Working Capital Management | CMA Inter Syllabus
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The financial management of business involves the management of long-term assets, long-term capital, and the management of short-term assets and liabilities. Management of working capital concerns with the management of assets such as cash, marketable securities, receivables, inventories and other current assets also liabilities include payables and accruals.
Working capital management is essentially the management of current assets and current liabilities in an organisation. It is concerned with the problems that has been arising in attempting to manage the current assets, the current liabilities and inter relationship that exists between them. The role of the working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.
1.1 Theoretical Underpinnings
Working capital typically means holdings of current assets or short-term assets such as cash, receivables inventories and marketable securities.
Working Capital - Meaning & Definition
The term working capital also called gross working capital refers to the firm’s aggregate of current assets. Current assets are those assets which can be convertible into cash within an accounting period, generally a year. Therefore, they are cash or mere cash resources of a business concern. However, we can understand the meaning of working capital from the following:
From the above definitions, we can say that the working capital is the firm’s current assets or the excess of current assets over current liabilities. However, the later meaning will be more useful in most of the times as in all cases we may not find excess of current assets over current liabilities.
Concept of Working Capital
Working capital has two concepts:
Gross working capital refers to the total of the current assets.
Net working capital refers to the excess of the current assets over current liabilities. Net working capital (NWC) can alternatively define as the part of the current assets which are financed with the long-term funds. Since, current liabilities represent sources of short-term funds, as long as the current assets exceeds the current liabilities, the excess must be financed with the long-term funds.
Though both concepts are important for managing it. Gross working capital is more helpful to the management in managing each individual current assets for day-to-day operations. But, in the long run, it is the net working capital that is useful for the purpose.
When we want to know the sources from which funds are obtained, it is not working capital that is more important and should be given greater emphasis. The definition given by the Accountants, U.S.A., will give clear view of working capital which is given below:
“Working capital sometimes called net working capital, is represented by excess of current assets over current liabilities and identifies the relatively liquid portion of total enterprise capital which constitutes a margin of better for maturing obligations within the ordinary operation cycle of the business.”
Each concern has its own limitations and constraints within which it has to decide whether it should give importance to gross or not working capital.
Concept of Zero Working Capital
The zero-working capital (ZWC) differs from the commonly used working capital i.e., current assets minus current liabilities.
The zero-working capital is inventory plus receivables minus payables.
| ZWC = Inventories (+) Receivable (-) Payables. |
The rationale is that inventories and receivables are the major constituents of current assets which affect sales. Further, suppliers finance inventories through account payable.
Current Assets
An asset is classified as current asset when:
Generally current assets of an organisation, for the purpose of working capital management can be classified into the following main heads:
Current Liabilities
A liability is classified as current liability when:
Generally current liabilities of an organisation, for the purpose of working capital management can be classified into the following main heads:
1.2 Planning of Working Capital
Working capital of a business should be commensurate with its needs. Too high or too low working capital of a business or two extremes of working capital are equally dangerous to the existence of the business enterprise itself.
High amount of working capital, though increases its liquidity position but reduces its profitability and on the other hand too low working capital though increases its profitability reduces its liquidity. Both such extreme situations may cause business concerns to shut down.
Danger of too high amount of Working Capital
Problems of inadequate or low amount of Working Capital
Determinants of Working Capital
The size or magnitude and amount of working capital will not be uniform for all organisations. It differs from one type of organisation to the other type of organisation. Depending upon various conditions and environmental factors of each and every organisation. There are many factors that determine the size of working capital. However, there are some factors, which are common to the most of the business concerns. Such factors are enumerated below:
If the dividend is to be declared in cash, such outflow reduces working capital and therefore, most of the business concerns declare dividend now-a-days in the form of bonus shares as such retain their cash. A shortage of working capital acts as powerful reason for reducing or skipping cash dividend.
The company policy of retaining or distribution of profits will also affect the working capital. More appropriation out of profits than distribution of profit necessarily reduces the requirements of working capital.
Types of Working Capital on the basis of Nature
There are two types of working capital, the distinction of which made keeping in view the nature of such funds in a business concern, which are as follows:
Every business concern has to maintain certain minimum amount of current assets at all times to carry on its activities efficiently and effectively. It is indispensable for any business concern to keep some material as stocks, some in the shape of work-in-progress and some in the form of finished goods.
Similarly, it has to maintain certain amount of cash to meet its day-to-day requirements. Without such minimum amount, it cannot sustain and carry on its activities. Therefore, some amount of working capital i.e., current assets is permanent in the business without any fluctuations like fixed assets and such amount is called working capital. To say precisely, permanent working capital is the irreducible minimum amount of working capital necessary to carry on its activities without any interruptions. It is that minimum amount necessary to outlays its fixed assets effectively.
On the other hand, temporary working capital is that amount of current assets which is not permanent and fluctu- ating from time to time depending upon the company’s requirements and it is generally financed out of short-term funds. It may also high due to seasonal character of the industry as such it is also called seasonal working capital.
1.3 Working Capital Cycle and Cash Cycle
Working Capital Cycle or Operating Cycle are synonymous terms in the context of management of working capital. Any business concern, whether it is of financial nature, trade organisation or a manufacturing organisation needs certain time to net fruits of the efforts. That is, by investment of cash, producing or doing something for some time will fetch profit. But soon after the investment of cash, it cannot get that profit by way of cash again immedi- ately. It takes time to do so. The time required to take from investment of cash in some assets and conversion of it again into cash termed as operating or working capital cycle. Here the cycle refers to the time period.
The following figures has shown the working capital cycle and case cycle of different types of organisations.
In case of manufacturing concerns, the operating cycle will be Raw materials → WIP → Finished goods → Sales → Debtors & Bills Receivable → Cash
In case of trading concerns, the opening cycle will be: Cash → Stock → Debtors → Cash
In case of financial concerns, the operating cycle will be: Cash → Debtors → Cash only
The operating cycle of a manufacturing company involves three phases:
Phase 1: Acquisition of resources such as raw material, labour, power and fuel, etc.
Phase 2: Manufacture of the product which includes conversion of raw material into work-in-progress into
finished goods.
Phase 3: Sale of the product either for cash or on credit. Credit sales create accounts receivable for collection The length of the operating cycle of a manufacturing firm is the sum of: (i) inventory conversion period (ICP)
and (ii) debtors (receivables) conversion period (DCP).
The inventory conversion period is the total time needed for producing and selling the product. Typically, it
includes: (a) raw material conversion period (RMCP), (b) work-in-process conversion period (WIPCP), and
finished goods conversion period (FGCP). The debtors’ conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and debtors’ conversion period is referred to as gross operating cycle (GOC).
| Gross operating cycle = Inventory conversion period (ICP) + Debtors conversion period (DCP) GOC = I CP + DCP |
Net operating cycle (NOC) is the difference between gross operating cycle and payables deferral period. Net operating cycle = Gross operating cycle (GOC) – Creditors deferral period (CDP).
| NOC = GOC - CDP |
Net operating cycle is also referred to as cash conversion cycle.
Inventory Conversion Period
The inventory conversion (ICP) is the sum of raw material conversion period (RMCP), work-in-process conversion period (WIPCP) and finished goods conversion period (FGCP):
| ICP = RMCP + WPCP +FGCP |
Raw Material Coversion Period (RMCP)
The raw material conversion period (RMCP) is the average time period taken to convert material in to work-in- process. RMCP depends on: (a) raw material consumption per day, and (b) raw material inventory.
| RMCP = Raw Material Inventory / [Raw material consumption / 360] |
Work-in-process Conversion Period (WIPCP)
Work-in-process conversion period (WIPCP) is the average time taken to complete the semi-finished work or work-in-process.
| WIPCP = Work-in-process Conversion Period/ [Cost of Production / 360] |
Finished Goods Conversion Period (FGCP)
Finished goods conversion period (FGCP) is the average time taken to sell the finished goods.
| WIPCP = Finished Goods Inventory / [Cost of Production / 360] |
Debtors (Receivable) Conversion Period (DCP)
Debtors' conversion period (DCP) is the average time taken to convert debtors into cash. DCP represents the average collection period.
| WIPCP = Finished Goods Inventory / [Cost of Production / 360] |
Creditors (Payables) Deferral Period (CDP)
Creditors (payables) deferral period (CDP) is the average time taken by the firm in paying its suppliers (creditors).
| DCP = Receivables / [Credit Sales / 360] = Debtors x 360 / Credit sales |
It is obvious from the above that the time gap between the sales and their actual realisation of cash is technically termed as Operating Cycle or Working Capital Cycle.
The period of working capital cycle may differ from one business enterprise to the other depending upon the nature of the enterprise and its activities. It means the pattern of working capital cycle do change according to its activities.
1.4 Estimation of Working Capital Requirements
In order to calculate the working capital needs, holding period of various types of inventories, the credit collection period and the credit payment periods are required. Working capital also depends on the budgeted level of activity in terms of production/sales. The calculation of WC is based on the assumption that the production/sales is carried on evenly throughout the year and all costs accrue similarly.
The steps involved in estimating the different items of CA and CL are as follows:
Estimation of Current Assets
i. Raw Materials Inventory
The investment in raw materials inventory is estimated on the basis of following equation:
[ Budgeted productions (in units) x Cost of raw materials per unit x Average inventory holding period (months or days) ] / 12 Months
ii. Work-in-Progress (WIP) Inventory
The relevant costs to determine work-in-process inventory are the proportionate share of cost of raw materials and conversion costs such as labour and manufacturing overhead costs excluding depreciation. Depreciation is excluded as it does not involve any cash expenditure.
[ Budgeted productions (in units) x Cost of raw materials per unit x Average inventory holding period (months or days) ] / 12 Months
iii. Finished Goods Inventory
Working capital required to finance the finished goods inventory is given below:
[ Budgeted productions (in units) x Cost of goods produced per unit (excluding depreciation) x Finished goods holding goods (months or days) ] / 12 Months
iv. Debtors
The working capital included in debtors should be estimated in relation to total cost price (excluding depreciation)
[ Budgeted credit sales (in units) x Cost of sales per unit (excluding depreciation) x Average debt collection period (months or days) / 12 months
v. Cash and Bank Balances
Apart from working capital needs for financing inventories and debtors, firms also find it useful to have some minimum cash balances with them. It is difficult to lay down the exact procedure of determining such an amount. This would primarily be based on the motives for holding cash balances of the business firm, attitude of management toward risk, the access to the borrowing sources in times of need and past experience, and so on.
Estimation of Current Liabilities
The working capital needs of business firms are lower to the that extent such needs are met through the current liabilities (other than bank credit) arising in the ordinary course of business. The important current liabilities (CL), in this context are, trade creditors, wages and overheads. Estimation of these liabilities are mentioned below:
i. Trade Creditors
Budgeted yearly productions (in units) x Raw material cost per unit x Credit period allowed by creditors (months or days) / 12 months
ii. Direct wages
Budgeted yearly productions (in units) x Direct labour cost per unit x Average time-lag in payment of wages (months or days) / 12 months
iii. Overheads
Budgeted yearly productions (in units) x Overhead cost per unit x Average time-lag in payment of wages (months or days) / 12 months
iv. Goods and Service Tax (GST)
Budgeted yearly productions (in units) x GST per unit x Average time-lag in payment of wages (months or days) / 12 months
Working Capital can be estimated by using the following format.
Determination of Working Capital
| Particulars | Amount (₹) |
| A. Estimation of Current Assets | |
| (i) Minimum desired cash and bank balances | xxx |
| (ii) Inventories | |
| Raw materials | xxx |
| Work-in-Progress | xxx |
| Finished Goods | xxx |
| (iii) Debtors* | xxx |
| Total Current Assets | xxx |
| B. Estimation of Current Liabilities | |
| (i) Creditors** | xxx |
| (ii) Wages | xxx |
| (iii) Overheads | xxx |
| (iv) Goods and Services Tax (GST) | xxx |
| Total Current Liabilities | xxx |
| C. Net Working Capital (A – B) | xxx |
| Add: Margin for contingency | xxx |
| D. Net Working Capital Required | xxx |
| *If payment is received in advance, the item would be listed in Current Liabilities. | xxx |
| **If advance payment is to be made to creditors, the item would appear under Current Assets. The same would be the treatment for advance payment of wages and overheads. | xxx |
Illustration 1
PQR Ltd. produces a product with the following revenue cost structure:
| Particulars | Cost per unit (₹) |
| Raw materials | 115 |
| Direct labour | 80 |
| Overheads | 37 |
| Total Cost | 232 |
| Profit | 58 |
| Selling Price | 290 |
The following additional information is available:
You are required to prepare a statement showing the working capital needed to finance a level of activity of 60,000 units of annual output. The production is carried throughout the year on even basis and wages and overheads accrue uniformly. Debtors are to taken at cost.
Solution:
Illustration 2
A and B Ltd is desired to purchase a business and has consulted you, and one point on which you are asked to advise them, is the average amount of working capital which will be required in the first year’s working.
You are given the following estimates and instructed to add 12 % to your computed figure to allow for contingencies.
| Particulars | Amount for the year (₹) |
| (i) Average amount blocked up for stocks: | |
| Stocks of finished product | 6,000 |
| Stock of stores and materials | 7,000 |
| (ii) Average credit given: | |
| Inland sales: 6 weeks’ credit | 3,12,000 |
| Export sales: 1.5 weeks’ credit | 78,000 |
| (iii) Average time lag in payment of wages and other outgoings | |
| Wages: 1.5 weeks | 2,60,000 |
| Stock and materials: 1.5 months | 52,000 |
| Rent and royalties: 6 months | 12,000 |
| Clerical staff: ½ month | 62,400 |
| Manager: ½ month | 4,800 |
| Miscellaneous expenses: 1.5 months | 52,000 |
| (iv) Payment in advance: | |
| Sundry expenses (paid quarterly in advance) | 8,000 |
| Undrawn profits on an average throughout the year | 10,000 |
Solution:
Illustration 3
A company has prepared its annual budget, relevant details of which are reproduced below:
|
(a) Sales ₹ 46.80 lakhs (25% cash sales and balance on credit) |
78,000 units |
|
(b) Raw material cost |
60% of sales value |
|
(c) Labour cost |
₹ 6 per unit |
|
(d) Variable overheads |
₹ 1 per unit |
|
(e) Fixed overheads |
₹ 5 lakhs (including ₹ 1,10,000 as depreciation) |
| Budgeted stock levels: | |
| Raw materials | 3 weeks |
| Work-in-progress | 1 week (Material 100%, Labour & Overheads 50%) |
| Finished goods | 2 weeks |
| Debtors are allowed credit | 4 weeks |
| Creditors allow credit | 4 weeks |
| Wages are paid by-weekly, i.e., by the 3rd week and by the 5th week for the 1st & 2nd weeks and the 3rd & 4th weeks respectively | |
| Lag in payment of overheads | 2 weeks |
| Cash-in-hand required | ₹ 50,000 |
Prepare the working capital budget for a year for the company, making whatever assumptions that you may find necessary.
Solution:
Illustration 4
A company plans to manufacture and sell 400 units of a domestic appliance per month at a price of ₹ 600 each. The ratio of costs to selling price are as follows:
| Particulars | (% of selling price) |
| Raw material | 30% |
| Packing materials | 10% |
| Direct labours | 15% |
| Direct expense | 5% |
Fixed overheads are estimated at ₹ 4,32,000 per annum.
The following norms are maintained for inventory management:
Raw materials 30 days
Packing materials 15 days
Finished goods 200 units
Work-in-progress 7 days
Other particulars are given below:
Prepare a Working Capital requirement forecast for the budget year.
Solution:
Illustration 5
a. From the following details, prepare an estimate of the requirement of Working Capital:
| Production | 60,000 units |
| Selling price per unit | ₹ 5 |
| Raw material | 60% of selling price |
| Direct wages | 10% of selling price |
| Overheads | 20% of selling price |
| Materials in hand | 2 months requirement |
| Production Time | 1 month |
| Finished goods in Stores | 3 month |
| Credit for Material | 2 month |
| Credit allowed to Customers | 2 month |
| Average cash balance | ₹ 20,000 |
Wages and overheads are paid at the beginning of the month following. In production, all the required materials are charged in the initial stage and wages and overheads accrue evenly.
b. What is the effect of double shift working on the requirement of working capital?
Solution:
Illustration 6
Solaris Ltd. sells goods in domestic market at a gross profit of 25%, not counting on depreciation as a part of the ‘cost of goods sold’. Its estimates for next year are as follows: Amount (₹ in lakh)
| Sales - Home at 1 month's credit | 1,200 |
| Exports at 3 months' credit, selling price 10% below home price | 540 |
| Materials used (suppliers extend 2 months' credit) | 450 |
| Wages paid, ½ month in arrears | 360 |
| Manufacturing expenses, paid 1 months in arrears | 540 |
| Administrative expenses, paid 1 months in arrears | 120 |
| Sales promotion expenses ( payable quartely - in advice) | 60 |
| Income-Tax payable in 4 instalments of which one falls in the next financial year | 150 |
The company keeps 1 month’s stock of each of raw materials and finished goods and believes in keeping ₹20 lakh as cash. Assuming a 15% safety margin, ascertain the estimated working capital requirement of the company (ignore work -in-process).
Solution:
Illustration 7
Camellia Industries Ltd. is desirous of assessing its Working Capital requirements for the next year. The finance manager has collected the following information for the purpose.
| Estimated cost per unit of finished product | (₹ in lakh) |
| Raw materials | 90 |
| Direct labour | 50 |
| Manufacturing and administrative overhead (Excluding depreciation) | 40 |
| Depreciation | 20 |
| Selling overheads | 30 |
| Total Cost | 230 |
The product is subject to excise duty of 10% (levied on cost of production) and is sold at ₹ 300 per unit.
Additional information:
i. Budgeted level of activity is 1,20,000 units of output for the next
ii. Raw material cost consists of the following:
Pig iron 65 per unit
Ferro alloys 15 per unit
Cast iron borings 10 per unit
iii. Raw materials are purchased from different suppliers, extending different credit Pig iron 2 months
Ferro alloys ½ months
Cast iron borings 1 month.
iv. Product is in process for a period of 1/2 Production process requires full unit (100 %) of pig iron and ferroalloys in beginning of production. Cast iron boring is required only to the extent of 50 % in the beginning and the remaining is needed at a uniform rate during the process. Direct labour and other overheads accrue similarly at a uniform rate throughout production process.
v. Past trends indicate that the pig iron is required to be stored for 2 months and other materials for 1 month.
vi. Finished goods are in stock for a period of 1 month
vii. It is estimated that one-fourth of total sales are on cash basis and the remaining sales are on credit. The past experience of the firm has been to collect the credit sales in 2 months.
viii. Average time-lag in payment of all overheads is 1 month and ½ month in the case of direct labour.
ix. Desired cash balance is to be maintained at ₹ 10
You are required to determine the amount of net working capital of the firm. State your assumptions, if any.
Solution:
Receivable refers the book debts or debtors owed to the firm by customers arising from sale of goods or services in the ordinary course of business. These constitute an important component of the current assets of a firm. However, debt involves an element of risk and bad debts also. Hence, it calls for careful analysis the important dimensions of the efficient management of receivables within the framework of a firm’s objectives of value maximization. The goal of receivables management is to maximize the value of the firm by achieving a tradeoff between risk and profitability.
2.1 Meaning and Objectives of Receivables Management
Management of receivables refers to planning and controlling of ‘debt’ owed to the firm from customer on account of credit sales. It is also called as trade credit management. The objectives of receivables management are as follows:
2.2 Costs of Maintaining Receivables
The costs with respect to maintenance of receivables can be identified as follows:
2.3 Benefits of Maintaining Receivables
Important benefits of maintaining receivables are as follows:
2.4 Factors Affecting the Size of Receivables
The size of accounts receivable is determined by a number of factors. Some of the important factors are as follows:
2.5 Optimum Size of Receivable
The optimum investment in receivables will be at a level where there is a trade-off between costs and profitability. When the firm resorts to a liberal credit policy, the profitability of the firm increases on account of higher sales. However, such a policy results in increased investment in receivables, increased chances of bad debts and more collection costs. The total investment in receivables increases and, thus, the problem of liquidity is created. On the other hand, a stringent credit policy reduces the profitability but increases the liquidity of the firm. Thus, optimum credit policy occurs at a point where there is a “Tradeoff” between liquidity and profitability as shown in the chart below.
The following are the aspects of credit policy:
2.6 Optimum Credit Policy
A firm should establish receivables policies after carefully considering both benefits and costs of different policies. These policies relate to:
(i) Credit Standards (ii) Credit Terms, and (iii) Collection Procedures.
Each of these are explained below:
2.7 Credit Evaluation of Customer
Credit evaluation of the customer involves the following five stages:
Stage 1: Gathering credit information of the customer through:
Stage 2: Credit analysis:
After gathering the above information about the customer, the credit-worthiness of the applicant is to be analysed by a detailed study of 5 C’s of credit as mentioned above.
Stage 3: Credit decision:
After the credit analysis, the next step is the decision to extend the credit facility to potential customer. If the analysis of the applicant is not upto the standard, he may be offered cash on delivery (COD) terms even by extending trade discount, if necessary, instead of rejecting the credit to the customer.
Stage 4: Credit limit:
If the decision is to extend the credit facility to the potential customer, a limit may be prescribed by the financial manager, say, ₹ 25,000 or ₹1,00,000 or so, depending upon the credit analysis and credit-worthiness of the customer.
Stage 5: Collection procedure:
A suitable and clear-cut collection procedure is to be established by a firm and the same is to be intimated to every customer while granting credit facility. Cash discounts may also be offered for the early payment of dues. These facilities faster recovery.
2.8 Evaluation of Credit Policy
Example 1
Generally two methods of evaluating the credit policies to be adopted by a company – (a) Total Approach and (b) Incremental Approach. The formats for the two approaches are given as under:
Statement showing the Evaluation of Credit Policies (based on Total Approach)
| Particulars | Present Policy | Proposed Policy I | Proposed Policy II | Proposed Policy III |
| (₹) | (₹) | (₹) | (₹) | |
| A. Expected Profit | ||||
| (a) Credit Sales | xxx | xxx | xxx | xxx |
| (b) Total Cost other than Bad Debts | ||||
| (i) Variable Costs | xxx | xxx | xxx | xxx |
| (ii) Fixed Costs | xxx | xxx | xxx | |
| xxxx | xxxx | xxxx | ||
| (c) Bad Debts | xxx | xxx | xxx | |
| (d) Cash Discount | ||||
| (e) Expected Net Profit before Tax (a-b-c-d) | xxx | xxx | xxx | xxx |
| (f) Tax | xxx | xxx | xxx | xxx |
| (g) Expected Profit after Tax (e – f) | xxxx | xxxx | xxxx | xxxx |
| B. Opportunity Cost of Investments in Receivables locked up in Collection Period | xxx | xxx | xxx | xxx |
| Net Benefits (A - B) | xxxx | xxxx | xxxx | xxxx |
Comment:
The Policy should be adopted since the net benefits under this policy are higher as compared to other policies.
Example 2
Statement showing the Evaluation of Credit Policies (based on Incremental Approach)
| Particulars | Present Policy | Proposed Policy I | Proposed Policy II | Proposed Policy III |
| (₹) | (₹) | (₹) | (₹) | |
| A. Incremental Expected Profit | ||||
| Credit Sales | xxx | xxx | xxx | xxx |
| (a) Incremental Credit Sales | xxx | xxx | xxx | xxx |
| (b) Less: Incremental Costs of Credit Sales | ||||
| (i) Variable Costs | xxx | xxx | xxx | xxx |
| (ii) Fixed Cost | xxx | xxx | xxxx | xxx |
| (c) Incremental Bad Debt Losses | xxx | xxx | xxx | xxx |
| (d) Incremental Cash Discount | xxx | xxx | xxx | xxx |
| (e) Incremental Expected Profit (a-b-c-d) | xxx | xxx | xxx | xxx |
| (f) Tax | xxx | xxx | xxx | xxx |
| (g) Incremental Expected profit after tax (e – f) | xxx | xxx | xxx | xxx |
| B. Required return on Incremental Investments | ||||
| (a) Cost of Credit Sales | xxx | xxx | xxx | xxx |
| (b) Collection Period (in days) | - | - | - | - |
| (c) Investment in Receivable (a × b/365 or 360) | xxx | xxx | xxx | xxx |
| (d) Incremental Investment in Receivables | xxx | xxx | xxx | xxx |
| (e) Required Rate of Return (in %) | % | % | % | % |
| (f) Required Return on Incremental Investments (d × e) | xxx | xxx | xxx | xxx |
| Incremental Net Benefits (A - B) | xxx | xxx | xxx | xxx |
Comment:
The Policy should be adopted since the net benefits under this policy are higher as compared to other policies.
2.9 Monitoring and Control of Receivables
Monitoring and control of receivables can be exercised in the following manner:
Illustration 8
XYZ Corporation whose current sales are in the region of ₹6 lakh per annum and an average collection period of 30 days wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following information;
The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable costs per unit are ₹ 2. The current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year. Which of the above policies would you recommend for adoption?
Solution:
Illustration 9
ABC Corporation is considering relaxing its present credit policy and is in the process of evaluating two proposed policies. Currently the firm has annual credit sales of ₹ 50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is ₹1,50,000. The firm is required to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the selling price. Given the following information, which is the better option?
| Present Policy | Policy Option I | Policy option II | |
| Annual credit sales | 50,00,000 | 60,00,000 | 67,50,000 |
| Accounts receivable turnover ratio | 4 times | 3 times | 2.4 times |
| Bad debt losses | 1,50,000 | 3,00,000 | 4,50,000 |
Solution:
Illustration 10
A firm is considering pushing up its sales by extending credit facilities to the following categories of customers:
The incremental sales expected in case of category (a) are ₹40,000 while in case of category (b) they are ₹50,000.
The cost of production and selling costs are 60% of sales while the collection costs amount to 5% of sales in case of category (a) and 10% of sales in case of category (b).
You are required to advise the firm about extending credit facilities to each of the above categories of customers.
Solution:
A susbstantial part of purchases of goods and services in business are on credit terms rather than against cash payment. While the supplier of goods and services tend to perceive credit as a lever for enhancing sales or as a form of non-price instrument of competition, the buyer tends to look upon it as a loaning of goods or inventory. Generally, the supplier’s credit is referred to as Accounts Payable, Trade Credit, Trade Bill, Trade Acceptance, Commercial Draft or Bills Payable depending on the nature of credit provided.
Payables or accounts payables are amounts due to vendors or suppliers for goods or services received that have not yet been paid for. They are short- term deferments of cash payments that the buyer of goods and services is allowed by the seller. Payables constitute current or short-term liabilities representing the buyer’s obligation to pay a certain amount on a date in the near future for value of goods or services received. The sum of all outstanding amounts owed to vendors or suppliers or third-party is shown as the accounts payable balance on the company’s balance sheet.
Payables management is the handling of a company’s unpaid debts to third-party vendors for purchases made on credit. Account payables management involves tasks such as seeking trade credit lines, acquiring favorable terms of purchase, and managing the timing and flow of purchase.
3.1 Types of Payables or Trade Credits
Generally, Payables or Trade Credits may be classified into three types:
These are discussed briefly as under:
3.2 Determinants of Payables/Trade Credit
3.3 Computation of Cost of Credit or payables
Cost of credit can be calculated in two situations:
To calculate nominal cost of credit on an annual basis of not considering discount, the formula is:
{ d / (100-d) x (365 days / t) }
Where,
d= Size of discount or discount percentage (%)
t=Allowed payment days – discount days
Illustration 10
A supplier of X Ltd. offers the company 2/15 net 40 payment terms. To translate the shortened description of the payment terms, the supplier will allow a 2% discount if paid within 15 days, or a regular payment in 40 days. Determine the cost of credit related to these terms.
Solution:
Inventory constitutes an important item in the working capital of many business concerns. Net working capital is the difference between current assets and current liabilities. Inventory is a major item of current assets. The term inventory refers to the stocks of the product a firm is offering for sale and the components that make up the product. Inventory is stores of goods and stocks. This includes raw materials, work-in-process and finished goods. Raw materials consist of those units or input which are used to manufacture goods that require further processing to become finished goods. Finished goods are products ready for sale. The classification of inventory and the levels of the components vary from organisation to organisation depending upon the nature of business. For example, steel is a finished product for a steel industry, but raw material for an automobile manufacturer.
Thus, inventory may be defined as “Stock of goods that is held for future use”. Since inventory constitute about 50 to 60 % of current assets, the management of inventories is crucial to successful Working Capital Management. Working capital requirements are influenced by inventory holding. Hence, there is a need for effective and efficient management of inventory A good inventory management is important to the successful operations of the most of the organizations, unfortunately the importance of inventory is not always appreciated by top management. This may be due to a failure to recognize the link between inventory and achievement of organisational goals or due to ignorance of the impact that inventory can have on costs and profits. Inventory management refers to an optimum investment in inventory. It should neither be too low to effect the production adversely nor too high to block the funds unnecessarily. Excess investment in inventory is unprofitable for the business. Both excess and inadequate investment in inventory is not desirable. The firm should operate within the two danger points. The purpose of inventory management is to determine and maintain the optimum level of inventory investment.
The purpose of inventory management is to determine and maintain the optimum level of inventory investment.
4.1 Techniques of Inventory Management
The financial managers should aim at an optimum level of inventory on the basis of the trade-off between cost and benefit to maximize owner’s health. Many mathematical models are available to handle inventory management problems. These are discussed below:
1. Economic Order Quantity: (EOQ)
The total costs of a material usually consist of Buying Cost, Total Ordering Cost and Total Carrying Cost. Economic Order Quantity is ‘The size of the order for which both ordering and carrying cost are minimum’.
Ordering Cost: The costs which are associated with the ordering of material. It includes cost of staff posted
for ordering of goods, expenses incurred on transportation, inspection expenses of incoming material etc.
Carrying Cost: The costs for holding the inventories. It includes the cost of capital invested in inventories.
Cost of storage, Insurance etc.
Buying Cost: Amount paid / payable to the supplier for the goods. It includes the purchasing price plus all non-deductible taxes.
The assumption underlying the Economic Ordering Quantity: The calculation of economic order of material to be purchased is subject to the following assumptions: -
The famous mathematician ‘WILSON’ derived the formula used for determining the size of order for each purchase at minimum ordering and carrying costs, which is as below:
Economic Ordering Quantity
A = Annual demand
O = Ordering Cost
C = Carrying Cost
Illustration 12
Calculate the Economic Order Quantity from the following information. Also state the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg
Order placing cost per order : ₹ 50
Cost per kg. of raw materials : ₹ 2
Storage costs : 8% on average inventory
Solution:
Illustration 13
The average annual consumption of a material is 18,250 units at a price of ₹36.50 per unit. The storage cost is 20% on an average inventory and the cost of placing an order is ₹ 50. How much quantity is to be purchased at a time?
Solution:
2. Fixing Levels of Materials
A. Maximum Level:
The Maximum Level indicates the maximum quantity of an item of material that can be held in stock at any time. The stock in hand is regulated in such a manner that normally it does not exceed this level.
While fixing the level, the following factors are to be taken into consideration:
| Maximum Level |
| Re-Order Level + Re-Order Quantity - (Minimum Rate of Consumption x Minimum Re-Order Period) |
B. Minimum Level:
The Minimum Level indicates the lowest quantitative balance of an item of material which must be maintained at all times so that there is no stoppage of production due to the material being not available.
In fixing the minimum level, the following factors are to be considered: -
| Maximum Level |
| Re-Order level - (Normal Rate of Consumption x Normal Re-Order Period) |
C. Re-Order Level
When the stock in hand reaches the ordering or re-ordering level, store keeper has to initiate the action for replenish the material. This level is fixed somewhere between the maximum and minimum levels in such a manner that the difference of quantity of the material between the Re-ordering Level and Minimum Level will be sufficient to meet the requirements of production up to the time the fresh supply of material is received.
The basic factors which are taken into consideration in fixing a Re-ordering Level for a store item include minimum quantity of item to be kept, rate of consumption and lead time which are applied for computing of this level.
| Re-Order level |
| Minimum Level + Consumption during lead time |
| Or |
| Minimum Level + (Normal Rate of Consumption × Normal Re-order Period) |
| Another formula for computing the Re-Order level is as below: |
| Re-Order level |
| Maximum Rate of Consumption × Maximum Re-Order period (lead time) |
D. Danger Level
It is the level at which normal issue of raw materials are stopped and only emergency issues are only made. This is a level fixed usually below the Minimum Level. When the stock reaches this level very urgent action for purchases is indicated. This presupposed that the minimum level contains a cushion to cover such contingencies. The normal lead time cannot be afforded at this stage. It is necessary to resort to unorthodox hasty purchase procedure resulting in higher purchase cost.
The practice in some firms is to fix danger level below the Re-Ordering Level but above the Minimum Level. In such case, if action for purchase of an item was taken when the stock reached the Re-Ordering Level, the Danger Level is of no significance except that a check with the purchases department may be made as soon as the Danger Level is reached to ensure that everything is all right and that delivery will be made on the scheduled date.
| Danger Level |
| Normal Rate of Consumption × Maximum reorder Period for emergency purchases |
Illustration 14
The components A and B are used as follows:
Normal usage............................................... 300 units per week each
Maximum usage.......................................... 450 units per week each
Minimum usage........................................... 150 units per week each
Reorder Quantity.............................. A- 2,400 units; B- 3,600 units.
Reorder period............................. A -4 to 6 weeks, B -2 to 4 weeks.
Calculate for each component:
(a) Re-order Level, (b) Minimum Level, (c) Maximum Level and (d) Average Stock Level
Solution:
3. ABC Analysis
The “ABC Analysis” is an analytical method of stock control which aims at concentrating efforts on those items where attention is needed most. It is based on the concept that a small number of the items in inventory may typically represent the bulk money value of the total materials used in production process, while a relatively large number of items may present a small portion of the money value of stores used resulting in a small number of items be subjected to greater degree of continuous control.
Under this system, the materials stocked may be classified into a number of categories according to their importance, i.e., their value and frequency of replenishment during a period. The first category (we may call it group ‘A’ items) may consist of only a small percentage of total items handled but combined value may be a large portion of the total stock value. The second category, naming it as group ‘B’ items, may be relatively less important. In the third category, consisting of group ‘C’ items, all the remaining items of stock may be included which are quite large in number but their value is not high.
This concept may be clear by the following example:
| Category | No.of Items | % of the Total No. of Items | Value (₹) | % of the Total Value of Item | Average Value (₹) |
| A | 75 | 6 | 70,000 | 70 | 933 |
| B | 375 | 30 | 20,000 | 20 | 53 |
| C | 800 | 64 | 10,000 | 10 | 12 |
| 1250 | 100 | 1,00,000 | 100 | 998 |
Category ‘A’ items represent 70% of the total investment but as little as only 6% of the number of items.
Maximum control must be exercised on these items. Category ‘B’ is of secondary importance and normal control procedures may be followed. Category ‘C’ comprising of 64% in quantity but only 10% in value, needs a simpler, less elaborate and economic system of control.
The advantages of ABC analysis are:
4. Perpetual Inventory System
Perpetual Inventory System may be defined as ‘a system of records maintained by the controlling department, which reflects the physical movements of stocks and their current balance’. Thus, it is a system of ascertaining balance after every receipt and issue of materials through stock records to facilitate regular checking and to avoid closing down the firm for stock taking. To ensure the accuracy of the perpetual inventory records (bin Card and Stores Ledger), physical verification of stores is made by a programme of continuous stock taking.
The operation of the perpetual inventory system may be as follows:
Perpetual inventory system should not be confused with continuous stock taking; Continuous stock taking is an essential feature of perpetual inventory system. Perpetual inventory means the system of stock records and continuous stock taking, whereas continuous stock taking means only the physical verification of the stock records with actual stocks.
In continuous stock taking, physical verification is spread throughout the year. Everyday 10 to 15 are taken at random by rotation and checked so that the surprise element in stock verification may be maintained and each item may be checked for a number of times each year. On the other hand, the surprise element is missing in case of periodical checking, because checking is usually done at the end of year.
Advantages of Perpetual Inventory System:
5. VED Analysis
VED stands for Vital, Essential and Desirable- analysis is used primarily for control of spare parts. The spare parts can be classified into three categories i.e Vital, Essential and Desirable- keeping in view the criticality to production.
Vital: The spares, stock-out of which even for a short time will stop the production for quite some time, and where in the stock-out cost is very high are known as Vital spares. For a car Assembly Company, Engine is a vital part, without the engine the assembly activity will not be started.
Essential: The spares or material absence of which cannot be tolerated for more than few hours or a day and the cost of lost production is high and which is essential for production to continue are known as Essential items. For a car assembly company ‘Tyres’ is an essential item, without fixing the tyres the assembly of car will not be completed.
Desirable: The Desirable spares are those parts which are needed, but their absence for even a week or more also will not lead to stoppage of production. For example, CD player, for a car assembly company.
Some spares though small in value, may be vital for production, requires constant attention. Such spares may not pay attention if the organization adopts ABC analysis.
6. FSN Analysis
FSN analysis is the process of classifying the materials based on their movement from inventory for a specified period. All the items are classified in to F-Fast moving, S- Slow moving and N-Non-moving Items based on consumption and average stay in the inventory. Higher the stay of item in the inventory, the slower would be the movement of the material. This analysis helps the store keeper / purchase department to keep the fast-moving items always available & take necessary steps to dispose off the non-moving inventory.
7. Just-in-Time (JIT)
Just in time (JIT) is a production strategy that strives to improve a business return on investment by reducing in-process inventory and associated carrying costs. Inventory is seen as incurring costs, or waste, instead of adding and storing value, contrary to traditional accounting. In short, the Just-in-Time inventory system focuses on “the right material, at the right time, at the right place, and in the exact amount” without the safety net of inventory.
The advantages of Just-in-Time system are as follows: -
8. Inventory Turnover Ratio
Inventory Turnover:
Inventory Turnover signifies a ratio of the value of materials consumed during a given period to the average level of inventory held during that period. The ratio is worked out on the basis of the following formula:
Inventory Turnover Ratio = Value of material consumed during the period / Value of average stock held during the period
The purpose of the above ratio is to ascertain the speed of movement of a particular item. A high ratio indicates that the item is moving fast with a minimum investment involved at any point of time. On the other hand, a low ratio indicates the slow-moving item. Thus, Inventory Turnover Ratio may indicate slow moving dormant and obsolete stock highlighting the need for appropriate managerial actions.
Illustration 15
Compute the Inventory Turnover Ratio from the following:
Opening Stock - ₹1,00,000
Closing Stock - ₹1,60,000
Material Consumed - ₹7,80,000
Solution:
Illustration 16
Two components A and B are used as follows:
Normal usage = 50 per week each
Re-order quantity = A- 300; B-500
Maximum usage = 75 per week each
Minimum usage = 25 per week each
Re-order period: A - 4 to 6 weeks; B - 2 to 4 weeks
Calculate for each component
(a) Re-order level; (b) Minimum level; (c) Maximum level; (d) Average stock level.
Solution:
Illustration 17
X Ltd. buys its annual requirement of 36,000 units in six installments. Each unit costs ₹1 and the ordering cost is ₹25. The inventory carrying cost is estimated at 20% of unit value. Find the total annual cost of the existing inventory policy. How much money can be saved by using E.O.Q?
Solution:
Illustration 18
The annual demand for an item is 3,200 units. The unit cost is ₹6 and inventory carrying charges is 25% p.a. If the cost of one procurement is ₹150, determine:
(a) E.O.Q (b) No. of orders per year (c) Time between two consecutive orders
Solution:
llustration 19
A company manufactures a special product which requires a component ‘Alpha’. The following particulars are
collected for the year 2021.
The company has been offered a quantity discount of 4% on the purchase of ‘Alpha’ provided the order size is 4,000 components at a time.
Required:
Solution:
The term “Cash” with reference to management of cash is used in two ways. In a narrow sense, cash refers to coins, currency, cheques, drafts and deposits in banks. The broader view of cash includes near cash assets such as marketable securities and time deposits in banks. The reason why these near cash assets are included in cash is that they can readily be converted into cash. Usually, excess cash is invested in marketable securities as it contributes to profitability.
Cash is one of the most important components of current assets. Every firm should have adequate cash, neither more nor less. Inadequate cash will lead to production interruptions, while excessive cash remains idle and will impair profitability. Hence, there is a need for cash management. It is concerned with the managing of (i) cash inflows and outflows of the firm; (ii) cash flows within the firm and (iii) cash balances held by the firm at a point of time by financing deficit or investing surplus cash.
Significance of Cash Management
The cash management assumes significance for the following reasons:
Thus, the aim of cash management is to maintain adequate cash balances at one hand and to use excess cash in some profitable way on the other hand.
5.1 Motives of holding Cash
Motives or desires for holding cash refers to various purposes. The purpose may be different from person to person and situation to situation. G.A. Pogue (1969) in his research paper Cash Management: A System Approach, stated three motives for holding cash such as (i) Transaction motives; (ii) Precautionary motives and (iii) Speculative motives. These are discussed below:
a. Transaction Motives: A firm needs cash for making transactions in the day-to-day operations. The cash is needed to make payments for purchases, wages, salaries, other expenses, taxes, dividend, The need to hold cash would not arise if there were perfect synchronisation between cash receipts and cash payments. When cash payments exceed cash receipts, the firm would maintain some cash balance to be able to make required payments. For transactions purpose, a firm may invest its cash in marketable securities. Generally, the firm will purchase securities whose maturity corresponds with some anticipated payments whose timing is not perfectly matched with cash receipts.
b. Precautionary Motives: Precautionary motive refers to hold cash as a safety margin to act as a financial In addition to the non-synchronization of anticipated cash inflows and outflows in the ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted or anticipated. A firm may have to face emergencies such as strikes and lock-up from employees, increase in cost of raw materials, funds and labor, fall in market demand and so on. But how much cash is held against these emergencies depends on the degree of predictability associated with future cash flows. If there is high degree of predictability, less cash balance is sufficient. Some firms may have strong borrowing capacity at a very short notice, so that they can borrow at the time when emergencies occur. Such a firm may hold very minimum amount of cash for this motive.
c. Speculative Motives: It refers to the need to hold cash in order to be able to take advantage of negotiating purchases that might happen, appealing interest rates and positive exchange rate fluctuations. Some firms hold cash in excess than transaction and precautionary needs to involve in
The advantages of speculative motives for holding cash are:
Besides, another motive to hold cash balance is to compensate banks for providing certain services and loans.
d. Compensating Motives: Banks provide a variety of services to business firms such as clearance of cheque, credit information, transfer of funds and so Bank either charge commission, fees for these services or seek indirect compensation. Usually, clients are required to maintain a minimum balance of cash to the bank. This balance is called compensating balance. Firms cannot utilize this balance for transaction purposes, rather banks can use this amount to earn a return.
5.2 Objectives of Cash Management
The basic objectives of cash management are:
The task before the cash management is to reconcile the two conflicting nature of objectives. Keeping in view, these two conflicting aspects of cash management, it requires to determine the need of cash balances and review of the approaches to achieve optimum cash balances. There is a need to discuss the factors affecting cash needs.
Factors determining Cash needs
Maintenance of optimum level of cash is the main problem of cash management. The level of cash holding differs from industry to industry, organisation to organisation. The factors determining the cash needs of the industry is explained as follows:
5.3 Models of Cash Management
The strategies for cash management or cash management models are discussed in detail in the following lines:
I. Projection of Cash Flows and Planning
The cash planning and the projection of cash flows is determined with the help of Cash Budget. 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. In other words, the net cash position i.e., surplus or deficiency of a firm is highlighted by the cash budget from one budgeting period to another period. Cash budget involves various elements.
The first element of a cash budget is the selection of period of time i.e., budget period. It is called planning horizon. The planning horizon means the time span and the sub-periods within that time span over which cash flows are to be projected.
The second element of the cash budget is the selection of the factors that have a bearing on cash flows. The
factors are generally divided into two broad categories: (a) Operating and (b) Financial.
II. Determining Optimal Level of Cash holding by the Company
The optimal level of cash holding by a company can be determined with the help of the following models:
These are discussed below:
a. Inventory Model (EOQ) to Cash Management (Baumol Model)
Economic Order Quantity (EOQ) model is used in determination of optimal level of cash of a company. 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. The carrying cost of holding cash refers to the interest foregone on marketable securities whereas cost of giving to the market means cost of liquidating marketable securities in cash.
|
|
| Where, |
| C = Optimum cash balance |
| A = Annual (or monthly) cash disbursement |
| F = Fixed cost per transaction |
| O = Opportunity cost of one rupee per annum (or per month) |
Assumption of the baumol Model:
The following are the assumptions of Baumol’s model:
Limitations of the Baumol Model
The limitations in Baumol’s Model are as follows:
Illustration 20
The outgoings of X Ltd. are estimated to be ₹ 5,00,000 p.a., spread evenly throughout the year. The money on deposit earns 12% p.a. more than money in a current account. The switching costs per transaction are ₹150. Calculate to optimum amount to be transferred.
Solution:
Illustraion 21
ABC Ltd. has an estimated cash payments of ₹8,00,000 for a one-month period and the payments are expected to steady over the period. The fixed cost per transaction is ₹250 and the interest rate on marketable securities is 12%p.a. Calculate the optimum transaction size.
Solution:
(b) Stochastic (Miller-Orr) Model:
The important limitation of the Baumol Model is that it does not allow the cash flows to fluctuate. So, the firms do not use their cash balance uniformly nor are they able to predict daily cash inflows and outflows. The Miller-Orr overcomes this shortcoming and allows for daily cash variation.
This model assumes that net cash flows are normally distributed with a zero value of mean and standard deviation. Miller-Orr model provides two control limits, Upper control Limit (UCL) and Lower Control Limit (LCL) as well as return point. When the cash flows of the firm fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance i.e., return point. Similarly, when the firm’s cash flows wander and hit the lower limit, then the firm sells sufficient marketable securities to bring the cash balance back to the normal level i.e., return point. This is shown in a diagram below:
The difference between the upper limit and the lower limit depends on the following factors:
The optimal point of cash balance (Z) is determined by using the formula:
Where,
Z = Target cash balance (Optimal cash balance) c = Transaction cost
k = Interest rate
s = Standard deviation of net cash flows.
It is observed from the above that the upper and lower limits will be far off from each other, if transaction cost is higher or cash flows show greater fluctuations. The limits will come closer as the interest increases. Z is inversely related to the interest rate. The upper and lower control limits can be shown:
Upper limit = Lower limit + Z Return Point = Lower limit + Z
Limitations: This model is subjected to some practical problems
Besides the practical difficulties in the application of the model, the model helps in providing more, better and quicker information for management of cash. It was observed that the model produced considerable cost savings in the real-life situations.
Illustration 22
The management of X Ltd. has a policy of maintaining a minimum cash balance of ₹5,00,000. The standard deviation of the company’s daily cash flows is ₹2,00,000. The annual interest rate is 14%. The transaction cost of buying or selling securities is ₹150 per transaction. Determine the upper control limit and the return point cash balance of X Ltd. as per the Miller-Orr Model.
Solution:
c. Probability Model
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.
Assumptions:
The probability model prescribed the decision rule for the finance manager that he should go on investing in marketable securities from the opening cash balance until the expectation, that the ending cash balance will be below the optimum cash balance, where the ratio of the incremental net return per rupee of investment is equal to the incremental shortage cost per rupee.
III. Strategy for Economizing Cash:
Once cash flow projections are made and appropriate cash balances are established, the finance manager should take steps towards effective utilization of available cash resources. A number of strategies have to be developed for this purpose. They are:
Illustration 23
United Industries Ltd. projects that cash outlays of ₹ 37,50,000 will occur uniformly throughout the coming year. United plans to meet its cash requirements by periodically selling marketable securities from its portfolio. The firm’s marketable securities are invested to earn 12% and the cost per transaction of converting securities to cash is ₹ 40.
Solution:
Illustration 24
The Cyberglobe Company has experienced a stochastic demand for its product. With the result that cash balances fluctuate randomly. The standard deviation of daily net cash flows is ₹1,000, The company wants to impose upper and lower bound control limits for conversion of cash into marketable securities and vice-versa. The current interest rate on marketable securities is 6%. The fixed cost associated with each transfer is ₹1,000 and minimum cash balance to be maintained is ₹10,000.
Compute the upper limit, return point and average cash balances.
Solution:
Long-term sources of finance primarily support fixed assets and secondarily provide the margin money for working capital. Whereas, short-term sources of finance more or less exclusively support the current assets. The need for working capital financing mainly because the investment in working capital/current assets i.e., raw materials, work-in-progress, finished goods and receivables which are typically fluctuates during the year. The main sources of working capital finance are shown below in a diagram.
The two important sources of finance for working capital are: (a) trade credit and (ii) bank credit or borrowings. Other sources of finance for working capital are (c) factoring and (d) commercial paper.
a. Trade Credit
Trade credit represents the credit extended by the supplier of goods and services. In practice, the purchasing firms do not have to pay cash immediately for the purchase made. This deferral of payments is a short-term financing that is called trade credit. Trade credit arises in the normal transactions of the firm without specific negotiations, provided the firm is considered creditworthy by its supplier. It is an important source of finance representing 25% to 50% of short-term financing in different industries. Trade credit is mostly an informal arrangement and is granted on an open account basis. Open account trade credit appears as sundry creditors known as accounts payable. Trade credit may also take the form of bills payable.
b. Bank Credit/ Borrowings
Working capital advances by commercial banks represents the most important source for financing current assets. In India, banks may give financial assistance in different shapes and forms. The usual form of bank credits are as follows:
These are discussed below:
c. Commercial Paper
Commercial paper is an unsecured, short-term promissory note issued by highly reputed and credit rated companies, mostly on a discount basis. Generally, large firms with considerable financial strength are able to issue commercial paper. Features, issuers and other aspects of commercial paper are discussed in section 6.3.3.
d. Factoring
Factoring, as a fund based financial service, provides resources to finance receivables as well as facilities the collection of receivables. It is another method of raising short-term finance through accounts receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediate payment for sales made on credit. A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it. Factors render services varying from bill discounting facilities offered by commercial banks to a total take-over of administration of credit sales including maintenance of sales ledger, collection of accounts receivables, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients. Factoring, may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, factoring in India is rendered by only a few financial institutions on a recourse basis. However, the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve Bank of India has recommended that banks should be encouraged to set up factoring divisions to provide speedy finance to the corporate entities.
In spite of many services offered by factoring, it suffers from certain limitations. The most critical fall outs of factoring include (i) the high cost of factoring as compared to other sources of short-term finance, (ii) the perception of financial weakness about the firm availing factoring services, and (iii) adverse impact of tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future sales.
6.1 Monthly Cash Flow Forecast and Analysis
Cash forecasting may be made on short or long-term basis. Generally, forecasts covering periods of one year or quarterly or monthly or less are considered short-term; those extending beyond one year are considered long-term. A monthly cash flow forecast is focused on the month-to-month management of cash and liquidity of the organisation.
The objectives of monthly cash flow forecasts are:
The monthly or short-term cash flow forecast helps in determining the cash requirements for a predetermined period to run a business. If the cash requirements are not determined, it would not be possible for the management to know how much cash balance is to be kept in hand, to what extent bank financing be depended upon and whether surplus funds would be available to invest in marketable securities.
To know the operating cash requirements, cash flow projections have to be made by a firm. There is hardly a perfect matching between cash inflows and outflows during the period. With the short-term cash forecasts, however, the financial manager is enabled to adjust these differences in favour of the firm.
One of the significant roles of the monthly cash flow or short-term forecasts is to pinpoint when the money will be needed and when it can be repaid. If monthly cash flow forecasts prepare properly, then it will not be difficult for the financial manager to negotiate short-term financing arrangements with banks. In that case, convince to the bankers about the ability of the management to run its business would be easier. Further, monthly or short-term cash flow forecasts is to help in managing the investment of surplus cash in marketable securities. Efficiently designed monthly cash flow forecast helps a firm to: (i) select securities with appropriate maturities and reasonable risk, (ii) avoid over and under-investing and (iii) maximize profits by investing idle money.
Monthly or Short-term Cash Flow Forecasting Methods
Two most commonly used methods of monthly or short-term cash forecasting are:
i. Receipt and Disbursements Method
This method is generally used to forecast for limited periods, such as a week or a month. Under this method, the cash flows can be compared with budgeted income and expense items. The salient objectives of this method are to summarize the cash flows during a pre-determined period, may be, monthly or quarterly. In case of some companies where each item of income and expense involves flow of cash, this method is favoured to keep a close control over cash.
The benefits of the receipt and disbursements methods are:
This method, however, suffers from the following limitations:
Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be delayed, or unanticipated demands may cause large disbursements.
ii. Adjusted Net Income Method
Adjusted net income method is sometimes called the sources and uses approach. This method is preferred for longer durations ranging from a few months to a year. This is a cash budgeting method that determines an organization’s cash flow by adjusting its net earnings on a cash basis. This method is appropriate in showing a company’s working capital and future financing needs. This method can be applied only in situations when a company’s net income is calculated for a period longer than half a year.
However, two objectives of the adjusted net income approach are: (i) to project the company’s need for cash at a future date and (ii) to show whether the company can generate the required funds internally, and if not, how much will have to be borrowed or raised in the capital market.
The benefits of the adjusted net income method are:
The major limitation of this method is:
6.2 Maximum Permissible Bank Finance (MPBF) Calculation
Maximum Permissible Banking Finance (MPBF) in Indian Banking Sector is mainly a method of working capital assessment. The Reserve Bank of India (RBI) has been trying, particularly from the mid-1960s onwards, to bring a measure of discipline among industrial borrowers and to redirect credit to the priority sectors of the economy. From time to time, the RBI issues guidelines and directives relating to matters like the norms for inventory and receivables, the MPBF, the form of assistance, the information and reporting system, and the credit monitoring mechanism. The important guidelines and directives have stemmed from the recommendations of various committees such as the Dehejia Committee, the Tandon Committee and the Chore Committee.
However, in recent years, in the wake of financial liberalization, the RBI has given freedom to the boards of individual banks in all matters relating to working capital financing.
From the mid-eighties onwards, special committees were set up by the RBI to prescribe norms for several other industries and revise norms for some industries covered by the Tandon Committee.
Dehejia Committee Report
The committee analysed the deficiencies of the then existing system of bank lending, based on cash credit system in 1968. The committee concluded that the diversion of bank finance for the acquisition of fixed and other non- current assets was made possible by the banker’s fixation on security under the cash credit lending system. The committee found that while theoretically commercial bank lending was for short-term purposes, in actual practice, it was not so. According to their report, a large part of bank lending was really long-term in character, and was repayable on demand only in name.
The major weaknesses in the then existing system of working finance to industry, as pointed out by the Dehejia Committee and again identified by the Tandon Committee, are summarized below:
Tandon Committee Report
The recommendations of the Dehejia Committee regarding plugging the loop holes in the existing credit system and change in the lending policy of the banks remained unimplemented. As a result, banks ‘oversold credit’ and large part of it remained unutilized. There was no exchange of information between the banks and the customer. The Reserve Bank in July, 1974, formed a committee under the chairmanship of Shri P.L. Tandon, then Chairman of the Punjab National Bank to review the system.
The recommendations of the Tandon Committee are based on the following notions:
Major recommendations of the committee are being summarized below:
The Tandon Committee Report has been widely debated and criticized. At the same time, it is true that bankers found difficulties in implementing the committee’s recommendations. However, the Tandon Committee report has brought about a perceptible change in the outlook and attitude of both the bankers and their customers. The report has helped in bringing a financial discipline through a balanced and integrated scheme for bank lending.
Methods of Maximum Permissible Bank Finance (MPBF)
The Tandon Committee suggested three methods of assessing Maximum Permissible Bank Finance which are discussed below:
First Method
In this method, the borrower will contribute 25 % of the working capital gap; the remaining 75 % can be financed from bank borrowings. This method will give a minimum current ratio of 1:1.
| Thus, the MPBF: 0.75 (CA-CL)-CL |
| Current Ratio will be: CR: { CA / (CL + MPBF) } |
| Current Ratio will be: CR: |
Second Method
In the second method, the borrower will contribute 25% of the total current assets. The remaining of the working capital gap (i.e., the working capital gap less the borrower’s contribution) can be bridged from the bank borrowings. This method will give a current ratio of 1.3:1.
| Particulars | 1st Methods (₹) | 2nd Method (₹) |
| Current Assets (CA) | 100 | 100 |
| Current liabilities, excluding bank borrowings, (CL) | 20 | 20 |
| Working Capital Gap (CA-CL) [A-B] | 80 | 80 |
| Borrower's Contribution |
20 20% of (C) |
25 25% of (A) |
| Permissible Bank Finance (C-D) | 60 | 55 |
The permissible bank borrowings with an example of above two methods are shown below:
Third Method
In the third method, borrower will contribute 100 % of core assets, as defined and 25 % of the balance of current assets. The remaining of the working capital gap can be met from the borrowings. This method will further strengthen the current ratio.
After introducing the new system of lending, in some cases the net working capital was negative while in others it was equal to 25% of working capital gap. Then the Committee allowed this deficiency to be financed, in addition to the permissible bank finance, by banks. However, it was regularized over a period of time depending upon the funds generating capacity and ability of the borrower. This type of credit facility was called working capital term loan. Generally, the working capital term loan was not allowed to be raised in the subsequent years. For additional credit requirement arising in subsequent years, the borrower’s long-term sources were required to provide 25% of the additional working capital gap. The banks could grant regular term loans against fixed assets.
Illustration 25
Compute “Maximum Bank Borrowings” permissible under Method I, II & III of Tandon Committee norms from the following figures and comment on each method.
| Current Liabilties | ₹ in lakh | Current Assets | ₹ in lakh |
| Creditors for purchases 200 | Raw materials | 400 | |
| Other Current liabilities 100 | 300 | Work in progress | 40 |
| Bank borrowings including bills discounted with bankers | 400 | Finished goods | 180 |
| Receivable including bills discounted with bankers | 100 | ||
| Other current assets | 20 | ||
| Total | 700 | Total | 740 |
Assume core current assets are ₹190 lakhs.
Solution:
Chore Committee Report
In April 1979, the Reserve Bank of India constituted a working group to review the system of cash credit under the chairmanship of Mr. K.B. Chore. The main terms of reference for the group were to review the cash credit system and suggest modifications and/or alternate types of credit facilities to promote greater credit discipline and relate credit limits to production. The major recommendations of the Committee are as follows:
6.3 Commercial Paper
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
However, the important features of commercial paper are as follows:
Hence, there is no well-developed secondary market for commercial paper.
Commercial Paper: Eligibility, Use and Maturity
Eligibility and Use
In India, the Reserve Bank of India regulates the issue of commercial papers. Those companies are allowed to issue commercial papers which have a tangible net worth of ₹5 crore, i.e., ₹50 million, the fund based working capital limit of not less than ₹5 crore, and the firm should be listed and it is required to obtain necessary credit rating from credit rating agencies. The minimum current ratio should be 1.33:1. All issue expenses will be borne by the issuing company. These norms imply that only the large, highly rated companies are able to operate in the commercial paper market in India.
The Vaghul Working Group had recommended that the size of a single issue should be at least ₹1 crore and the size of each commercial paper should not be less than ₹5 lakh. The RBI had provided for the minimum issue of ₹25 lakh (rather than ₹5 lakh as recommended by the Vaghul Committee)
Maturity Period
As per the RBI Guidelines, initially, corporates were permitted to issue CP with a maturity between a minimum of three months and a maximum of upto six months from the date of issue. Since October 18, 1993, the maximum maturity period of CP was increased to less than one year. Subsequently, the minimum maturity period had been reduced from time to time and since May 25, 1998, it was reduced to 15 days. Presently, CP can be issued for maturity period between a minimum of 15 days and a maximum upto one year from the date of issue.
In USA, there is no prescription of minimum and maximum maturity period of CP but for practical matter, it is limited upto 270 days. However, 1-day to 7-day CPs are very popular of which 1-day CP constitutes the substantial component of the CP market. In UK also, there is no restriction but in France, initial maturity ranges from 1 day to upto 1 year.
Cost
Though the Reserve Bank of India regulates the issue of commercial paper, the market determines the interest rate. In USA, the interest rate on a commercial paper is a function of prime lending rate, maturity, credit-worthiness of the issuer and the rating of the paper provided by the rating agency.
In India, the cost of a CP will include the following components:
Interest rate on commercial paper is generally less than the bank borrowing rate. A firm does not pay interest on commercial paper rather sells it at a discount rate from face value. The yield of commercial papers can be calculated as follows:
Interest yield = ( face value - sale price ) / ( Sale price x 360 days / Days of maturity )
Suppose a firm sells 120-day commercial paper (₹100 face value) for ₹96 net, the interest yield will be 12.5%.
Interest yield = ( ₹ 100 - ₹ 96 / ₹ 96 ) x ( 360 days / 120 days )
= 0.125
= 12.5%
Interest on CP is tax deductible: therefore, the after-tax interest will be less. Assuming that the firm’s marginal tax rate is 35 %, the after-tax interest yield is 8.13%.
Therefore, interest yield after tax = 0.125 (1 – 0.35) = 0.0813 or 8.13%.
Illustration 26
XYZ Ltd. issued commercial paper as per the following details:
Date of issue 17th December, 2022
Date of Maturity 17th March, 2022
Size of issue ₹10 crore
No. of Days 90 Days
Interest rate 11.25%
Face value ₹100
What was the net amount received by the company on issue of commercial paper?
Solution:
6.4 Export Financing - Pre shipment and Post shipment packing credit
Export finance is a process of funding the exporters to facilitate their business in the global market. In simple words, it is a cash flow solution for exporters to cater to their production and other global transaction requirements including working capital. International businessmen require export finance when they want to assure the affordability of the production of goods along with an assurance of getting paid on-time while sending goods to another country.
Importance of Export Finance
Export finance services help the exporters mitigate their risk of default of payment on the hands of the importers as well as fills the gap between manufacturers and overseas suppliers. The exporter agrees on the payment terms of the importer and ships the goods overseas but the payment is at risk to be received later. Export finance allows the businesses to sell their goods & services to another country and enables them to get access to working capital requirements before the importer pays the amount for the purchased products.
There are several other reasons to get export finance such as:
Types of Export Finance/Credit
Export finance can broadly be classified under tow heads:
Pre-shipment Finance:
This includes –
Post-shipment Finance:
This consists of -
Pre-shipment Export Credit or Packing Credit
‘Pre-shipment / Packing Credit’ means any loan or advance granted or any other credit provided by a bank to an exporter for financing the purchase, processing, manufacturing or packing of goods prior to shipment / working capital expenses towards rendering of services on the basis of letter of credit opened in his favour or in favour of some other person, by an overseas buyer or a confirmed and irrevocable order for the export of goods / services from India or any other evidence of an order for export from India having been placed on the exporter or some other person, unless lodgement of export orders or letter of credit with the bank has been waived. Packing credit is sanctioned/granted on the basis of letter of credit or a confirmed and irrevocable order for the export of goods / services from India or any other evidence of an order for export from India.
Pre-shipment Finance is issued by a financial institution when the seller wants the payment of the goods before shipment. The main objectives behind pre-shipment finance or pre-export finance are to enable exporter to:
Requirement of getting Packing Credit
This facility is provided to an exporter who satisfies the following criteria
Packing credit facility can be provided to an exporter on production of the following evidences to the bank:
The confirmed order received from the overseas buyer should reveal the information about the full name and address of the overseas buyer, description quantity and value of goods (FOB or CIF), destination port and the last date of payment.
Eligibility
Pre shipment credit is only issued to that exporter who has the export order in his own name. However, as an exception, financial institution can also grant credit to a third-party manufacturer or supplier of goods who does not have export orders in their own name.
In this case some of the responsibilities of meeting the export requirements have been out sourced to them by the main exporter. In other cases where the export order is divided between two more than two exporters, pre shipment credit can be shared between them.
Post-shipment Export Finance
Post-shipment finance or credit means any loan or advance granted or any other credit provided by a bank to an exporter of goods / services from India from the date of extending credit after shipment of goods / rendering of services to the date of realisation of export proceeds as per the period of realization prescribed by Reserve Bank of India (RBI). This includes any loan or advance granted to an exporter, in consideration of, or on the security of any duty drawback allowed by the Government from time to time. As per extant guidelines of RBI, the period prescribed for realisation of export proceeds is 12 months from the date of shipment.
Post-shipment advance can mainly take the form of -
i. Export bills purchased/discounted/negotiated
In the first two instances, the exporter submits the bill of lading or airway bill, commercial invoice, packing list, certificate of origin, purchase order and other necessary export documents with the bank. The bank extends post-shipment credit at a concessional interest rate by purchasing or discounting these bills. In the third option (export bills negotiated), finance is provided under a letter of credit – a document issued by the importer’s bank (called an issuing bank) as a promise to pay the exporter an agreed upon sum of money. Post-shipment credit under a letter of credit is considered more secure as the issuing bank guarantees payment to the lending bank.
ii. Advances against bills for collection
Instead of submitting export bills for discount or purchase, the exporter may arrange for them to be sent to the overseas buyer for collection of payment. In such a scenario, the bank grants the exporter an advance against a portion of the collection bills. When payment is received from the importer, it is credited as post- shipment credit. Exporters use this option when there are discrepancies in bills drawn under the letter of credit.
iii. Advances against duty drawback receivable from Government
In India, duty drawback is a government scheme that supports exports by offering exporters a rebate on customs and excise duties charged on imported or excisable material used in the production of goods meant for export. It is disbursed by the customs department on submission of export documents. Banks offer credit against such duty drawback receivable from the government after confirming the exporter’s eligibility. The lending bank must also be authorized to receive the claim amount from the concerned government authority.
iv. Advance against export on consignment basis
Banks also extend post-shipment credit against exports made on consignment basis – which means the exporter ships the goods to an agent, who sells the goods and makes remittances to the exporter as and when the goods are sold. The exporter receives payment only for the quantity that gets sold. Precious and semi- precious stones, tea, coffee, and wool are examples of goods exported on consignment basis. To avail of post-shipment credit against such exports, the exporter must provide an undertaking that the sales proceeds will be delivered by a specified date. The advance is adjusted against the proceeds realized later.
v. Advance against undrawn balance
In some cases, exporters leave a small portion of the invoice value undrawn for final adjustments towards differences in exchange rates, consignment weight, quality factors, and so on. This undrawn balance is usually 10 % of the total invoice value. Banks offer advances against undrawn balances provided the exporter gives an undertaking that they will make good on the balance amount within six months of the payment due date or date of shipment, whichever is earlier. The lender also takes into account the importer’s track record before making such an advance.
Who can get post-shipment finance?
What documents are required for post-shipment credit?
An exporter will be expected to submit shipping documents that serve as evidence that the goods have been shipped for export. These include:
Apart from these documents, the lender might demand additional documents depending on the type of post-ship- ment credit availed.
Soled Case 1
From the following projections of XYZ Ltd for the next year, you are required to work out the working capital (WC) required by the company. (₹)
| Annual Sales | 14,40,000 |
| Cost of production including depreciation | 12,00,000 |
| Ra material purchases | 7,05,000 |
| Monthly expenses | 30,000 |
| Anticipated opening stock of raw material | 1,40,000 |
| Anicipated closing stock of raw material | 1,25,000 |
| Inventory norms: | |
| Raw material (month) | 2 |
| Work-in-progress | 15 |
| Finished goods (months) | 1 |
The firm enjoys a credit of 15 days on its purchases, and allows 1 month’s credit on its supplies. The company has received an advance of ` 15,000 on sales orders.
You may assume that production is carried on evenly throughout the year, and the minimum cash balance desired to be maintained is ` 10,000.
Solution:
Solved Case 2
XYZ Ltd. sells its products on a gross profit of 20 % on sales. The following information is extracted from its annual accounts for the current year ended March 31. (₹)
| Sales at 3 months' credit | 40,00,000 |
| Raw material | 12,00,000 |
| Wages paid-average time lag 15 days | 9,60,000 |
| Manufacturing expenses paid-one months in arrears | 12,00,000 |
| Administrative expenses paid-one months in arrears | 4,80,000 |
| Sales production expenses-payable hald-yearly in advance | 2,00,000 |
The company enjoys one month’s credit from the suppliers of raw materials and maintains 2-month’s stock of raw materials and months’ stock of finished goods. The cash balance is maintained at ₹1,00,000 as a precautionary measure. Assuming a 10 % margin, find out the working capital requirements of XYZ Ltd.
Solution:
Solved Case 3
ABC Ltd wishes to arrange for overdraft facilities with its bankers during the period April to June of a particular year when it will be manufacturing mostly for stock.
a. Prepare a cash budget for the above period from the following data, indicating the extent of bank facilities the company will require at the end of the each month.
| Month | Sales ₹ | Purchases ₹ | Wages ₹ |
| February | 1,80,000 | 1,24,000 | 12,000 |
| March | 1,92,000 | 1,44,000 | 14,000 |
| April | 1,08,000 | 2,43,000 | 11,000 |
| May | 1,74,000 | 2,46,000 | 10,000 |
| June | 1,26,000 | 2,68,000 | 15,000 |
b. 50% of the credit sales are realised in the month following the sales, and the remaining sales in the second month following; creditors are paid in the month following the purchase.
c. Cash in bank on April 1 (estimated) ₹ 25,000.
Solution:
A. Theorectical Question:
1. Working capital is calculated as
Answer: d. Liquid assets less current liabilities
2. The basic current liabilities are
Answer: d. accounts payable and bills payable
3. There are two concepts of working capital – gross and
Answer: b. Net
4. Working capital is also known as
Answer: b. Operating
5. working Capital refers to the firm’s investment in current
Answer: c. Gross
6. In finance, “working capital” means the same thing as
Answer: a. Current
7. working capital refers to the difference between current assets and current
Answer: b. Net
8. A net working capital will arise when current assets exceed current liabilities.
Answer: d. Positive
9. A net working capital occurs when current liabilities are in excess of current
Answer: b. Negative
10. is not an advantages of trade credit.
Answer:
11. refers to the funds, which an organisation must possess to finance its day to day
Answer: c. Working Capital
12. Investment in current assets should be
Answer: a. just adequate
13. varies inversely with
Answer: c. Liquidity
14. Capital intensive firms rely on
Answer: a. debt
15. On the basis of , working capital is classified as gross working capital and net working
Answer: a. concept
16. cycle analyzes the accounts receivable, inventory, and accounts payable cycles in terms of a number of days?
Answer: d. Operating
17. method is not used for calculating working capital
Answer: a. Trial and error method
18. On the basis of , working capital may be classified as: 1) Permanent or fixed working 2) Temporary or variable working capital.
Answer: b. time
19. Operating cycle is also called as
Answer: b. Working capital cycle
20. Spontaneous financing consists of
Answer: d. accounts payable
21. Conversation of marketable securities into cash entails a fixed cost of ₹1,000 per What will be the optimal conversation size as per Baumol model of cash management?
Answer: b. ₹ 316,228
22. Average collection period is 2 months, cash sales and average receivables are ₹5,00,000 and ₹6,50,000 The sales amount would be-
Answer: c. ₹ 44,00,000
23. If the current ratio is 4:1 and working capital is ₹25,20,000, find the amount of current assets and current liabilities.
Answer: a. Current Assets ₹ 43,20,000 and Current Liabilities ₹ 18,00,000
24. X distributes its products to more than 500 retailers. The company’s collection period is 30 days and keeps its inventory for 20 days. The operating cycle would be
Answer: d. 50 Days
1. What do you mean by Working Capital?
Answer:
2. Discuss different types of Working Capital.
Answer
3. What are the significances of Working Capital Management?
Answer:
4. Explain in brief the Working Capital Cycle and Cash Cycle.
Answer:
5. Discuss the importance of Receivables Management.
Answer:
6. What do you mean by Payable Management?
Answer:
7. What do you mean by Inventory Management?
Answer:
8. State the objectives of Cash Management
Answer:
9. Write a short note on ‘Monthly Cash Flow Forecast’.
Answer:
10. How to calculate Maximum Permissible Bank Finance (MPBF)?
Answer:
11. Write a short note on Commercial Paper.
Answer:
1. Discuss different models of Cash Management.
Answer:
2. What is Export Financing? Discuss about Pre-Shipment and Post-Shipment Packing Credit.
Answer:
3. How are net working capital, liquidity, technical insolvency, and risk related?
Answer:
4. What is the basic premise of the hedging approach for meeting funds requirements? What are the effects of this approach on the profitability and risk?
Answer:
5. What is the conservative approach to financing funds requirements? What kind of profitability-risk trade-off is involved?
Answer:
6. If a firm has constant funds requirement throughout the year, which, if any, of the three financing plans is preferable? Why?
Answer:
7. Length of operating cycle is a major determinant of working capital needs of a business Explain.
Answer:
8. Distinguish between: (a) Gross working Capital and Net Working Capital, (b) Permanent and Temporary Working Capital (c) Production and Operating Cycle.
Answer:
B. Numerical Questions:
1. ABC has the following selected assets and liabilities: (₹)
| Cash | 45,000 |
| Retained earnings | 1,60,000 |
| Equity share capital | 1,50,000 |
| Debtors | 60,000 |
| Inventory | 1,11,000 |
| Debentures | 1,00,000 |
| Provision for taxation | 57,000 |
| Expenses outstanding | 21,000 |
| Land and building | 3,00,000 |
| Goodwill | 50,000 |
| Furniture | 25,000 |
| Creditors | 39,000 |
You are required to determine (i) gross working capital, and (ii) net working capital.
Answer:
2. While preparing a project report on behalf of a client, you have collected the following Estimate the net working capital required for that project. Add 10% to your computed figure to allow for contingencies.
| Estimated cost per unit of production | (₹) |
| Raw material | 80 |
| Direct labour | 30 |
| Overheads (exclusive of depreciation) | 60 |
| Total | 170 |
Additional Information
You may assume that the production is carried on evenly throughout the year (52 weeks) and wages and over- heads accrue similarly. All sales are on credit.
Answer:
3. The balance sheet of X Ltd. stood as follows as on March 31 of the current year.
| Liabilities | (₹ ) | Assets | (₹ ) |
| Current liabilities (CL) | 2,000 | Current assets | 8,000 |
| Long-term funds | 22,000 | Fixed assets | 16,000 |
| 24,000 | 24,000 |
If Current assets earn 2%, Fixed assets earn 14%, Current liabilities cost 4% and long-term funds cost 10%, calculate (a) total profits on assets and the ratio of Current assets to total assets, (b) the cost of financing and the ratio of Current liabilities to total assets, and (c) net profitability of the current financial plan.
Answer:
4. Prudential has investigated the profitability of its assets and the cost of its funds. The results indicate:
The current balance sheet is as follows
| Liabilities | (₹ ) | Assets | (₹ ) |
| Current liabilities (CL) | 2,000 | Current assets | 8,000 |
| Long-term funds | 22,000 | Fixed assets | 16,000 |
| 24,000 | 24,000 |
Answer:
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