TYBCom Financial Management Past Paper PDF 2021-2022

Study material - Faculty of Commerce - The M.S University of Baroda Note: The study material is not exhaustive. These are only guidelines. The examples given are issued to save time in dictation. Students are required to refer to reference books. T.Y.B.COM [CBCS] (2021-22)...

Study material - Faculty of Commerce - The M.S University of Baroda Note: The study material is not exhaustive. These are only guidelines. The examples given are issued to save time in dictation. Students are required to refer to reference books. T.Y.B.COM [CBCS] (2021-22) SEMESTER V – FINANCIAL MANAGEMENT UNIT-II Working Capital Management Meaning of working capital: Capital required by a firm can be classified into two main categories: 1. Fixed capital and 2. Working capital. Every business needs funds for two purposes: 1. For its establishment and 2. To carry out its day-to-day operations. Long-term funds are required to create production facilities through the purchase of fixed assets such as plant and machinery, land and building, furniture etc. Investment in these assets is blocked on a permanent basis. It is called fixed capital. Funds are also required to carry out day-to-day business operations. It is known as working capital. Working capital refers to that part of the total capital, which is available and used for carrying on the routine or regular or day-to-day business operations. Thus the capital required for purchasing raw materials, payment of direct and indirect expenses, maintaining production, investment in stocks & stores, accounts receivables and for maintaining optimum level of cash is known as working capital. In short, it is the capital with which business runs. Working capital, in other words is that part of the total capital which is required for financing current assets such as cash, inventories, accounts receivables (debtors), marketable securities etc. Funds invested in current assets are revolving or circulating fast and are being constantly converted from cash to inventories to receivables and back to cash. Hence, working capital is also known as circulating capital or revolving capital. Classification or Kinds of working capital: Working capital may be classified in two ways: 1. On the basis of Concept 2. On the basis of Time On the basis of concepts, working capital is classified as gross working capital and net working capital. This classification is important from the point of view of the financial manager. On the basis of time, working capital may be classified as: 1. Permanent or Fixed working capital 2. Temporary or Variable working capital 1 1  Kinds of working Capital On the basis of On the basis of Concept Time Gross Net Permanent or Fixed Temporary or Variable Working Capital Working Capital Working Capital Working Capital (A) WORKING CAPITAL ON THE BASIS OF CONCEPT : 1. Gross Working Capital : In broad sense, the term working capital refers to the gross working capital. Gross working capital is the capital invested in total current assets of the firm. Current assets are those assets which can be converted into cash within a short period of time, normally not exceeding one year or normal operating cycle, whichever is longer. GROSS WORKING CAPITAL = TOTAL CURRENT ASSETS The gross working capital is always positive. Every increase in current assets increases the gross working capital. It is a quantitative concept. It indicates the total working capital required to be invested in different components of current assets. The gross working capital is financial or going concern concept. The Gross Working Capital is sometimes preferred to the net concept of working capital because it contributes to the earnings of the firm. Fixed assets though essential for a business organization do not by itself produce revenue or income. Fixed assets act with current assets to generate revenue or income. Every management is more interested in the total current assets with which it has to operate than the sources from where it is made available. The gross working capital concept takes into consideration the fact that every increase in the funds of firm would increase in working capital. For determining the rate of return on investment in working capital, the gross working capital concept is more useful. 2. Net Working Capital : In narrow sense, the term working capital refers to the net working capital. Net Working Capital is the excess of Current Assets over Current Liabilities. Current liabilities are those liabilities, which are to be paid within a short period of time normally one accounting year or normal operating cycle whichever is shorter. Current liabilities are normally paid out of the funds arising from realization of current assets or the income of the business. 2 2  NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES. Net working capital may be positive or negative or nil. When the total current assets exceed the current liabilities, the working capital is positive and when the total current liabilities exceed total current assets, the working capital is negative. When both are equal, the net working capital is nil. Net Working Capital (Positive) = Current Assets – Current Liabilities. Net Working Capital (Negative) = Current Liabilities – Current Assets. Net Working Capital ( Nil ) = Current Assets = Current Liabilities. The net working capital is a qualitative concept. It emphasizes the liquidity aspect of working capital. It indicates the firm’s ability to meet its short-term creditors and its operating expenses. The net working capital is an accounting concept of working capital. (B) WORKING CAPITAL ON THE BASIS OF TIME : 1. Permanent or Fixed or Regular Working Capital: Permanent working capital is the amount of working capital which is required to maintain minimum level of current assets to carry out the normal business operations. For example, every firm has to maintain: 1. Minimum level of inventory ( i.e. raw materials, work-in-progress, finished goods, spares) 2. Minimum level of debtors 3. Minimum level of cash balance, Minimum level of bank balance (i.e. compensatory balance) etc. The minimum level of current assets is called permanent or fixed working and is permanently blocked in current assets. As the business grows, the requirements of permanent working capital also increase due to the increase in current assets. The permanent working capital is permanently needed for the business and therefore it should preferably be financed out of long term fund. Temporary or Variable or Seasonal Working Capital: Temporary working capital is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Temporary working capital is a part of total working capital which is required by a business over and above permanent working capital. It is the additional working capital required to meet fluctuations in sales above the present level. This extra working capital needed to support the increased volume of sales is known as Temporary or Fluctuating or Variable working capital. Following are the examples of temporary working capital: 1. Piling of stock of raw materials in peak seasons. 2. Extra investment in receivables is required during peak season. 3. Over-time and Extra-shift working, Employment of temporary workers etc. Temporary working capital differs from permanent working capital in the sense that it is required for short period and can not be permanently employed gainfully in the business. Following figures shows the difference between permanent and temporary working capital. 3 3  Stable Firm Growing Firm Temporary or Variable Working Capital Temporary or Variable Working Capital Permanent or Fixed Permanent or Fixed Working Capital Working Capital Time Time In figure : 1. Permanent working capital is stable or fixed over time while the temporary working capital fluctuates. In figure : 2. Permanent working capital is also increasing with passage of time due to expansion of business but even then it does not fluctuate as variable working capital which some times increases and sometimes decreases. Determinants of working capital requirements / Factors affecting working capital requirements: The working capital requirements of a concern depend upon number of factors. It is not possible to rank them because all such factors are of different importance and influence of individual factor changes for a firm over time. However, following are important factors generally influencing the working capital requirements. 1. Nature of the business : The working capital requirements of a firm basically depend upon the nature of the business. Public utility concerns like Electricity Board (G.E.B.), Railways, Airways, Bus transport, Water supply etc. require very limited amount of working capital because they provide services for cash and do not sell products and as such no funds are tied up in inventories and receivables. On the other hand, Trading and Financial firms need large amount of working capital because they require more investment in current assets as compared to fixed assets. Trading concerns have to carry large stock of variety type of products, more receivables and liquid cash. Manufacturing concerns also require large amount of working capital for the purchase of raw materials, maintaining the stock of inventories, financing the receivables and meeting operating expenses like salary, wages etc. Generally speaking, trading and financial concerns require large amount working capital than public utility concerns. The manufacturing concerns fall between these two. 2. Size of business : The size of business has also an important impact on working capital requirements. The working capital requirements would be different between two firms doing same type of business. A firm with larger scale of operations will require more working capital than a firm with smaller scale of operations. 3. Production Policy : A steady production policy accumulates inventories during off season and it increases the requirements of working capital. It also increases the inventory carrying costs and risks. Depending upon the kind of 4 4 items manufactured, a firm should formulate its production policy. The production may be reduced during the off season to avoid overstocking and increased during the peak season. 4. Production Cycle: Production cycle is the time taken by a firm to convert its raw materials into finished goods. Longer the production cycle, larger the requirements of working capital as more funds would be tied up in the inventories. The length of production cycle depends upon the nature of the business. A firm can minimize its requirements of working capital either by choosing the shortest production process if alternative production processes are available for producing products or by receiving advance from customers against their orders. 5. Seasonal Variations: In certain industries, raw material is not available throughout the year. They have to buy raw materials in bulk during the season and stock it for the use during the entire year. A huge amount of working capital requirement is therefore required to purchase the materials during such season and blocked in the form of material inventories. Generally, during peak season, a firm requires larger working capital than in the off season. 6. Business Cycle: Business cycle refers to alternate expansion and contraction in business activity. In boom period, when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business, etc. During this period, extra amount of investment in fixed assets may be made by some firms to increase their production capacity. This also increases the requirements of working capital. On the other hand, during depression, when sales are falling, a firm may have large amount of working capital lying idle as the inventories remain unsold and book debts (debtors or accounts receivables) uncollected. 7. Rise in price level: Continuous rise in price level increases the requirement for additional working capital to maintain the same level of activity. In rise in price level, for the same level of current assets, a higher cash outlay is required. A firm has to take care of this aspect while planning its capital structure otherwise; it has to cut down its present level of activity. In context to rise in price level, the problem of working capital becomes more acute when a firm plans for the replacement of fixed assets. The effect of rise in prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices. Those firms which can immediately revise their product prices with rising prices levels may not face a severe working capital problem. 8. Growth and Expansion of the business: The requirements of working capital also increase with the growth and expansion activities of the business. In general, for normal rate of expansion in the volume of business i.e. steady growing firm, the retained profits are useful for the requirement of working capital. But in fast growing firm, larger amount of working capital is required to finance the additional fixed assets and current assets in order to sustain its growing need of production and sales. It should be noted that a growing firm needs fund continuously. 9. Rate of Stock Turnover: There is a high degree of inverse co-relationship between the quantum of working capital and the speed with which the sales are affected. A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm having a low rate of turnover. For example, in case of precious stone dealers, the turnover is very slow. They have to maintain a large variety of stocks and the 5 5 movement of stocks is very slow. Thus, the working capital requirements of such dealer shall be higher than that of a provision store. 10. Working capital cycle: In a manufacturing concern, the working capital cycle starts with purchase of raw materials and end with the realization of cash from the sale of finished goods. The cycle involves purchase of raw materials, its conversion into finished goods through work-in-progress with progressive increment of labour and service costs, conversion of finished goods into sales, debtors and receivables and ultimately realization of cash and this cycle continue again from to purchase of raw material and so on. The speed with which the working capital complete one cycle determines the requirements of working capital: longer the period of the cycle, larger is the requirement of working capital and vice versa. 11. Credit Policy: The credit policy of a firm in its dealing with debtors and creditors both influence the requirements of working capital. A firm that purchases its raw materials or products on credit and sells its products on cash requires lesser amount of working capital. On the other hand, a firm buying its raw materials or products for cash and sells on credit, will require larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bill receivables. A firm following liberal credit policy without rating credit worthiness of customers will find problems in collection of funds from them. Such firm will require more working capital. In contrast to this, a firm following stringent credit policy will require less working capital. A firm get liberal credit from its suppliers (creditors) need less working capital and vice versa. Similarly, a firm gets bank credit on easy terms will require less working capital than a firm without such facility. 12. Earning capacity and Dividend policy: A firm with high earning capacity may generate cash profits from operations and contribute to their working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend. A strong cash or working capital position may justify dividend payment even though earnings are not sufficient to cover the payments. On the other hand, shortage in working capital may act as a strong reason for reducing cash dividend. Proposed dividend also serves as an indirect source of working capital because there is always a time gap between dividend declared and that paid. So unless, dividend is actually paid, it will remain in the form of working capital. 6 6  Working Capital Management: MEANING: Working capital management means management of current assets and current liabilities. OBJECTIVES OF WORKING CAPITAL MANAGEMENT: The fundamental object of working capital management is to manage the current assets and current liabilities in such a way that maximizes the profitability and maintain adequate liquidity of the firm. Liquidity and profitability are two important objectives of working capital management. Financial manager cannot afford to stick to only one of these objectives. There should be proper balance between these two. Survival and growth of a firm depends on its profitability and liquidity. If the size of current assets is large, it will strengthen the firm’s liquidity position but profitability may be adversely affected, as funds will remain idle. Conversely, if the size of current assets is small, it will have adverse effect on the liquidity position and the firm will become more risky but the overall profitability may improve. There is inverse relationship between liquidity and profitability and a finance manager has to trade off between these two. The relationship between these two is shown in the following diagram. Liquidity Optimum Profitability Size of Current Assets The liquidity and profitability are also two important and major aspects of corporate business life. “No firm can survive without liquidity”. “A firm may exist without making any profits but cannot survive without liquidity”. A firm not making profits may be treated as sick, but one having no liquidity may soon meet with its downfall and ultimately die. The finance manager therefore, must determine the optimum level of current assets and current liabilities. He must ensure that appropriate sources of funds are used to finance current assets and should also see that short-term liabilities of the firm are met well in time. 7 7 Policies of Working Capital Management: There are two different policies of working capital management: 1. Current Assets Financing Policies. 2. Current Assets Investment Policies. Working Capital Policies and Liquidity & Profitability: Working capital management is best described as the management of all aspects of current assets and current liabilities. In managing working capital, not only investment in current assets is significant but the financing of current assets is also equally important. Wealth of the shareholders is maximized when the amount of investment in current assets and mixing of funds used for financing the current assets both are optimum. Investment policies and financing policies directly affect the twin objectives of working capital management i.e. liquidity and profitability. Liquidity means ability of a firm to pay its short-term liabilities as and when they become due. Lack of liquidity damages the credit standing of the firm and it may increase the risk of ‘technical insolvency’. Excess of liquidity reduces the risk and profit of the firm. Profitability is the rate of return on firm’s investment. Excess investment in current assets increases the liquidity and reduces the risk but it also reduces the profitability. An unwarranted investment in current assets and defective financing policies both reduce the return on investment of the firm and wealth of the shareholders. A trade off between these two conflicting goals is a sine qua non for realizing wealth maximizing objective. The following chart shows this trade off. Working Capital Management Policies Investment Financing Policies Policies Investments in Financing Mix by C.A. L.T.F. and S.T.F. Liquidity Profitability Liquidity Profitability Wealth Maximization 8 8 In evaluating any working capital policy of the firm and its effect on liquidity and profitability, the three basic assumptions are necessary to be made: 1. All firms are manufacturing firms. 2. Current assets are less profitable than fixed assets (ROI on CA is less than FA). 3. Short-term funds are less costly than long-term funds. (A) Current Assets Financing Policies: Broadly speaking, there are two sources for financing current assets: 1. Long-term sources 2. Short term sources Financing Mix Spontaneous Negotiated Sources Sources Short-Term Long-Term Sources Sources 1. Trade Credit 1. Bank overdraft 1. Share Capital 2. Outstanding 2. Cash Credit 2. Retained Earnings Expenses. 3. Public Deposits 3. Debentures 3. Bills payable etc 4. Short-Term Loans 4. Financial 5. Bills Discounting Institutions Loans 6. Commercial Papers 7. Factoring etc. A source is said to be spontaneous when its use is automatic or arises in the normal course of business activities. A source is said to be negotiated when its use depends on prior deliberations between the borrower and the lender. Since spontaneous sources are automatic, therefore, a question arises as to what portion of current assets should be financed by long-term sources and by short-term sources? There are three basic approaches or policies for financing the current assets. 1. Hedging or Matching Approach 2. Conservative Approach. 3. Aggressive Approach. 9 9  1. Hedging or Matching Approach. As per this approach, the life of the assets is matched with the maturity period of the liabilities. For example : A 7 year loan may be raised to finance a machine with an expected life of 7 years. A 20 year building can be financed by a 20 year debentures. Stock to be sold in a month can be financed with one month bank loan and so on. The justification of matching policy is that since the purpose of financing is to invest in an asset, the liability should be liquidated when the life of the asset expires. Use of long-term funds for financing short-term assets (i.e. temporary current assets) will be costly as the funds will remain idle after the expiry of life of the assets. Similarly, financing long-term assets ( i.e. permanent current assets and fixed assets) with short-term funds is inconvenient and costly as they are to be renewed on continuous basis up to the lives of the assets concerned. As per this approach, the financing pattern of the assets would be as follows :  Long-term funds : Fixed assets + Permanent current assets  Short-term funds : Temporary current assets. Temporary Current Assets S.T.Funds Permanent Current Assets L.T.Funds Fixed Assets Years The above figure shows that when the level of permanent current assets increases, the use of long-term funds also increases. Temporary current assets are financed entirely by short-term funds. Thus, when there is no need for temporary current assets, there will be no short-term financing. 2. Conservative Approach : An exact matching between life of the current assets and maturity period of the liabilities may be difficult in practice. As such, firms in practice may either adopt conservative approach or aggressive approach. As per conservative approach, a firm relies heavily on long-term funds for financing its fixed assets, permanent current assets and also a part of temporary current assets. The use of short- term fund is limited to emergency situations or when there is an unexpected outflow of funds. As per this approach, the financing pattern of the assets would be as follows : Long-term funds : Fixed assets + Permanent current assets + Part of the temporary current assets. Short-term funds : Balancing portion of Temporary current assets. 10 10  Temporary Current Assets S.T.Funds Permanent Current Assets L.T.Funds Fixed Assets Years In this case, a firm meets its peak requirements only from short-term funds. When the long-term funds will be released, it may be invested in marketable securities to store liquidity during off season and apply the same to meet a part of its seasonal requirements. 3. Aggressive Approach: An aggressive approach is said to be pursued when a firm uses more short-term funds than long funds to finance its assets. Under an aggressive approach, a firm finances its entire temporary as well as a part of permanent current assets with short-term funds. But reliance on more and more on short-term funds will be riskier as these funds will have to be renewed for financing a part of permanent current assets (i.e. hard core current assets) on continuous basis. As per this approach, the financing pattern of the assets would be as follows: Long-term funds: Fixed assets + Part of the Permanent current assets Short-term funds: Balance portion of the Permanent Current assets + Temporary current assets. Temporary Current Assets S.T.Funds Permanent Current Assets L.T.Funds Fixed Assets Years 11 11 (B) Current Assets Investment Policies: It is always true that for a given level of sales a firm may have different combination of fixed assets and current assets. A firm may have also different levels of current assets to support the same level of activity. A firm may have large investment or small investment in current assets. For better management of assets and higher return on investment, there should be optimum investment in both fixed assets and current assets. Optimum level of investment should also be fixed for each type of current assets. From the point of view of investment in current assets, there may be three approaches: 1. Conservative Approach 2. Aggressive Approach 3. Moderate Approach. 1. Conservative Approach: As per this approach, relatively high level of investment in current assets is made to support a given level of sales. According to this approach, a firm does not want to take risk of maintaining a low level of current assets. But holding more and more current assets may adversely affect profitability. 2. Aggressive Approach: According to this approach, relatively low level of investment in current assets is made to support a given level of sales. By reducing investment in current assets it may attempt to increase the return on investment but it is likely to expose to more risk. 3. Moderate Approach: According to this approach, neither very high level nor very low level of investment in current assets is made to support a given level of sales. Moderate investment in current assets is made to support the same level of operational activities. In order to analyze the investment policies pursued by the firm for financing the current assets, the ratio of current assets to total assets can be used. It may be stated that fixed assets remaining constant, a high ratio indicates more investment in current assets i.e. conservative policy followed by the firm and low ratio means less investment in current assets i.e. aggressive policy followed by the firm. When the ratio is moderate, it indicates moderate investment in current assets and moderate policy pursued by the firm. This can be explained with a diagram as follows: Conservative Approach High Ratio C.A. Moderate Approach C.A. Moderate Ratio Aggressive Approach Low Ratio CA Fixed Assets Production & Sales 12 12 Operating Cycle: Operating cycle refers to length of time between purchasing materials and receiving cash from debtors. In other words, it is the time period that elapses between purchase of raw materials and collection of cash from customers. The operating cycle for a company begins with the purchase of raw materials which are paid for after a delay which represents the ‘accounts payable period.’ The raw material is then converted by the production process into finished goods and then sold. The time lag between purchase of raw materials and sale of finished goods is known as ‘inventory period’. Upon sale of goods on credit terms, the customers pay their bill sometimes after the sale. The time lag between date of sale of goods and date of collection from customers or debtors is known as ‘accounts receivable period.’ The operating cycle therefore refers to the period that a firm takes for holding various types of inventories, the credit collection period and the credit payment period. The operating cycle ‘generally’ involved in the different stages of operation such as: Stage I : Holding inventories i.e stock of Raw Materials and consumable stores for production. Stage II : Stock of work-in-progress or Semi-Finished Goods. Stage III : Stock of finished Goods Stage IV : Collection of Accounts Receivables or Book Debts. Debtors Accounts Receivables Sale Finished Cash OPERATING CYCLE Goods Work Raw in Finished Materials Progress Goods The operating cycle is shown in the above diagram. The time lag between the purchase of raw materials and the collection of cash for sales is referred to as the ‘operating cycle.’ Whereas the time lag between the purchase of raw materials for cash and the collection of cash for sales from customer is referred to as the ‘cash cycle.’ The operating cycle is the sum of ‘inventory period’ and the ‘accounts receivable period’, whereas, the ‘cash cycle’ is equal to the ‘operating cycle’ less the ‘accounts payable period.’ 13 13 Forecast/Estimate of working capital requirements: Working capital is the lifeblood of the business. No business can successfully run without an adequate amount of working capital. To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance. So that arrangements can be made to procure adequate working capital. For estimation of working capital requirements, a number of factors have to be considered. For manufacturing concern, the following factors have to be taken into consideration while making an estimate of working capital requirements. 1. Total cost incurred on material, labour and overheads. 2. Raw Materials holding Period i.e. the period for which raw materials are to remain in stores before they are issued for production. 3. Conversion Period (Working-in-progress Period) i.e. the period for converting raw material into finished goods. 4. Finished Goods holding Period i.e. the period for which finished goods has to keep in the warehouse before sale. 5. Credit Period allowed to customers i.e. the period of credit allowed to customers for making the payments. 6. Credit Period given by the suppliers i.e. the period of credit given by the suppliers for making the payments. 7. Credit Period for expenses i.e. time lag in the payment of wages and other expenses. 8. The amount of cash required to pay day-to-day operational expenses of the business. 9. The average amount of cash required to make the advance payments if any. Note : 1. In case of purely trading concerns, points number 1, 2 and 3 would not arise but all other factors from points number 4 to 9 are to be taken into consideration. 2. For the total amount blocked in current assets estimated on the basis of first 1 to 5 items and last 8 and 9 items, the total of the current liabilities i.e. 6 and 7 items are to be deducted to find out the requirements of working capital. 1 14  Manufacturing Concern Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : For …..months’ of consumption …….. 2. Stock of Work-in Progress : For …..months’ production Raw Materials …….. Direct Labour …….. Overheads …….. …….. 3. Stock of Finished Goods : For …..months’ cost of goods sold Raw Materials …….. Direct Labour …….. Overheads …….. …….. 4. Sundry Debtors : For …..months’ sale Raw Materials …….. Direct Labour …….. Overheads …….. …….. 5. Advance Payments : if any …….. 6. Cash on hand : required to meet day-to-day operational expenses …….. 7. Any Other : if any …….. Total Less : Current Liabilities : Financed from Spontaneous Sources 1. Sundry Creditors : For …..months’ purchase of raw materials …….. 2. Outstanding Expenses For …..months’ expenses …….. 3. Any Other from Spontaneous Sources ……. Total …….. Working Capital Requirements xxxxx Add : Provision for contingencies …….. Net Working Capital Requirements from Negotiated Sources xxxxx Notes : 1. Profits should be ignored for the following reasons : a. Profits may or may not be used as working capital. b. Even if profits are to be used for working capital, it has to be reduced by the amount of income tax, drawings, dividends etc. 2. Calculation of work-in-progress depends upon its degree of completion as regards materials, labour and overheads. If nothing is mentioned, take 100% cost of materials, labour and overheads because in such a case, the average period of work-in-progress must have been calculated as equivalent period of completed units. 3. Calculation of stock of finished goods and debtors should be made at cost unless otherwise stated in example. 2 15 1. From the following particulars, prepare a Statement showing the working capital required to produce 12,000 units per annum. Elements of Cost Cost p.u. Raw Materials 5 Labour Charges 3 Overheads 2 Total Cost 10 Profit @ 20% on cost 2 Selling Price 12 Additional information: 1. Raw materials are to remain in store on an average : 1 month 2. Materials are in process on an average : 2 months 3. Finished Goods in warehouse on an average : 3 months 4. Credit period allowed to customers (Debtors) : 4 months 5. Credit period allowed by suppliers (Creditors) : 2 months It may be assumed that production and overheads accrue evenly throughout the year. ---------------------------------------------------------------------------------------------------------------------------- Solution 1: Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : (1 Month ) 5,000 x 1 5,000 2. Stock of Work-in Progress : (2 Months) 20,000 Raw Materials 5,000 x 2 10,000 Direct Labour 3,000 x 2 6,000 Overheads 2,000 x 2 4,000 3. Stock of Finished Goods : (3 Months) 30,000 Raw Materials 5,000 x 3 15,000 Direct Labour 3,000 x 3 9,000 Overheads 2,000 x 3 6,000 4. Investment in Debtors (at cost) : (4 Months) 40,000 Raw Materials 5,000 x 4 20,000 Direct Labour 3,000 x 4 12,000 Overheads 2,000 x 4 8,000 5. Advance Payments : if any Nil 6. Cash on hand : required to meet day-to-day operational expenses Nil Total 95,000 Less : Current Liabilities : 1. Sundry Creditors : (2 Months) 5,000 x 2 10,000 2. Outstanding Expenses : Nil Net Working Capital Required 85,000 Calculation of elements of cost Per Month : Annual Production : 12,000 units Monthly Production : 12,000 / 12 = 1,000 units per month Average Cost of Production Per Month: Materials : 1,000 units x 5 p.u. = 5,000 Labour : 1,000 units x 3 p.u. = 3,000 Overhead : 1,000 units x 2 p.u. = 2,000 Total Cost 1,000 units x 10 p.u. = 10,000 3 16 2. A proforma Cost Sheet of a company provides the following: Elements of Cost Cost p.u. Raw Materials 80 Labour Charges 30 Overheads 60 Total Cost 170 Profit @ 15% on selling price 30 Selling Price 200 Additional information: 1. Raw materials are in store on an average : 1 month 2. Materials are in process on an average : ½ month 3. Finished Goods are in store on an average : 1 month 4. Credit period allowed to customers (Debtors) : 2 months 5. Credit period allowed by suppliers (Creditors) : 1 month 6. Lag in payment of wages : 1 ½ Weeks 7. Lag in payment of overheads : 1 month 8. ¼ of the output is sold against cash 9. Cash on hand is expected to be : Rs. 25,000 Prepare a statement showing Working Capital Requirements for 1,04,000 units produced during the year. It may be assumed that production and overheads accrue evenly throughout the year. Further assume that 4 weeks is equivalent to 1 month. Solution 2: Workings : Calculation of elements of cost Per Week : Annual Production : 1,04,000 units Weekly Production : 1,04,000 / 52 weeks = 2,000 units per week Average Cost of Production Per Week: Materials : 2,000 units x 80 p.u. = 1,60,000 Labour : 2,000 units x 30 p.u. = 60,000 Overhead : 2,000 units x 60 p.u. = 1,20,000 Total Cost 2,000 units x 170 p.u. = 3,40,000 Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : (4 Weeks ) 1,60,000 x 4 6,40,000 2. Stock of Work-in Progress : (2 Weeks ) 6,80,000 Raw Materials 1,60,000 x 2 3,20,000 Direct Labour 60,000 x 2 1,20,000 Overheads 1,20,000 x 2 2,40,000 3. Stock of Finished Goods : (4 Weeks ) 13,60,000 Raw Materials 1,60,000 x 4 6,40,000 Direct Labour 60,000 x 4 2,40,000 Overheads 1,20,000 x 4 4,80,000 4. Investment in Debtors (at cost) : (8 Weeks ) 20,40,000 Raw Materials 1,60,000 x 8 x 3/4 9,60,000 Direct Labour 60,000 x 8 x 3/4 3,60,000 Overheads 1,20,000 x 8 x 3/4 7,20,000 6. Cash on hand : required to meet day-to-day operational expenses 25,000 Total 47,45,000 Less : Current Liabilities : 1. Creditors for goods (Trade Creditors) : (4 Weeks) 1,60,000 x 4 6,40,000 2. Creditors for Expenses - Wages : (1 ½ Weeks) 60,000 x 1.5 90,000 3. Creditors for Expenses – Overheads :(4 Weeks) 1,20,000 x 4 4,80,000 12,10,000 Net Working Capital Required 35,35,000 4 17 3. A proforma Cost Sheet of a Company provides the following : Elements of Cost Percentage Raw Materials 40% Labour Charges 20% Overheads 20% Additional information: 1. Selling Price is Rs. 15 per unit 2. Raw materials are in store on an average : 2 month 3. Materials are in process on an average : 1½ month 4. Finished Goods are in store on an average : 3 months 5. Credit period allowed to customers (Debtors) : 2 months 6. Credit period allowed by suppliers (Creditors) : 2 month 7. Cash on hand to meet day-to-day expenses : Rs. 1,40,000 It is proposed to maintain a present level of activity of 2,40,000 units produced during the year. You may assume that sales and production follow consistent pattern during the year. You are required to prepare a statement of Working Capital requirements. Solution 3 : Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : (2 Month ) 120,000 x 2 2,40,000 2. Stock of Work-in Progress : (1½Month) Raw Materials 120,000 x1½ 1,80,000 Direct Labour 60,000 x 1½ 90,000 Overheads 60,000 x1½ 90,000 3,60,000 3. Stock of Finished Goods : (3 Months) Raw Materials 1,20,000 x 3 3,60,000 Direct Labour 60,000 x 3 1,80,000 Overheads 60,000 x 3 1,80,000 7,20,000 4. Investment in Debtors (at cost) : (2 Months) Raw Materials 1,20,000 x 2 2,40,000 Direct Labour 60,000 x 2 1,20,000 Overheads 60,000 x 2 1,20,000 4,80,000 5. Cash on hand to meet day-to-day expenses 1,40,000 Total 19,40,000 Less : Current Liabilities : 1. Sundry Creditors : (2 Month) 1,20,000 x 2 2,40,000 Working Capital Required 17,00,000 2. Elements Percentage Cost p.u. 3. Calculation of production per month. Materials : 40% 6 Annual Production : 2,40,000 units Labour : 20% 3 Monthly Production : 2,40,000/12 = 20,000 units p. m. Overheads : 20% 3 Average Cost of Production Per Month: Total Cost 80% 12 Materials : 20,000 x 6 p.u. = 1,20,000 Profit (Diff.) 20% 3 Labour : 20,000 x 3 p.u. = 60,000 Selling Price 100% 15 Overhead : 20,000 x 3 p.u. = 60,000 Total Cost : 20,000 x 12 p.u. = 2,40,000 5 18  EXAMPLES FOR PRACTISE : 4. A proforma Cost Sheet of Mangal Limited provides the following : Elements of Cost Percentage Raw Materials 40% Labour Charges 30% Overheads 20% Additional information: 1. Selling Price is Rs. 20 per unit 2. Raw materials are in store on an average : ½ month 3. Materials are in process on an average : 1 month 4. Finished Goods are in store on an average : 1½ months 5. 50% of Sales is cash Sales. 6. Credit period allowed to customers (Debtors) : 2 months 7. Credit period allowed by suppliers (Creditors) : 1 month 8. Cash on hand to meet day-to-day expenses : Rs. 1,20,000 It is proposed to maintain a present level of activity of 1,20,000 units produced during the year. You may assume that sales and production follow consistent pattern during the year. Prepare a Statement of Working Capital requirements. 5. A proforma Cost Sheet of Priyanka Limited provides the following : Elements of Cost Amt. (Rs.) Raw Materials 40 Labour Charges 30 Overheads 20 Total Cost 90 Profit 10 Selling Price 100 Additional information: 1. Raw materials are in store on an average : ½ month 2. Materials are in process on an average : 2½ month 3. Finished Goods are in store on an average : 1½ months 4. 40% of output is sold against cash. 5. Credit period allowed to customers (Debtors) : 2 months 6. Credit period allowed by suppliers (Creditors) : 1 month 7. Cash on hand to meet day-to-day expenses : Rs. 30,000 8. Lag in payment of wages : ½ month 9. Lag in payment of Overheads : 1½ months It is proposed to maintain a present level of activity of 60,000 units produced during the year. You may assume that sales and production follow consistent pattern during the year. Prepare a Statement of Working Capital requirements. 6. A proforma Cost Sheet of Pawar Limited provides the following : Elements of Cost Cost p.u. Raw Materials 50 Labour Charges 30 Overheads 10 Total Cost 90 Profit 10 Selling Price 100 Additional information: 1. Raw materials are in store on an average : 4 weeks 2. Materials are in process on an average : 1½ month 3. Finished Goods are in store on an average : 2 weeks 4. 30% of output is sold against cash. 5. Credit period allowed to customers (Debtors) : 2 months 6. Credit period allowed by suppliers (Creditors) : 1 month 7. Cash on hand to meet day-to-day expenses : Rs. 50,000 8. Lag in payment of wages : 1½ weeks 9. Provide Rs.20,000 for contingencies. 6 19  It is proposed to maintain a present level of activity of 1,56,000 units produced during the year. You may assume that sales and production follow consistent pattern during the year. Prepare a Statement of Working Capital requirements. [Assume 1 month = 4 weeks] Solution 4 : Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : ( ½ Month ) 80,000 x ½ 40,000 2. Stock of Work-in Progress : (1 Month) Raw Materials 80,000 x 1 80,000 Direct Labour 60,000 x 1 60,000 Overheads 40,000 x 1 40,000 1,80,000 3. Stock of Finished Goods : (1 ½ Months) Raw Materials 80,000 x 1 ½ 1,20,000 Direct Labour 60,000 x 1 ½ 90,000 Overheads 40,000 x 1 ½ 60,000 2,70,000 4. Investment in Debtors (at cost) : (2 Months) Raw Materials 80,000 x 2 x 50% 80,000 Direct Labour 60,000 x 2 x 50% 60,000 Overheads 40,000 x 2 x 50% 40,000 1,80,000 5. Cash on hand to meet day-to-day expenses 1,20,000 Total 7,90,000 Less : Current Liabilities : 1. Sundry Creditors : (2 Month) 80,000 x 1 80,000 Working Capital Required 7,10,000 Elements Percentage Cost p.u. Calculation of production per month. Materials : 40% 8 Annual Production : 1,20,000 units Labour : 30% 6 Monthly Production : 1,20,000/12 = 10,000 units p. m. Overheads : 20% 4 Average Cost of Production Per Month: Total Cost 90% 18 Materials : 10,000 x 8 p.u. = 80,000 Profit (Diff.) 10% 2 Labour : 10,000 x 6 p.u. = 60,000 Selling Price 100% 20 Overhead : 10,000 x 4 p.u. = 40,000 Total Cost : 10,000 x 18 p.u = 1,80,000 Solution 5: Workings : Calculation of elements of cost Per month : Annual Production : 60,000 units Weekly Production : 60,000 / 12 months = 5,000 units per month Average Cost of Production Per Week: Materials : 5,000 units x 40 p.u. = 2,00,000 Labour : 5,000 units x 30 p.u. = 1,50,000 Overhead : 5,000 units x 20 p.u. = 1,00,000 Total Cost 5,000 units x 90 p.u. = 4,50,000 7 20  Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : 1. Stock of Raw Materials : ( ½ month ) 2,00,000 x ½ 6,40,000 2. Stock of Work-in Progress : ( 2 ½ months ) Raw Materials 2,00,000 x 2 ½ 5,00,000 Direct Labour 1,50,000 x 2 ½ 3,75,000 Overheads 1,00,000 x 2 ½ 2,50,000 11,25,000 3. Stock of Finished Goods : ( 1 ½ months ) Raw Materials 2,00,000 x 1 ½ 3,00,000 Direct Labour 1,50,000 x 1 ½ 2,25,000 Overheads 1,00,000 x 1 ½ 1,50,000 6,75,000 4. Investment in Debtors (at cost) : (2 months ) Raw Materials 2,00,000 x 2 x 60 % 2,40,000 Direct Labour 1,50,000 x 2 x 60 % 1,80,000 Overheads 1,00,000 x 2 x 60 % 1,20,000 5,40,000 6. Cash on hand : 30,000 Total 30,10,000 Less : Current Liabilities : 1. Creditors for goods (Trade Creditors) : (1 month) 2,00,000 x 1 2,00,000 2. Creditors for Expenses - Wages : ( ½ month) 1,50,000 x ½ 75,000 3. Creditors for Expenses – Overheads : (1 ½ month) 1,00,000 x 1 ½ 1,50,000 4,25,000 Net Working Capital Required 25,85,000 Solution 6. Workings : Calculation of elements of cost Per Week : Annual Production : 1,56,000 units Weekly Production : 1,56,000 / 52 weeks = 3,000 units per week Average Cost of Production Per Week: Materials : 3,000 units x 50 p.u. = 1,50,000 Labour : 3,000 units x 30 p.u. = 90,000 Overhead : 3,000 units x 10 p.u. = 30,000 Total Cost 3,000 units x 90 p.u. = 2,70,000 Statement of Working Capital Requirements Particulars Rs. Rs. Current Assets : Amount blocked in C.A. during operating cycle 1. Stock of Raw Materials : (4 Weeks ) 1,50,000 x 4 6,00,000 2. Stock of Work-in Progress : (6 Weeks ) Raw Materials 1,50,000 x 6 9,00,000 Direct Labour 90,000 x 6 5,40,000 Overheads 30,000 x 6 1,80,000 16,20,000 3. Stock of Finished Goods : (2 Weeks ) Raw Materials 1,50,000 x 2 3,00,000 Direct Labour 90,000 x 2 1,80,000 Overheads 30,000 x 2 60,000 5,40,000 4. Investment in Debtors (at cost) : (8 Weeks ) Raw Materials 1,50,000 x 8 x 70 % 8,40,000 Direct Labour 90,000 x 8 x 70 % 5,04,000 Overheads 30,000 x 8 x 70 % 1,68,000 15,12,000 5. Cash on hand 50,000 Total 43,22,000 Less : Current Liabilities : 1. Creditors for goods (Trade Creditors) : (4 Weeks) 1,50,000 x 4 6,00,000 2. Creditors for Expenses - Wages : (1 ½ Weeks) 90,000 x 1 ½ 1,35,000 7,35,000 35,87,000 Add: Provision for contingencies 20,000 Net Working Capital Required 36,07,000 8 21 Cash Management Management of cash is an important function of the finance manager. It is concerned with the managing of:- (i) Cash flows into and out of the firm; (ii) Cash flows within the firm; and Cash balances held by the firm at a point of time by financing deficit or investing surplus cash. The main objectives of cash management for a business are:- Provide adequate cash to each of its units; No funds are blocked in idle cash; and The surplus cash (if any) should be invested in order to maximize returns for the business. A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and costs. The Need for Cash The following are three basic considerations in determining the amount of cash or liquidity as have been outlined by Lord Keynes: Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt payments. Normally, inflows of cash from operations should be sufficient for this purpose. But sometimes this inflow may be temporarily blocked. In such cases, it is only the reserve cash balance that can enable the firm to make its payments in time. Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may present themselves and which may be lost for want of ready cash/settlement. Precautionary needs: Cash may be held to act as for providing safety against unexpected events. Safety as is explained by the saying that a man has only three friends an old wife, an old dog and money at bank. Cash Budget: Cash Budget is the most significant device to plan for and control cash receipts and payments. This represents cash requirements of business during the budget period. The various purposes of cash budgets are:- Coordinate the timings of cash needs. It identifies the period(s) when there might either be a shortage of cash or an abnormally large cash requirement; It also helps to pinpoint period(s) when there is likely to be excess cash; It enables firm which has sufficient cash to take advantage like cash discounts on its accounts payable; and Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage of cash) on favorable terms. On the basis of cash budget, the firm can decide to invest surplus cash in marketable securities and earn profits. Main Components of Cash Budget Preparation of cash budget involves the following steps:- (a) Selection of the period of time to be covered by the budget. It is also defining the planning horizon. (b) Selection of factors that have a bearing on cash flows. The factors that generate cash flows are generally divided into following two categories:- 22  (i) Operating (cash flows generated by operations of the firm); and (ii) Financial (cash flows generated by financial activities of the firm). METHODS OF CASH FLOW BUDGETING A cash budget can be prepared in the following ways: 1. Receipts and Payments Method: In this method all the expected receipts and payments for budget period are considered. All the cash inflow and outflow of all functional budgets including capital expenditure budgets are considered. Accruals and adjustments in accounts will not affect the cash flow budget. Anticipated cash inflow is added to the opening balance of cash and all cash payments are deducted from this to arrive at the closing balance of cash. This method is commonly used in business organizations. 2. Adjusted Income Method: In this method the annual cash flows are calculated by adjusting the sales revenues and cost figures for delays in receipts and payments (change in debtors and creditors) and eliminating non-cash items such as depreciation. 3. Adjusted Balance Sheet Method: In this method, the budgeted balance sheet is predicted by expressing each type of asset and short-term liabilities as percentage of the expected sales. The profit is also calculated as a percentage of sales, so that the increase in owner’s equity can be forecasted. Known adjustments, may be made to long-term liabilities and the balance sheet will then show if additional finance is needed. It is important to note that the capital budget will also be considered in the preparation of cash flow budget because the annual budget may disclose a need for new capital investments and also, the costs and revenues of any new projects coming on stream will need to be incorporated in the short-term budgets. The Cash Budget can be prepared for short period or for long period. Optimum Cash Balance: A firm should maintain optimum cash balance to cater to the day-to-day operations. It may also carry additional cash as a buffer or safety stock. The amount of cash balance will depend on the risk-return trade off. The firm should maintain an optimum level i.e. just enough, i.e. neither too much nor too little cash balance. This, however, poses a question. How to determine the optimum cash balance if cash flows are predictable and if they are not predictable? CASH MANAGEMENT MODELS In recent years several types of mathematical models have been developed which helps to determine the optimum cash balance to be carried by a business organization. The purpose of all these models is to ensure that cash does not remain idle unnecessarily and at the same time the firm is not confronted with a situation of cash shortage. All these models can be put in two categories:- Inventory type models; and Stochastic models. Inventory type models have been constructed to aid the finance manager to determine optimum cash balance of his firm. William J. Baumol’s economic order quantity model applies equally to cash management problems under conditions of certainty or where the cash flows are predictable.However, in a situation where the EOQ Model is not applicable, stochastic model of cash management helps in determining the optimum level of cash balance. It happens when the demand for cash is stochastic and not known in advance. William J. Baumol’s Economic Order Quantity Model, (1952) 23 According to this model, optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum. The carrying costs refer to the cost of holding cash, namely, the interest foregone on marketable securities. The transaction costs refer to the cost involved in getting the marketable securities converted into cash. This happens when the firm falls short of cash and has to sell the securities resulting in clerical, brokerage, registration and other costs. The optimum cash balance according to this model will be that point where these two costs are minimum. The formula for determining optimum cash balance is: 2UP C S Where, C = Optimum cash balance U = Annual (or monthly) cash disbursement P = Fixed cost per transaction. S = Opportunity cost of one rupee p.a. (or p.m.) This can be explained with the following diagram: The model is based on the following assumptions: (i) Cash needs of the firm are known with certainty. (ii) The cash is used uniformly over a period of time and it is also known with certainty. (iii) The holding cost is known and it is constant. (iv) The transaction cost also remains constant. Ex.1. A firm maintains a separate account for cash disbursement. Total disbursement are ` 1,05,000 per month or ` 12,60,000 per year. Administrative and transaction cost of transferring cash to disbursement account is ` 20 per transfer. Marketable securities yield is 8% per annum. DETERMINE the optimum cash balance according to William J. Baumol model. Ans : 2×`12,60,000×` 20 The optimum cash balance C = =`25,100 0.08 24  Credit Management Credit policy variables The important dimensions of a firm’s credit policy are 1. Credit standards 2. Credit period 3. Cash Discount 4. Collection effort These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers and collection expenses. For purpose of expository convenience we examine these variables independently. Credit Standards : A pivotal question In the credit policy of a firm is : What standards should be applied in accepting or rejecting an account for credit granting ? A firm has a wide range of choice in this respect. At one of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating may be. At the other end, it may decide to grant credit to all customers irrespective of their credit rating. Between these two extreme positions lie several possibilities, often the more practical ones. In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bed det loss, a larger investment in receivables and a higher cost of collection. Stiff credit standards have opposite effects. They tend to depress sales, reduce the incidence of bed det loss, decrease the investment in receivables and lower the collection cost. 1. ABC Limited has classified its customers into five risk categories as follows: Category Percentage of Bad Debts Average Collection Period 1 1% 30 Days 2 2% 45 Days 3 5% 60 Days 4 10% 100 Days 5 20% 150 Days Presently ABC Ltd allows unlimited credit to customers in categories 1 through 3, limited credit to customers in category 4 and no credit to customers in category 5. Due to this policy, ABC Ltd rejects orders of Rs. 30 lakhs from customers in category 4 and Rs.60 lakhs from customers in category 5. The variable cost to sales ratio for ABC Ltd is 75% and the opportunity cost of funds for ABC Ltd is 25%. Should ABC Ltd grant credit to all customers in categories 4 and 5 as well? Solution 1. The effect of Granting Credit to customers in category 4 and 5 (Credit Standards) Particulars Category 4 Category 5 ACP = 100 Days ACP = 150 Days A Increase in Sales 30,00,000 60,00,000 B Increase in Variable Cost (75% of Sales) 22,50,000 45,00,000 C Increase in contribution margin =(A-B) 7,50,000 15,00,000 D Bad Debts 3,00,000 12,00,000 E Investment in receivables 6,25,000 18,75,000 Sales x ACP x VC ratio 360 F Opportunity cost of Investment in receivables 1,56,250 4,68,750 (25% of E) G Effect on profit 2,93,750 (1,68,750) (C-D-F) ABC Limited is advised to grant credit to all customers in category 4 but no credit to customers in category 5. Credit period: The credit period refers to the length of the time customers are allowed to pay for their purchases. It generally varies from 15 days to 60 days. When a firm does not extend any credit, the credit period obviously. If a firm allows 30 days, say, of credit, with no discount to induce early payments, its credit terms are stated as ‘ net 30’. Lengthening of the credit period pushes sales up by including existing customers to purchase more and attracting additional customers. This is, however, 1 25 accompanied by a larger investment in debtors and a higher incidence of bed det loss. Shortening of the credit period would have opposite influences: It tends to lower sales, decrease investment in debtors, and reduce the incident of bed det loss. 2. HCL Limited has an annual turnover of Rs. 100 lakhs and an average collection period of 30 Days. The marketing director of the company believes that a longer credit period will stimulate additional sales. Of course, it is likely to be accompanied by higher defaults. The expected impacts of longer credit periods on sales and defaults is given below: Credit Policy Increase in collection period Increase in Sales Bad debts % 1 15 Days Rs. 5,00,000 2% 2 30 Days Rs. 10,00,000 4% The selling price of the product is Rs.50 and the variable cost per unit is Rs.30. The bad debts percentage currently is 1%. HCL Ltd requires a return of 20% on its investments. Assume that a year consist of 360 days. Advise whether HCL Ltd should increase the credit period? Solution 2.The Effect of Extending Credit Period (Rs. in Lakhs) Particulars Existing Option 1 Option II 30 Days 45 Days 60 Days A Expected Sales 100 105 110 B Variable cost (60% of Sales) 60 63 66 C Contribution (A-B) 40 42 44 D Bad Debts 1.00 2.10 4.4 E Investment in Receivables 5.00 7.875 11.00 Sales x ACP x VC ratio 360 F Opportunity cost of Investment in Receivables( 20% of E) 1.00 1.575 2.2 G Profit (C-D-F) 38.00 38.325 37.40 Since profit is maximized under Option-1, HCL Ltd is advised to increase the credit period from present 30 days to 45 days. Cash Discount: Firms generally offer cash discounts to induce customers to make prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a discount of 2 per cent is offered if the payment is made by the tenth day: otherwise the full payment is due by the thirtieth day. Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount period is lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly), and increase the cost of discount. To illustrate how the effect of cash discount on profit may be estimated, let us consider an example 3. Navneet Ltd. has annual credit sales of Rs.50 lakhs. Navneet Ltd. currently extends a credit of 60 days to its customers. However, it does not offer any discount for prompt payment. The company is considering a plan to offer discount of “2/10, net 60.” It is expected that 50% of the customers will avail the discount and the average collection period of the firm will reduce to 35 days from the current 60 days. The ratio of variable cost to sales is 70%. Navneet Ltd. requires a return of 25% on its investment. Should Navneet Ltd. offer discount for prompt payment? Evaluate the proposal. Assume that there are 360 days to a year. Solution 3 Cash Discount for prompt payment Particulars Rs. A Annual Credit Sales 50,00,000 B Cash Discount on50% of Sales 50,00,000 x 0.50 x0.20 50,000 C Present Investment in Receivable (50,00,000/360)x 60 days x 0.70 5,83,333 D Expected Investment in Receivables if Cash Discount is offered (50,00,000/360)x 35 days x 0.70 3,40,278 E Reduction in Investment in Receivables [C-D] 2,43,055 F Savings in Interest on account of reduction in Investment in Receivables = 2,43,055 x 25% 60,764 Since the savings in interest on account of reduced investment in receivables (60,764) exceeds the cash discount given by the firm (Rs.50,000), it is advisable to offer cash discount for prompt payment. 2 26  Collection Effort: The collection programme of the firm, aimed at timely collection of receivables, may consist of the following:  Monitoring the state of receivables  Dispatch of letters to customers whose due date is approaching  Telegraphic and telephonic advice to customers around the due date  Threat of legal action to overdue accounts  Legal action against overdue accounts A rigorous collection programme tends to decrease sales, shorten the average collection period, reduce bad debt percentage, and increase the collection expense. A lax collection programme, on the other hand, would push sales up, lengthen the average collection period, increase the bad debt percentage, and perhaps reduce the collection expense. To illustrate how the effect of a more rigorous collection programme on profit may be estimated, let us consider an example. 4. Pioneer Ltd. currently sells 60,000 units of a product at Rs.250 per unit. All sales are on credit. The variable cost per unit is Rs.150; the average collection period is 75 days, bad debts are 5% of sales; and the collection expenses are Rs.1,00,000. Pioneer Ltd. is considering a tighter collection policy. It expects that such a policy will bring down the average collection period to 50 days and bad debts to 3%. However, it will cause a 5% decline in sales and a 100% increase in collection expenses. If Pioneer requires a 20% return on its investments, should it tighten its collection policy? Assume that there are 360 days to a year. Solution 4. Effect of tightening the collection policy Particulars Current Policy New Policy ACP (75 Days) ACP (50 Days) A Sales 1,50,00,000 1,42,50,000 B Variable cost (60% of sales) 90,00,000 85,50,000 C Contribution (A-B) 60,00,000 57,00,000 D Bad Debts 7,50,000 4,27,500 E Investment in Receivables 18,75,000 11,87,500 Sales x ACP x VC ratio 360 F Required Rate of Return on Investment (20% of E) 3,75,000 2,37,500 G Collection Expenses 1,00,000 2,00,000 H Profit (C-D-F-G) 47,75,000 48,35,000 Since the switch from the current policy to the new policy increases the profit by Rs. 60,000 (48,35,000-47,75,000); It is advisable to tighten the collection policy. 5. Sardar Limited presently has an annual turnover of Rs.36,00,000 and an average collection period of 30 days. The marketing director of the company believes that a longer credit period will stimulate additional sales. Of course, it is likely to be accompanies by higher defaults. The expected impacts of longer credit periods on sales and defaults is given below: Credit Policy Increase in Credit Period Increase in Sales Bad debts % 1 30 days Rs. 12,00,000 5% 2 60 days Rs. 24,00,000 10% The selling price of the product is Rs.100 and the variable cost per unit is Rs.40. The bad debts percentage currently is 2%. Sardar Limited requires a return of 20% on its investments. Assume that a year consists of 360 days. Which credit period Sardar Limited should grant to customers? Particulars Present policy Credit Policy 1 Credit Policy 2 Collection period 30 days 60 days 90 days Sales 36,00,000 48,00,000 60,00,000 Less : Variable cost (14,40,000) (19,20,000) (24,00,000) Contribution 21,60,000 28,80,000 36,00,000 Less: Bad debts (72,000) (2,40,000) (6,00,000) Investment in receivables 1,20,000 3,20,000 6,00,000 ( Sales /360 x VCR x ACP ) Less: Min. required return@ 20% (24,000) (64,000) (1,20,000) Estimated profit 20,64,000 25,76,000 28,80,000 Sardar Ltd. Should grant credit for 90 days (as per Credit policy 2 – increase collection period by 60 days) to customer as it increases profit by Rs.8,16,000 compared to present policy. 3 27 6. Nick Ltd. has annual sales of Rs.10 million. Company extends a credit of 90 days to its customers. However, it does not offer any discount for prompt payment. The chief executive officer of company is considering a plan to offer discount 5/10, net 90. It expects that half of the customers will avail the discount and average collection period will reduce to 50 days from current 90 days. The variable cost to sales ratio is 60% and minimum required rate of return on the investment is 20%. Should company offer discount for prompt payment? (Assume 360 days in a year) PARTICULARS AMT. A Annual sales 1,00,00,000 B Cash discount on 50 % sales 2,50,000 1,00,00,000 x 50 % x 5 % C Present investment in receivables 15,00,000 1,00,00,000 x 60 % x 90/360 D Expected investment in receivables 8,33,333 1,00,00,000 x 60 % x 50/ 360 E Reduction in investment in receivables (C – D) 6,66,667 F Savings in interest on account of reduction in investment in receivables (E X 20 %) 1,33,333 Since the savings in interest on account of reduction in investment in receivables (Rs.1,33,333) is less than the cash discount given by the firm (Rs.2,50,000), it is advisable not to offer cash discount for prompt payment 7. Ajeet Ltd. has annual sales of Rs.3 million. All sales are on credit. The variable cost is 60% of the sales, the average collection period is 60 days, bad debts are 6% of sales and collection expenses are Rs.50,000. The company is considering a tighter collection policy. It expects that such a policy will bring down the average collection period to 45 days and bad debts to 4%. However it will cause 10% decline in sales and 100% increase in collection expenses. If the company requires 10% return on its investments, should it tighten its collection policy? (Assume 360 days in a year) Particulars Present policy New Policy (tighter policy) Collection period 60 days 45 days Sales 30,00,000 27,00,000 Less : Variable cost @ 60% (18,00,000) (16,20,000) Contribution 12,00,000 10,80,000 Less: Bad debts (1,80,000) (1,04,000) Investment in receivables 3,00,000 2,02,500 ( Sales/360 x VCR x ACP ) Less: Min. required return@ 10% (30,000) (20,250) Less: Collection exp (50,000) (1,00,000) Estimated profit 9,40,000 8,55,750 Ajeet Ltd. Should not tighten it’s collection policy as it result into decrease in profit by Rs.84,250 compared to Present Policy. 8. Amit Ltd. has classified its customers into three categories as follows: Category Percentage of Bad debts Average Collection Period 1 2 30 days 2 4 45 days 3 10 60 days Presently company allows unlimited credit to customers in category 1, limited credit to customers in category 2 and no credit to customer in category 3. Due to this policy, company rejects orders of Rs. 10,00,000 from customers in category 2 and Rs. 20,00,000 from customers in category 3. The variable cost to sales ratios is 75% and opportunity cost of capital is 20%. Should the company grant credit to all customers in categories 2 and 3 as well? (Assume 360 days in a year) Particulars Category 2 Category 3 Collection period 45 days 60 days Sales 10,00,000 20,00,000 Less : Variable cost (7,50,000) (15,00,000) Contribution 2,50,000 5,00,000 Less: Bad debts (40,000) (2,00,000) Investment in receivables 93,750 2,50,000 ( Sales/360 x VCR x ACP Less: Min. required return@ 20% (18,750) (50,000) Estimated effect on profit 1,91,250 2,50,000 4 28