Working Capital Policy

Prof S N Rao

Working Capital Policy

Concepts of Working Capital
Characteristics of current assets
Factors influencing Working Capital
requirement
Level of current assets
Current asset financing policy
Operating cycle analysis
Cash requirement for working
capital
Prof S N Rao

Concepts of Working Capital

Gross Working Capital
Net Working Capital

Prof S N Rao

Proportions of CAs &FAs

CAs
10-20
20-30
30-40
40-50
50-60
60-70
70-80
80-90

FAs
80-90
70-80
60-70
50-60
40-50
30-40
20-30
10-20

Industry
Hotels & Service Ind
Electricity generation & distribution
Aluminum, Shipping
Iron and Steel, Chemicals
Tea plantation
Cotton textiles & Sugar
Food Processing, Tobacco
Trading & construction

Prof S N Rao

Characteristics of CAs
Short life span & swift
transformation
Cash: 7-10 days
Debtors: 30-60 days
Inventories: 2-60 days

Prof S N Rao

Current Asset Cycle

Finished goods

Work in process
Debtors

Raw material
Cash
Prof S N Rao

Implications for WC Mgt

Working capital decisions are
repetitive and frequent
There is close interaction among
working capital components

Prof S N Rao

Factors influencing WC requirements

Nature of business
Seasonality of operations
Production policy/strategy
Market conditions
Conditions of supply

Prof S N Rao

Working Capital Policy Decision

Current Asset Policy
What should be the level of current
assets in relation to sales (CA/Sales)?

Current Asset Financing Policy

What should be the level of short-term
financing in relation to long-term
financing?
(ST loans/LT loans OR ST loans/NCA )
Prof S N Rao

Types of WC Policy
Level of
Short Term
Financing
(ST/LT)

Aggressive OR
Restrictive
Working Capital
Policy

Moderate
Working Capital
Policy

Moderate
Working Capital
Policy

Conservative OR
Flexible
Working Capital
Policy

Level of Current Assets (CA/Sales)

Prof S N Rao

10

Optimal Level of CAs

c
o
s
t
s

Total costs
Carrying costs
Shortage costs
CA* Prof S N Rao
Level of Current Assets

11

Financing of CAs
Fluctuating CA

Permanent CA
FA
requirement
Time

Prof S N Rao

12

Matching Principle
Maturity of the sources of financing
should match the maturity of the
assets being financed
Fixed assets and permanent current
assets should be financed by longterm sources of finance
Fluctuating current assets should be
financed by short-term sources of
finance
Prof S N Rao

13

Operating Cycle and Cash Cycle

Order placed Stocks arrive
Inventory period

A/R period

A/P period
Cash paid for
material
Operating cycle period
Cash cycle period

Prof S N Rao

14

Operating Cycle for AL

Avg Inventory
COGS/Day
Inventory period

2002
557
5.36
104

2003
503
5.69
88

Avg Debtors
Net Sales/Day

580
6.37

506 462
7.55 9.42

432
11.64

Debtors period

91

67

49

37

155

108

93

Operating cycle period 195

Prof S N Rao

2004
459
7.84
59

2005
538
9.68
56

15

Operating Cycle for AL

Avg Creditors

2002
314

2003
326

2004
390

2005
549

COGS-Emp cost

1698

1779

2545

3169

(COGS-Emp C)/day

4.65

4.87

6.97

8.68

67
155
88

56
108
52

63
93
30

Creditors period
68
Operating cycle period 195
Cash cycle period
127

Prof S N Rao

16

Estimation of Cash WC
Requirement
Estimate the cash cost of various
current assets required by the firm
Deduct the spontaneous current
liabilities from the sum of cash cost
of current assets
The difference, plus margin of safety,
is Cash Working Capital required

Prof S N Rao

17

Working Capital Requirement on

Cash Basis-Example
Sales (credit period: 2months)

Rs.240 m

Materials (Credit period: 2 months)

Rs.72 m

Wages (paid monthly in arrear)

Rs.48 m

Mfg exp outstanding at the end of year

(cash expenses,paid one month in
arrear)

Rs.4

Total administrative exp,paid as incurred Rs.30

Prof S N Rao

18

Working Capital Requirement on

Cash Basis
The company sells its products on
gross profit of 25%, counting
depreciation as part of the COP
It keeps two months stock of Rmone
months stock of FG, and cash
balance of Rs.5 m
Assuming 10% safety margin, work
out the WC requirements on cash
basis (ignore WIP)
Prof S N Rao

19

Cash Management

Prof S N Rao

20

Cash Management
Short-term cash forecasting (Cash
Budgeting)
Reports for Control
Factors for efficient cash
management
Investment of surplus funds
(treasury Mgt)
Prof S N Rao

21

Short-term Cash Forecasting

Helpful in
Estimating cash
requirements/surplus
Planning short-term
financing/investments
Scheduling payments in connection
with capital expenditure projects
Planning purchases of materials
Developing credit policies
Prof S N Rao

22

Short-term Cash Forecasting

Receipt item
Cash sales

Basis of Estimation
Est.sales and its division
between cash and cr.
sales
Collection of A/R
Credit policy
Int. and div. receipts Firms portfolio of sec.
Increase in loans,
deposits, and issue
of new securities
Sale of assets

Firms financing plan

Proposed disposal of
assets
Prof S N Rao

23

Short-term Cash Forecasting

Payment item
Cash purchases

Payment for
purchases
Wages and salaries

Mfg expenses

Basis of Estimation
Estimated purchases
and its division
between cash/credit
purchase
Credit policy of
suppliers
Manpower employed
and wages/salary
structure
Production plan
Prof S N Rao

24

Short-term Cash Forecasting

Payment item
Gen & Admin& sellig
expenses

Capital equip
purchases
Repayment of loans
and retirement of
securities

Basis of Estimation
Admin&sales personnel
and proposed sales
promotion and
distribution expenses
Capital expenditure
budget and payment
pattern
Financing plan

Prof S N Rao

25

Reports for Monitoring and Control

Daily Cash Report:
Opening Balance
Receipts:
-Cash Sales
-Collection of credit
sales
-Borrowings
-Others
Total Receipts
Prof S N Rao

26

Reports for Monitoring and Control

Payments:
-Cash purchases of
RM
-Payments made for
credit purchases
Repayment of loans
Others
Total Payments
Net cash flow
Closing Balance
Prof S N Rao

27

Reports for Monitoring and Control

Daily Treasury Report
Cash
Opening balance
Receipts
Payments
Closing balance

Prof S N Rao

28

Reports for Monitoring and Control

Daily Treasury Report
Marketable
Securities
Opening balance
Purchases
Sales
Closing balance

Prof S N Rao

29

Reports for Monitoring and Control

Daily Treasury Report
Accounts
Receivable
Opening balance
Bills raised
Cash receipts
Closing balance

Prof S N Rao

30

Reports for Monitoring and Control

Daily Treasury Report
Accounts Payables
Opening balance
Bills received
Cash payments
Closing balance

Prof S N Rao

31

Reports for Monitoring and Control

Daily Treasury Report
Opening net treasury
position
Closing net treasury position

Prof S N Rao

32

Factors for Efficient Cash Management

Prompt billing
Expeditious collection of cheques
Centralized purchases and payments
to suppliers

Prof S N Rao

33

Investing Surplus Cash

Two basic problems
Determination of surplus cash
During normal period
During peak period

Surplus cash = actual cash - Min cash

req.

Prof S N Rao

34

Investing Surplus Cash

Determination of channels of
investment
Criteria for investment:
Security
Liquidity
Yield
maturity

Prof S N Rao

35

Investing Surplus Cash

Purpose of holding Criteria for
surplus cash
investment
To meet un-foreseen
payments

Safety and liquidity

To make available on Safety and

certain definite dates maturity
General reserves not Safety and yield
required to meet any
specific payments
Prof S N Rao

36

Forms of Liquidity
Cash balance (4% -5% of CAs)
Cash credit arrangement
Benefits: lesser after tax cost
Disadvantages: imposition of penal
interest on under/over utilization and
close scrutiny of budgets of the
company by banks

Marketable securities
T Bills,Govt Bonds,CPs,ICDs, CDs, Bill
Disc,other Capital market securities
Prof S N Rao

37

Choice of Liquidity Mix

Depends on
Uncertainty surrounding the cash
flow projections
Attitude of the management towards
risk
Ability to raise non-bank funds
Ability to control its cash flows
Prof S N Rao

38

Cash Management Models

Baumol Model
Miller and Orr Model

Prof S N Rao

39

Baumol Model
Assumptions
It is possible to forecast cash
requirements with certainty
Cash payments occur uniformly over the
period
Opportunity cost of holding cash is
known and it does not change over the
period

Prof S N Rao

40

Miller Orr Model

Assumptions
Changes in the cash balance over given
period are random in size as well as
direction

Questions to be answered
When should transfer be effected
between marketable securities and
cash?
What should be the magnitude of these
transfers?
Prof S N Rao

41

Credit Management

Prof S N Rao

42

Credit Policy Variables

Credit standards
Credit period
Cash discount
Collection effort

Prof S N Rao

43

Credit Policy Variables

Credit standards
What standard should be applied in accepting or
rejecting an account for granting credit?
Not to extend credit to any customer
Extend credit to every customer

Actual credit standards lie between the two extreme

positions
Liberal credit standards
Push up sales
Lead to higher bad debt loss
Higher collection cost
Requires more investment in receivables

Stiff credit standards have the opposite effects

Change in credit standard has impact on profit
Prof S N Rao

44

Credit Policy Variables

Credit period
Varies from 15-60 days
Stated as net 30 or net 60
Lengthening of credit period
Pushes up sales
Results in higher investment in debtors
Leads to higher bad debt loss

Shortening of credit period has opposite

impact
Change in credit period has impact on profit
Prof S N Rao

45

Credit Policy Variables

Cash discount
Offered to induce customers to make prompt payments
The discount percentage and discount period is reflected
in credit terms
Example: 2/10, net 45
Liberalizing cash discount policy may mean higher
discount percent and/or longer discount period
Results into
Higher sales
Lower average collection period
Lower investment in debtors
Higher cost of discount

Tightening cash discount policy will have opposite effect

Change in discount policy has impact on profit
Prof S N Rao

46

Credit Policy Variables

Collection effort

Monitoring the state of receivables

Dispatch of letters to customers whose due date is
approaching
Electronic and telephonic advice to customers around
the due date
Threat of legal action to overdue accounts
Legal action against overdue accounts
Rigorous collection efforts
tends to decrease sales
Shorten average collection period
Reduce bad debt loss
Increase collection cost

Lax collection effort will have opposite effect

Change in collection effort has impact on profit
Prof S N Rao

47

Credit Evaluation
Assessment of credit risk
Helps in establishing credit limits
Errors
Type-I error: a low risk customer is
misclassified as a high risk customer
Type-II error: a high risk customer is
misclassified as a low risk customer

Prof S N Rao

48

Credit Evaluation
Traditional Credit Evaluation

Assessment of prospective customer in terms of

Character: willingness to honor obligations

Capacity: ability to meet obligations from OCFs
Capital: availability of capital for meeting obligations in
case OCFs are not sufficient
Collateral: security offered by the customer in the form of
pledged assets
Conditions: the general conditions that affect the
customers ability to meet obligations

Sources of information

Financial statements
Bank reference
Experience of the firm
Stock market performance of customer firm

Prof S N Rao

49

Credit Evaluation
Numerical Credit Scoring
Identify factors relevant for credit evaluation
Assign weights to these factors that reflect
their relative importance
Rate the customer on various factors using
suitable rating scale
Convert factor into factor score
Add all the factor scores to get the overall
customer rating index
Based on the rating index, classify the
customer
Prof S N Rao

50

Credit Evaluation
Construction of Credit Rating Index
(based on a 5 point rating scale)
Factor

Factor weight

Rating

Factor Score

Past payment

0.30

1.2

Net profit
margin

0.20

0.8

Current ratio

0.20

1.0

D/E ratio

0.10

0.40

Return on
equity

0.20

1.0

Rating Index

Prof S N Rao

4.20

51

Credit Evaluation
Risk Classification Scheme
Category or Risk Class Description
1

Customer with no risk of default

Customers with negligible risk

(default rate less than 2%)

Customers with little risk (default rate

between 2%-5%)

Customers with some risk (default

rate between 5%-10%)

Customers with significant risk

(default rate of more than 10%)
Prof S N Rao

52

Credit Evaluation
Discriminant Analysis
Identify two key variables for assessing credit
risk of customers
Plot all the customers , both who paid dues in
time and who defaulted, on a graph based on
these two variables
Identify dividing line between good customers
and bad customers
Find the equation for the dividing line
Compute the cutoff value
Classify the customers based on the cut-off
value
Prof S N Rao

53

Credit Granting Decision

Compute expected profit of offering
credit without repeat order and with
repeat order
If it is positive, offer credit

Prof S N Rao

54

Control of Credit-Days Sales

Outstanding (DSO)
Month Sales

Receivables

Jan

150

400

Feb

156

450

Mar

158

375

Apr

160

420

May

155

410

June 158

380

Month
Jan 150
Feb 200
Mar 250
Apr 120
May 220
June 250

Prof S N Rao

Sales
Receivables
400
450
500
350
380
400
55

Control of Credit-Aging Schedule (AS)

Age group

Percent of receivables

0-30

35

31-60

40

61-90

20

>90

5
Prof S N Rao

56

Limitations of DSO & AS

Influenced by sales pattern
Payment behavior of customers
If sales are increasing/decreasing
DSO and the AS will defer from what
they would be if sales are constant
This holds even when payment
behavior of the customer remain
unchanged
Prof S N Rao

57

Collection Matrix/Payment Pattern

%of ARs collected
during the

Jan

Feb

Mar

Month of sales

10

10

10

One month after sales

30

25

20

Two months after sales

30

35

20

Three months after

30
sales
Four months after sales -

25

20

30

Prof S N Rao

58

Credit Management in India

Credit Policy
No formalization of credit policy
Too general statement of policy
Credit period: 0-60 days
Cash discount for prompt payments
is not common

Prof S N Rao

59

Credit Management in India

Credit Analysis
No detailed analysis of financial
statements
Customers are required to furnish 2-3
references
Independent agencies for credit rating are
coming up
Credit information from bank is too
general
Large companies classify customers based
on credit worthiness
Prof S N Rao

60

Credit Management in India

Control of Receivables
No systematic methods for
controlling and monitoring
receivables
Normal measures of credit
management
Bad debt losses
Average collection period
Aging schedule
Prof S N Rao

61

Inventory Management

Prof S N Rao

62

Inventory Management
Types of Inventory
EOQ Model
Order point
Factors affecting inventory levels
Valuation of Stock
Monitoring and Control of Inventory

Prof S N Rao

63

Types of Inventory
Process inventory
Movement inventory
Organization inventory

Prof S N Rao

64

EOQ Model
Assumptions
Usage is known
Even usage
Immediate replenishment
Only two costs: ordering and
carrying
Ordering cost is constant
Carrying cost is fixed % of the avg
inventory
Prof S N Rao

65

Ordering Point
If lead time and usage are stable:
Ordering point
= lead time for procurement X daily usage
If lead time and usage are volatile
Ordering point
= ( Avg lead time for procurement X
Average daily usage) + Safety stock
Prof S N Rao

66

Factors Influencing level of

inventory

Prof S N Rao

67

Factors influencing inventory

Anticipated scarcity
Expected price change
Obsolescence risk
Govt restrictions
Marketing considerations

Prof S N Rao

68

Pricing of Raw Material

FIFO Method
LIFO Method
WA Cost Method
Std Cost Method
Current Cost Method

Prof S N Rao

69

Valuation of Inventory
Direct/Variable Costing
Fixed Mfg exp are treated as period
cost
Value of WIP&FG is lower under this
method

Absorption/Total Costing
Fixed Mfg exp are treated as product
cost
Value of WIP & FG is higher under
this method
Prof S N Rao

70

Monitoring and Control of Inventory

ABC Analysis
Ratio Analysis
JIT
Out sourcing
Computerized inventory control
system

Prof S N Rao

71

Inventory Management in India

Inventory levels in India are high due to
Sever penalty for stock out and no
penalty for excess inventory
Lengthy and cumbersome import
process
High inflation
Lack of standardization
Long lead time
Prof S N Rao

72

Inventory Management in India

Common tools of Inventory Mgt
FSN Analysis
Inventory turn over ratios
ABC Analysis

Prof S N Rao

73

Sources of WC Finance

Prof S N Rao

74

Sources of WC Finance
Accruals
Trade Advances
Trade credits
CPs
Public deposits
Bank Finance
ICDs
Rights Debentures
Factoring

Prof S N Rao

75

Accruals
Wages &Taxes
Cost free sources
Not amenable to control by Mgt

Prof S N Rao

76

Trade advances
Common in cases of expensive
products
Monopoly markets
Cost free?

Prof S N Rao

77

Trade Credit
Represents the credit extended by
the supplier of goods and services
Spontaneous source of finance
Constitutes 25%-50% of WC finance
Is it cost free?

Prof S N Rao

78

Commercial Paper
Introduced in Jan 1990
In FY 2012-13 alone, Corporate India
raised about Rs.3.72 lakh Cr. through
4,856 issues (Prime Database).
Maturity period: 7-364 days
Sold at discount redeemed at face
value
Traded on SBI-DFHI
Generally held till maturity
Prof S N Rao

79

Commercial Paper
Regulations
Net worth of at least Rs. 4 cr
Sanctioned WC limit by Banks/FIs
FV of CPs issued should not exceed
WC limit
Listed company

Prof S N Rao

80

Commercial Paper
Rated P1/A2
Enjoys health code no 1
Min issue size is Rs.25 lakh and min
denomination is Rs.5 lakh
Cost?

Prof S N Rao

81

CP issue of ONGC Videsh Ltd

(OVL)
Issue size: Rs.5,250 cr
The largest CP issue in India
Maturity: 1 year
Implied yield: 8.15%
Post-tax interest cost: 5.5%
Yield on 1-year T-bill: 4.75%
Guaranteed by ONGC which Cash balance of
Rs.25,000 crs
Issue date: First week of Jan 2009

Prof S N Rao

82

CP issue of ONGC Videsh Ltd

(OVL)
Objective: To part finance the
acquisition of UK based Imperial
Energy
Total acquisition price: USD 2.1 b
CP issue amount: around USD 1b
Balance amount is provided by ONGC
as long-term debt
Prof S N Rao

83

Public Deposits
Can not exceed 25% of NW
Maturity: 6 months 3 years
DRR
Disclosure of financial performance
Cost?

Prof S N Rao

84

Public Deposit Schemes of Tata Motors

Scheme-A:
Quarterly Income Plan

Scheme-B
Cumulative Deposit Plan

Period

Min
Amt

Int Rate
(p.a)

Period

Min
Amt

Int Rate
(p.a.)

Maturity
value

Implied
yield

1 year

20000

10%

1 year

20000

10%

22 076

10.36%

2 years

20000

10.5%

2 years

20000

10.5%

24 607

10.92%

3 years

20000

11%

3 years

20000

11%

27 696

11.46%

0.5% additional interest for senior citizens/shareholders/employees

The issue was floated in Nov 2009

Prof S N Rao

85

Public Deposit Schemes of

Bombay Dyeing
Period: 36 months
Interest rate: 10.5% p.a. payable quarterly
Effective interest rate: 10.36%
Floated in Jan 2009
Godrej & Boyce Mfg Company
Period: 3 years
Interest rate: 10% p.a. payable half yearly
Effective interest rate: 10.25%
Floated in August 2008
Prof S N Rao

86

Public Deposits
Maturity

HDFC

Bajaj Fin

M&M Fin

Shriram
TFC

12 months

8.75%

9.75%

9.25%

9.25%

24 months

9.05%

9.75%

10%

9.75%

36 months

9.15%

10%

10.25%

10.75%

Prof S N Rao

87

Bank Finance
CC/OD
Loans
Purchase/Discount of Bills
LCs
Security
Hypothecation
Pledge
Mortgage
MPBF & Margin
Cost?
Prof S N Rao

88

ICDs
Call deposits
Three-month deposits
Six-month deposits
No regulations
Secrecy
Importance of personal contacts
Cost?
Prof S N Rao

89

Rights Debentures
Amount should not exceed
20% of the (GWC LT funds available
for WCF) OR
20% of paid-up capital incl Pref Cap and
free reserves , whichever is lower
D/E ratio, including proposed debenture
issue, should not exceed 1:1

Cost?
Prof S N Rao

90

Debenture Issue of
Shriram Transport Finance Co. Ltd

Issue size: Rs.500 cr with option to

retain over subscription upto Rs.500
cr
Issue period: 27 Jul 2009-14 Aug
2009
Min amount: Rs.10000
Maturity: 3 years/5 years
Interest rateL 10.75% to 11.5%
Prof S N Rao

91

Factoring
It is a powerful financial instrument
specially designed to meet the post
sales working capital requirements of
the industrial, trade &
service
sectors, it is a portfolio of
complementary financial services.
Besides financing up to 80% of the
invoice value, the package includes:
Prof S N Rao

92

Factoring
Sales ledger administration
Debtor collection
Credit information services
Advisory services

Prof S N Rao

93

Factoring
Types of Factoring
With recourse factoring
Without-recourse factoring
Undisclosed factoring

Prof S N Rao

94

Factoring
Benefits of Factoring
Instant access to cash
Make payments to creditors, avail
cash discounts
Maintenance of sales ledger
Collection of debtors
Clients can focus on other functions
Prof S N Rao

95

Factoring
Eligibility
Mfg, trading or services company
Should have sound financial base
Turnover of not less than Rs.50 lacs
Strong and prompt customer base

Prof S N Rao

96

Factoring
Where Factoring is not suitable
Where large volume of cash sales
take place
Engaged in speculative business
Selling highly specialized capital
equipments or made-to-order
goods
Prof S N Rao

97

Factoring
Where credit period offered to the
buyers is more than 180 days
Where there is consignment sale
Where sales are to the
sister/associated companies
Where sales are to the public at large
Cost?
Prof S N Rao

98

Some Factoring Companies

Cabank Factors
SBI Factors
IFCI Factors

Prof S N Rao

99

Prof S N Rao

100