WORKING CAPITAL MANAGEMENT AND CONTROL Dr. Monika Goel monikagoel@gmail.com

Working Capital Management:

Working Capital Management Working capital = current assets – current liabilities Working capital management refers to choosing the levels and mix of: cash , marketable securities, receivables and inventories. different types of short-term financing

Classification of Working Capital:

Classification of Working Capital Gross and net working capital Permanent and temporary working capital

Three Broad Decisions:

Three Broad Decisions the level of current asset the structure/composition of current assets the financing of current asset.

Determinants of Working Capital:

Determinants of Working Capital Nature of Business Degree of Seasonality Production Policies Growth Position of the Business Cycle Competitive Conditions Production Collection Time Period Dividend policy and sales policy

The Balance-Sheet Model of the Firm:

The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long-term investments should the firm engage in? The Capital Budgeting Decision

The Balance-Sheet Model of the Firm:

The Balance-Sheet Model of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

The Balance-Sheet Model of the Firm:

The Balance-Sheet Model of the Firm How much short-term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

The Operating Cycle and the Cash Cycle:

The Operating Cycle and the Cash Cycle Time Accounts payable period Cash cycle Operating cycle Cash received Accounts receivable period Inventory period Finished goods sold Firm receives invoice Cash paid for materials Order Placed Stock Arrives Raw material purchased

The Operating Cycle and the Cash Cycle:

The Operating Cycle and the Cash Cycle In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables. Cash cycle = Operating cycle – Accounts payable period

Review question:

Review question Silver Coin Ltd. is a manufacturing company. It has received an export order of 1,80,000 units. The finance manager of the company is estimating working capital requirements for the production to meet export order. Following information is given for the year 2009-10 : Production in 2008-09 was 1,80,000 units and it is estimated that in 2009-10 the level will be maintained. Each unit will remain in process for one month. Raw material being channelised into the pipelines immediately and the labour and overhead costs accruing evenly during the month. Final production will be stored in warehouse awaiting despatch for 3 months. Credit allowed by creditors is 1.5 months from the date of delivery of raw materials. Credit permitted to debtors is 2.5 months from the date of despatch . Selling price per unit is Rs.15. The expected ratios of cost to the selling price are raw material 50%, direct wages 15% and overheads 20%. Raw materials are expected to remain in store for an average of 1.5 months before issue to production. There is regular production and sales cycle. The company maintains Rs.60,000 as cash in hand. Wages and overheads are paid on the first of each month for the previous month. You are required to submit the working capital requirement to the finance manager of Silver Coin Ltd.

Review Question:

Review Question The management of Laxmi Ltd. has called for a statement showing the working capital needed to finance a level of activity of 6,00,000 units of output for the year 2009. The cost structure for the company’s product for the abovementioned level is given as under : Cost Per Unit (Rs.) Raw materials 20 Direct labour 5 Overheads 15 Total costs 40 Profit 10 Selling price 50 Past trends indicate that raw materials are in stock on an average for three months. Work-in-progress will approximate to half a month’s production. Finished goods remain in warehouse on an average for two months. Suppliers of materials extend one month’s credit. Two months’ credit is normally allowed to debtors. A minimum cash balance of Rs.1,00,000 is expected to be maintained. The production pattern is assumed to be even during the year. You are required to prepare the statement of working capital determination.

Review Question:

Review Question Mona Machines Ltd. has provided you the following information : Production for the year ... 69,000 units Finished goods in store ... Average 3 months Raw materials in store ... Average 2 months’ consumption Work-in-progress (assume 50% completion stage with full material consumption) ... Average 1 month Credit allowed by creditors ... Average 2 months Credit given to debtors (assume at selling price) ... Average 3 months Selling price per unit ... Rs. 50 Raw material cost ... 50% of selling price Direct wages ... 10% of selling price Overheads ... 20% of selling price Company keeps Rs. 1,00,000 in cash. There is regular production and sale cycle, and wages and overheads accrue evenly. Wages are paid in the next month of accrual. Material is introduced in the beginning of production cycle. You are required to calculate working capital requirement of Mona Machines Ltd.

Some Aspects of Short-Term Financial Policy:

Some Aspects of Short-Term Financial Policy There are two elements of the policy that a firm adopts for short-term finance. The Size of the Firm’s Investment in Current Assets Usually measured relative to the firm’s level of total operating revenues. Flexible Restrictive Alternative Financing Policies for Current Assets Usually measured as the proportion of short-term debt to long-term debt. Flexible Restrictive

Carrying Costs and Shortage Costs:

Carrying Costs and Shortage Costs Carrying costs increase with the level of investment in current assets. They include the costs of maintaining economic value and opportunity costs ( Eg ., Interest , warehousing costs) Shortage costs decrease with increases in the level of investment in current assets. They include trading costs and the costs related to being short of the current asset (for example, sales lost as a result of a shortage of finished goods inventory).

Carrying Costs and Shortage Costs:

Carrying Costs and Shortage Costs $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA* Minimum point

The Size of the Investment in Current Assets:

The Size of the Investment in Current Assets Determined by its short-term financial policies. These financial policies can be flexible or restrictive Flexible policy actions include: Keeping large cash and securities balances Keeping large amounts of inventory Granting liberal credit terms Restrictive policy actions include: Keeping low cash and securities balances Keeping small amounts of inventory Allowing few or no credit sales

Appropriate Flexible Policy:

Appropriate Flexible Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA* Minimum point A flexible policy is most appropriate when carrying costs are low relative to shortage costs.

When a Restrictive Policy is Appropriate:

When a Restrictive Policy is Appropriate $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA* Minimum point A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.

Alternative Financing Policies for Current Assets:

Alternative Financing Policies for Current Assets In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt. In this world, net working capital is always zero.

Alternative Asset Financing Policies Flexible Policy = conservative:

Alternative Asset Financing Policies Flexible Policy = conservative Flexible Policy always implies a short-term cash surplus and a large investment in cash and marketable securities.

Alternative Asset Financing Policies Restricitve Policy = aggressive:

Alternative Asset Financing Policies Restricitve Policy = aggressive Restrictive Policy uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal variations.

A Compromise Financing Policy:

A Compromise Financing Policy With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially finance seasonal variations in current asset needs . Short-term borrowing is used when the reserve is exhausted.

Which Financing Policy is Best?:

Which Financing Policy is Best? • Cash Reserves + Low chance of Financial Distress + Less Time in searching ST financing - Do not earn any interest Maturity Hedging + Use LT financing for LT assets and ST financing for ST assets - ST interest rates are more volatile: so avoid using ST financing for LT assets Relative Interest Rates If LT interest rates are lower, finance core part of ST needs from LT funds If ST interest rates are lower, better to use ST financing

Maturity Matching Approach:

Maturity Matching Approach Hedge risk by matching the maturities of assets and liabilities. Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing . There are no excess funds.

Maturity Matching Approach:

Maturity Matching Approach

Review Questions:

Review Questions Comment on the following Most businesses need cash funds to meet contingencies. Playing with float is a risky proposition. Failure of a firm is technical if it is unable to meet its current obligations.

Inventory Management:

Inventory Management Two basic questions in inventory management are (1) how much to order (or produce), and (2) when to order (or produce).

ABC Analysis…:

29 ABC Analysis … Class A items are those on which the annual dollar volume is high. They represent 70-80% of total inventory costs, but they account for only 15% of total inventory items. Class B items are those on which annual dollar volume is medium. They represent 15-25% of total dollar value, and they account for 30% of total inventory items on the average. Class C items are low dollar volume items. They represent only the 5% of total dollar volume, but they include as many as 50-60% of total inventory items.

ABC Analysis…:

30 ABC Analysis … Percent of Annual Dollar Volume Percent of Inventory Items 80 Class A Items 20 20 50 100 Class C Items

ABC Analysis…:

31 ABC Analysis … Some of the Inventory Management Policies that may be based on ABC analysis include: a) Class A items should have tighter inventory control. b) Class A items may be stored in a more secure area. c) Forecasting Class A items may warrant more care.

Just-in-Time Inventory:

32 Just-in-Time Inventory Just in Time Inventory is the minimum inventory that is necessary to keep a system perfectly running. With just in time (JIT) inventory, The exact amount of items arrive at the moment they are needed , Not a minute before OR not a minute after. To achieve JIT inventory, Managers should Reduce the Variability Caused by some Internal and External Factors. ( Goldratt’s boys scout example – Apply the pace of the slowest boy). A production line cannot work faster than the slowest workstation Existence of Inventory hides the variability. What causes variability?

Rocks located along the way:

33 Rocks located along the way Others Waiting Time Move Time Queue Time Set-up Time Run Time Input Output Lead Time Cycle Time T he section called “Others” are the Rocks on the river. Those rocks include Quality Variability, In-transit Delays, Machine Breakdowns, Large Lot-sizes, Inaccurate drawings, Employee attendance variability.

Just-In-Time Production:

34 Just-In-Time Production JIT production means (1) Elimination of Waste, (2) Synchronized Manufacturing, and (3) Little Inventory. Reducing the order batch size can be a major help in reducing inventory. Average Inventory = (Maximum Inventory + Minimum Inventory) / 2 Average Inventory drops as the inventory re-order quantity drops because the maximum inventory level drops.

Inventory Related Costs: Holding, Ordering and Set-up Costs:

35 Inventory Related Costs: Holding, Ordering and Set-up Costs Holding Costs are the costs associated with holding or “carrying” inventory over time. It includes costs related to storage; such as insurance, extra staffing, interest, and so on. Some example holding costs are : building rent or depreciation, building operating cost, taxes on building, insurance on building, material handling equipment leasing or depreciation, equipment operating cost, handling manpower cost, taxes on inventory, insurance, etc.

Inventory Related Costs: Ordering and Set-up Costs…:

36 Inventory Related Costs: Ordering and Set-up Costs … Ordering Costs include, cost of supplies, order processing, clerical cost, etc. The ordering cost is valid if the products are purchased NOT produced internally. Set-up cost is the cost to prepare a machine for manufacturing an order. Set-up cost is highly correlated with set-up time. Machines that traditionally have taken long hours to set up Are Now being set up in less than a minute by employing FMSs or CIM systems. Reducing set up times is an excellent way to Reduce Inventory.

Inventory Models:

37 Inventory Models Demand for an item is either dependent on the demand for other items or it is independent. For example, demand for refrigerator is independent of the demand for cars. But, demand for auto tires is certainly dependent on the demand of cars. W e will deal with the Independent Demand Situation. In the dependent demand situation we use Material Requirement Planning (MRP) systems.

What to answer?:

38 What to answer? In the independent demand situation, we should be interested in answering: a) When to place an order for an item, and b) How much of an item to order.

Independent Demand Inventory Models:

39 Independent Demand Inventory Models There are Four Basic Independent Demand Inventory Models: 1) Economic Order Quantity (EOP) Model (the most known model). 2) Production Order Quantity Model. 3) Back order inventory model. 4) Quantity discount model.

Economic Order Quantity (EOQ) Model:

40 Economic Order Quantity (EOQ) Model EOQ model makes a number of assumptions: 1-) Demand is known and constant. 2-) Lead time (the time between placement of order and receipt of the order) is constant and known. 3-) Orders arrive in one batch at a time, and they arrive in one point in time. 4-) Quantity discounts are not possible. 5-) The costs include only setup cost (or ordering cost when buying) and holding cost. 6-) Orders are always placed at the right times. Therefore, stock outs (or shortages) can be completely avoided.

With these assumptions in EOQ Model, the graphic of inventory usage over time is as follows::

41 With these assumptions in EOQ Model , the graphic of inventory usage over time is as follows: Inventory Level Time Q Average Inventory Level Usage Rate 0 Q = order quantity (That is also equal to the Maximum Inventory) Minimum Inventory = 0 When inventory level reaches 0, a new order is placed and received.

Objective: Minimize total cost:

42 Objective: Minimize total cost The objective of inventory models is to minimize total cost. If we minimize the setup and holding costs, we will be able to minimize total cost . As the quantity ordered (Q) increases, holding cost increases, and setup cost decreases.

Where the total cost is minimum?:

43 Where the total cost is minimum? Annual Cost Order Quantity (Q) Annual Holding Cost Setup Cost (Ordering Cost) Total Cost Minimum Total Cost Optimal Order Quantity ( Q* ) Optimal order quantity (Q*) occurs at a point where setup cost is equal to the total (annual) holding cost .

Finding the optimum…:

44 Finding the optimum… Optimal order quantity (Q*) occurs at a point where setup cost is equal to the total (annual) holding cost . By using this fact, we can write an equation for Q* as follows: D: Annual Demand in units for the inventory item. S: Setup cost (or the ordering cost) for each order. Notice: (Setup cost for production, order cost for buying). H: Annual Holding cost of inventory per unit.

Finding the optimum…:

45 Finding the optimum… There will be (D/Q) times of ordering in a whole year. Therefore, Annual Setup Cost = (D/Q) . S Average Annual Holding Cost = (Average Inventory) . H = (Q/2) . H

Finding the optimum…:

46 Finding the optimum… We get optimum point by setting: Annual Setup Cost = Annual Holding Cost (D/Q) . S = (Q/2) . H Therefore, Q 2 = 2DS / H Q* = [2DS / H] 1/2 Q* value is also called as the EOQ .

Example:

47 Example An Inventory model has the following characteristics: Annual Demand (D) = 1000 units Ordering (Setup) cost (S)= $10 per order; Holding cost per unit per year (H) = $.50 Assume that there are 270 working days in a year (excluding holidays and weekends).

Example…:

48 Example … Questions : a) Find the Economic Order Quantity (Q*) for this inventory model. b) How many orders should be placed during one year? c) What is the expected time between two consecutive orders? d) What is the total annual cost of this inventory model?

Example…:

49 Example … Answers : a) EOQ= Q* = [2(1000)10 / .50] 1/2 = 200 units b) Expected number of orders placed during the year (N) = D / Q* = 1000 / 200 = 5 times. c) Expected time between orders (T) = (Working days in a year) / N = 270 / 5 = 54 days. d) Total Annual Cost = Annual Setup Cost + Annual Holding Cost = DS / Q* + (Q*) H / 2 = 1000 (10) / 200 + (200) (.50) / 2 = $100

Considering the Reorder Point:

50 Considering the Reorder Point So far, we only decided how much to order (That is Q*). Now, we should find what time to order. We assumed that firm will wait until its inventory reaches to zero before placing an order. And, we also assumed that the Orders will receive immediately. However, there is a time between placement and receipt of an order.

Considering the Reorder Point…:

51 Considering the Reorder Point … This is called LEAD TIME or delivery time. Here, we will use the term “Reorder Point” (ROP) for when to order. ROP (in units) = (Demand Per Day) x (Lead time for a new order in days) ROP = d x L

Reorder Point…:

52 Reorder Point … Inventory Time (Days) Q* Slope = d (units/day) ROP (units) L = Lead Time ROP = d . L When the inventory level reaches the ROP, a new order is required. It will take a time that is equal to the Lead Time (L) to receive the new order.

Reorder Point…:

53 Reorder Point … Here, Demand per day (d) is found by the following equation: d = D / Number of working days in a year This ROP equation assumes that demand is uniform and constant. If this is not the case, an extra (safety) stock is added (because of uncertainty).

Example:

54 Example Annual demand for an item is D = 8000/year. This year there will be 200 working days in a year. Delivery of an order for this item takes 3 working days (L = 3 days).

Example…:

55 Example … Questions : a) Find the demand per day for this item. b) What is the ROP for this item?

Example…:

56 Example … Answers : a) Demand per day for this item (d) = 8000 / 200 = 40 units / day. b) ROP = d . L = 40 . 3 = 120 units. When inventory level becomes 120 units, an Order should be placed.

Review Question:

Review Question Vaibhav Ltd. is engaged in manufacturing of machines used in construction. It is considering the possibility of purchasing from a supplier a component it now makes. A supplier has agreed to supply the component in the required quantities at a unit price of Rs.18. The transportation and insurance charges are Re.l per unit. Presently, the company produces the component from a single raw material in economic lots of 3,000 units at a cost of Rs.4 per unit. The average annual demand is 40,000 units. The annual holding cost for company is Re.0.50 per unit and it has set a minimum stock level of 800 units. The direct labour costs of the component are Rs.12 per unit. The company also hires a machine at a rate of Rs.400 per month on which the components are produced. Suggest whether the company should produce or procure the component. Hint answer: cost of making: 646681; cost of purchasing 760000

Production Order Quantity Model:

58 Production Order Quantity Model In EOQ Model, We assumed that the entire order was received at one time. However, Some Business Firms may receive their orders over a period of time. Such cases require a different inventory model. Here, we take into account the daily production rate and daily demand rate.

Production Order Quantity Model..:

59 Production Order Quantity Model .. Inventory Time Maximum Inventory t Production occurs at a rate of p Demand occurs at a rate of d

Production Order Quantity Model..:

60 Production Order Quantity Model .. Since this model is especially suitable for production environments, It is called Production Order Quantity Model . Here, we use the same approach as we used in EOQ model. Lets define the following: p: Daily Production rate (units / day) d: Daily demand rate (units / day) t: Length of the production in days. H: Annual holding cost per unit

Production Order Quantity Model..:

61 Production Order Quantity Model .. Average Holding Cost = (Average Inventory) . H = (Max. Inventory / 2) . H In the period of production: Max. Inventory = (Total Produced) – (Total Used) = p x t – d x t Here, Q is the total units that are produced. Therefore, Q = p x t and t = Q / p

Production Order Quantity Model..:

62 Production Order Quantity Model .. If we replace the values of t in the Max. Inventory formula: Max. Inventory = p (Q/p) - d (Q/p) = Q - dQ/p = Q (1 – d/p) Annual Holding Cost = (Max. Inventory / 2) . H = Q/2 (1 – d/p) . H Annual Setup Cost = (D/Q) . S

Production Order Quantity Model..:

63 Production Order Quantity Model .. Now we will set : Annual Holding Cost = Annual Setup Cost Q/2 (1 – d/p) . H = (D/Q) . S This formula gives us the optimum production quantity for the Production Order Quantity Model. It is used when inventory is consumed as it is produced .

Backorder Inventory Model:

64 Backorder Inventory Model In this model, we assume that stock outs (and backordering) are allowed. In addition to previous assumptions, we assume that sales will not be lost due to a stock out. Because, we will back order any demand that can not be fulfilled. B: Backordering cost per unit per year b: The amount backordered at the time the next order arrives Q – b: Remaining units after the backorder is satisfied

Backorder Inventory Model…:

65 Backorder Inventory Model … Inventory Time (Q - b) b T1 T2 b Q 0

Backorder Inventory Model…:

66 Backorder Inventory Model … Total Annual Cost = Annual Setup Cost + Annual Holding Cost + Annual Backordering Cost Annual Setup (Ordering) Cost = (D/Q) . S Annual Holding Cost = (Average Inventory Level) . H Average Average inventory Proportion of time Inventory = level during there is inventory Level in stock period in stock = (Q – b) / 2 . T1 / T

Backorder Inventory Model…:

67 Backorder Inventory Model … By using the graphical ratios, we know that: T1 / T = (Q – b) / Q Therefore, if we replace T1/T in the above equation we get Average Inventory Level = (Q – b) 2 / 2Q (Q – b) 2 Annual Holding Cost = ---------- . H 2Q

Backorder Inventory Model…:

68 Backorder Inventory Model … Annual Backordering Cost = (Average Backordering units) . B Average Backordering = ( Average number of stock outs during out of stock period ) x ( Proportion of time inventory is on backorder ) Average Backordering = b / 2 . T2 / T By using the graphical ratios, we know that: T2 / T = b / Q Therefore, if we replace T2/T in the above equation we get : Average Backordering = b 2 / 2Q and b 2 Annual Backordering Cost = ---------- . B 2Q

Backorder Inventory Model…:

69 Backorder Inventory Model … DS (Q – b) 2 b 2 Total Cost (TC) = ------- + ---------- . H + --------- . B Q 2Q 2Q We find optimum order quantity (Q*) and optimum backordering quantity (b*) by taking the derivatives of dTC / dQ = 0 and dTC / db = 0 and then putting the values in their places. We find that :

Review Question:

Review Question The following information is related to Evergreen Ltd : Unit cost 200 Order cost 320 Inventory carrying cost 40 Back order cost (stock out cost) 20 Annual demand 2,000 units You are required to compute the following : ( i ) Minimum cost order quantity (ii) Time between orders (iii) Minimum back order quantity (iv) Maximum inventory level (v) Overall annual cost.

Quantity Discount Model:

71 Quantity Discount Model A quantity discount is simply a reduced price (P) for an item when it is purchased in LARGER quantities. A typical quantity discount schedule is as follows: Alternative Quantity Discount (%) Discount (unit) Price 1 0-999 0 $5.00 2 1000-1999 4 $4.80 3 2000- 5 $4.75

Quantity Discount Model…:

72 Quantity Discount Model … Since the unit cost for the Third discount is the lowest, We might be tempted to order 2000 or more units. However, this quantity might not be the one that minimizes the Total Cost. Remember that, As the quantity goes up, the holding cost increases. Here, there is a trade off between reduced product price (P) and increased holding cost (H).

Quantity Discount Model…:

73 Quantity Discount Model … Total Cost = Setup Cost + Holding Cost + Product Price (Cost) Total Cost = DS / Q + QH / 2 + PD where P is the price per unit To determine the minimum Total Cost, we perform the following process which includes 4 steps: Step 1 : Assume that I: is a percentage value, and I . P represents the holding cost as a percentage of price per unit (P).

Quantity Discount Model…:

74 Quantity Discount Model … For each discount alternative, calculate a value of Q* = [2DS / IP] 1/2 Here, instead of using a value of H, the holding cost is equal to I . P That is, If the item is expensive (such as a Class A Item), Its holding cost will be higher. Since the price of item (P) is a factor in Annual Holding Cost, we can no longer assume that the holding cost is constant (such as H) when price changes.

Quantity Discount Model…:

75 Quantity Discount Model … Step 2 : For any discount alternative, If the calculated optimum order quantity (Q*) is too low to qualify for the discount range, Then, Adjust the order quantity upward to the lowest quantity that will qualify for the particular discount alternative. Step 3 : Using the total cost (TC) equation above, compute a total cost for every order quantity (Q). Use the adjusted Q values . Step 4 : Select the discount alternative which has the minimum Total Cost (TC).

Example:

76 Example Consider the quantity discount schedule given in the beginning (above). Assume that the Ordering (Setup) Cost (S) is $49 per each order. Annual Demand (D) is 5000 units, and Inventory carrying charge is a percentage (I=0.20) of product cost (P). Question : What order quantity will minimize the total inventory cost.

Example…:

77 Example … Answer : Step 1 : Compute Q* for every discount range.

Example…:

78 Example … Step 2 : Adjust values of Q* that are below allowable discount ranges. - For Q1, allowable range is 0-999. Since Q1* = 700 is between 0 and 999, It does not have to be adjusted. - For Q2, allowable range is 1000-1999. Since Q2* = 714 is not in the allowed range, we adjust it to the lowest allowable value, That is Q2* = 1000. - For Q3, allowable range is 2000-. Since Q3* = 718 is not in the allowed range, we adjust it to the lowest allowable value, That is Q3* = 2000.

Example…:

79 Example … Step 3 : Compute total cost for each of the order quantities (Q*) : 5000 x Unit price $49 x (5000 / 700) (Average Inventory x Holding Cost) = (Q / 2) x (I x P) = (700 / 2) x (5 x 0,20)

Example…:

80 Example … Step 4 : An Order quantity of 1000 units will minimize the total cost. However, if the third discount cost is lowered to $4.65, selecting t his discount alternative (2000 units) would be the optimum solution.

Probabilistic Models:

81 Probabilistic Models So far we assumed that demand is constant and uniform. However, In Probabilistic models, demand is specified as a probability distribution. Uncertain demand raises the possibility of a stock out (or shortage). (Why?)

Probabilistic Models:

82 Probabilistic Models One method of reducing stock outs is to hold extra inventory (called Safety Stock ). In this case, we change the ROP formula to include that safety stock (ss). ROP = d . L d = daily demand, and L = Order Lead Time Now it will be as follows: ROP = d . L + (ss) where (ss) is the safety stock

Finding A Safety Stock Level:

83 Finding A Safety Stock Level Managers may want to limit the possibility of stock out only to a small percentage, say 5%. If demand level is assumed to be a normal distribution, By using mean and standard deviation of the normal distribution, We can determine a safety stock that is necessary for %95 service level.

Example:

84 Example The SAC company carries an inventory item that has a normally distributed demand. The mean demand is ( = 350) units and standard deviation is ( = 10).

Example…:

85 Example … x : mean demand + safety stock x - z = ------ Using a standard Normal table we find z = 1.65 for 95% confidence. We use the properties of a standardized normal curve to get a z value that corresponds to the.95 of the curve.

Example…:

86 Example … Therefore, x - ss z = ------ = ---- = 1.65 ss = 16.5 units Reorder point is elevated up by 16.5 units.

Example…:

87 Example …

Slide 88:

Banking Norms and Macro Aspect of Working Capital Management

Regulation of bank finance:

Regulation of bank finance Implemented by RBI in mid 1960s in order to Measure of discipline among industrial borrowers. Redirect credit to the priority sector of the economy RBI has been issuing guidelines and directives to the banking sector toward this end.

Committees:

Committees To control the tendency of over-financing and the diversion of the banks funds . Tandon committee. Daheija committee. Chore committee. Marathe committee.

Tandon committee:

Tandon committee Reserve Bank of India setup a committee under the chairmanship of Shri P.L. Tandon in July 1974. The practices of most of the banks are still influenced by tandon committee recommendations though financial liberalization occurred in 1990s.

Backorder Inventory Model:

92 Backorder Inventory Model In this model, we assume that stock outs (and backordering) are allowed. In addition to previous assumptions, we assume that sales will not be lost due to a stock out. Because, we will back order any demand that can not be fulfilled. B: Backordering cost per unit per year b: The amount backordered at the time the next order arrives Q – b: Remaining units after the backorder is satisfied

Tandon committee:

Tandon committee The terms of reference of the Committee were: 1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper end use of funds and keeping a watch on the safety of advances; 2. To suggest the type of operational data and other Information that may be obtained by banks periodically from the borrowers and by the Reserve Bank of India from the leading banks; 3. To make suggestions for prescribing inventory norms for the different industries, both in the private and public sectors and indicate the broad criteria for deviating from these norms ;

Tandon committee:

Tandon committee 4. To make recommendations regarding resources for financing the minimum working capital requirements ; 5. To suggest criteria regarding satisfactory’ capital structure and sound financial basis in relation to borrowings ; 6. To make recommendations as to whether the existing pattern of financing working capital requirements by cash credit/overdraft system etc., requires to be modified , if so, to suggest suitable modifications

Tandon committee:

Tandon committee Recommendations Norms of current asset. Maximum permissible bank finance. Emphasis on loan systems. Periodic information and reporting system .

Tandon committee:

Tandon committee Norms for current assets . They defined the norms(15 industries) for Raw materials Stock in progress Finished goods Receivables

Tandon committee:

Tandon committee Maximum permissible bank finance (MPBF ) Three methods for determining MPBF Method 1: MPBF=0.75(CA-CL) Method 2: MPBF=0.75(CA)-CL Method 3: MPBF=0.75(CA-CCA)-CL CA- current asset, CL- current liabilities, CCA- core current assets (permanent component of working capital).

Tandon committee:

Tandon committee Current Assets Rs.(in millions) Raw material 18 Work in process 5 Finished goods 10 Receivables(including billsDiscounted ) 15 Other current assets 2 — 50 — Current Liabilities Trade Creditors - 12 Other current liabilities - 3 Bank borrowings (including Bills discounted)- 25 — 40 — MPBF for Mercury Company Limited as per above methods are: Method 1: 075(CA-CL) = 075(50-15) = Rs.26.25 million Method 2: 0.75(CA)-CL = 0.75(50)-15 = Rs.22.5 million Method 3: 0.75(CA-CCA)-CL = 0.75(50-20 )-15 = Rs.7.5 million Method 2 is adopted.

Tandon committee:

Tandon committee Style of credit Only a portion of MPBF must be cash credit component and the balance must be in the form of working capital demand loan. Information system: . quarterly information system-form I Estimate production and sale for current and ensuring quarter. The estimate of current asset and liabilities for the ensuing quarter.

Slide 100:

Quarterly information system-form II Production and sales during current year and for the latest completed year. Asset and liabilities for the latest completed year. Half yearly operating statements- form III Actual and estimated operating performance for the half year ended. Half yearly operating statements- form IIIB Actual and estimated sources and uses of funds for the half year ended.

Chore Committee(1979):

Chore Committee(1979) This committee was formed by RBI to review the cash credit system of banks. The important recommendations of the Committee are as follows: 1. The banks should obtain quarterly statements in the prescribed format from all borrowers having working capital credit limits of Rs. 50 lacs and above. 2. The banks should undertake a periodical review of limits of Rs. 10 lacs and above.

Chore Committee:

Chore Committee 3. The banks should not bifurcate cash credit accounts into demand loan and cash credit components. 5. Banks should discourage sanction of temporary limits by charging additional one per cent interest over the normal rate on these limits. 6. The banks should fix separate credit limits for peak level and non-peak level, wherever possible. 7. Banks should take steps to convert cash credit limits into bill limits for financing sales.

Marathe committee:

Marathe committee A committee set up to review the licensing policy for new urban co-operative banks. Headed by S. S. Marathe of the Reserve Bank of India (RBI) Board, the committee’s prescriptions submitted in May 1992, favour a liberal entry policy and include : Establishment of new urban co-operative banks on the basis of need and potential, and achievement of revised viability norms. The one-bank-per-district approach is to be discarded. Achieving prescribed viability norms in terms of share capital, initial membership and other parameters within a specified time. Introduction of a monitoring system to generate early warning signals and for the timely detection of sickness.

Dahejia committee(1968):

Dahejia committee(1968) Existing deficiencies . It is the borrower who decides how much would borrow, the banker does not decide how much he would lend and is, therefore not in a position to do credit sales. The bank credit is treated is considered as first source of finance. Amount of credit extended is based on the amount of securities available and not the level of operations of the borrower.

Present practice:

Present practice Assessment of working capital requirement. Projected balance sheet method. Cash budget method Turnover method Current ratio norm. 1.33 is considered only as benchmark and banks do accept a lower current ratio.

Present practice:

Present practice Emphasis on loan system Bulk of the working capital limit is in the form of working capital demand loan and only a small portion in cash credit component. Financial follow up results FFR I- simplified form of form II used under tandon. Has to be submitted on quarterly basis. FFR II- simplified form of form III. Has to be submitted in half yearly basis.

Cash Budgeting:

Cash Budgeting A cash budget is a primary tool of short- tun financial planning. The idea is simple: Record the estimates of cash receipts and disbursements. Cash Receipts Arise from sales, but we need to estimate when we actually collect. Cash Outflow Payments of Accounts Payable Wages, Taxes, and other Expenses Capital Expenditures Long-Term Financial Planning

Cash Budgeting:

Cash Budgeting The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

The Short-Term Financial Plan:

The Short-Term Financial Plan The most common way to finance a temporary cash deficit to arrange a short-term loan. Unsecured Loans Line of credit down at the bank Secured Loans Accounts receivable financing can e either assigned or factored. Inventory loans use inventory as collateral. Other Sources Banker’s acceptances Commercial paper.

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