MODULE 5 SHORT-TERM FINANCING AND INVESTMENT DECISIONS In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day operations of a concern. This is related to short-term assets and short-term sources of financing. Hence it deals with both assets and liabilities—in the sense of managing working capital itis the excess of current assets over current liabilities. Concept of Working Capital The funds invested in current assets are termed as working capital. It is the fund that is needed to run the day-to-day operations. It circulates in the business like the blood circulates in a living body. Generally, working capital refers to the current assets of a company that are changed from one form to another in the ordinary course of business, i.e. from cash to inventory, inventory to work in progress (VIP), WIP to finished goods, finished goods to receivables and from receivables to cash. There are two concepts in respect of working capital: 1. Gross working capital and 2. Net Working capital. Gross Working CapitalThe sum total of all current assets of a business concern is termed as gross working capital. So, Gross working capital = Stock + Debtors + Receivables + Cash. Net Working Capital The difference between current assets and current liabilities of a business concem is termed as the Net working capital. Hence, Net Working Capital = Stock + Debtors + Receivables + Cash — Creditors — Payables. Nature of Working Capital The nature of working capital is as discussed below: 1. Itis used for purchase of raw materials, payment of wages and expenses. 2. It changes form constantly to keep the wheels of business moving. 3. Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise. 4. It generates the elements of cost namely: Materials, wages and expenses. 5. It enables the enterprise to avail the cash discount facilities offered by its suppliers 6. It helps improve the morale of business executives and their efficiency reaches al the highest climax. 7. St facilitates expansion programmes of the enterprise and helps in maintaining operational efficiency of fixed assets.Need for Working Capital Working capital plays a vital role in business. This capital remains blocked in raw materials, work in progress, finished products and with customers. 1, Adequate working capital is needed to maintain a regular supply of raw materials, which in turn facilitates smoother running of the production process. £ F 2. Working. capital ensures the regular and timely payment of wages and salaries, thereby. improving the morale and efficiency of employees. 3. Working.capital is heeded for the efficient use of fixed assets. 4.-In order to. enhance goodwill a healthy level of working capital is needed. It is necessary to build a good reputation and to make payments to creditors in time. ‘ 5. Working capital helps avold the possibitty of \inder: capitalization. 6. It is neéd -d to pick up stock of raw materials even during economic 7. Working capit al needed in order to pay a fair rate of dividend and interest in time, which increases ‘the confidence of the investors in the firm. Importance of Working Capital ‘ It is said that working capital i is the. lifeblood of a business. Every business “needs funds in order to run its day-to-day activities. 1. St helps measure profitability of an enterprise. In its absence, there would be neither production nor profit. 2. Without adequate working capital an entity cannot meet its short-term liabilities in time, 3. A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill4 SuScent working capital helps maintain an uninterrupted flaw of production by supplying raw materials and payment of wages § Sours’ working capital helps maintain optimum level of investment in current assets. 6 It enhances liquidity. solvency. credit worthiness and the reputation of enterprise. Prowdes necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis. Components of Working Capital: A. Current Assets These assets are generally realized within a short period of time, i.e. within one year. Current assets include: > |. Inventories or Stocks a. Raw materials b. Work in progress ¢. Consumable Stores d. Finished goods 2 Sundry Debtors 3. Bills Receivable 4. Pre-payments 5. Short-term Investments 6. Accrued income and 7. Cash and Bank BalancesB. Current Liabilities Current liabilities are those which are generally paid in the ordinary course of business within a short period of time, i.e. one year. Current liabilities include: 1. 2. 3. 4, 5. 6. 7 8. Sundry Creditors Bills Payable Accrued Expenses Bank Overdrafts Bank Loans (short-term) Proposed Dividends Short-term Loans Tax Payments Due Factors Determining the Requirements of Working Capital 1. Sales:Among the various factors, size of the sales is one of the important factors in determining the amount of working capital. In order to increase sales volume, the enterprise needs to maintain its current'assets, In the course of period, the enterprise becomes in the position to keep a steady ratio of its current assets to annual sales. As a result, the turnover ratio, i.e., current assets to turnover increases reducing the length of Operating cycle. Thus, less the operating cycle period, less will be requirements for working capital and vice versa.2. Length of Operating Cycle:Conversion of cash through various stages viz., raw material, semi-processed goods, finished goods, sales, debtors and bills receivables into cash takes a certain period of time that is known as ‘length of operating cycle’. Longer the operating cycle time, the more is the working capital required. 3. Nature of Business:The requirement of working capital also varies among the enterprises depending upon the nature of the business. For instance, trading companies require more working capital than manufacturing companies. This is because the trading business ‘requires large quantities of goods to be held in stock and also carry large amounts of working capital than manufacturing concerns.In both these types of businesses, the value of current assets is 80% to 90% of the value of total assets. The investment in current assets is relatively smaller in the case of hotels and restaurants because they mostly have cash sales, and only small amounts of debtors’ balances. 4. Terms of Credit:Another important factor-that determines the amount of working capital requirements relates to the terms of credit allowed to the customers. For instance, an enterprise may allow only 15 days credit, while another may allow 90 days credit to its customers. Besides, an enterprise may extend credit facilities to its all customers, while another enterprise in the same business may extend credit only to select and those too reliable customers only.Then, the requirements for working capital will naturally be more if the credit period is longer and credit facilities are extended to all customers, no matter how reliable or unreliable they are. This is because there will be a longer balance of debtors and that too for a relatively longer period which will obviously demand for more capital.On the contrary, if supplies of raw materials are available on favourable conditions or terms of credit i.e., the payment will be made after a relatively longer period of time, the requirement for working capital will be correspondingly smaller.§, Seasonal Variations:The seasonal enterprises, j.e., the enterprise whose operations pick up seasonally may require more working capital to meet their increased operations during the particular season. A popular example of seasonal enterprise may be sugar factories whose operations are highly seasonal. inventories are large in size but turnover is 6, Turnover of Inventories: slow, the small-scale enterprise will need more working capital. On the contrary, if inventories are small but their turnover is quick, the enterprise will need a small amount of working capital. . Nature of Production Technology:In case of labour intensive technology, the unit will need more amount to pay the wages and, therefore, will require more working capital. On the other hand, if the production _ technology is capital- intensive, the enterprise will have to make less payment for expenses like wages. As a result, enterprise will require less working capital 8. Contingencies:lf the demand for and price of the products of small- scale enterprises are subject to wide variations or fluctuations, the contingency provisioris will have to be made for meeting the fluctuations. This will obviously increase the requirements for working capital of the small enterprises. While one can add certain other factors to this list, the said factors appear to be the major ones in. determining the requirement of working capital of a small-scale enterprise. Sources of working capital 1. Public Deposits is a significant source of working capital. Itis an unsecured foan. It is taken by the company from the depositor for a short period. The maximum duration is three years. It has a high rate of interest, It is very Popular in India. All types of companies widely use it because it gives many benefits. The procedure for taking it is simple. It is very economical.Here, the company can trade on equity, the, capital becomes flezible, so on. However, it Is not suitable for all firms and is only suitable for reputed ones. . Bank Credit is also called Bank Loan. It is a well-known source of working capital. Manufacturing and trading companies use it. It is a secured loan. That is, the company first has to give some security to the bank only then the bank approves the loan. Once approved, later the company has to pay interest on the loan, Commercial and Co-operative Banks give bank credit. It is given for short and long periods. It is very lengthy and time-consuming. It involves many formalities. Therefore, many companies take private loans instead of bank foans. Banks give credit through following ways: 41, Demand Loans, 2. Advances, 3. Overdrafts, 4, Cash Credit, 5. Letter of Credit, 6. Discounting of Bills, etc. . Trade Credit; Dealers purchase goods from the company and sometimes . give an advance payment. This advance payment is called Advance from Dealers or Trade Credit. The company uses this money as a working capital. So, trade credit is another source of working capital. It is readily available. It is given for 60 to 90 days. Here, the rate of interest is low. Companies that have a monopoly in the market gets this credit. It is given for the Consumer Durable Goods like scooters, motorbikes, cars, televisions, refrigerators, etc. r4, Advance from Customers: Sometimes, customers also make an advance payment to the company. The company uses this money paid in advance as a working capital. Hence, the advance from customers is a source of working capital for it. For example, a luxury automobile manufacturer gets an advance from customers who have booked a car. Today, it is difficult to get such an advance from customers because of rising competition in the market. a . Income from Sales: The company sells its goods and earns income. This income later gets used as a working capital. Income earned. from sales is the largest source of working capital for most companies. 2 . Self Financing: The company does not distribute its all profits to the shareholders. It saves a part of profits. This saving gets used as a working capital. So, the company uses its own savings as working capital. Such behaviour is called Self Financing or Ploughing Back of. Profits. Self-financing is very economical ‘because there is no need to pay any interest. 7. Issue of Shares: The company issues shares to the public. It gets equity share capital. This equity share capital gets used as a long-term working capital. Equity share capital is the best source of working capital because there is no interest payment on it. Also, the company need not repay the equity share capital. 8, Issue of Debentures: 1. The company issues different types of debentures to get debenture capital. The company uses debenture capilal as a working capital So, the issue of debentures is a significant source of working capital2. In India. debentures are very popular. It receives a good response from the public. Therefore, most companies use debenture capital as working capital. However, debenture capital is a borrowed capital. Therefore, the company has to repay it at a high rate of interest 8. Cash Credit is also an important source of working capital. It is a secured loan. It is similar to Overdraft. The company is allowed to withdraw money from the bank up to a certain limit. Bank charges interest on the amount that is withdrawn. 10. Discounting Bills is another important source of working capital. The company sells goods on credit. It gets Bills Receivable from the debtors. Banks discount these bills. Here, it is not necessary to wait for the maturity of the bills. So, the company receives money very quickly from the bank. This money is also a working capital. 11.Packing Credit is a loan facility given to the exporters by commercial banks. It is also called Pre-Shipment Finance. This loan is offered to the exporters only if they have a Letter of Credit. This money gets used as a working capital. 42. Cornmercial Paper is a short-term promissory note. It is unsecured. Only well-established companies can issue it. Banks and_ financial institutions purchase it. It is purchased, at a discount. This discount is just like interest. The banks provide short-term finance to established companies in exchange for commercial paper. It is given for a short period of 90 to 180 days.BCCI ST Colt Estimating working Capital noods There are broadly three methods of estimating or analyzing the Fequirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle mothod, Estimating working capital means calculating fulure working capital. It should be as accurate as possible because the planning of working capital would be based on these estimates and bank and other financial institutes finance the working capital needs to bo based on such estimates only, Percontago of Salos Mothod tis the easiest of the methods for calculating the working capital fequirement of a company, This method is based on the principle of ‘history repeats itsell’, For estimating, a relationship of sales and working capital is worked out for say last 6 years. If il is constantly coming near say 40% Leworking capital fevel is 40% of sales, the next year estimation is done based on this estimate. If the expected sales are 500 million dollars, 200 million dollars would be required as working capital. The advantage of this method is that it is very simple to understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also, this method is not applicable because there is no past. Regression Analysis Method This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish a trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). The slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where the regression line and working Capital axis meets (Will not go deeper into statistical details). At the end of the statistical exercise with past revenue and working capital data. Operating Cycle Method ‘This is probably the best of the methods because it takes into account the actual business or industry situation into consideration while giving an estimate of working capital. A general rule can be stated in this method. Longer the working capital operating cycle, higher would be the Fequirement of working capital and vice versa. We would agree to the point also, The following formula can be used fo estimate or calculate the working capital Working Capital = Cost of Goods Sold (Estimated) x(No. of Days of Operating Cycle / 365 Days) + Bank and Cash BalanceManaging cash Cash management is the process of collecting and managing cash flows. Cash management can be important for both individuals and companies. In business, it is a key component of a company's financial stability. For individuals, cash is also essential for financial stability while also usually considered as part of a total wealth portfolio. Individuals and businesses have a wide range of offerings available across the financial marketplace to help with all types of cash management needs. Banks are typically a primary financial service provider for the custody of cash assets. There are also many different cash management solutions for individuals and businesses seeking to obtain the best return on cash assets or the most efficient use of cash comprehensively.Cash is the primary asset individuals and companies use to pay their obiigatons on 2 reguiar basis. In business, companies have a multitude of cash imfows and outfiows that must be prudently managed in order to meet payment obigstons, plan for future payments, and maintain adequate business stability. For individuals, maintaining cash balances while also eaming a return on idle cash are usually top concems. In corporate cash management, also often known as treasury management, business managers. corporate treasurers, and chief financial oScers are typically the main individuals responsible for overall cash menagement strategies. cash related responsibilities, and stability analysis. Many companies may outsource part or all of their cash management responsibilities to different service providers. Regardless, there are several key metics that ere monitored and analyzed by cash management executives on a cally, monthly, quarterly, and annual basis. The cash fiow statement is a central component of corporate cash flow maenegement While it is often transparently reported to stakeholders on a guarterly basis, parts of it are usually maintained and tracked intemally on a daily basis. The cash fiow statement comprehensively records all of a business's cash flows. It includes cash received from accounts receivable, cash Paid for accounts pay2bie, cash paid for investing, and cash paid for financing. The bottom line of the cash flow statement reports how much cash a company has readily available > Cash management is the process of managing cash inflows and outflows. _ > There 2re many cash management considerations and solutions available in the financial marketplace for both individuals and businesses. > For businesses, the cash flow Statement is a central component of cash flow management,Cash Management Models Cash management requires a practical approach and a strong base to determine the requirement of cash by the organization to meet its daily expenses. For this purpose, some models were designed to determine the level of money on different parameters. The two most important models are discussed in detail below: The Baumol's EOQ Model The Miller - Orr' ModelThe Baumol’s EOQ Model Based on the Economic Order Quantity (EOQ), in 1952, William J. Baumol gave Baumol's EOQ model, which influences the cash management of the company. This model emphasizes. on maintaining the optimum cash balance in-a year to meet the business expenses on the one hand and grab the profitable investment opportunities on the other side. The following formula of the Baumol’s EOQ Model determines the level of cash which is to be maintained by the organization: Where, ‘C' is the optimum cash balance; Fis the fixed transaction cost; 'T is the total cash requirement for that period; is the rate of interest during the period The Miller ~ Orr’ Model According to Merton H. Miller and Daniel Orr, Baumol's model only determines the cash withdrawal; however, cash is the most uncertain element of the business. There may be times when the organization will have surplus cash, thus discouraging withdrawals; instead, it may require to make investmentsTherefore, the company needs to decide the return point or the level of money to be maintained, instead of determining the withdrawal amount. This model emphasizes on withdrawing the cash only if the available fund is below the return Point of money whereas investing the surplus amount exceeds this level, Given below is the graphical representation of this model: Where, ‘Z’is the spread of cash; ‘UL'is the upper limit or maximum level ‘LL is the lower limit or the minimum level ‘RP’ is the Return Point of cash We can see that the above graph indicates a lower limit which is the minimum cash a business Fequires to function. Adding up the spread of cash (Z) to this lower limit gives us the return point or the average cash requirement.Cash Management Definition: Cash Management refers to the collection, handling, control and investment of the organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound cash flow position in the organization. Receivables Cash Management -_ Any amount which the company has earned however not yet received, i.e. its outstanding and is expected to be received in future, is known as receivables. An organization must manage its receivables to maintain the surplus cash inflow. It helps the firm to fulfil its immediate cash-requirements. The cash receivables must be planned in such a way that the organization can realise its debts quickly and should allow a short credit period to the debtors. Payables Cash Management The payables refer to the payment which is unpaid by the organization and is to be paid off shortly.Objectives of Cash Management Following purposes of cash management will resolve the above queries: Objectives of Cash Management LAST lc nd Planning Capital Expenditure ene lur) Urea SS 3 eee ere ale IEE) er > Fulfil Working Capital Requirement: The organization needs to maintain ample liquid cash to meet its routine expenses which are possible only through effective cash management. > Planning Capital Expenditure: It helps in planning the capital expenditure and determining the ratio of debt and equity to acquire finance for this purpose. > Handling Unorganized Costs: There are times when the company encounters unexpected circumstances like the breakdown of machinery. These are unforeseen expenses to cope up with; cash ‘surplus is a lifesaver in such conditions. > Initiates Investment: The other aim of cash management is to invest the idle funds in the right opportunity and the correct proportion. > Better Utilization of Funds: It ensures the optimum utilization of the available funds by creating a proper balance between the cash in hand and investment. > Avoiding Insolvency: If the business does not plan for efficient cash management, the situation of insolvency may arise. It is either due to Jack of liquid cash or not making a profit out of the money available.2 FUNCTIONS OF CASH i Conti olling ¢ Cash Flows _ atid — ofCash > Investing Idle Cash: The company needs to look for various short term investment alternatives to utilize surplus funds. > Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is an essential function of the business. > Planning of Cash: Cash management is all about planning and decision making in terms of maintaining sufficient cash in hand and making wise investments. Managing Cash Flows: Maintaining the proper flow of cash in the organization through cost-cutting and profit generation from investments is necessary to attain a positive cash flow. Optimizing Cash Level: The organization should continuously function to ‘maintain the required level of liquidity and cash for business operations.Cash Management Strategies Cash management involves decision making at every step. It is not an immediate solution but a strategic approach to financial problems. Following are the strategies of cash management: Business Line of Credit Money Market Fund emi] Lockbox Account — | vei Sweep Account NORGE) Cash Deposits (CDs) 1. Business Line of Credit: The organization should opt for a business line of credit at an initial stage to meet the urgent cash requirements and unexpected expenses. 2. Money Market Fund: While carrying on a business, the surplus fund should be invested in the money market funds. These are readily convertible into cash whenever required and yield a considerable profit over the period. Lockbox Account: This facility provided by the banks enables the companies to get their payments mailed to its post office box. This lockbox is managed by the banks to avoid manual deposit of cash regularly. Sweep Account: The organizations should avail the facility of sweep 2ccounts which is a mix of savings and fixed deposit accounts. Thus, the fminimum balance of the savings account is automatically maintained, and the excess sum is transferred to the fixed deposit account Cash Deposits (CDs): if the company has a sound financial Position and can predict the expenses well along with availing of a lengthy period, it can ‘nvest the surplus cash in the cash deposits. These GDs yield good interest, but early withdrawals are liable to penalties.ELC Foos Limitations of Cash Management Cash management is a very time consuming and skilful activity which is required to be performed regularly As it requires financial expertise, the company may need to hire consultants or other experts to perform the task by paying administrative and consultation charges. ‘Small business entities which are managed solely, face problems such as lack of skills, knowledge, time and risk-taking ability to practice cash management. Marketable Securities Marketable securities are liquid financial instruments that can be quickly converted into cash at a reasonable price. The liquidity of marketable securities ‘comes from the fact that the maturities tend to be less than one year, and that the rates at which they can be bought or sold have liltle effect on prices. > Marketable securities are assets that can be liquidated to cash quickly. ~ These short-term liquid securities can be bought or sold on a public stock exchange or a public bond exchange. > These securities tend to mature in a year or less and can be either debt or equity. - > Marketable securities include common stock, Treasury bills, and money market instruments, among others. Marketable securities are defined as any unrestricted financial instrument ‘hat can be bought or sold on a public stock exchange or a public bond exchange. Therefore, marketable securities are classified as either marketable equily security or marketable debt security. Other requirements of marketable Securities Include having a strong secondary market that can facilitate quick buy 4nd sell transactions, and having a secondary market that provides accurate Price quotes for investors. The return on these lypes of securities is low, due to the fact that marketable securities are highly liquid and are considered safe investments,Types of Marketable Securities Equity Securities Marketable equity securities can be either cornmon s ock of pref stock. They are equity securities of a public company held by another corporation and are listed in the balance sheet of the holding company. If the stock is expected to be liquidated or traded within one year, the holding company wil ist it as a current asset. Conversely, if the company expects to hold the stock for longer than one year, it will ist the equity as a non-currentt asset. All marketable equity securities, both current and non current, are listed at the lower value of cost or market. If, however, a company invests in another company’s equity in order to acquire or control that company, the securities aren't considered merketeble equity securities. The company instead lists them as a long-term investment on its balance sheet. Debt Securities Marketable debt securities are considered to be any short-term bond issued by a public company held by another company. Marketable debt securities are normally held by a company in lieu of cash, so it's even more important that there is an established secondary market. All marketable debt securities are held at cost on a company's balance sheet as a current asset until a gain or loss is realized upon the sale of the debt instrument. Marketable debt securities are held as short-term investments and are expected to be sold within one year. If a debt security is expected to be held for ‘Jonger than one year, it should be classified as a long-term investment on the company's balance sheet.Managing debtors Debtors are people or businesses who owe you money. Proper management of your debtors will help you get paid faster and prevent bad debts. Prompt collection of debtors' accounts will also help you maintain a healthy cash flow. Giving your customer an invoice or bill after they have supplied a product or service is a way of offering credit, since you have to wait for the payment. By giving your customers time to pay for goods or services already delivered, you: are making it easier for them to make purchases. This will increase sales, but will reduce the cash flow critical to your business. Managing debtors is often referred to as credit management, and includes: > collecting debts on time > setting credit limits and payment terms > making credit applications and credit checks > enforcing a clear credit policy > considering debtor finance. Debt management also involves keeping debtor records — this is a legal tax requirement. There are also laws governing how you are allowed to follow up debts with your customers. Inventory management Inventory management is a systematic approach to sourcing, storing, and selling inventory—both raw materials (components) and finished goods (products).Inventory management Inventory management is a systematic approach to sourcing, storing, and selling inventory—both raw materials (components) and. finished goods (products), In business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost as well as Price. There are various types of inventory management techniques which can help in efficient inventory management. They are as follows: ‘Types of Inventory Management Techniques [4 ABC Analysis 3. Material Requirements Planning (MRP) Method (6. VED Analysis | 7. Fast, Slow & Non-moving (FSN) Method ABC Analysis /BC analysis stands for Always Beller Control Analysis. It is an inventory management technique where inventory items are classified into three categories namely: A, B, and C. The items in A category of inventory are closely controlled as it consists of high-priced inventory which may be less in number but are very expensive. The items in B category are relatively less expensive inventory as ‘compared to A category and the number of items in B category is moderate so contol level is also moderate. The C category consists of a high number of inventory items which require lesser investments so the control level is minimum.Just In Time (JIT) Method In Just in Time method of inventory control, the company keeps only as much inventory as it needs during the production process. With no excess inventory in hand, the company saves the cost of storage and insurance. The company orders further inventory when the old stock of inventory is close to replenishment. This is a little risky method of inventory management because a little delay in ordering new inventory can lead to a stock out situation. Thus this method requires proper planning so that new orders can be timely placed. Material Requirements Planning (MRP) Method Material Requirements Planning is an inventory control method in which the manufacturers order the inventory after considering the sales forecast. The MRP system integrates data from various areas of the business where inventory exists. Based on the data and demand in the market, the manager would carefully place the order for new inventory with the material suppliers. Economic Order Quantity (EOQ) Model Economic Order Quantity technique focuses on taking a decision regarding how much quantity of inventory should the company order at any point of time and when they should. place the order. In this model, the store manager will reorder the inventory when it reaches the minimum level. EOQ model helps to save the ordering cost and carrying costs incurred while placing the order. With the EOQ model, the organization is able to Place the right quantity of inventory. Minimum Safety Stocks The minimum Safety stock is the level of inventory which an organization maintains to avoid the stock-out situation. It is the level when we place the new order before the existing inventory is over.VED Analysis VED stands for Vital Essential and Desirable. Organizations mainly use this technique for controlling spare parts of inventory. Like, a higher level of inventory is required for vital parts that are very costly and essential for Production. Others are essential spare parts, whose absence may slow down the Production process, hence it is necessary to maintain such inventory. Similarly, an organization can maintain a low level of inventory for desirable parts, which are not often required for production. Fast, Slow & Non-moving (FSN) Method This method of inventory control is very useful for controlling obsolescence. All the items of inventory are not used in the same order; some are required frequently,.while some are not required at all. So this method classifies inventory into three categories, fast-moving inventory, slow-moving inventory, and non-maving inventory. The order for new inventory is placed based on the utilization of inventory. Inventory management is an essential part of every business. With an effective inventory management system in place, the business can significantlyreduce its various costs like warehousing cost, inventory cattying cost, ordering cost, cost of obsolescence, ele. It improves the supply chain of the business. Managers are able to forecast the level of production al which they need fo place. new onders for inventory. Hence, organizations should take all the necessary steps to maintain an effective inventory management and control system, Practical Problems 1. From the following information compute the working capital requirement for a company. a. Annual sales 2,00,000 units . Selling price 8 per unit - Percentage net profit on sales 25% . Average credit period allowed by suppliers - 4 weeks . Average stock holding in terms of sales requirement - 12 weeks b. c. d. Average credit period allowed to customer - 8 weeks e. f. g. Allow 10% for contingencies Solution: ‘The above problem can be solved in the following manner. @. By computing cost of sales, this is done by removing the percentage of profit. 'b. By correctly classifying information into Current assets and fixed assets. Calculation of Cost of Sales Costofsales = Sales - Profit = 16,00,000- x16,00,000= 16,00,000 - 4,00,000 = 12,00,000 Statement showing the Working Capital Calculation Current Assets Debtors = 1,84,615 2 12,00,000x = Stock = 2,76,923 Pea 4,61,538 Less : Current Liabilities Creditors : 12,00,000 x = 92,308 Add: 10% Net Working Capital 3,69,230 contingencies 36,923 Net Working Capital 4,06,153 2. ABC Ltd., sells its product at gross profit to 20% on sales. The information extracted from Company's annual accounts for the year ended 31-3-2009. Sales at 3 months credit: 40,00,000 Raw materials: 42,00,000 Wages paid (15 days in arrears): —9,60,000 Manufacturing expenses (paid one month in arrears): 12,00,000 Administration expenses (paid one month in arrears): 4,80,000 Sales promotion expenses payable half year in advance: 2,00,000The company enjoys one month credit from suppliers of raw materials and maintains two months stock of raw materials and half month finished goods stock. Cash balance is % 1,00,000. Find out net working capital requirements for the company. Solution: Cost Sheet Particulars Amount Raw Materials 12,00,000 (+) Wages 9,60,000 Prime Cost ; 21,60,000 (+) Manuf expels Z f 12,00,000 Works Factory Cost % 33,60,000 (+) ‘Administration Expenses ~ | 4,80,000 Cost of Production 38,40,000 (Cost of goods sold) (+) Sales promotion expenses 2,00,000 Cost of Sales : - | 40,40,000 Calculation of NWC requiremonts for tho company : Current Assets : 41, Cash balance 1,00,000 2. Debtors (40,40,0000x ay 10,10,000 ’3. Prepaid sales promotion 1,00,000 expenses. 4, Inventory 00 Raw Material (12,00,000x 2,00,0 F.G. (38,40,000x +) 4,60,000 Total Current Assets (A) Current 15,70,000 Liabilities : 1. O/s wages (9,60,000x 1) 80,000 2. Ols Manuf expenses (12,00,000x —4) : 1,000 3. O/s Admin expenses (4,80,000x 4) 40,000 4. Creditors (12,00,000x <5) 1,00,000 “Total Current Liabilities (B) 3,20,000 Net Working capital requirement (A-B) 12,50,000 3. Foods Ltd., is Presently operating at 60% level producing 36,000 packets of snack foods and Proposes to increase the capacity utilisation in tho corning year by 33 1/3% over tho oxisting level of production.The following data has boon suppliod, a. Unit cost structure of the product at current lovel:Raw Material 40 Wages 20 Variable overheads: 20 Fixed overhoad 10 Profit 30 Solling Prico 120 b, Raw matorials will romain in stores for ono month before being issued for production. Material will romain in process for further one month. Suppliers grant 3 months credit to the company. c. Finished goods remain in godown for one month. d. Debtors are allowed credit for 2 months. e. Lag In wages and overhead payments Is ono month. Preparo a projected profitability statement and the working capital requirement at the now level, assuming that a minimum cash balance of & 19,500 has to be maintained. Solution: Proposed capacity = 36,000 + (36,000 x 1/3) = 48,000 Calculation of Working Capital A. Investment in Inventory e () Raw materials : 1 month + 48,000x40x 1 1,60,000(® Workin process : 1 month 48,000N (40420420) > 3,20,000 (iid Finished Goods: 1 month, 48000X(40 + 20 + 20)> 3,20,000 8,00,000 B. Investment in Debtors : (2 months) All sales are credit sales - Assumption (40 + 20#10 + 20) 48,000x 7,20,000 Cash Balance c 19,500 Investment in Current Assets (A+B+C) D. 15,39,500 E. Current Liabilities 1. Creditors — 3 months (40x48,000) x 3 4,80,000 2. Deferred wages - 1 Month (48,000 x 20) x > 80,000 3. Deferred overheads -1 month (48,000 x 20)x 180,000 Total Deferred Paymont [E(| + 2+3)] B 6,40,000 G._Net working Capital (D-F) 8,99,500 Project Profitability Statement Sales 57,60,000 (120%48,000) Less: Cost of goods sold Raw material (40 x 48,000) , 19,20,000 - Wages (20 x 48,000) : 9,60,000 - Var. overheads (20 x 48,000) ~ 9,60,000 - Fixed overhead (10 x 36,000) 3,60,000 e Net profit : 15,60,000 4. A proforma cost sheet of a company provides the following » particulars. Material 40 % Material 40% Direct labour 20% Over heads 20% The following information Is also available.a. It is proposed to maintain a lovol of activity of 7,00,000 Units.Solling price ¥ 42 por unit. b, Raw materials are expected to remain in stores for an averago period of one month. ©. Materials will be in process on an average half -a - month 4. Finished goods are required to be in stock for an average period of one month. e. Credit allowed to debtors is two months. f. Credit allowed by supplier's is one month. Estimate working capital requirements. Solution: Cost Sheet for a single product Materials (12x40%) 48 Direct Labour (12x20%) 24 Overheads (12x20%) 24 96 Profit (Bal Fig) 24 Selling Price 12.0 Statement of Working Capital requirements Particulars z Current Assets 80,000Raw Materials (one month) 2,00,000x =H. x Work In Progress (half month) 40,000 Raw Materials 2,00,000 x 12 x <1 x : 20 472 Direct Labour 2,00,000x 12 x 22 x 42 20,000 2 12 Overheads 2,00,000x 12 x 2h x 42 20,000 Finished goods (one month) 2,00,000x9.6% 4,60,000 Debtors (two months) 2,00,000x 12 x2 4,00,000 Total Current Assets | “| 7,20,000 Less: Current Liabilities Creditors 2,00,000x 12 x #2 x 4 80,000 Net Working Capital 6,40,000 5. A firm has current sales of %:2,56,48,750. The firm has unutilized capacity, In order to boost its sales, it is considering a relaxation in its credit policy. The proposed terms of credit will be 60 days credit against the present policy of 45 days. As a result, the bad debts will increase from 1.5% to 2% of sales. The firm's sales are expected to increase by 10%. The variable operating costs are 72% of the sales. The firm's corporate tax rate is 35% and it requires an after tax return of 15% on its investments, Should the firm change Its credit period?Solution: Particulars @ Investment in debtors if credit period is 60 days(2,56,48,750x45/360) 32,06,C94 Increase in investment in debtors 14,968,177 Current bad debts (2.56,48,750x1.5/100) 3,84,731 Expected bad debts (2,56,48,750x110/100x2/100) 564,273 Increase in bad debts 1,79,542 Calculation of incremental profit (After tax) Increase in sales with 60 days credit period (2,56,48.750x10/100) 25.64,875 Contribution from increased sales (25,64,875x28/100) 718,165 Less: Increase in bad debts 1,79,542 Increase in operating profits §,38,623 Less: Tax @35% 1,88,518 Net increase in operating profits “350,105. | Rate of return on increased investment in debtors = x 100 = 23.40% Analysis: If the credit policy is changed from 45 days to 60 days, the company vail ean an additional net profit of ® 3,60,105 which amounts to 23.40% return on naeased investment in debtors balances. The required rate of return after tax is only 15% and hence there is an incremental return of 8.40%. Therefore, it is Suggested to increase the credit period to 60 days