Académique Documents
Professionnel Documents
Culture Documents
Session 8
Operating Cycle
Operating cycle
WCC is defined as the time period required for the whole operation starting with cash to cash plus (assumes profit). It expresses in month days. Operating cycle - OC is equal to the length of inventory and receivables conversion period. OC = R + W + F + D C R = Raw material W = Work in process F = Finished goods waiting period D = Debtors collection period C = Creditors payment period. It helps not only in forecasting working capital requirement but
+ = +
Inventories Raw Material Work in progress Finished goods
Gross WC = all current assets Net WC = current assets current liabilities Current assets;
Inventories
Raw material Work in progress Finished goods Others
Current liabilities
Sundry creditors Trade advances
Helps in arranging loans from banks & others on easy and favourable terms Enables a concern to avail cash discount and hence reduce cost. Ensures regular supply of raw material. Regular payment of salaries, wages and other day to day comittment. Enables a concern to face business crisis.
Excess or Inadequate WC
Ideal funds. Loss of return on investment It may lead to unnecessary purchasing & accumulation of inventories. It may implies to defective credit policy or liberal policy
Growth and expansion activities Price level changes Inventory policy Dividend policy
Nature of Business
Nature of Business Small trading concern or retail shop Requirement of WC Small Reason Operating cycle period is small sinceMostly cash sales Carry small quantities of goods Small debtors balance Carry small amount of cash Operating cycle period is small sinceLarge quantity of stock Carry large amount of cash and debtors balance Carry large quantity of raw material, work in progress, finished goods, debtors and cash
Large
Manufacturing firm
Large
Nature of business Public utility (electricity generation and supply, water supply) Hotels, Restaurants and eating houses
Requirement of WC Small
Reason They have cash sales They supply services and not products They mostly have cash sales and only small amount of debtors balance They require large quantities of goods to be held in stock They carry large debtors balance They carry large debtors balance
Small
Trading firms
Large
Financial firms
Large
Production policy
Production of ceiling fan through out the year
Market condition
Depends on competition.
Disadvantages of excess Working Capital Ideal funds Unnecessary purchasing Inefficiency in the organisation Due to low rate of return on investment, market value of shares may fall. Disadvantages of short Working Capital Cant pay off short term liabilities Difficult for firm to exploit favourable market conditions Improper utilisation of fixed assets.
Step 1:Make the estimates of various current assets as follows: Stock of = est annual cost of RM to be consumed x avg RM holding period raw mat. 12 months or 365 days Stock of = est annual cost of goods to be produced x avg WIP holding period WIP 12 months or 365 days Stock of = est annual cost of goods to be produced x avg FG storage period Fin Goods. 12 months or 365 days Average = estimated annual cost of credit sales x avg collection period Trade debtor 12 months or 365 days Cash and bank balance = minimum as desired by the firm
Step 3: make estimate of WC by taking out the difference between the current asset and current liability
RECEIVABLES MANAGEMENT
Session 8
Receivables Management
Receivables management means planning, directing and controlling of receivables. It answers the following questions:
To whom credit should be allowed How much credit should be allowed How much amount of credit should be alloed
What are receivables? Receivables are sales made on credit basis. Receivab les Operating Cycle
Cash
Understanding Receivables As a part of the operating cycle Time lag b/w sales and receivables creates need for working capital Inventory
GRANTING CREDIT
Basic decisions
S MANAGEMENT
Decision based on cost-benefit analysis Positive net benefit-Credit granted (Highest Net benefit policy chosen) Negative net benefit- Credit not granted
COLLECTION COST: Administrative costs incurred in collecting the accounts receivable. CAPITAL COST: Cost incurred for arranging additional funds to support credit sales. DELINQUENCY COST: Cost which arises if customers fail to meet their obligations. DEFAULT COST: Amounts which have to written off as bad debts.
S MANAGEMENT
The 5 Cs of Credit
Customer Evaluation- The 5 Cs Character- Reputation, Track Record Capacity- Ability to repay( earning capacity) Capital- Financial Position of the co. Collateral- The type and kind of assets pledged Conditions- Economic conditions & competitive factors that may affect the
profitability of the customer
To get info on the 5 Cs a firm may rely on: Financial statement Bank references Experience of the firm Prices and Yields on securities
Direct Credit Information Exchanges provide participants with credit information Bank Checking may provide vague credit information (from the applicant's bank)
FCU check
Credit Standards
Credit Terms
Collection Efforts
1.Credit Standard
Credit Standards are the minimum requirements for extension of credit to a customer Liberal Credit Standards
Push sales by attracting more customers, higher incidence of bad debts loss, a larger investment in receivables, higher collection expenses.
Stiff credit standards
Opposite effect
Credit Standard
Standard Effect on sales Effect on Effect on credit bad debts administration cost Increase in credit administration cost
Soft Increase in Increase standards sales in Bad debts Tight Decrease standards in sales
Credit Term
Credit Period
It is the length of time for which credit is granted net 60
Cash Discount
2/20 net 60
Effect on Effect on investment bad debts in accounts receivables Increase in Increase in investment bad debts in accounts receivables
Soft Term
Increase in sales
Tight Term
Decrease in Decrease in Decrease in Decrease sales investment bad debts in accounts receivables
Collection Efforts
Monitoring the state of receivables Dispatch of letter to customers whose due date is approaching Telegraphic and telephone advice around due date. Threat of legal action to overdue accounts. Legal action against overdue accounts. A rigorous collection programme
Decreases sales, shorten the average collection period, reduce bad debts %, increase the collection expenses.
A lax collection programme
Opposite influence
Collection Policy
Collection Policy is the set of procedures for collecting a firm's accounts receivable when they are due Introduction
Bad debt expenses are a function of both credit policy and collection policy
In general, increasing collection expenditures reduce bad debt
Particular
Pres.policy
Pro policy
A. Incremental Expected Profit: 1. Incremental Credit sales 2. Incremental Credit Cost( VC & FC) 3. Incremental Bad debts losses 4. Incremental Cash discount 5. Incremental Expected profit 6. Less tax 7. Incremental Profit after tax B.Req return on incremental investments: 1. Cost of credit sales 2. Collection period 3. Investment in recievabless (1 x 2/365) 4. Incremental investment in rec. 5. Req rate of return 6. Req rate of return on incremental investment (4 x 5)
Inventory Management
Inventory Management
It means planning, organising, directing and controlling of inventory. How much inventory should be ordered at a particular point of time? It answers:
How much to order When to place an order
EOQ
It is the order which is placed when the stock reaches re-order level. EOQ refers to the quantity of inventory, at which total of ordering and carrying cost is minimum. The objective of EOQ is to determine that order size which is most economical to order
Ordering cost
Carrying cost
The term ordering cost refers to the cost The term carrying cost refers to the cost incurred for aquiring inputs. These cost incurred in maintaining a given level of includes: inventory. These cost includes: 1. Cost of placing an order 2. Cost of transportation 1. Cost of storage cost 3. Cost of receiving goods 2. Cost of handling material 4. Cost of inspecting goods 3. Cost of Insurance 4. Cost of obsolescence There is inverse relation with ordering 5. Cost of store staff cost and ordering size There is positive relationship between order size and carrying cost Larger the order size Lower the ordering Larger the order costs because of size fewer order Higher the carrying costs because of high average inventory Lower the carrying costs because of low average inventory
Assumptions of EOQ
Annual usage (consumption) of inventory is known Rate of usage is known and constant Ordering cost are known and constant Carrying cost are known and constant Zero lead time/ delivery peroid.
Formula
EOQ = AO C
A = annual consumption of Input O = ordering cost per order C = carrying cost per unit No. of orders per year = total annual consumption (in units) / order size Frequency of orders = 365 days / No. of orders in a year Total annual ordering & carrying cost at EOQ = 2AOC
Inventory Management
Session 7
Re-order Quantity
EOQ
Reorder Level
The objective of fixing re order level is to determine when fresh order should be placed. ROL = Maximum rate of consumption X max re order period
Maximum level
It is that level of stock above which the stock in hand should not normally be allowed to exceed. It is the largest quantity of a particular material which may be held in the store at anytime. Objective is to avoid the cost of over stocking cost of storage, insurance,risk etc
Max level = Re-order level + Re-order quantity (minimum consumption x min reorder period)
Minimum level
It is the lowest quantity of a particular material which must be held in the store at all time. The objective of fixing the min. level is to avoid the costs of under stockingsuch ascost of stoppage of production, cost of idle labour , cost of idle plant & machinery.
Formula: Min level = Re-order Level (Normal consumption x normal re-order period)
Danger level
It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made on special requisition approved by the authority The level is fixed after considering following factors:
Average consumption Max re-order period for emergency purchases
ABC Analysis
ABC analysis is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved.
Catego Composition ry A
Degree of control High degree of control is exercised by use of various techniques such as fixing stock level like max level, min level, reorder level. Moderate degree of control is exercised. Order are placed on a periodic review basis
It consist of those items which require relatively moderate investments ( say about 20% of total value of stores) but constitute relatively moderate percentage (say 20%) of total items of stores It consist of those items which require small investments ( say about 10% of total value of stores) but constitute a large percentage (say 70%) of total items of stores
Lower degree of control is exercised. Order of large size are placed either after 6 months or once in a year to minimize ordering costs and to take advantage of bulk purchase
ABC Analysis
Inventory Management
Inventory is necessary to permit the production-sale process to operate with a minimum of disturbance Inventory may represent as much as 42% of a typical manufacturing firm's current assets and about 18% of its total assets Inventory is commonly under the control of the production/operations manager, but the financial manager generally acts as a watchdog and advisor in matters concerning inventory
Inventory Fundamentals
Types of Inventory include: Raw materials used in the manufacture of finished products Work-in-process which consists of items in production Finished goods which are produced but not yet sold Differing Viewpoints About Inventory Level Financial Manager: low levels to minimize cost Marketing Manager: high levels to minimize stockouts and maximize customer service Manufacturing Manager: high levels to ensure timely and low-cost production Purchasing Manager: high levels (of raw materials) to secure low cost per unit and ensure ready availability