only on amount actually borrowed,
not total amount available.
 Sources of Short-term
Financing
2. Commercial bank loans (continued)
• Unsecured loan: “full faith and credit”
obligation of borrowing firm
– No specific assets are pledged as
collateral for loan, but bank has general
claim against firm’s assets if firm
defaults on loan
 Sources of Short-term
Financing
2. Commercial bank loans (continued)
Secured loan: firm pledges specific asset as
collateral for loan (i.e. accounts receivable,
inventory)
– If firm defaults on loan, asset may be seized
by bank and liquidated to satisfy loan balance
– Any excess bank receives above amount of
principal and interest due on loan must be
returned to borrower
 Sources of Short-term
Financing
3. Commercial paper: short-term corporate
IOU that is sold in large dollar amounts
through commercial paper dealers
– Sold by large corporations
– Usually purchased by other corporations (as an outlet
for marketable securities) or by financial institutions
(i.e. banks, money market mutual funds)
– Not available means of financing for small business
organizations
 Sources of Short-term
Financing
Financing Accounts Receivable
• Accounts receivable: used as collateral for
short-term loans
• Three methods of accounts receivable
financing:
1. Pledging
2. Assigning
3. Factoring
 Sources of Short-term
Financing
Financing Accounts Receivable
1.Pledging
– Bank or other lender makes loan of some
percentage of value of receivables but does not take
possession of them
– Receivables merely serve as collateral in the event
of default
– If loan is not paid on time, bank has right to take
possession of receivables and collect amount
necessary to satisfy loan principal and interest due
 Sources of Short-term
Financing
Financing Accounts Receivable
1.Pledging
– Any excess money collected above amount owed
must be returned to borrower
– Banks commonly loan 50-80% of face amount of
receivables
– Amount loaned depends mainly on credit reputation
of borrower and quality of receivables pledged
– Quality of receivables is a function of credit rating of
customer accounts and age of receivables
 Sources of Short-term
Financing
Financing Accounts Receivable
2. Assigning
– Borrowing firm signs over its right to collect account
to lender
– Lender advances money to borrower up to some
predetermined percentage of accounts receivable
and then collects directly from customer account
– Payments received in excess of amount loaned are
property of borrower (treated as part of “circulating
pot” of money from which borrower may draw funds
as needed)
 Sources of Short-term
Financing
Financing Accounts Receivable
2. Assigning
- Lenders commonly lend 75-90% of face value of
receivables assigned
– Percentage loaned is a function of credit rating of
borrower and quality of accounts receivable
 Sources of Short-term
Financing
Financing Accounts Receivable
• Pledging/Assigning (continued)
– Lender has recourse to borrower if account
fails to pay
– Lender only acts as supplier of funds so if
borrower defaults, borrower suffers bad-debt
loss, not lender
– Cost of pledging and assigning are about
equal
 Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring
– Lender buys accounts receivable outright
from borrower at discount from face value
and assumes burden of collecting
receivables
• Burden includes assumption of bad-debt losses
• If account does not pay, lender has no recourse
on borrowing firm
 Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring (continued)
• Lenders provides three services
1. Provide financing of accounts receivable for
borrowing firms
2. Act as borrowing firm’s credit department
3. Assumes risk of bad-debt losses
• Transfers risk from borrowing firms to factor
• Most expensive form of accounts receivable
financing
 Sources of Short-term
Financing
Inventory Financing
• Commonly arranged through:
1. Blanket liens
2. Trust receipts
3. Field-warehousing arrangements
 Sources of Short-term
Financing
Inventory Financing
1.Blanket lien
– Firm pledges its inventory as collateral for
short-term loan, but lender has no physical
control over inventory
– If borrower defaults, lender has right to seize
inventory and sell it to pay off loan principal
and interest; any funds realized in excess of
amount owed must be returned to borrower
 Sources of Short-term
Financing
Inventory Financing
2.Trust receipt
– Legal document that creates lien on specific
item of inventory
– Commonly arranged for “big ticket” items (i.e.
inventory held by automobile dealers,
jewelers, or heavy equipment dealers
– When item is sold, amount loaned against
item must be remitted to lender
 Sources of Short-term
Financing
Inventory Financing
3. Field-warehousing arrangement
– Inventory pledged as collateral is physically maintained
on premises of borrower but is under control of lender
– Physical movement of inventory items into or out of
warehouse is supervised by independent third party
employed by lender
– As inventory items are moved into warehouse, loans are
made to borrower
– As items are released and sold, loans are paid off
– Particularly appropriate for financing seasonal inventory
buildups
 6 Rules of Credit Monitoring
• Character
• Capital
• Capacity
• Collateral
• Condition
• Compliance
 Lending Methods by Tondon
Committee Maximum Permissible Bank
Finance (MPBF)
• Method 1 - MPBF = .75 (CA-CL)

– Borrowers to bring 25% of net working

capital
– Bank to finance 75% of net working
capital (excluding bank borrowings)
 Lending Methods by Tondon
Committee Maximum Permissible Bank
Finance (MPBF)

• Method 2 - MPBF = .75 (CA) –CL

– Borrowers to bring 25% of current assets

– Bank to finance 75% of Current Assets
less current liabilities (other than bank
borrowings)
 Lending Methods by Tondon
Committee Maximum Permissible Bank
Finance (MPBF)

• Method 2 - MPBF = .75 (CA) – CL

– Borrowers to bring 25% of current assets

– Bank to finance 75% of Current Assets
less current liabilities (other than bank
borrowings)
Lending Norms Chore
Committee
Lending Norms by Nayak
Committee
Credit Monitoring Arrangement
(CMA)
 Assessment of working capital
finance by bank
• ABC industries CFO has called for a statement showing
the working capital needs to finance a project.
• Projected output will be 1,80,000 units in the first year
• Cost structure of the project is as below
– Raw Material Rs 20/per unit
– Direct Labor Rs 5/per unit
– Overheads Rs 10/per unit
– Depreciation Rs 5/per unit
– Profit Rs 10/per unit
– Selling Price Rs 50/per unit
 Assessment of working capital
finance by bank
• Additional Information-
– Minimum cash balance to maintain is Rs 20,000.
– Av Raw Material Stock will be for 2 months
– Av Finished Goods Stock will be for 1 month
– Supplier’s credit will be 1 month
– 25% sales will be on cash, remaining will be on 1
month credit
• You are required to calculate maximum working
capital finance as per Tondon committee’s method 1
and 2.
 Working Capital of AB
Associates
Particulars Per Unit Total (Rs)
Raw Material 20 36,00,000
Direct Labor 5 9,00,000
Overheads 10 18,00,000
Depreciation 5 9,00,000

Cost of Production 40 72,00,000

Profit 10 18,00,000
Sales 50 90,00,000
 Statement of Working Capital
Requirement
Particulars Total (Rs)
Current Assets
Raw Material Inventory 3600000*2/12 6,00,000
Finished Goods Inventory 7200000/12 6,00,000
Debtors 9000000*.75*2/12 5,62,500
Cash Requirement 20,000
Total Current Assets 17,82,500
Current Liabilities
Creditors 3600000/12 3,00,000
Net Working Capital 14,82,500
 Maximum WC finance as per
Tondon Committee
Particulars Total (Rs)
First Method of Lending
75% of net working capital 1482500*.75 11,11,875
MPBF – 1st Method of Lending .75 (CA-CL) 11,11,875

Second Method of Lending

75% of current assets 1782500*.75 13,36,875

Less : Current Liabilities -3,00,000

MPBF – 2nd Method of Lending .75 (CA) -CL 10,36,875

 Exercise 2
In continuation of Exercise 1, please calculate
MPBF as per 3rd method of lending by Tondon
Committee. Please core current assets are 40%
of total current assets.
MPBF as per 3rd Lending Method

Particulars Total (Rs)

Total Current Assets 17,82,500
Less : Core Current Assets -7,13,000 10,69,500
(40%)
Current Liabilities 3,00,000
(10,69,500*.75)- 3,00,000

MPBF – 3rd Method of .75 (CA-CCA) -CL 5,02,125

Lending
Please forward your query

To: karora1@amity.edu