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Title: CAIIB-FM-Module D topics


1
CAIIB-FM-Module D topics
  • Marginal Costing
  • Capital Budgeting
  • Cash Budget
  • Working Capital

2
COSTING
  • Cost accounting system provides information about
    cost
  • Aim best use of resources and maximization of
    returns
  • cost amount of expenditure incurred( actual
    notional)
  • Purposes profit from each job/product, division,
    segmentpricingdecisioncontrolprofit planning
    inter firm comparison

3
Marginal costing
  • Marginal costing distinguishes between fixed cost
    and variable cost
  • Marginal cost is nothing but variable cost of
    additional unit
  • Marginal cost variable cost
  • MC Direct Material Direct Labour Direct
    expenses

4
Marginal costing problems
  • Sales (-) variable cost () contribution
  • Contribution(/ divided by) sales
  • () C.S. Ratio
  • ContributionFixed cost ()Break even point
  • Fixed Cost (/ divided by) contribution per unit
    break even units

5
Basic formulaSales price (-) variable cost
contribution
SP less VC Contribution
10 6 4
9 6 3
8 6 2
7 6 1
6 6 0
5 6 (1)
4 6 (2)
6
Marginal costing problems
  • SP Rs.10, VC Rs.6 Fixed Cost Rs.60000
  • Find
  • Break even point (in Rs. in units)
  • C/S ratio
  • Sales to get profit of Rs.20000

7
Marginal costing problems
  • Sales Rs.100000
  • Fixed Cost Rs.20000
  • B.E.Point Rs.80000
  • What is the profit ?

8
Management decisions- assessing profitability
CONTRIBUTION/SALESC.S.RATIO
Product sp vc Contribtion c/s Ratio ranking
A 20 10 10 10/20 50 1
B 30 20 10 10/30 33 2
C 40 30 10 10/40 25 3
9
DECISION when limiting factors
SP Rs.14 Rs.11
VC 8 7
Contribution Per unit 6 4
Labour hr. pu 2 1
Contri.per hr 3 4
10
DECISIONS
  • Make or buy decisions
  • Close department
  • Accept or reject order
  • Conversion cost pricing

11
Marginal costing
  • cost-volume-profit analysis is reliant upon a
    classification of costs in which fixed and
    variable costs are separated from one another.
    Fixed costs are those which are generally time
    related and are not influenced by the level of
    activity.
  • Variable cost on the other hand are directly
    related to the level of activity if activity
    increases, variable costs will increase and
    vice-versa if activity decreases.

12
Marginal costing
  • USES OF COST-VOLUME-PROFIT ANALYSIS
  • The ability to analyse and use cost-volume-profit
    relationship is an important management tool. The
    knowledge of patterns of cost behaviour offers
    insights valuable in planning and controlling
    short and long-run operations. The example of
    increasing capacity is a good illustrations of
    the power of the technique in planning.
  • The implications of changes in the level of
    activity can be measured by flexing a budget
    using knowledge of cost behaviour, thereby
    permitting comparison to be made of actual and
    budgeted performance for any level of activity.

13
Marginal costing
  • LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS
  • A major limitation of conventional CVP analysis
    that we have already identified is the assumption
    and use of linear relationships. Yet another
    limitation relates to the difficulty of dividing
    fixed costs among many products and/or services.
    Whilst variable costs can usually be identified
    with production services, most fixed cost
    usually can only be divided by allocation and
    apportionment methods reliant upon a good deal of
    judgement. However, perhaps the major limitation
    of the technique relates to the initial
    separation of fixed and variable costs.

14
Marginal costing
  • ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING
  • ADVANTAGES
  • 1. More efficient pricing decisions can be made,
    since their impact on the contribution margin can
    be measured.
  • 2. Marginal costing can be adapted to all costing
    system.
  • 3. Profit varies in accordance with sales, and is
    not distorted by changes in stock level.
  • 4. It eliminates the confusion and
    misunderstanding that may occur by the presence
    of over-or-under-absorbed overhead costs in the
    profit and loss account.

15
Marginal costing
  • 5. The reports based on direct costing are far
    more effective for management control than those
    based on absorption costing. First of all, the
    reports are more directly related to the profit
    objective or budget for the period. Deviations
    from standards are more readily apparent and can
    be corrected more quickly. The variable cost of
    sales changes in direct proportion with volume.
    The distorting effect of production on profit is
    avoided, especially in month following high
    production when substantial amount of fixed costs
    are carried in inventory over to next month. A
    substantial increase in sales in the month after
    high production under absorption costing will
    have a significant negative impact on the net
    operating profit as inventories are liquidated.

16
Marginal costing
  • 6. Marginal costing can help to pinpoint
    responsibility according to organisational lines
    individual performance can be evaluated on
    reliable and appropriate data based on current
    period activity. Operating reports can be
    prepared for all segments of the company, with
    costs separated into fixed and variable and the
    nature of any variance clearly shown. The
    responsibility for costs and variances can then
    be more readily attributed to specific
    individuals and functions, from top management to
    down management

17
Marginal costing
  • DISADVANTAGES OF MARGINAL COSTING
  • 1. Difficulty may be experienced in trying to
    segregate the fixed and variable elements of
    overhead costs for the purpose of marginal
    costing.
  • 2. The misuse of marginal costing approaches to
    pricing decisions may result in setting selling
    prices that do not allow the full recovery of
    overhead costs.
  • 3. Since production cannot be achieved without
    incurring fixed costs, such costs are related to
    production, and total absorprtion costing
    attempts to make an allowance for this
    relationship. This avoids the danger inherent in
    marginal costing of creating the illusion that
    fixed costs have nothing to do with production.

18
CAPITAL BUDGETING
  • It involves current outlay of funds in the
    expectation of a stream of benefits extending far
    into the future

Year Cash flow
0 (100000)
1 30000
2 40000
3 50000
4 50000
19
CAPITAL BUDGETING
  • A capital budgeting decision is one that involves
    the allocation of funds to projects that will
    have a life of atleast one year and usually much
    longer.
  • Examples would include the development of a major
    new product, a plant site location, or an
    equipment replacement decision.
  • Capital budgeting decision must be approached
    with great care because of the following reasons
  • Long time period consequences of capital
    expenditure extends into the future and will have
    to be endured for a longer period whether the
    decision is good or bad.

20
CAPITAL BUDGETING
  • . Substantial expenditure it involves large sums
    of money and necessitates a careful planning and
    evaluation.
  • Irreversibility the decisions are quite often
    irreversible, because there is little or no
    second hand market for may types of capital
    goods.
  • Over and under capacity an erroneous forecast of
    asset requirements can result in serious
    consequences. First the equipment must be modern
    and secondly it has to be of adequate capacity

21
CAPITAL BUDGETING
  • Difficulties
  • There are three basic reasons why capital
    expenditure decisions pose difficulties for the
    decision maker. These are
  • Uncertainty the future business success is
    todays investment decision. The future in the
    real world is never known with certainty.
  • Difficult to measure in quantitative terms Even
    if benefits are certain, some might be difficult
    to measure in quantitative terms.
  • Time Element the problem of phasing properly the
    availability of capital assets in order to have
    them come on stream at the correct time.

22
CAPITAL BUDGETING
  • Methods of classifying investments
  • Independent
  • Dependent
  • Mutually exclusive
  • Economically independent and statistically
    dependent
  • Investment may fall into two basic categories,
    profit-maintaining and profit-adding when viewed
    from the perspective of a business, or service
    maintaining and service-adding when viewed from
    the perspective of a government or agency.

23
CAPITAL BUDGETING
  • Expansion and new product investment
  • Expansion of current production to meet increased
    demand
  • Expansion of production into fields closely
    related to current operation horizontal
    integration and vertical integration.
  • Expansion of production into new fields not
    associated with the current operations.
  • Research and development of new products.

24
CAPITAL BUDGETING
  • Reasons for using cash flows
  • Economic value of a proposed investment can be
    ascertained by use of cash flows.
  • Use of cash flows avoids accounting ambiguities
  • Cash flows approach takes into account the time
    value of money
  • For any investment project generating either
    expanded revenues or cost savings for the firm,
    the appropriate cash flows used in evaluating the
    project must be incremental cash flow.
  • The computation of incremental cash flow should
    follow the with and without principle rather
    than the before and after principle

25
Types of capital investments
  • New unit
  • Expansion
  • Diversification
  • Replacement
  • Research Development

26
Significance of capital budgeting
  • Huge outlay
  • Long term effects
  • Irreversibility
  • Problems in measuring future cash flows

27
Facets of project analysis
  • Market analysis
  • Technical analysis
  • Financial analysis
  • Economic analysis
  • Managerial analysis
  • Ecological analysis

28
Financial analysis
  • Cost of project
  • Means of finance
  • Cost of capital
  • Projected profitability
  • Cash flows of the projects
  • Project appraisal

29
Decision process
INVESTMENT OPPORTUNITIES
PROPOSALS
PLANNING PHASE
REJECTED OPPORTUNITIES
Improvement in planning Evaluation procedure
Improvement in planning Evaluation procedure
PROPOSALS
NEW INVESTMENT OPPORTUNITIES
EVALUATION PHASE
Rejected Proposals
PROJECTS
SELECTION PHASE
Rejected projects
ACCEPTED PROJECTS
IMPLEMENTATION PHASE
ONLINE PROJECTS
CONTROL PHASE
PROJECT TERMINATION
AUDITING PHASE
30
Methods of capital investment appraisal
DISCOUNTING NON-DISCOUNTING
Net present value (NPV) Pay back period
Internal rate of return (IRR) Accounting rate of return
Profitability Index or Benefit cost ratio
31
Present value of cash flow stream- (cash outlay
Rs.15000)_at_ 12
Year Cash flow PV factor _at_12 PV
1 1000 0.893 893
2 2000 0.799 1594
3 2000 0.712 1424
4 3000 0.636 1908
5 3000 0.567 1701
6 4000 0.507 2028
7 4000 0.452 1808
8 5000 0.404 2020 13376
32
Present value of cash flow stream- (cash outlay
Rs.15000 )_at_10
Year Cash flow PV factor _at_10 PV
1 2000 0.909 1818
2 2000 0.826 1652
3 2000 0.751 1502
4 3000 0.683 2049
5 3000 0.621 1863
6 4000 0.564 2256
7 4000 0.513 2052
8 5000 0.466 2330 15522
33
Methods of capital investment appraisal
  • Solution IRR NAV
  • Project A 20 309
  • Project B 15 1441
  • These project are mutually exclusive
  • The IRR ranks project A higher, whereas the NPV
    ranks project B first.
  • The conflict arises because B is ten times the
    size of A. This gives a higher NPV but in
    relative terms it is less profitable with a lower
    percentage return. Naturally, B is preferable
    because it gives the greatest increase in
    shareholders wealth.

34
Methods of capital investment appraisal
  • The advantages of IRR over NPV are
  • 1. It gives a percentage return which is easy to
    understanding at all levels of management.
  • 2. The discount rate/required rate of return does
    not have to be known to calculate IRR. It does
    have to be decided upon at sometime because IRR
    must be compared with something. The discussion
    as to what is an acceptable rate of return can
    however be left until much later stage. In a NPV
    calculation the discount rate must be specified
    prior to any calculation being performed.

35
Methods of capital investment appraisal
  • The advantages of NPV over IRR are
  • 1. NPV gives an absolute measure of profitability
    and hence immediately shows the increase in
    shareholders wealth due to an investment
    decision.
  • 2. NPV gives a clear answer in an accept/reject
    decision. IRR gives multiple answers.
  • 3. NPV always gives the correct ranking for
    mutually exclusive project while IRR may not.
  • 4. NPVs of projects are additive while IRRs are
    not.
  • 5. Any changes in discount rates over the life of
    a project can more easily be incorporated into
    the NPV calculation.
  • The NPV approach provides as absolute measure
    that fully represents in value of the company if
    a particular project is undertaken. The IRR by
    contrast, provides a percentage figure from which
    the size of the benefits in terms of wealth
    creation cannot always be grasped.

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41
Future value
  • Assume that an investor has 1000 and wishes to
    know its worth after four years if it grows at 10
    percent per year. At the end of the first year,
    he will have 1000 X 1.10 or 1,100. By the end
    of the year two, the 1,100 will have grown to
    1,210 (1,100 X 1.10). The four-year pattern is
    indicated below.

42
BUDGET
  • Quantitative expression of management objective
  • Budgets and standards
  • Budgetary control
  • Cash budget

43
PROFIT PLANNING
  • Budget budgetary control
  • Marginal costing
  • CVP and break even point
  • Comparative cost analysis
  • ROCE

44
PRICING DECISIONS
  • Full cost pricing
  • Conversion cost pricing
  • Marginal cost pricing
  • Market based pricing

45
PRICING DECISIONS
  • PRICING AND ITS OBJECTIVES
  • The objective of pricing in practice will
    probably be one of the following
  • (a) To skim the market (in the case of new
    products) by the use of high prices
  • (b) To penetrate deeply into the market (again
    with new products) at an early stage, before
    competition produces similar goods
  • (c) To earn a particular rate of return on the
    funds invested via the generating of revenue and
  • (d) To make a profit on the product range as a
    whole, which may involve using certain items in
    the range as loss leaders, and so forth.

46
PRICING DECISIONS
  • Full cost pricing
  • The object is to recover all costs incurred plus
    a percentage of profit. It is a method best used
    where the product is clearly differentiated and
    not in immediate, direct competition. It would
    not lend itself to situation where price tended
    to be determined by the market,

47
PRICING DECISIONS
  • Conversion cost pricing
  • Conversion cost consists of direct labour cost
    and factory overhead, ignoring the cost of the
    raw material on the grounds that profit should be
    made within the factory and not upon materials
    bought from suppliers.

48
PRICING DECISIONS
  • Marginal cost pricing
  • Briefly it is that cost which would not be
    incurred if the production of the product were
    discontinued. An important advantage of
    differential cost of pricing is the flexibility
    it gives to meet special short-term
    circumstances, while accepting that full costs
    must be recovered in the long term. This is by no
    means always desirable in the short term. For
    example, there may be surplus productive capacity
    in a factory, in which case any opportunity to
    accept an order which covers differential cost
    and makes a contribution to fixed cost and profit
    should be accepted. Any contribution is better
    than none.

49
PRICING DECISIONS
  • Market based pricing
  • This can be based on the value to a customer of
    goods or services and involves variable pricing.
    It also takes account of the price he is able and
    willing to pay for the goods or services.
    Businesses using this approach develop special
    products or services which command premium
    prices.
  • The other market-based approach is to price on
    the basis of what competitors are charging.

50
Operating leverageFinancial leverage
  • OL amount of fixed cost in a cost structure.
    Relationship between sales and op. profit
  • FL effect of financing decisions on return to
    owners. Relationship between operating profit and
    earning available to equity holders (owners)

51
Working capital
  • Current assets less current liabilities net
    working capital or net current assets
  • Permanent working capital vs. variable working
    capital

52
Working capital cycle
  • cashgt Raw material gt Work in progress gt finished
    goods gt Sales gt Debtors gt Cashgt
  • Operating cycle it is a length of time between
    outlay on RM /wages /others AND inflow of cash
    from the sale of the goods

53
Matching approach to asset financing

Total Assets
Short-term Debt

Fluctuating Current Assets
Long-term Debt Equity Capital
Permanent Current Assets
Fixed Assets
Time
54
Accounts Payable
Value Addition
Raw Materials
W I P
THE WORKING CAPITAL CYCLE(OPERATING CYCLE)
Finished Goods
Cash
Accounts Receivable
SALES
55
  • Operating cycle concept
  • A companys operating cycle typically consists of
    three primary activities
  • Purchasing resources,
  • Producing the product and
  • Distributing (selling) the product.
  • These activities create funds flows that are
    both unsynchronized and uncertain.
  • Unsynchronized because cash disbursements (for
    example, payments for resource purchases) usually
    take place before cash receipts (for example
    collection of receivables).
  • They are uncertain because future sales and
    costs, which generate the respective receipts and
    disbursements, cannot be forecasted with complete
    accuracy.

Working capital cycle
Working capital cycle
56
Working capital
  • FACTORS DETERMINING WORKING CAPITAL 1.    
    Nature of the Industry2.     Demand of
    Industry3.     Cash requirements4.     Nature
    of the Business5.     Manufacturing time6.    
    Volume of Sales7.     Terms of Purchase and
    Sales8.     Inventory Turnover9.     Business
    Turnover10. Business Cycle11. Current
    Assets requirements12. Production Cycle

57
Working capital
  • Working Capital Determinants (Contd)13.    
    Credit control14.     Inflation or Price level
    changes15.     Profit planning and
    control16.     Repayment ability17.     Cash
    reserves18.     Operation efficiency19.    
    Change in Technology20.     Firms finance and
    dividend policy 21.     Attitude towards Risk

58
TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF CONCEPT
BASIS OF TIME
Permanent / Fixed WC
Temporary / Variable WC
Gross Working Capital
Net Working Capital
Special WC
Seasonal WC
Regular WC
Reserve WC
59
Working capital
  • Working Capital Levels in Different Industries
  • A retailing company usually has high levels of
    finished goods stock and very low levels of
    debtors. Most of the retailers sales will be for
    cash, and an independent credit card company or a
    financial subsidiary of the retail business
    (which on occasions is not consolidated in the
    group accounts). The retailing company, however,
    usually has high levels of creditors. It pays its
    suppliers after an agreed period of credit. The
    levels of working capital required are therefore
    low

60
Working capital
  • Excess of current assets over current liabilities
    are called the net working capital or net current
    assets.
  • Working capital is really what a part of long
    term finance is locked in and used for supporting
    current activities.
  • The balance sheet definition of working capital
    is meaningful only as an indication of the firms
    current solvency in repaying its creditors.
  • When firms speak of shortage of working capital
    they in fact possibly imply scarcity of cash
    resources.
  • In fund flow analysis an increase in working
    capital, as conventionally defined, represents
    employment or application of funds.

61
Working capital
  • In contrast, a manufacturing company will require
    relatively high levels of working capital with
    investments in raw materials, work-in-progress
    and finished goods stocks, and with high levels
    of debtors. The credit terms offered on sales and
    taken on purchases will be influenced by the
    normal contractual arrangements in the industry.

62
Working capital
  • Debtors Volume of credit sales
  • Length of credit given
  • Effective credit control and cash
    collection
  • Stocks Lead time safety level
  • Variability of demand
  • Production cycle
  • No. of product lines
  • Volume of
  •    planned output
  •     actual output
  •    sales
  • Payables Volume of purchases
  • Length of credit allowed
  • Length of credit taken Discounts
  • Short-term finance All the above
  • Other
    payments/receipts
  • Availability of
    credit Interest rates

63
Working capital
  • Cash Levels
  • it is necessary to prepare a cash budget where
    the minimum balances needed from month to month
    will be defined.
  • business is seasonal, cash shortages may arise in
    certain periods. Generally it is thought better
    to keep only sufficient cash to satisfy
    short-term needs, and to borrow if longer-term
    requirements occur
  • The problem, of course, is to balance the cost of
    this borrowing against any income that might be
    obtained from investing the cash balances.
  • The size of the cash balance that a company might
    need depends on the availability of other sources
    of funds at short notice, the credit standing of
    the company and the control of debtors and
    creditors

64
Working capital
  • Debtors
  • The debtors problem again revolves around the
    choice between profitability and liquidity. It
    might, for instance, be possible to increase
    sales by allowing customers more time to pay, but
    since this policy would reduce the companys
    liquid resources it would not necessarily result
    in higher Profits.
  • historical analysis or the use of established
    credit ratings to classify groups of customers in
    terms of credit risk

65
Working capital
  • Establish clear credit practices as a matter of
    company policy.
  • Make sure that these practices are clearly
    understood by staff, suppliers and customers.
  • Be professional when accepting new accounts, and
    especially larger ones.
  • Check out each customer thoroughly before you
    offer credit. Use credit agencies, bank
    references, industry sources etc.
  • Establish credit limits for each customer... and
    stick to them.
  • Have the right mental attitude to the control of
    credit and make sure that it gets the priority it
    deserves.

66
Working capital
  • 7. Continuously review these limits when you
    suspect tough times are coming or if
    operating in a volatile sector. 8. Keep
    very close to your larger customers. 9.
    Invoice promptly and clearly. 10. Consider
    charging penalties on overdue accounts. 11.
    Consider accepting credit /debit cards as a
    payment option. 12. Monitor your debtor
    balances and ageing schedules, and don't
    let any debts get too large or too old.

67
DIMENSIONS OF RECEIVABLES MANAGEMENT
OPTIMUM LEVEL OF INVESTMENT IN TRADE
RECEIVABLES Profitability Costs
Profitability
Optimum Level
Liquidity
Stringent Liberal
68
Working capital-FACTORING
  • Factoring
  • Definition
  • Factoring is defined as a continuing legal
    relationship between a financial institution (the
    factor) and a business concern (the client),
    selling goods or providing services to trade
    customers (the customers) on open account basis
    whereby the Factor purchases the clients book
    debts (accounts receivables) either with or
    without recourse to the client and in relation
    thereto controls the credit extended to customers
    and administers the sales ledgers.

69
Working capital-FACTORING
  • It is the outright purchase of credit approved
    accounts receivables with the factor assuming bad
    debt losses.
  • Factoring provides sales accounting service, use
    of finance and protection against bad debts.
  • Factoring is a process of invoice discounting by
    which a capital market agency purchases all trade
    debts and offers resources against them.

70
Working capital-FACTORING
  • Debt administration
  • The factor manages the sales ledger of the client
    company. The client will be saved of the
    administrative cost of book keeping, invoicing,
    credit control and debt collection. The factor
    uses his computer system to render the sales
    ledger administration services.

71
Working capital-FACTORING
  • Different kinds of factoring services
  • Credit Information Factors provide credit
    intelligence to their client and supply periodic
    information with various customer-wise analysis.
  • Credit Protection Some factors also insure
    against bad debts and provide without recourse
    financing.
  • Invoice Discounting or Financing Factors
    advance 75 to 80 against the invoice of their
    clients. The clients mark a copy of the invoice
    to the factors as and when they raise the invoice
    on their customers.

72
Working capital-FACTORING
  • Services rendered by factor
  • Factor evaluated creditworthiness of the customer
    (buyer of goods)
  • Factor fixes limits for the client (seller)
    which is an aggregation of the limits fixed for
    each of the customer (buyer).
  • Client sells goods/services.
  • Client assigns the debt in favour of the factor
  • Client notifies on the invoice a direction to the
    customer to pay the invoice value of the factor.

73
Working capital-FACTORING
  • Client forwards invoice/copy to factor along with
    receipted delivery challans.
  • Factor provides credit to client to the extent of
    80 of the invoice value and also notifies to the
    customer
  • Factor periodically follows with the customer
  • When the customer pays the amount of the invoice
    the balance of 20 of the invoice value is passed
    to the client recovering necessary interest and
    other charges.
  • If the customer does not pay, the factor takes
    recourse to the client.

74
Working capital-FACTORING
  • Benefits of factoring
  • The client will be relieved of the work relating
    to sales ledger administration and debt
    collection
  • The client can therefore concentrate more on
    planning production and sales.
  • The charges paid to a factor which will be
    marginally high at 1 to 1.5 than the bank
    charges will be more than compensated by
    reductions in administrative expenditure.
  • This will also improve the current ratio of the
    client and consequently his credit rating.
  • The subsidiaries of the various banks have been
    rendering the factoring services.
  • The factoring service is more comprehensive in
    nature than the book debt or receivable financing
    by the bankers.

75
Working capital- INVENTORY MANAGEMENT
  • Managing inventory is a juggling act.
  • Excessive stocks can place a heavy burden on the
    cash resources of a business.
  • Insufficient stocks can result in lost sales,
    delays for customers etc.
  • INVENTORIES INCLUDE
  • RAW MATERIALS, WIP FINISHED GOODS

76
FACTORS INFLUENCING INVENTORY MANAGEMENT
  • Lead Time
  • Cost of Holding Inventory
  • Material Costs
  • Ordering Costs
  • Carrying Costs
  • Cost of tying-up of Funds
  • Cost of Under stocking
  • Cost of Overstocking

77
Working capital
  • Cost of Working capital
  • The other aspect of the working capital problem
    concerns obtaining short-term funds. Every source
    of finance, including taking credit from
    suppliers, has a cost the point is to keep this
    cost to the minimum. The cost involved in using
    trade credit might include forfeiting the
    discount normally given for prompt payment, or
    loss of goodwill through relying on this strategy
    to the point of abuse. Some other sources of
    short-term funds are bank credit, overdrafts and
    loans from other institutions. These can be
    unsecured or secured, with charges made against
    inventories, specific assets or general assets.

78
Working capital
  • Disadvantages of Redundant or Excess Working
    Capitalõ Idle funds, non-profitable for
    business, poor ROIõ Unnecessary purchasing
    accumulation of inventories over required level
    õ  Excessive debtors and defective credit
    policy, higher incidence of B/D.õ Overall
    inefficiency in the organization.õ When there is
    excessive working capital, Credit worthiness
    suffers õ  Due to low rate of return on
    investments, the market value of shares may fall

79
Working capital
  • Disadvantages or Dangers of Inadequate or Short
    Working Capital õ Cant pay off its short-term
    liabilities in time. õ  Economies of scale are
    not possible.õ  Difficult for the firm to
    exploit favourable market situations
    õ  Day-to-day liquidity worsensõ  Improper
    utilization the fixed assets and ROA/ROI falls
    sharply

80
Working capital cycle
  • Example X Company plans to attain a sales of Rs
    5 crores. It has the following information for
    production and selling activity. It is assumed
    that the activities are evenly spread through out
    the year.
  • (a) Average time raw materials are kept in
    store prior to issue for production.2months
  • (b) Production cycle time or work-in-progress
    cycle time. 2months
  • (c) Average time finished stocks are kept in
    sale in unsold condition 1/2 months
  • (d) Average credit available from suppliers
    1 1/2 months
  • (e) Average credit allowed to customer
    1 1/2 months
  • (f) Analysis of cost plus profit for above sales
  • Rs. In Crores
  • Raw Materials 50 2.50
  • Direct Labour 20 1.00
  • Overheads 10 0.50
  • Profit 20 1.00
  • Total 100 5.00
  • -----------

81
Working capital cycle
  • Calculation of Wokring Capital Requirement
  • 1. Total months to be financed to Raw Material
    Months
  • Time in raw material store 2
  • Working progress cycle 2
  • Finished goods store 1/2
  • Credit given to customer 1 1/2


  • 6
  • Less Credit available from suppliers 1 ½
  • ----------------
  • Total months to be financed to Raw Materials
    4 ½
  • ----------------
  • 2. Total months to be financed to Labour
  • Production cycle 2
  • In Finished stock store ½
  • Credit to customer 1
    ½
  • Total Months to be financed 4

82
Working capital cycle
  • 3. Total months to be finacned to overhead
  • Production cycle 2
  • In finished goods stores ½
  • Credit to customer 1 ½
  • -------------
  • 4
  • Less Credit from suppliers
    1 ½
  • -------------
  • Total months to be financed 2 ½
  • 4. Maximum working capital required Rs in
    crores
  • Raw Materials 4 ½ / 12 2.50 0.94
  • Direct Labour  4 / 12     1.00



    0.33
  • Overheads 2 ½ 0.50 0.10
  • -------
  • Maximum Working Capital
    1.37
  • -------

83
E N D
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