Working Capital Management

INVENTORIES MANAGEMENT

Since inventories constitute about 50 to 60 percent of current assets,

ECONOMIC ORDERING QUANTITY (EOQ)

Cost of carrying includes the cost of storage, insurance, obsolescence, interest on capital invested.

Maximum Level = Re-order level—(Minimum consumption) × (Minimum lead times)  + Reordering quantity.

Minimum Level = Re-order level – (Average usage  ×  Average lead time).

Re-order level   =   Maximum usage X  Maximum lead time or Minimum level +

Consumption during lead time.

Re-ordering Quantity (How much to purchase):  It is also called Economic Ordering Quantity.

Danger Level - This is the level below the minimum stock level.

Perpetual Inventory System

The Institute of Cost and Management Accountants, London defines the perpetual inventory system as “A system of records maintained by the controlling department, which reflects physical movements of stocks and their current balance.”

This system consists of the following three:

a. Bin cards i.e. Quantitative Perpetual Inventory.

b. Stores ledger i.e. Quantitative and Value Perpetual Inventory.

c. Continuous Stock taking i.e. Physical Perpetual Inventory

Combining ABC analysis and HML classification, it will be more useful to an organization.

Just in Time (JIT)

Toyota Motors has first time suggested just – in – time approach in 1950s. This means the material will reach the points of production process directly form the suppliers as per the time schedule.

Inventory Turnover Ratio: Cost of goods sold / average total inventories. The higher the ratio, more the efficiency of the firm.

 

 

 

 

CASH MANAGEMENT

  Cash is the most liquid current assets.  Cash is the common denominator to which all current assets can be reduced because the other major liquid assets.

Transactions motive - This motive refers to the holding of cash, to meet routine cash requirements in the ordinary course of business.

Precautionary motive - Apart from the non-synchronisation of expected cash receipts and payments in the ordinary course of business, a firm may be failed to pay cash for unexpected contingencies. For example, strikes, sudden increase in cost of raw materials etc. Cash held to meet these unforeseen situations is known as precautionary cash balance.

Speculative motive - Sometimes firms would like to hold cash in order to exploit, the profitable opportunities as and when they arise.

Compensation motive - This motive to hold cash balances is to compensate banks and other financial institutes for providing certain services and loans.

Objectives

The basic objectives of cash management are

(i) to make the payments when they become due and

(ii) to minimize the cash balances.

The cash budget is the most important tool in cash management. It is a device to help a firm to plan and  control the use of cash.  It is a statement showing the estimated cash inflows and cash outflows over the firm’s planning horizon.

The optimum level of cash balances of a company can be determined in various ways : They are

a) Inventory model (Economic Order Quantity) to cash management

b) Stochastic model

c) Probability model

d)The BAT Model

 

a)     Inventory model (Economic Order Quantity) According to this model optimal level of cash balance is one at which cost of carrying the inventory of cash and cost of going to the market for satisfying cash requirements is minimum.

b)     Stochastic (irregular) Model - This model is developed to avoid the problems associated with the EOQ model.  This model was developed by Miller and Orr.  The basic assumption of this model is that cash balances are irregular, i.e., changes randomly over a period of time both in size and direction and form a normal distribution as the number of periods observed increases.  The model prescribes two control limits Upper control Limit (UCL) and Lower Control Limit (LCL). When the cash balances reaches the upper limit a transfer of cash to investment account should be made and when cash balances reach the lower point a portion of securities constituting investment account of the company should be liquidated to return the cash balances to its return point. The control limits are converting securities into cash and the vice – versa, and the cost carrying stock of cash.

Miller and Orr model is the simplest model to determine the optimal behavior in irregular cash flows situation.  The model is a control limit model designed to determine the time and size of transfers between an investment account and cash account.

 

c)     Probability Model - This model was developed by William Beranek. Beranek observed that cash flows of a firm are neither completely predictable nor irregular (stochastic).  The cash flows are predictable within a range.  This occurrence calls for formulating the demand for cash as a probability distribution of possible outcomes.

According to this model, a finance manager has to estimate probabilistic out comes for net cash flows on the basis of his prior knowledge and experience.  He has to determine what is the operating cash balance for a given period, what is the expected net cash flow at the end of the period and what is the probability of occurrence of this expected closing net cash flows.

The optimum cash balance at the beginning of the planning period is determined with the help of the probability distribution of net cash flows.  Cost of cash shortages, opportunity cost of holding cash balances and the transaction cost.

d)     The BAT Model

The Baumol-Allais-Tobin (BAT) model is a classic means of analyzing the cash management problem. It is a straightforward model and very useful for illustrating the factors in cash management and, more generally, current asset management.

 

Strategy towards accelerating cash inflows

i)                   Quick deposit of customer’s cheques.

ii)                Establishing collection centres.

iii)               Lock-box method.

 Strategy for slowing cash outflows

i)                   Delaying outward payment

ii)                Making pay roll periods less frequent.

iii)               Solving disbursement by use of drafts.

iv)               Playing the float.

v)                 Centralized payment system

vi)              By transferring funds from one bank to another bank firm can maximize its cash turnover.

 

 

CASH MANAGEMENT

 

Debtors form about 30% of current assets in India.

The goal of receivables management is to maximize the value of the firm by achieving a tradeoff between risk and profitability.

If a firm’s credit terms are “Net 15”, it means the customers are expected to pay within 15 days from the date of credit sale.

If the terms of cash discount are changed from “Net 30” to “2/10 Net 30”, it means the credit period is of 30 days but in case customer pays in 10 days, he would get 2% discount on the amount due by him.

The optimum investment in receivables will be at a level where there is a trade-off between costs and profitability.

Thus, optimum credit policy occurs at a point where there is a “Trade-off” between liquidity and profitability.

 Credit standard of a customer : 5 C’s of credit :

a. Character of the customer i.e. willingness to pay.

b. Capacity—ability to pay.

 c. Capital—financial resources of a customer.

d. Conditions—special conditions for extension of credit to doubtful customers and prevailing economic and market conditions and;

e. Collateral security.

 

Five “C’s”.  Character, Capacity, Capital, Collateral and Conditions.

 

Credit evaluation of the customer involves the following 5 stages

i.                    Gathering credit information of the customer

ii.                 Credit analysis

iii.               Credit decision

iv.               Credit limit

v.                  Collection procedure

 

WORKING CAPITAL CYCLE

Working Capital Cycle is also known as Operating cycle. Operating cycle is the total time gap between the purchase of raw material and the receipt from Debtors.

O = R + W + F + D – C

Where,

O = Duration of operating cycle.

R = Raw material storage period.

W= Work-in-process period.

F = Finished goods storage period.

D =Debtors collection period, and

C = Creditors payment period.

 

Cash is the central reservoir of a firm and ensures liquidity.

 

WORKING CAPITAL POLICIES

Matching Approach

It suggests that if the need is short term purpose, raise short – term  loan or credit and if the need is for a long term, one should raise long term loan or credit.  Thus, maturity period of the loan is to be matched with the purpose and for how long.  This is called matching approach.

 

The working capital management is a razor edge exercise for financial manager of an enterprise.

Letter of Credit:  A letter of credit is an arrangement whereby a bank helps its customer to obtain credit from its (customer’s) suppliers.

 

The Tandon Committee had suggested three methods for determining the maximum permissible bank finance (MPBF).