SUMMARY
SUMMARY
OF SLIDES
OF SLIDES
FIN 722
FIN 722
LESSON 23
LESSON 23
EXAMPLE EXAMPLE
–
– A firm has 100 shares outstanding and the par value of share is Rs.100. The company intends to pay allA firm has 100 shares outstanding and the par value of share is Rs.100. The company intends to pay all
of its earnings in dividends. The cash flow for year 1 &
of its earnings in dividends. The cash flow for year 1 & 2 to be paid as 2 to be paid as dividend is rs.10,00dividend is rs.10,000 that means0 that means Rs.100 dividend per share.
Rs.100 dividend per share.
–
– The other option is to pay a The other option is to pay a dividend of Rs. 110 after first year and Rs. 89 after second year as dividend.dividend of Rs. 110 after first year and Rs. 89 after second year as dividend.
Assuming 10% required rate of return. Assuming 10% required rate of return.
–
– What is the value of the What is the value of the firm with new dividend policyfirm with new dividend policy??
Solution Solution • • P Poo = D= D11/(1 + R)/(1 + R)11 + D + D22/ (1+R)/ (1+R)22 •
•that is:that is:
= 100 /1.10 + 100/(1.10) = 100 /1.10 + 100/(1.10)22 = 173.55
= 173.55 •
•Now if the second option is adopted, then value of firm is:Now if the second option is adopted, then value of firm is: P Poo = D1/(1 + R) = D1/(1 + R)11 + D2/ (1+R) + D2/ (1+R)22 = 110 /1.10 + 89*/(1.10) = 110 /1.10 + 89*/(1.10)22 = 173.55 = 173.55 •
•*why it is 89*why it is 89 – – let’s see.let’s see.
•
•We have only Rs. 10,000 of cash flow for dividend payout. but under later option we need a cash flowWe have only Rs. 10,000 of cash flow for dividend payout. but under later option we need a cash flow of
of
•
•110 x 100 = 11,000 - a deficit of Rs 1000.110 x 100 = 11,000 - a deficit of Rs 1000.
•
•Suppose we seek a loan to bridge this deficit. In the next year we need to pay dividend, return the loanSuppose we seek a loan to bridge this deficit. In the next year we need to pay dividend, return the loan and to pay interest on loan (assume 10% Rate)
and to pay interest on loan (assume 10% Rate) •
•Loan repayment and interest will be Rs. 1100 and the balance amount left for dividend will beLoan repayment and interest will be Rs. 1100 and the balance amount left for dividend will be 20,000
20,000 – – 1,100 = 8,900 which equals Rs 89 per share dividend. 1,100 = 8,900 which equals Rs 89 per share dividend.
–
– DIVIDEND RELEVANCE:DIVIDEND RELEVANCE: –
– As a mean As a mean of resolving the uncertainty early, investors prefer dividend income rather than non-of resolving the uncertainty early, investors prefer dividend income rather than non-dividend paying.
dividend paying. –
– Liquidity preferenceLiquidity preference
–
–
– FINANCIAL SIGNALING:FINANCIAL SIGNALING: –
– Image of the company improved by Image of the company improved by paying dividend.paying dividend.
–
– None payment of Dividend adversely effect company’s image.None payment of Dividend adversely effect company’s image.
–
– DDividends have impact on share prices because it ividends have impact on share prices because it indicate the firm’s profitability as well.indicate the firm’s profitability as well.
–
– Accounting earningAccounting earnings may not s may not be a influencing factor as be a influencing factor as compared to increase in dividend.compared to increase in dividend.
–
– TAXATION ON CAPITAL GAINS VS DIVIDENDS:TAXATION ON CAPITAL GAINS VS DIVIDENDS: –
– In Pakistan no tax levied on Capital Gain but tax is In Pakistan no tax levied on Capital Gain but tax is paid on Dividend.paid on Dividend.
RESIDUAL DIVIDEND POLICY RESIDUAL DIVIDEND POLICY
•
•Debt Equity Ratio of 0.50Debt Equity Ratio of 0.50 – – firm wishes to maintain it. After tax profit rs.1,000. If no dividend is paid, firm wishes to maintain it. After tax profit rs.1,000. If no dividend is paid,
equity will increase. It means that firm will seek loan to maintain D/E Ratio. for example, after tax profit equity will increase. It means that firm will seek loan to maintain D/E Ratio. for example, after tax profit of Rs.1000/- the firm must borrow Rs.500 in order to maintain D/E of 0.50.
of Rs.1000/- the firm must borrow Rs.500 in order to maintain D/E of 0.50.
•
•The first thing would be to determine the funds that can be generated without selling additionalThe first thing would be to determine the funds that can be generated without selling additional
shares. shares.
Residual Dividend Policy Residual Dividend Policy
Sr. Sr. No.
No. After After TaxTax Earning Earning New New Investment Investment Additional Additional Debt Debt Retained Retained Earning Earning Additional Additional Stock Stock Dividends Debt/Equity Dividends Debt/Equity 1 1 2,000.00 2,000.00 6,000.00 6,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 - - 0.500.50 2 2 2,000.00 2,000.00 5,000.00 5,000.00 1,500.00 1,500.00 2,000.00 2,000.00 1,000.00 1,000.00 - - 0.500.50 3 3 2,000.00 2,000.00 4,000.00 4,000.00 1,250.00 1,250.00 2,000.00 2,000.00 500.00 500.00 - - 0.500.50 4 4 2,000.00 2,000.00 3,000.00 3,000.00 1,000.00 1,000.00 2,000.00 2,000.00 - - - - 0.500.50 5 5 2,000.00 2,000.00 2,000.00 2,000.00 666.67 666.67 1,333.33 1,333.33 - - 666.67 666.67 0.500.50 6 6 2,000.00 2,000.00 1,000.00 1,000.00 333.33 333.33 666.67 666.67 - - 1,333.33 1,333.33 0.500.50 7 7 2,000.00 2,000.00 - - 2,000.002,000.00 CONCLUSION CONCLUSION
•A firm must endeavor to establish a dividend policy that maximizes shareholders wealth.
•Mostly it is believed that if a firm does not have investment opportunities on its plate, it should return / distribute funds to shareholders.
•It is not necessary to pay out everything but firm may wish to stabilize the dividends.
•There must be preference for dividend.
•It appears realistic to have some value associated with modest dividend as compared to nothing.
FINANCIAL PLANNING & FORECAST
– BUDGETS – FUNCTIONS AND PREPARATION OF BUDGET CASH BUDGETS:
- SALES FORECAST
- DIRECT COST FORECAST / ESTIMATE - OTHER RECEIPT & DISBURSEMENT - NET CASH FLOW
– CASH FLOW STATEMENT– ACCOUNTING:
•INDIRECT METHOD – IAS DEFINITION •PARTS OF CASH FLOW
•ANALYZING CASH FLOW - FORECAST FINANCIAL STATEMENTS •PLANNING PROCESS:
– Identify objectives or targets
– Develop Courses Of Action To Achieve Objectives – Evaluate every alternative
– Choose a course of action – strategy to achieve
– Implement a plan
– Lead to controlling CONTROL PROCESS
Plans put to operation – last stage of planning -Actual results are recorded
-Actual results are compared with actual -Feedback is prepared
-Two types of Feed back
-Negative Feed back -Positive Feed back
-Feedback is used to change the strategy -Feedback & feed forward control
•CHANGE THE STRATEGY OR COURSE OF ACTION:
– If something went wrong with strategy, the course of action is fine tuned or changed to ensure
future actual results conform to original plan. •DO NOTHING:
– If the results are in line with the planned, no action is required.
•CHANGE THE PLAN:
– Targets or plan itself is revised rather than changing strategy. For example the targeted profit is
scaled down.
BUDGET AS PLANNING & CONTROLLING TOOL Budget:
– Transform yours objectives into monetary values.
BUDGET PREPARATION PROCESS •BUDGET POLICY & DETAILS
– Budgeting committee – Budgeting period – Time
– Communicating to all
•DETERMINING THE LIMITING FACTOR
(either capacity or sales forecast)
LESSON 24
SALES BUDGET PREPARATION
– Sale forecast & Production budget
OTHER ANCILLARY POLICY ISSUES DETERMINATION – Finished goods level
– Materials ending inventory – Production cost budget
•FUNCTIONAL BUDGETS •NEGOTIATION
•MASTER BUDGET OR CORPORATE BUDGET •FINALIZATION OF BUDGET & IMPLEMENTATION •CONTROLLING STAGE
•VARIANCE ANALYSIS
– Difference between actual and budgeted numbers is known as variance. •INVESTIGATION
PURPOSE & OBJECTIVES OF BUDGET
•Path to achieve the corporate objectives
•Compel Planning
•Increased Responsibility Accounting •Ensures Control
•Increased Coordination
•Source of Motivation CASH BUDGETS
•A statement that incorporates both inflows and outflows. •Based on the timings of each component.
COMPONENTS OF CASH BUDGET
•Non-cash items are not considered.
•Every item involving cash is included and considered. •Example: Depreciation is a non-cash items.
•Accruals are not taken into cash budgets.
•Profits and losses are not related to cash budgets.
•Above all the essence of cash budget is the timing of occurrence of every line item.
EXAMPLE
•M/S Hi Land Ltd is in the process of preparing cash budget for the 1st quarter of 2007. The following information is available:
•Opening cash balance is Rs.
2,000/-•Forecast sales are Rs 50,000/- each for Nov. 06 to Jan. 07 and Rs. 65,000 per month for Feb. & Mar. 07. •80% sales is on credit basis and 20% on cash.
•Debtors pay after two months from the sale date.
•Materials cost will be Rs. 34,000/- for Nov. & Dec. 07 & Rs. 35,000/-, Rs. 36,000/- & Rs. 37,000/- for Jan to Mar. 07 respectively.
•Creditors are paid after one month.
•Electricity bill is paid in following month. Dec to Mar. expense is estimated at Rs. 6,000 per month. •Recurring expense will be Rs. 4,000 per month for Nov. & Dec. 06 and Rs. 6,000, Rs 9000 & Rs. 12,000 for Jan. to Mar. 07 and are paid in the month of incurrence.
•A new assets will be purchased in Jan 07 for Rs. 12,000/-. payment will be made in Feb. 07.
•An old assets will be disposed off in January for Rs. 1,000/- and the receipt will hit the bank on first of February 07.
•Required:
•Prepare the cash budget for the first quarter of year 2007 and provide your feedback to the management.
Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 INFLOWS Rs. TOTAL SALES 50,000.00 50,000.00 50,000.00 65,000.00 65,000.00 SALES - CREDIT 80% 40,000.00 40,000.00 40,000.00 SALES - CASH 20% 10,000.00 13,000.00 13,000.00 SALES INFLOW 50,000.00 53,000.00 53,000.00 OTHER RECEIPTS SALE OF ASSET - 1,000.00 -TOTAL INFLOWS 50,000.00 54,000.00 53,000.00
OUTFLOWS MATERIALS COST 34,000.00 34,000.00 35,000.00 36,000.00 36,000.00 CREDITORS PAYMENT 34,000.00 35,000.00 36,000.00
ELECTRICITY 6,000.00 6,000.00 6,000.00
RECURRING EXP 6,000.00 9,000.00 12,000.00
CAPITAL PAYMENTS - 12,000.00
-TOTAL INFLOWS 46,000.00 62,000.00 54,000.00
NET CASH FLOW 4,000.00 (8,000.00) (1,000.00)
OPENING CASH 2,000.00 6,000.00 (2,000.00)
ENDING CASH 6,000.00 (2,000.00) (3,000.00)
CASH FLOW STATEMENT
•Purpose of Cash Flow Statement is to provide information about the inflows and outflows of cash and
cash equivalents.
•Cash And Cash Equivalent has two characteristics:
•The inflows and outflows are grouped into three categories.
– both readily convertible into cash – without loss of value
•CASH FLOW STATEMENT IS DIVIDED INTO THREE CATEGORIES
– OPERATING ACTIVITIES – INVESTING ACTIVITIES – FINANCING ACTIVITIES
PURPOSE OF CASH FLOW STATEMENT
•To identify and assess the ability to generate future net cash flow from operations to pay debt, interest
and dividends
•External financing requirements.
•To see the effects of cash & non cash investing and financing transactions.
•Assess the reasons for differences between income and associated cash receipts and payments.
METHODS OF PREPARING CASH FLOW STATEMENT •COMPLIANCE OF IAS 07:
– DIRECT METHOD – BENCHMARK
– INDIRECT METHOD – ALLOWED ALTERNATIVE
EXAMPLE: INDIRECT METHOD
HI LAND LIMITED INCOME STATEMENT
For the year Ended December 31, 2005 Rs.
SALES 290,000.00
Less COST OF SALES 174,000.00
Less OPERATING EXP
Administrative Exp 45,000.00
Selling & Marketing 20,900.00
Depreciation 13,000.00
Less Interest Exp 15,400.00
Gain on Sale of Land 2,500.00
Profit before taxes 24,200.00
Provision for taxes 9,700.00
Net Income 14,500.00 HI LAND LIMITED BALANCE SHEET AS ON DECEMBER 31, 2005 2005 2004 Fixed Assets Land 148,400.00 100,000.00
Buildings 465,000.00 415,000.00 Less: Accumulated Depreciation (217,000.00) (205,000.00)
396,400.00 310,000.00 Intangible Assets: Patents 5,000.00 6,000.00 CURRENT ASSETS Inventory 175,000.00 153,000.00 Accounts Receivable 109,000.00 90,000.00 Prepaid Expenses 15,500.00 17,000.00
Cash & Bank 50,000.00 55,000.00
349,500.00 315,000.00 Investment - Land - 27,500.00 TOTAL ASSETS 750,900.00 658,500.00 CURRENT LIABILITIES Accounts Payable 69,000.00 75,000.00 Accrued Liabilities 24,500.00 20,000.00 93,500.00 95,000.00
Long Term Liabilities:
Premium on Bonds 29,400.00 30,000.00 229,400.00 230,000.00 TOTAL LIBILITIES 322,900.00 325,000.00 SHAREHOLDERS' EQUITY Share Capital 335,500.00 255,500.00 Retained Earnings 92,500.00 78,000.00 Total Equity 428,000.00 333,500.00
TOTAL LAIBILITIES & EQUITY 750,900.00 658,500.00
HI LAND LIMITED CASH FLOW STATEMENT
For the Year Ended December 31, 2005 (INDIRECT METHOD)
A CASH FLOW FROM OPERATING ACTIVITIES Rs.
Net Income 14,500.00
Adjustment for Non-Cash items:
Gain on Sale of Land (2,500.00) Operating profit before working capital changes 25,000.00
Change in working capital
Increase in Inventory (22,000.00)
Increase in Accounts Receivable (19,000.00)
Decrease in Prepaid Expenses 1,500.00
Decrease in Accounts Payable (6,000.00)
Increase in Accrued Liabilities 4,500.00
Decrease in Amortization of Bond Premium (600.00)
Cash Generated from operations (16,600.00)
LESSON 25
CASH FLOW STATEMENT
•Three segments of preparing Cash Flow Statement:
–
OPERATING ACTIVITIES–
INVESTING ACTIVITIES–
FINANCING ACTIVITIES HI LAND LIMITED BALANCE SHEET AS ON DECEMBER 31, 2005 2005 2004 Fixed Assets Land 148,400.00 100,000.00 Buildings 465,000.00 415,000.00Less: Accumulated Depreciation (217,000.00) (205,000.00) 396,400.00 310,000.00 Intangible Assets: Patents 5,000.00 6,000.00 CURRENT ASSETS Inventory 175,000.00 153,000.00 Accounts Receivable 109,000.00 90,000.00 Prepaid Expenses 15,500.00 17,000.00
Cash & Bank 50,000.00 55,000.00
349,500.00 315,000.00 Investment - Land - 27,500.00 TOTAL ASSETS 750,900.00 658,500.00 CURRENT LIABILITIES Accounts Payable 69,000.00 75,000.00 Accrued Liabilities 24,500.00 20,000.00 93,500.00 95,000.00
Long Term Liabilities:
Bonds 200,000.00 200,000.00
229,400.00 230,000.00 TOTAL LIBILITIES 322,900.00 325,000.00 SHAREHOLDERS' EQUITY Share Capital 335,500.00 255,500.00 Retained Earnings 92,500.00 78,000.00 Total Equity 428,000.00 333,500.00
TOTAL LAIBILITIES & EQUITY 750,900.00 658,500.00
HI LAND LIMITED CASH FLOW STATEMENT
For the Year Ended December 31, 2005 (INDIRECT METHOD)
A CASH FLOW FROM OPERATING ACTIVITIES Rs.
Net Income 14,500.00
Adjustment for Non-Cash items:
Add Depreciation and Amortization 13,000.00
Gain on Sale of Land (2,500.00)
Operating profit before working capital changes 25,000.00
Increase in Inventory (22,000.00)
Increase in Accounts Receivable (19,000.00)
Decrease in Prepaid Expenses 1,500.00
Decrease in Accounts Payable (6,000.00)
Increase in Accrued Liabilities 4,500.00
Decrease in Amortization of Bond Premium (600.00)
Cash Generated from operations (16,600.00)
HI LAND LIMITED CASH FLOW STATEMENT
For the Year Ended December 31, 2005 (INDIRECT METHOD)
CASH FLOW FROM INVESTING ACTIVITIES
Proceeds from Sale of Land 27,500.00
Gain on Sale of Land 2,500.00
Purchase/addition to Asset - Building (50,000.00)
Purchase/addition to Asset - Land (48,400.00)
Net cash used in investing activities (68,400.00) CASH FLOW FROM FINANCING ACTIVITIES
Increase in Common Stock - New shares issued 80,000.00
NET INCREASE/(DECREASE) IN CASH EQUIVALENTS (5,000.00)
CASH AND CASH EQUIVALENTS AT THE BEGINING OF THE PERIOD 55,000.00
CASH AND CASH EQUIVALENTS AT THE END 50,000.00
Cash Budget Vs. Cash Flow
•Cash Budget Pre Operations
•Cash Flow Statement Post Operations
WORKING CAPITAL MANAGEMENT
•These activities are in sequence: •How much inventory to procure?
•Payment to creditors and expenses borrow? •Production of goods/ Manufacturing
•Sales credit extension period / Cash sales •Collection of funds and application
OPERATING AND CASH CYCLE
•OPERATING CYCLE:
•The time between receiving the raw materials and collection of amount against credit sales
from debtors is called Operating Cycle.
•CASH CYCLE:
•The time period between cash payment and cash receipts.
•EXAMPLE:
•We buy inventory on credit on Jan. 01, 2006 worth Rs. 10,000/-. settle the creditor on Feb. 01. After a month (on march 01) a debtor buys the finished goods for Rs. 14,000/- and pays after 1.50 months (on 15th April 2006.
•The period from the date of acquisition of inventory Jan. 01, 06 to the date of receipt of cash from debtor – 15th April 2006 is known as operating cycle.
•Normally operating cycle is expressed in days. In this example, the length of Operating Cycle is 105 days.
•Inventory period: the period of time it takes to procure, produce and sell the inventory.
•In our example, inventory acquisition date Jan. 01, 06 to march 01, 2006 – 60 days is known as
Inventory period.
•Accounts receivable period: the time to recover the sales.
•In our example, march 01 to April 15 – 45 days period is termed as accounts receivable period.
THE CASH CYCLE:
•We pay for inventory after 30 days, on Jan. 31.
•On this date we have to obtain loan from bank to pay off Rs. 10,000/- because at this date we have not sold our product which was manufacture from the goods bought (on credit) from the vendors.
•We borrowed on Jan. 31 and will pay on 15th April when we get cash from debtors. Borrowed for 105-30= 75 days.
•This 75 days period is known as cash cycle.
•The time period from 1st Jan. to 31st Jan. (30 days) is known as Accounts Payable Period. WE CAN CALCULATE THE CASH CYCLE AS UNDER;
CASH CYCLE = OPERATING CYCLE – A/P PERIOD
75 = 105 - 30
EXAMPLE: OPERATING & CASH CYCLE
OPENING CLOSING AVG
INVENTORY 2,000.00 3,000.00 2,500.00 DEBTORS 1,600.00 2,000.00 1,800.00 CREDITORS 750.00 1,000.00 875.00 NET SALES 11,500.00 COST OF SALE 8,200.00 OPERATING CYCLE
INVENTORY TURNOVER= COS/AVG INV 3.28 TIME
A/R TURNOVER = CREDIT SALES/AVG AR 6.39 TIMES (ASSUMED ALL SALES ON CREDIT)
RECEIVABLE PERIOD = 365 DAYS / AR TURNOVER 57.13 DAYS
OPERATING CYCLE = Inventory Period +AR Period 168.41 = 111.28 Days + 57.13 Days CASH CYCLE:
Payable Turnover = COS /Avg. Payable = 9.37 Times
AP Period = 365 days / AP Turnover = 38.95 Days
Cash Cycle = Operating Cycle – Accounts Payable period 129.46= 168.41Days - 38.95 Days
Recap
Two types of Cash Flow:
–
Pre-Operation Cash Budget–
Post- Operation Cash Flow StatementDifference between Cash Budget & Cash Flow Statement Statutory Requirement:
–
Cash Flow Statement: Statutory obligation to prepare CFS in order to compliance with IAS 07.On the other hand, there is no statutory obligation to prepare Cash Budget. Format:
–
Cash Budget based on estimated data. CFS based on actual data. Benchmark is direct method.Normally CFS also prepare through indirect method.
WORKING CAPITAL MANAGEMENT
GROSS WORKING CAPITAL = TOTAL INVESTMENT IN CURRENT ASSETS NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES
SIGNIFICANCE OF WORKING CAPITAL
•Plenty of funds are invested in current assets.
•Considerable time of financial manager is devoted to working capital decision.
•Working capital matters are dealt with on day to day basis unlike capital structure or dividend
policy.
•Above all, working capital decision effect Risk & Profitability.
Three concepts associated:
•RISK
•PROFITABILITY •LIQUIDITY
LEVEL OF INVESTMENT
OPTIMAL LEVEL OF CURRENT ASSETS’S INVESTMENT:
•Adequate or Lowest level of current assets should be maintained that support your sales or
productions that lower your cost. RELIANCE ON SHORT TERM FINANCING
1- Short term loans carry lower interest rates. 2- Flexibility of short term loan
–
e.g. Overdraft and Running Finance etc.•This suggest that investment in current assets should be kept low. •High level of Current Liabilities.
•Negative Net Working Capital. •This strategy will increase the Risk.
Two Reasons for maintaining Minimum Working Capital Balance:
•To fulfill Short Term Obligations.
•To support Sales or Production Activities.
–
High level of investment in current assets.–
Support any level of Production and Sales.–
High liquidity level.–
Avoid short-term financing to reduce risk, but decreases the potential for maximum valuecreation because of the high cost of long-term debt and equity financing.
–
Borrowing long-term is considered less risky than borrowing short-term.–
This approach involves the use of long-term debt and equity to finance all long-term fixedassets and permanent assets, in addition to some part of temporary current assets.
•The firm has a large amount of net working capital. It is a relatively low-risk position. •The safety of conservative approach has a cost.
•Long-term financing is generally more expensive than Short term financing.
AGGRESSIVE WORKING CAPITAL POLICY
–
Low level of investment–
Support low level of Production & Sales Activity.–
More short-term financing is used to finance current assets.–
Firm risk increases, due to the risk of Fluctuating Interest Rates, but the potential for higherreturns increases because of the generally low-cost financing.
–
Borrowing short-term is considered more risky than borrowing long-term.–This approach involves the use of short-term debt to finance at least the firm's temporary assets, some or all of its permanent current assets, and possibly some of its long-term fixed assets. (Heavy reliance on short term debt).
–The firm has very little Net Working Capital. It is more risky. MODERATE WORKING CAPITAL POLICY
•This approach tries to balance Risk, Profitability and liquidity.
•Temporary current assets that are only going to be on the balance sheet for a short time should
be financed with short-term debt, Current liabilities.
•And Permanent Current Assets and Long Term Fixed Assets that are going to be on the balance
sheet for a long time should be financed from long term debt and equity sources.
•The firm has a moderate amount of net working capital. It is a relatively amount of risk
balanced by a relatively moderate amount of expected return.
•In the real world, each firm must decide on its balance of financing sources and its approach to
working capital management based on its particular industry and the firm's risk and return strategy.
PROFITABILITY AND WC POLICIES
Ranking of Working Capital Policies with regard to Return on Investment: ROI = NET PROFIT / TOTAL ASSET
OR
ROI = Net profit / (Cash + Receivables + Inventory) + Fixed Assets
As the inventory will decrease the return on investment will increase as suggested by the above equation.
Under Aggressive policy, profitability is greater than Conservative. LIQUIDITY & PROFITABILITY
•lenders prefer a company having:
–
Large excess of current assets over current liabilities.–
Whereas the owners prefer a high return.•Current assets have the advantage of being liquid, but holding them is not very profitable. •Accounts Receivable earns no return.
•Inventory earns no return until it is sold.
•Non-current assets can be profitable, but they are usually not very liquid.
•Firms are usually faced with a trade-off in their working capital management policy.
•They seek a balance between liquidity and profitability that reflects their desire for profit and their need for liquidity.
RISK & RETURN OF CURRENT LIABILITIES
•A firm's working capital is financed from:
–
Long-term borrowing–
Short-term borrowing,–
Spontaneous•The choice of the firm's working capital financing depends on manager's desire for profit
versus their degree of risk aversion.
•The balance between the risk and return of financing options depends on the firm, its financial
managers, and its financing approaches.
OPTIMAL LEVE OF CURRENT ASSETS
•A firm's optimal level of current assets is reached when the optimal level of
–
Inventory–
Accounts Receivable–
Cash or Cash equivalent • and other current assets is achieved.PROJECTING THE ALL THREE POLICIES CONSERVATIVE = A
MODERATE = B AGGRESSIVE = C
LIQUIDITY PROFITABILITY RISK
HIGH A C C
NOR B B B
LOW C A A
THE CHART TELL US TWO THINGS
•Profitability varies inversely with Liquidity;
–
Increased Liquidity can be achieved at the expense of (decreased) Profitability.•Profitability & Risk have same direction;
–
In order to have greater Profitability, we need to take greater Risk.CONCLUSION
Optimal level of each current asset will depend on the management’s attitude towards Risk & Return.
LESSON 27
CLASSIFICATION OF WORKING CAPITAL •Classification by Component:
– Like Cash, Receivables, Inventory, Investments (Short Term)
•Classification by Time:
– Like Temporary Current Assets & Permanent Current Assets
•Temporary Working Capital
•
•Permanent working capitalPermanent working capital is the amount of investment in current assets that is required to support is the amount of investment in current assets that is required to support the minimum long term needs.
the minimum long term needs.
CURRENT ASSETS FINANCING CURRENT ASSETS FINANCING Short Term & Long
Short Term & Long Term Investment Mix:Term Investment Mix:
•
•A trade off between risk and profitability is required when we are faced with current assetsA trade off between risk and profitability is required when we are faced with current assets
financing decisions. financing decisions.
•
•It is assumed that It is assumed that a company has a company has a definite policy vis-à-vis payment to a definite policy vis-à-vis payment to creditors, taxes Andcreditors, taxes And
expenses. The reason being that a firm cannot stretch these outflows by a reasonable time expenses. The reason being that a firm cannot stretch these outflows by a reasonable time period.
period. Short Term & Long
Short Term & Long Term Investment Mix:Term Investment Mix:
•
•In other words, creditors / accounts payable and In other words, creditors / accounts payable and accruals are dormant decision variables whenaccruals are dormant decision variables when
it comes to current asset financing. it comes to current asset financing.
•
•These current liabilities are known These current liabilities are known as spontaneous financing.as spontaneous financing. •
•Residual policy have Residual policy have different approaches for financing.different approaches for financing. •
•How mix develop to finance temporary current assets and permanent current assets?How mix develop to finance temporary current assets and permanent current assets?
Hedging approach to Current Assets
Hedging approach to Current Assets FinancingFinancing •
•Each asset will be offset with a financing instrument having same maturity.Each asset will be offset with a financing instrument having same maturity. •
•Temporary current assets should be financed with short term debts.Temporary current assets should be financed with short term debts. •
•Permanent portion of Permanent portion of current assets (and all non current assets (and all non current assets) should be financed with longcurrent assets) should be financed with long term loans and equity.
term loans and equity. •
GRAPHICAL VERSION OF HEDGING POLICY GRAPHICAL VERSION OF HEDGING POLICY
Only short term variations would be financed through short term loans.Only short term variations would be financed through short term loans.
If we finance this portion through long term loans, then we will pay interest on loan when actuallyIf we finance this portion through long term loans, then we will pay interest on loan when actually funds are not needed.
funds are not needed.
Short term loan/financing is flexible.Short term loan/financing is flexible.
Short term loans shall only be Short term loans shall only be employed in the period of employed in the period of seasonal lessened activity.seasonal lessened activity.
We pay off the loan We pay off the loan liability when not needed to avoid interest cost.liability when not needed to avoid interest cost.
Borrowing and payment of short term loans can be arranged to correspond to the expected caBorrowing and payment of short term loans can be arranged to correspond to the expected ca variations.
variations.
On Eid, (increased activity) inventory will increased and that increase shall be On Eid, (increased activity) inventory will increased and that increase shall be financed through shortfinanced through short term borrowing.
term borrowing.
Inventory will squeeze due to increased sales and Inventory will squeeze due to increased sales and receivables will expand.receivables will expand.
That cash used to That cash used to pay off the pay off the loan (and creditors) now comes through collection of accountsloan (and creditors) now comes through collection of accounts receivable.
receivable.
Short term loan to support seasonal need would generate necessary cash to repayment in normalShort term loan to support seasonal need would generate necessary cash to repayment in normal course of o
course of operation.peration.
This is This is known as known as Self-LiquidSelf-Liquidating Principle.ating Principle.
Short Term Vs Long Term Financing Short Term Vs Long Term Financing
•
•Under uncertainty, net cash flow will not exactly match the maturity of debt.Under uncertainty, net cash flow will not exactly match the maturity of debt. •
•This aspect is of crucial importance when it comes to risk and profitability trade off.This aspect is of crucial importance when it comes to risk and profitability trade off. •
THE RISK THE RISK
•
•Shorter the maturity date of debt, the greater the risk Shorter the maturity date of debt, the greater the risk of default ofof default of –
– Repayment of PrincipalRepayment of Principal –
– Interest costInterest cost •
•Renewal or Roll over at maturity: If short term financing used to fund long term assets. Result longRenewal or Roll over at maturity: If short term financing used to fund long term assets. Result long
term assets will generate cash flow in the long term. but you have to repay short term loan in short term assets will generate cash flow in the long term. but you have to repay short term loan in short period
period
–
– Problem of liquidityProblem of liquidity –
– Resultantly short term debt may not get renewal or roll over at maturity.Resultantly short term debt may not get renewal or roll over at maturity. •
•Committing funds to long term asset from short term borrowing carries risk of lenders calling backCommitting funds to long term asset from short term borrowing carries risk of lenders calling back
loans early. loans early.
SHORT TERM INTEREST RATE SHORT TERM INTEREST RATE
•
•Short term interest rates comparatively less than long term ratesShort term interest rates comparatively less than long term rates •
•But more fluctuations in short term rate than long term interest rates.But more fluctuations in short term rate than long term interest rates.
TRADE OFF TRADE OFF
The longer the maturity date, more costly the financing is.The longer the maturity date, more costly the financing is.
Long term debt carries higher interest cost.Long term debt carries higher interest cost.
A company may pay interest on loan even when funds are not needed.A company may pay interest on loan even when funds are not needed.
Trade off between Risk & Trade off between Risk & ProfitabilitProfitability.y.
Short term debt has more risk than long term but less costly.Short term debt has more risk than long term but less costly.
The trade off is the lag between the expected cash flow & payment of debt.The trade off is the lag between the expected cash flow & payment of debt.
The Margin oThe Margin of Safety will depend of management’s risk preference.f Safety will depend of management’s risk preference.
And management’s decision regarding the maturity of debt wAnd management’s decision regarding the maturity of debt w ill determine the portion of currentill determine the portion of current assets financed by current liabilities and Portion to
assets financed by current liabilities and Portion to be financed on long term basis.be financed on long term basis.
CONSERVATIVE POLICY CONSERVATIVE POLICY
Firm finances a part of seasonal fund requirements less accounts payable on long term basis.
If cash flow estimates do not deviate far from actual, it will pay interest on debt (shaded area) when actually funds are not needed.
Higher the long term financing line, more Conservative Policy and higher cost.
AGGRESSIVE POLICY
The company must arrange renewal of short term debt. It involves risk.
The greater portion of permanent current assets is financed with short term debt, more aggressive policy it is.
Expected margin of safety regarding short term and long term financing can be positive, negative or neutral.
Margin of safety can be increased by more financing in the liquid assets.
Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or carrying larger amounts of current assets.
WORKING CAPITAL POLICIES
•Aggressive Policy •Conservative Policy
WORKING CAPITAL MANAGEMENT
•Guiding force:
•Management attitude (Planning Process) •Vision about money market, business etc.
LESSON 28
WORKING CAPITAL MANAGEMENT
•Factors affect working capital management •Profitability •Liquidity •Risk •Management attitude •Interest cost – Long term – Short term
DETERMINING W-C REQUIREMENTS: EXAMPLE
•The following information pertains to M/S No-one Limited:
•Estimated Turnover Rs. 1,000,000/-•Direct cost: – Direct materials 25% – Direct labor 20% – Variable overheads 10% – Fixed overheads 10%
– Selling & admin 5%
•Credit terms are as under:
•Direct Materials 2 Months •Direct Labor 1 Month •Variable Overheads 1.5 Months •Fixed Overheads 2 Months •Selling & Admin. 1 Month
Average duration/turnover:
Accounts receivables take 2 months before realization. Raw materials are in stock for 4 months.
WIP represents one month production 50% complete. Finished good represents 1.5 months production. WIP & FG are valued at material, Labor & VOH Cost.
Compute the working capital requirements of the company.
WORKING CAPITAL REQUIREMENTS
Estimated Turnover 1,000,000.00
1 Annual Cost Of Cost Items: % Of Turnover Annual Cost
Direct Materials 25 250,000.00
Direct Labor 20 200,000.00
Variable Overheads 10 100,000.00
Fixed Overheads 10 100,000.00
Selling & Admin 5 50,000.00
2 Average Value Of Current Assets Period
Raw Materials
4 months in
stock 83,333.33
Work in Process 22,916.67
Direct materials 50% complete 10,416.67
Variable overheads 50% complete 4,166.67 Finished Goods 68,750.00 Direct materials 1.5 month production 31,250.00 Direct labor 1.5 month production 25,000.00 Variable overheads 1.5 month production 12,500.00 Accounts Receivable 2 166,666.67
Gross Working Capital 341,666.67
3 Average Value Of Current Liabilities
Direct materials 2 41,666.67
Direct labor 1 month 16,666.67
Variable overheads 1.5 months 12,500.00
Fixed overheads 2 month 16,666.67
Selling & admin 1 month 4,166.67
91,666.67 4 Net Working Capital=
Current Asset - Current Liabilities
3
Average Value Of Current Liabilities
Direct materials 2 41,666.67
Direct labor 1 month 16,666.67
Variable overheads 1.5 months 12,500.00
Fixed overheads 2 month 16,666.67
Selling & admin 1 month 4,166.67
91,666.67
4
Net Working Capital=
341,666.67-91,666.67 250,000.00 Current Asset - Current Liabilities
OVERTRADING
It occurs when a company tries to do too much with too little long term capital.
In other words, a firm is trying to satisfy huge level of sale or productions from lowest level of inventory.
This liquidity problem emerges from the situation when a firm does not have enough cash flow to pay off the debt.
INDICATIONS
•Rapid increase in Turnover/Sales, current assets (and may be in fixed assets) •Payments to creditors are stretched.
•More reliance on short term finances.
•Proportion of assets financed by equity is decreased and vice versa. •Liquidity Deteriorates.
•Results in negative Net Working Capital. •Debt equity ratio changes significantly. How to get ride off Over Trading?
•Injected fresh capital
•Revised strategy in short run -trimming unnecessary plans. •Control over Inventory and Debtors.
Individual Component of Working Capital:
•Inventory •Receivable
CASH MANAGEMENT •Motive to hold cash:
•TRANSACTION MOTIVE •PRECAUTIONARY MOTIVE •SPECULATIVE MOTIVE
How much cash or cash equivalents a company should hold?
•Holding too much cash or near cash items has a cost in terms of “Loss of Earnings” •Liquidity and profitability trade off is of crucial importance to a financial manager.
CASH FLOW PROBLEMS
•Growth
•Seasonal business: Like on Eid and Religious occasions, the business activity increases. •Capital expense or one-off expenditure.
•Loss Making
HOW TO IMPROVE CASH FLOW •Float:
– Decreasing the receipt Float. •Deferring Capex and developmental work. •Early recovery of cash flows.
•Liquidate Short Term Investments. •Deferring payments to creditors. •Rescheduling loan payments.
•Planning is of vital importance especially rolling cash budgets.
Investing Surplus Cash Flow
•Important factors: •Liquidity
•Profitability •Safety
•Maturity – early liquidation penalty?
INVENTORY APPROACH TO CASH MANAGEMENT
•Two types of costs involved in cash holding:
– FIXED COST
•To raise loans or capital.
– VARIABLE COST
•Opportunity cost, surrendering the return by investing money.
ECONOMIC ORDER QUANTITY
Q=√2FS/I Where:
•S= Amount of consumption or demand in each period •F= Fixed cost of obtaining new funds
•I = Interest cost of holding cash •Q= Optimal cash holding level
EXAMPLE
Liquid Limited has a fixed cost at present of Rs.10,000 to seek fresh finances. Per cash budget, the cash requirements for the next 4 periods of a year each would be Rs. 100,000. The interest cost of fresh finances will not be less than 14%. Interest on deposits at present is 8%.
•How much finance should the firm raise at a time?
SOLUTION
•HOLDING COST =14% - 8% = 6% •OPTIMUM LEVEL OF Q
= √(2 x 10,000 x 100,000 / 0.06) = 182,574
This is for 182,574/100,000 = 1.83 years. In other words, this amount is enough for almost two years. (Almost. 1.83 is rounded off)
DRAWBACKS OF EOQ APPROACH
•You can’t predict future cash requirements with c ertainty.
•There are many cost associated with running out of cash which are not considered.
•There may be some other cost of holding cash which increase with the average amount held.
LESSON 29
MILLER-ORR MODEL OF CASH MANAGEMENT
There would be some upper limit or lower limit of cash balance movement.
Miller-Orr Model tries to establish optimal cash holding between the upper and lower limits of cash balance movements.
MILLER-ORR MODEL
When cash balance reaches point ‘A’, the upper limit.
Company will invest the surplus to bring down the cash balance to return point. When cash balance touches down point ‘B’, the lower limit.
The company would liquidate some of its investment to bring the balance back to return point. How the upper and lower limits are determined?
Spread
•Spread is the difference between lower limit and upper limit.
–
Variance of Cash Flow–
Transaction Cost–
Interest RateSteps to be followed to use MILLER-ORR MODEL
•Determine lower limit for the cash balance. This may be zero.
•Calculate cash flow variance on daily basis. This sample size may be of 100-days period •Observe the interest rates and note the transaction costs
•Calculate the upper limit and return point.
EXAMPLE: MILLER ORR MODEL
Minimum cash balance is Rs. 100,000/- Daily cash flow variance is Rs. 2,000,000/-.
Transaction cost of selling & buying securities is Rs. 500/-. Interest rate is Rs.9% per annum.
Required: Work out the upper limit and return point using miller model. SOLUTION
Spread = 3(3/4 x ((TC x V)/I)1/3 •Where:
•TC = Transaction Cost •V = Cash Flow Variance •I = Interest
Putting values:
= 3(3/4 x ((500 x 2,000,000)/(0.09/365) 1/3 Spread = 42,855.12
•Now we can calculate the Upper Limit and Return Point: •Upper Limit = Min Cash Balance + Spread
= 100,000 + 42855.12 = 142,855.12
•Return Point = Min Cash Balance + 1/3 x Spread = 100,000 + (42855.12)x 1/3 = 114,285.04
DECISION
And if cash balance fall to 100k, sell securities worth 14k to get back to Return Point.
MANAGEMENT OF INVENTORY There are three types of Inventories:
•Raw materials inventory •Work in process inventory •Finished good inventory
SIZE OF ORDER
CONTROL OVER INVENTORY
EOQ is used to determine the optimum size of stock purchase in order to reduce the inventory costs.
DISCOUNTS
If discounts are available on stock purchase, then EOQ would not be considered. Need to work out net benefit.
INVENTORY COSTS
•HOLDING COST •ORDERING COST •SHORTAGE COST
HOLDING COST CONSISTS OF:
–
Investment in stocks–
Warehousing cost–
Handling cost–
Insurance cost–
Pilferage cost ORDERING COST–
Delivery costSHORTAGE COST CONSISTS OF:
–
Contribution from lost sales–
Cost of change in customer’s loyalty o r future cash flow deterioration cost.HOLDING COST DEFINED
In business management, holding cost is money spent to keep and maintain a stock of goods in storage.
The most obvious holding costs include rent for the required space; equipment, materials, and labor to operate the space; insurance; security; interest on money invested in the inventory and space, and other direct expenses.
Some stored goods become obsolete before they are sold, reducing their contribution to revenue while having no effect on their Holding cost.
Some goods are damaged by handling, weather, or other mechanisms. Some goods are lost through mishandling, poor record keeping, or theft, a category euphemistically called Shrinkage.
Holding cost also includes the opportunity cost of reduced responsiveness to customer’s c hanging requirements, slowed introduction of improved items, and the inventory's value and direct
expenses, since that money could be used for other purposes. ECONOMIC ORDER QUANTITY
•This is the optimal size of material per order that will minimize the cost. •We can use the following formula for EOQ:
EOQ = √2xC0x D/CH
•Where:
•D = stock consumption •P = Purchase price
•C0= Cost of placing one order
•CH= Holding cost per unit of stock in one period
•Q = Reorder Quantity
EXAMPLE: ECONOMIC ORDER QUANTITY
Demand of a raw material is 80,000 kg per year. The ordering cost is Rs. 90 per order. Holding cost per kg is estimated at Rs. 4.
Calculate the following:
–The order size to minimize the stock costs. –Number of orders per year.
–Length of stock cycle. SOLUTION
•a) Order Size:
•EOQ = √2xC0xD/CH •= √2 x 90 x 80,000/4 •= 1897 Or 1900 Kg
•b) Order Per Year:
• = Annual Demand / Economic Order Size • = 80,000 / 1900 = 42.10 Orders
•c) Stock Cycle will be: • = 365 / 42
• = 9 Days (Rounded Off)
RE-ORDER LEVEL
Re-order level is the stock level (in kg) when replenishment order should be made.
Time period involved between placing an order and receiving the order. This is known as Lead Time. Placing order after the stock runs out may result in loss of sales and loss of cash flow.
Placing order to late and too soon have costs.
SAFETY STOCK
•Safety Stock: Inventory stock held in reserve as a cushion against uncertainty in usage and/or lead
time.
•Price Breaks – Discounts & EOQ:
•Business always tries to save cost in order to increase profitability. When a vendor offers discounts
(Price breaks) for buying a specific quantity which is not in line with the EOQ, then business has to consider the net saving.
•Increase in order size does increase inventory costs but if that cost is off-set by the purchase cost
beyond that increase, then EOQ is not financially feasible. EXAMPLE: PRICE BREAKS
Demand of a raw material is 80,000 kg per year. the ordering cost is Rs. 90/- per order. Material is priced at Rs. 100 per kg. Holding cost per kg is estimated at 2% of purchase price. The vendor offer 5%
discount if the minimum order size is 5000kg. What do you suggest to the firm? Solution: EOQ = √(2 x 90 x 80,000)/2% (100) = 2683 Units A- NO DISCOUNT
Purchase Cost
= 80,000 x 100
= 8,000,000.00
Holding Cost
= 80,000 x (2% x 100)
= 160,000.00
Order Cost
= 42.10 X 90
=
3,789.00
Total Cost
= 8,163,789.00
Per Kg Cost = 963789/80000 = 102.05 /Kg
B- When Discount is 5% on Qty order of 5000 Units:
Total Orders
Annual Demand / 5000
=80,000 /5,000
= 16 OrdersPurchase Cost
= 80,000 x (100-5%)
= 7,600,000.00Holding Cost
= 80,000 x (2% x 95)
= 152,000.00Ordering Cost
= 16 x 90
= 1,440.00Total Cost
= 7,753,440.00Cost Per Kg = 913440/80000 = 96.42 / Kg
SAVING UNDER OPTION B:
Per unit price before discount
= 102.05
Per unit price after discount
= 96.42
Per unit saving
= 5.63
Annualized saving
= 80,000 x 5.63 = 450,400
STOCKOUTS
•STOCKOUTS: The situation when a firm runs out of stock which results in shutdown of slow down of
production / sales.
•In order to avoid stock out situation, a safety stock level should be procured and maintained.
LESSON 30
EXAMPLE: STOCK OUT
Five Star Limited consume 100,000/- kg per year. each order is for 5000 kg and stock out is 2000 units. The stock out probability acceptance level is set to 10%. per unit stock out cost is Rs. 5/-. Holding cost is
estimated at Rs. 2/- per kg. being an inventory manager, determine stock out cost and amount of safety stock to be kept on hand.
STOCKOUT COST =
= AC / Q x S x Sc x Ps •Where:
•AC = Annual Consumption •Q = Order Quantity
•S = Stock out in Unit •Sc = Stock out Unit Cost
•Ps = Accepted Probability of Stock out
•Plugging values, we get
• = 100000/5000 x 2000 x 5 x 0.10 • =
20,000/-•SAFETY STOCK LEVEL Let X = Safety Stock
•Then,
•Stock out Cost = Carrying Cost x Safety Stock = 20,0000 = 2 * X
X = 20,000 /2 = 10,000 UNITS
ECONOMIC ORDER POINT
EOP is the level of inventory that signals the time to place re-order of materials using EOQ amount. Safety stock is considered in the calculations.
•EOP = SL + F √S x EOQ x L •Where
•S= Consumption Per Period •L= Lead Time
•F= Stock out Acceptance Factor •EOQ = Economic Order Quantity
•S = 2000 Units •EOQ = 60 Units •L = 1/4 Month
•F= 1.10 (This Represents The Stock out level of say, 10%) EOP = SL + F √S x EOQ x L
= 2000 x 1/4 + 1.10 √2000 x60 x 1/4 = 691 Units
•Financial managers must try to establish inventory level that results in greater savings.
•QUESTION : A company is in process of re-visiting its inventory policy. The current inventory turns over
18 time per year. Variable costs are 75% of sales value. If inventory levels are increased the company anticipates additional sales and less of an incidence of inventory stock outs. the rate of return is 14%.
Actual and estimated sales & inventory levels are as under:
SALES TURN OVER
750,000 18
810,000 15
890,000 12
960,000 8
REQUIRED: Work out the level of inventory that results in highest saving.
SOLUTION: INVENTORY COST SAVING
Over Inventory Cost Profit Saving 750,000.00 18.00 41,666.67 -810,000.00 15.00 54,000.00 1,726.67 15,000.00 13,273.33 890,000.00 12.00 74,166.67 2,823.33 20,000.00 17,176.67 960,000.00 9.00 106,666.67 4,550.00 17,500.00 12,950.00 Rate of Return 0.14 Contribution Margin 0.25
GRAPHICAL INVENTORY COSTS
JUST-IN-TIME (JIT)
Zero inventory level.
Order the goods on daily basis.
it results in reducing inventory costs near to zero.
Better control over spoilage and shrinkage / reduction in wastage.
JIT is possible only when vendors are located very close to business premises or production facility.
Very sensitive issue. Greater probability of Stock outs. May turn the overall benefits to losses. May not be feasible for every business. Some business may maintain some inventory items on
JIT and others on EOQ etc.
DEBTORS MANAGEMENT
Significant funds are invested in debtors.
Debtors are important factor / element of Cash Cycle. Interest cost is associated with offering credit to debtors. Debtors are measure in days.
Investment in debtors
CREDIT CONTROL POLICY: COMPONENTS
•Extending credit to customers requires careful planning and to devise policy and procedures. •Credit policy set up requires dealing with:
– Terms of Sale
– Credit Analysis
– Collection Policy
•Lets discuss each component in detail.
1. TERMS OF SALE
There are three factors underlying terms of sale: •Credit period to be granted
•Cash discount & Period of discount •Credit instrument
CREDIT PERIOD:
Credit period will vary from firm to firm, industry to industry and business to business. normally the range is 30 to 120 days.
If cash discount is offered then period is divided into two components:
– Net Credit Period – Cash Discount Period
Credit period begins from the invoice date. This represents the dispatch of goods to buyer. Many terms are used:
– ROG= RECEIPT OF GOODS – 2/10, NET 30
– 2/10, EOM
CREDIT PERIOD
Factors influencing credit period:
•Buyer’s Inventory Period •Buyer’s Operating Cycle
– Inventory Period
– Accounts Receivable Period Inventory Period:
•The period of time it takes to procure, produce and sell the inventory to the debtors.
Accounts Receivable Period:
•The time to receive the cash from the debtors.
Main Points to keep in view
If seller’s credit extension period exceeds the buyer’s inventory period, then seller is not only financing the buyer’s inventory purchases but also a part of the receivable as well.
If seller’s credit extension period exceeds the buyer’s operating cycle, then seller is effectively financing the buyer’s need beyond the purchase and sale of seller’s merchandise.
The other factors that merit consideration are:
•Perishability •Collateral
•Size of the account •Competition
•Customer Type
TERMS OF SALE:
•There are three factors underlying terms of sale: •Credit Period to be granted
•Cash Discount •Credit Instrument
LESSON 31
CASH DISCOUNTS
For Example: Cost of Credit
The sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.
If buyer gives up discount, he pays Rs. 100,000/- on 30th day, and will loose Rs. 2,000/- (100,000 x 2%).
Look, foregoing Rs 2,000/- may look small but let’s annualize it and express it in %age: 2,000/98,000 = 0.020408 or 2.0408%
Note this is for 20 days.
For computing the loss of not taking discount on annual basis: We will have 365/20 = 18.25 – 20 days period in one year. EAR = (1.020408)18.25= 44.58%
This is only for Rs 2,000 on Rs 100,000. you can well imagine the business activity that runs in million of Rupees.
For seller, shorten the average collection period by offering discounts.
SHORTENING ACP
•A firm has 30 days collection period and it is offering terms of 2/10, net 30 and estimates that around
50% customers will avail this opportunity by paying within 10 days. Remaining 50% will pay after 30 days. Now the ACP will be as follows:
50% x 10 Days + 50% x 30 Days = 20 Days
•If average sales are Rs. 2 Million per month, then receivable:
Rs. 2 Million x 1/3 = 666,666.00
CREDIT INSTRUMENTS
•There are two types of Credit Instruments
–INVOICE
–DISPATCH NOTE ANALYZING CREDIT POLICY
Following factors to be considered:
Revenue effects:
Granting credit period results in delayed revenue receipts. Offering discounts may or may not be utilized by the customers. Firm may charges higher prices for longer period and may increase revenue.
Cost effect:
Whether firm sells on cash or credit it has to pay for the cost of sale. Payment to firm’s creditor rests on the cash to be received from debtors.
COST OF DEBT:
When a firm extends credit to customers, it must finance the resulting receivable. Cost of short term borrowing is an important factor in the decision to grant credit to customers.
PROBABILITY OF DEFAULT:
Chances of default or bad debt are always there.
DISCOUNTS:
When firm offers discount to customers, there is a cost when some customers choose to pay early to seek discounts.
CONSIDERING EXTENSION OF CREDIT
•The increased sales that can be stimulated. •Profitability of extra sales.
•Required Rate of Return on extra sales. •Effect on Average Collection Period.
EVALUATING CREDIT WORTHINESS OF CUSTOMERS
•A firm who intends to grant credit to customers must seek information about the customers
reputation and credit worthiness.
•There are several information sources commonly used.
–
Financial statements of vendor–
Market reputation–
Banks–
Financial strength–
General economic conditions in vendors industry.COLLECTION POLICY
•Monitoring of ACP •Control
•Aging Schedule
– A compilation of accounts receivable by the age of each account..
•Collection effort for overdue Or Delinquent accounts
DEBTORS’ MANAGEMENT Mini Case Study
•A firm is considering to change existing credit policy which will increase the Avg. Collection Period from
one month to two months but it will ensure 20% increase in sales.
•Selling Price Per Unit Rs
Existing Annual Sales Rs. 2.00 M
• Required Rate of Return is 15%.
•25% increase in sales will result in additional investment of Rs. 150,000 in stocks and additional
creditors of Rs.
40,000/-•Advise the firm whether to change the existing policy if:
•The existing customers take two month credit period, and •Only new customers only take two month credit.
Solution: Debtors Management
Sale Price 12.00
Variable Cost 10.20
Sales 2,000,000.00
Return 15.00
Contribution Margin 1.80
Contribution /Sale Ratio 15.00
Increase 1.20
Inc. In Stock 150,000.00
Inc. In Creditor 40,000.00
Particulars Amount in Rs.
Increase in sales - 20% 400,000.00
Increase in cont. margin 60,000.00
A ALL CUSTOMERS TAKE TWO MONTHS CREDIT
Total turnover after 20% increase 2,400,000.00
Avg. debtors - 2 months 400,000.00
Existing debtors 1 month 166,666.67
Increase in debtors 233,333.33
Increase in stocks 150,000.00
Less: increase in creditors 40,000.00
Net increase in working capital 343,333.33
ROI ON EXTRA INVESTMENT 17.48
B ONLY NEW CUSTOMERS TAKE 2 MONTH CREDIT
Increase in sales 400,000.00
Increase in debtors 66,666.67
Increase in stock 150,000.00
Less: increase in creditors 40,000.00
Increase in net working capital 176,666.67
ROI ON EXTRA INVESTMENT 33.96
In both cases new policy look favorable and financially viable. DISCOUNTS
Evaluate the Discounts.
More precisely, we must work out what level of discount can be offered to debtors for early payment.
The other aspect would be to know the effect of this discount of the sales, ACP and Profit. This example deals a situation where early payment does not effect the sales.
EXAMPLE– DISCOUNT NOT EFFECTING VOLUME
A company has decided to offer 2% discount to customers if they pay the invoice within 10 days. The current sales level is Rs. 10 million and existing terms are 2 month. This discount offering is only intended to reduce the credit terms. The company has estimated that around 75% of customers will avail this opportunity.
•Required: If the ROI is 18%, what will be effect of % discount?
Solution: Debtors Management
Sale 10,000,000.00
Discount offered 0.02
Discount validity days 10.00
No of customer to avail discount 0.75 Existing collection time - days 2.00 month
New collection time - days 1.00 month
Return on investment 0.18
A) UNDER NO DISCOUNT POLICY Existing volume of Debtors
=10,000,000/12 x 2 1,666,666.67
B) UNDER DISCOUNT POLICY 622,146.12
i)
75% customers will avail 2% Discount and will pay in 10 days
=10,000,0000 x 75% x 10/365 205,479.45 ii) 25% customer will pay after 2 months
=10,000,000 x 25% x 2/12 416,666.67
Reduction in Debtors 1,044,520.55
Saving on Reduction in Debtors
=1,044,520.55 x 18% 188,013.70
Cost of Discount 2%
=10,000,000 x 75% x 2% 150,000.00
Net Saving under New Policy 38,013.70
EXTENTION OF CREDIT
Not always the companies consider reduction in credit period.
Some time the companies may consider increase in sales by increasing the debtor period. This increase in extension should be evaluated in terms of value addition.
When cost of extending period is less than the benefit, only when the policy will be accepted.
EXAMPLE: EXTENSION OF CREDIT
M/s Red Cloud Ltd’s income statement for the period just ended has been presented as under:-•Sales
2,100,000/-•Cost of sales 1,470,000/-•Gross profit 630,000/-•Bad debts
31,500/-•Profit
598,500/- The management is contemplating a strategy of easing the credit terms by extending the current one month collection period to two month. The new policy details are as under: Increase in sales under new policy will be 20% over and above the current level.
Average collection period will be two months
Bad debts will also increase to 3% from existing 1.5% level.
•Other details:
Cost of sales are 80% variable and 20% fixed. Fixed portion will not increase when sales will increase by 25%. Stock and creditors level will remain unchanged.
Do you think the New Policy is worth undertaking? Solution: Debtors Management
ROI 0.15
Existing Bad Debt 0.02 COS Var. 0.80
COS % 0.70 COS Fix. 0.2
New Bad Debt Level 0.03 Inc. in Sales 0.2
Var. COS 0.56 C/S 0.44 Existing sales 2,100,000.00 Cost of sales 1,470,000.00 Gross profit 630,000.00 Bad debt 31,500.00 Net profit 598,500.00
Variable Cost of sales COS=1470000 x Variable Portion of 80% 1,176,000.00
Cont Margin = 2,100,000 - 1,176,000 924,000.00
C/S ratio = 924,000 / 2,100,000 0.44 or 44%
Increase in Contribution Margin Sales=2,100,000 x Inc. 20%x C/S Ratio 0.44 184,800.00
Increase in Bad Debts
= Sales 2.1m X Increase (1+0.2)xBad Debt 0.03
- BD=31,500 44,100.00
Intended investment in debtors (New Sales (2.1 million + 20%) /12) x 2 420,000.00 Existing investment in debtors = 2.1million / 12 175,000.00
Additional investment required 245,000.00
Cost of Additional Investment = 245,750 x ROI 15% 36,750.00
Net Benefit =140700 - 36750 103,950.00
LESSON 32
Factoring
A firm may employ a specialized entity to manage account receivables. This specialized entity is called Factor.
Main function of a factor is to collect the accounts receivables on behalf of seller but may also involve in invoicing and sales accounting.
Factor makes advance payments to seller in return for commission of certain %age of total debt. This is often referred as Factor Financing.
In case of action against defaulters, factor initiate action. Factor also take over the risk of loss in case of bad debt. This type of factoring is known as Non-Recourse.
Significant positive effect on cash cycle.
Ensuring early payments to vendors and benefit of obtaining early payment discounts. Optimum stock level can be maintained.
Financing (Factor) is directly linked to level of sales/accounts receivables. Reduction in collection expense and staff payroll costs.
May have adverse effect on customers’ loyalty. (Factors attitude may be harsh with customers) and may tarnish company’s image.
Example: Factoring
A company is considering to seek the services of a factor because of poor collection of debtors which has pushed up the ACP from 30 days to 45 days coupled with bad debt of 1% of annual sales. Sales are Rs.1.80 Million.
With factoring in place, the company will save Rs. 25,000 per year on account of debtors administration and collection costs, bring down ACP to 30 days but will cost 2% of sales.
Factor will provide 80% on invoice value of sales and will charges 11% interest. Rest 20% shall be paid after 30 days. The company can obtain short term loan @ 10%. Sales are assumed evenly spread over the months.
Required: Evaluate the Policy? Debtors Management
Solution: Factoring Cost Data
Credit Sales Annual 1,800,000.00
Current ACP Days 45.00
Cost of Short Financing 0.10
Bad Debts (1%) 0.010
Factor Financing (80%) 0.800
Factor Financing Days 30.000
Factor Fee (2%) 0.0200
Existing Cost Components
Current Annual Cost 22,191.78 =Sales 1.8Million x 45/365 x 10%
Bad Debts 0.1% 18,000.00 = 1.8M x 1%
Administration Cost 25,000.00 Total Existing Cost 65,191.78 Cost of Factoring
Factor Financing Cost 13,019.18 = (1.8Million x 80%) x 30/365 x 11% Factor will provide 80% Finance, 20% will be through Short Term Financing:
Short Term Financing Cost 2,958.90 = (Sale 1.8M x 20%) x 30/365 x 10% Cost of Factoring 36,000.00 = Sales (1.8M) x 2% Factor Fee Total Cost of Factoring 51,978.08
Net Saving 13,213.70
Solution
We need to work out the total cost of employing factor and saving thereof.
In this case the comparison is between the existing cost of debtor administration and cost of factoring.
If the later is less than the former, then we will accept or implement the new policy, otherwise not.
It is “Current Cost Vs Factor Cost”
•CREDITORS MANAGEMENT OR •MANAGEMENT OF CREDITORS
Example: Creditors Management
A vendor has offered credit terms of 2/15, net 50 to M/s ABC Limited. The company can invest in Short Term Securities @ 24%. The average creditors level is Rs. 100,000.
Evaluate the offer from vendor. Example: Creditors Management
If ABC Ltd refuses discount and pay after 50 days, then interest cost will be:
= 2/( 100 – 2 ) x 365 / 35 D = Days in terms when Discount is valid T= Reduction in days if Discount availed
Discount 2% 2
Discount Validity Days 15
Reduction in days is discount taken 35
Total Days 50
Average Creditors 100,000.00
Short Investment Return 24
Accept Discount
Saving will be 2% of Avg. Creditors 2,000.00 Discount is Declined
ABC can invest the money in Short Securities
For 35 days to earn @ 24% 2,301.37
Benefit of Rejection is > Discount It is better to Decline the Discount.
Mergers and Acquisitions
Combination of two business for increasing the value of business through Synergies in the form of Acquisition or Merger.
A process of accruing an other company.
Acquisition is also known as takeover. (Purchase Merger)
Mergers may be termed as Amalgamation. (Also consolidation Mergers) Two businesses become single entity after Merger or Acquisition.
Vertical Mergers
Purpose of Combinations
Main purpose of combinations is to cultivate Synergies.
Synergy is a force that creates enhanced cost efficiencies when two business Merge.
The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.
•Sources of Synergies are as under:
- Scale of Economies
- Staff Reduction/Cost Cutting - Financial Strength
- Market/Distribution Network - Acquisition of New Technology
Synergy from Operational Economies Horizontal Combination:
When two companies in similar business combine horizontal combination, to reduce cost and increase profit / value due to large economies of scale.
In other words both companies are in Direct Competition and have same product line but may or may not have same markets
Vertical Mergers:
This may be eliminating backward or forward Integration. This type of Mergers increase value by the middleman/level.
