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Financial statements and cash flow analysis Meaning Relationship b/w financial statements Cash cycle Importance of cash management for business Cash conversion period Credit policy Inflow and outflow of cash Projecting operating expenses Projecting cost of goods sold Projecting major purchases Projecting for debt payments Putting the projections together Cash-flow surpluses and shortages The Importance of Cash Management Cash vs. Cash Flow Components of cash flow Sources of finance Funding Options Types of analysis Financial Ratios
4. Cash flow management
5. Cash budget
6. Cash flow statement
7. Funding a Business
8. Financial analysis
Goals and drawbacks The interpretation of company accounts Framework for linking financial business objectives Liquidity ratios Profitability analysis ratios Activity analysis ratios Capital structure analysis ratios Capital market analysis ratios Nature and Importance of working capital Working capital cycle The Management of Working Capital Approaches to Working Capital Management Working Capital Analysis Factors influencing working capital Consequences of under and over assessment of working capital Financing Working Capital How is working capital reflected in balance sheet Working capital ratios Why hold Inventory The cost of Inventory Opposing Views of Inventory Why We Want to Hold Inventories? Why We Do Not Want to Hold Inventories? Independent Demand and Dependent Demand Inventory Systems Inventory Costs Behavior of EOQ Systems Successful inventory management
9. Performance analysis of the company
10. Working capital
12. Basic financial tools and terms
Objective Identify ways a financial statement impacts my company. Demonstrate how different financial instruments impact financial statements. Identify the characteristics of the statement of cash flows. List ways a company's financial statements can impact the value of its stock. Calculate a company’s profitability ratios. Calculate a company's liquidity ratios. Ways to manage the finances to achieve the strategic goals of the institution To increase profitability To reach self-sufficiency/breakeven point. To increase efficiency especially reducing the cost per client Find the optimum level of each different operational expense including the cost of funds. To manage the costs of human resources as part of overall human resource management. How to manage liquidity—i.e., how to keep solvent at the same time as disbursing the maximum number of loans, setting a target level of liquidity. What is the best financing structure, i.e., how much debt including from commercial sources and how much capital do you need? What should the asset structure be? How to manage the fixed assets, i.e., the depreciation policy, how to finance them, are they insured, are they safe? How to undertake trend analysis and to compare actual performance against planned performance
Analysis of the company/organization
History Founded in 1958 by Sh SL Minda, the Minda Group today is one of the leading manufacturers of automobile components with a turnover of Rs. 3,690 million and employs 3,000 people India-wide. The group is a major supplier to OEM's both in India and overseas. The group companies are accredited with quality and environment certification and have collaborations and strategic alliances with international manufacturers. The Group manufactures different lines of automobile parts:
STEERING LOCK CUM IGNITION SWITCH IMMOBILISER & ALARM FUEL TANK CAP LOCK
SEAT LOCK / CABLE ASSY. FLASHER
REGULATOR RECTIFIER INTELLIGENT CDI
TOOL BOX LOCK
Profile: For over four decades, MINDA has been a major presence in India's automobile industry. These forty-five years have been interspersed by a number of technological innovations that have gone on to become industry standards. . For assimilating the latest technologies, Minda has entered into strategic alliances and technical collaborations with leading international companies. This has provided Minda
with the cutting edge in product design and technology to meet strict international quality standards. Organization & Management To ensure product specialization and optimization of capacity the manufacturing is managed between the Ashok Minda and NK Minda groups. Royal Enfield. Maruti (Suzuki). Honda Scooters. Mahindras. GERMANY..500 03-04 995 04-05 1. We are one of India's leading manufacturers of Security systems.000 Rs. Couplers & Terminals and Instrument Clusters catering to all major two & four wheeler vehicles manufacturer in India. Escorts. LML (Piaggio). The Groups' companies are accredited with QS 9000 and ISO-14001 certification from TUV. Hero Motors. Kinetic Engg. Wiring harnesses. Daewoo. etc. Fiat. Sales Growth 2.472 01-02 2. Kinetic Honda. Mercedez Benz. Telco.000 500 - 667 02-03 744 1. Peugeot. This also encourages synergies in manufacturing and product development.750 2. The products are well accepted worldwide both with O.E.M's and the after market. TVS-Suzuki. Piaggio. Million 1. Minda is a major supplier to General Motors India. Ford.500 06-07 07-08 Year Export Sales 1. Bajaj (Kawasaki).968 5 .496 05 -06 1.
Design Capability Process Improvement Productivity Value Engineering Cost Quality Focus Area Delivery Development On time First Time Righ t 6 .
the disbursement of expenses. Financial analysis is required in every such case. and the approval of capital expenditures. the recognition of sales. equipment ordered. and makes no judgment about 7 . such as income statements. balance sheets. In addition. and cash flow statements. that the balance sheet only lists these resources. the finance function reports on these internal control systems through the preparation of financial statements. Financial analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. and new projects undertaken based on clear investment return criteria. Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions. The finance function in business organizations involves evaluating economic trends. Finance is the language of business. finance involves analyzing the data contained in financial statements in order to provide valuable information for management decisions. however. setting financial policy. The balance sheet outlines the financial and physical resources that a company has available for business activities in the future. Goals are set and performance is measured in financial terms. Plants are built. It is important to note. Finally. Documents Used in Financial Analysis Balance sheet Profit & Loss statement Funds flow statement Cash flow statement The two main sources of data for financial analysis are a company's balance sheet and income statement. It also involves applying a system of internal controls for the handling of cash.Financial Statements and Cash Flow Analysis Financial statements provide information about the financial activities and position of a firm. the valuation of inventory. and creating long-range plans for business activities.
such as accounts receivable. copyrights. 8 . long-term investments. the balance sheet is more useful in analyzing a company's current financial position than its expected performance. Balance Sheet and Cash Flow reports.how well they will be used by management. creditworthiness. For this reason. and equipment. Further insight can be gleaned from a straightforward analysis of the figures from the Profit and Loss. financial health and even their expansion plans for the future. and intangible assets like patents. chief executive and finance director. including fixed assets like property. Assets generally include both current assets (cash or equivalents that will be converted to cash within one year. Using company accounts The wealth of information can be obtained from company accounts. inventory. plant. Both the total amount of assets and the makeup of asset accounts are of interest to financial analysts. The main elements of the balance sheet are assets and liabilities. The information can provide a valuable insight into our customers and their business: their trading performance. and goodwill). and prepaid expenses) and non-current assets (assets that are held for more than one year and are used in running the business. Much of this is simply stated in the notes or can be gleaned from the written reports from the chairman.
It is not the passive. cash management is as much an integral part of your business cycle as. totally unforgiving.Cash-flow management In its simplest form cash flow is the movement of money in and out of your business. Cash flow is the life-blood of all growing businesses and is the primary indicator of business health. You need to control the process and there is always scope for improvement. Rather it has to be tracked. The effect of cash flow is real. if mismanaged. protected. for example. immediate and. making and shipping widgets or preparing and providing detailed consultancy services 9 . chased and captured. controlled and put to work. It does not arrive in your bank account willingly. inevitable outcome of your business endeavors. cash is not given. Cash needs to be monitored. There are four principles regarding cash management: • First. • Second.
But what is crucially important is to actively manage and control these cash inflows and outflows. It must be emphasized that profits are not the same as the cash flow. of our business. you need information. It is the timing of these money flows which can be vital to the success. Inflows are most likely from the: • Receipt of monies from the sale of goods/services to customers • Receipt of monies on customer accounts outstanding 10 . in addition. You will find. or otherwise. Cash flow can be described as a cycle: business uses cash to acquire resources.• Third. therefore. always the norm. funds are collected and deposited and so the cycle repeats. grant you a commercial edge in all your transactions. be masterful Professional cash management in business is not. you need immediate access to information on: your customers’ credit worthiness your customers’ current track record on payments outstanding receipts your suppliers’ payment terms short-term cash demands short-term surpluses investment options current debt capacity longer-term projections • Fourth. that the cash management process has a double benefit: it can help you to avoid the debilitating downside of cash crises and. unfortunately. The resources are put to work and goods and services produced. For example. such that may worry whether company can survive. It is possible to project a healthy profit for the year and yet face a significant and costly monetary squeeze at various points during the year. These are then sold to customers. Inflows Inflows are the movement of money into the business.
etc. week or even on daily basis. Cash Outflows (a) Cash purchases (b) Cash payment to creditors 11 . (d) Cash receipt of other revenue income (e) Cash received from sale of investments or assets. deposits.• Proceeds from a bank loan • Interest received on investments • Investment by shareholders in the company Outflows Outflows are the movement of money out of the business. a half or a quarter year. The main sources for these flows are given hereunder: Cash Inflows (a) Cash sales (b) Cash received from debtors (c) Cash received from loans. Outflows are most likely from: • Purchasing finished goods for re-sale • Purchasing raw materials and other components needed for the manufacturing of the final product • Paying salaries and wages and other operating expenses • Purchasing fixed assets • Paying principal and interest on loans • Paying taxes Cash Budget Cash budget basically incorporates estimates of future inflows and outflows of cash over a projected short period of time which may usually be a year. There are two components of cash budget (i) (ii) Cash inflows and Cash outflows. Effective cash management is facilitated if the cash budget is further broken down into month.
Total cash outflows Opening cash balance Add/deduct surplus/deficit during the month (I – II ) Closing cash balance (III – IV) Minimum level of cash balance Estimated excess or shortfall of cash (V – VI) Total cash inflows Estimates cash outflows Cash-flow management is vital to the health of our business. III. each time through the cycle. But not necessarily. VI. etc. Hopefully. More often than not. A suggestive format for ‘Cash Budget’ Particulars Month January February March Estimated cash inflows ------------------------------I. ----------------II. a little more money is put back into the business than that flows out. VII.(c) Cash payment for other revenue expenditure (d) Cash payment for assets creation (e) Cash payment for withdrawals. V. 12 . taxes (f) Repayment of loans. and if we don’t carefully monitor our cash flow and take corrective action when necessary. IV. Cash outflows and inflows seldom seem to occur together. our business may find itself sinking into trouble.
we can start to plot our cash-flow profile and importantly if we can plan a response in accordance with these answers. There are three key components: 1. 13 . A manufacturer will have funds tied up in physical stocks while service organizations will have funds tied up in work-in-progress that has not been invoiced to the customer. Managing cash flow allow us to narrow or completely close our cash-flow gap and we do this by examining the different items that affect the cash flow of our business as listed above. leaving our business short. Advantages of managing cash flow The advantages are • We should know where our cash is tied up • We can spot potential bottlenecks and act to reduce their impact • We can plan ahead • We can reduce dependence on bankers and save interest charges • We can identify surpluses which can be invested to earn interest • We are in control of your business and can make informed decisions for future development and expansion Cash conversion period The cash conversion period measures the amount of time it takes to convert product or service into cash inflows. This money shortage is our cash-flow gap.cash inflows seem to lag behind our cash outflows. Answer the following questions: • How much cash does business have? • How much cash does business generate? • How much cash does my business need in order to operate? • When is it needed? • How do my income and expenses affect my capacity to expand my business? If we can answer these questions. This is important for both manufacturing and service industries. we are then starting to manage our cash flow. The inventory conversion period – The time taken to transform raw materials into a state where they are ready to fulfill customers’ requirements.
the faster we can spend it in pursuit of further profit. to payment. The total time taken is the receivables conversion period. The quicker we can collect cash.g. Completing each event takes a certain amount of time.2. 3. The flow chart represents each event in the receivables conversion period. but it is essential to consider the overall needs of the business. Accelerating cash inflows Accelerating cash inflows will improve our overall cash flow. The net period of (1+2)-3 gives the cash conversion period (or working capital cycle). Accelerating our cash inflows involves streamlining all the elements of the cash conversion period: • The customer’s decision to buy • The ordering procedure • Credit decisions 14 . The receivables conversion period – The time taken to convert sales into cash inflows. The chart below is an illustration of the typical receivables conversion period for many businesses. The payable deferrable period – The time between purchase/usage of inputs e. Shortening the receivables conversion period is an important step in accelerating our cash inflows. materials. The trick is to minimize (1) and (2) and maximize (3). labour. etc.
price lists. by telephone. it is best to anticipate a request for an increase in their credit limit whenever 15 . precise and easy. Use of accessible. It should not be arrived at by default. shipping and handling • Invoicing the customer • The collection period • Payment and deposit of funds Customer purchase decision and ordering Without a customer. Start credit decision-making process when first meeting with new prospective customers or clients. up-to-date catalogues. displays. Credit policy Company’s credit policy is important. Provide ways to bypass the postal service. This may be a reasonable level of risk and may ensure that new business is not lost. Make the ordering process quick. the financial controller and the Board. Checking credit references. obtaining credit reports and chasing references will cost time and resources. the procedure for authorizing any exemption and the requirements for regular reporting. or via fax. It should be a Board decision and should determine such items as company’s credit criteria. proposals or quotations to keep our customer informed. With existing customers or clients.• Fulfillment. the company’s standard payment terms. Accept orders over the Internet. the person responsible for obtaining that credit rating. Customer credit worthiness Credit checks for new customers and reviews for existing customers are important. The policy should be written down and kept up to date with supplements as necessary concerning any changes to the creditworthiness of specific customers. If necessary. The policy should be disseminated to all sales staff. Make sure that business is advertising effectively and making it easy for the customer to place an order. there will be no cash inflow to manage. the credit rating agency to be used. consider allowing small orders to get underway quickly with a small start limit for new accounts. any warnings or notes of current poor experience.
This can be accomplished by monitoring customers’ current credit limits and payment performance and comparing them with your expected levels of future business. On a ‘welcome letter’ restate the terms and conditions. that is.possible. to be upfront about terms for payment. Ask yourself: • Do you methodically check the financial standing of all new customers before executing the first order? • Do you periodically review the financial standing of existing customers? • Do you undertake a full recheck of the financial standing of existing customers whose purchases have recently shown a substantial increase? • Do you use the telephone when checking trade references? Suppliers will often tell you over the telephone what they would not put in writing • Do you recognize that salesmen are by nature optimists? Use other sources of information before increasing/establishing credit for customers • Is there one person in your firm who is ultimately responsible for supervising credit and for ensuring the prompt collection of monies due and who is accountable if the credit position gets out of hand? • Are you clear in your own mind as to how you assess credit risks and how you impose normal limits – both in terms of total indebtedness for each customer’s account and also in terms of payment period? • Do you make your credit terms very clear? In a sales negotiation it is professional. ‘payment terms: X days from invoice date – payment to reach us by (date)’ To save time and resources use the 80/20 rule to identify the few accounts that buy most of your sales.g. On an ‘Account Application Form’ include a paragraph for the buyer to sign. On ‘Invoices and Statements’ show the payment terms boldly on the front. undertake only brief checks on smaller ones. not anti-selling. On an ‘Order Acknowledgement’ again stress your payment terms and conditions of sale. list accounts in descending order of value and give the top 80 per cent a full credit check and review. A full credit report on a limited company will cost in the region of from a 16 . On invoices also show the due date e. agreeing to comply with your stated payment terms and conditions of sale. Review the check on specific smaller accounts if monitoring starts to reveal a poor payment performance.
This information can be received online. registered lending and a recommended credit rating. we need to create a cash-flow budget that extends for several years into the future. to avoid expensive. increasing or advancing receipts. such as a short-term loan. Credit agencies should give you full customer details. The agency will provide a full description to accompany the score. county court judgments. The cash-flow budget can help predict your business’s cash-flow gaps – periods when cash outflows exceed cash inflows when combined with your cash reserves. financial results. a six-month cash-flow budget is probably about right. If we want to apply for a loan. uncontrolled overdrafts. It predicts future events early enough for you to take some corrective action and yet may minimize the amount of uncertainty involved in the budget preparation. A typical cash-flow budget predicts cash inflows and outflows on a month-to-month. weekly or daily basis. If our customer is a sole trader or a partnership we can still obtain information in the same way as we would with a limited company. But for our business needs. 20/100 would probably indicate that the company is either unlikely to survive or may be a new start-up with little capital (or both). as part of the application process. 60/100 is not so safe. to fill the cash-flow gaps. These steps might include lowering our investment in accounts receivable or inventory. payment experience of other suppliers. or at least narrowed.e. 80/100 would indicate a safe risk. The reference agency will also provide a rating/score i. Cash-flow budget The cash-flow budget projects your business cash inflows and outflows over a certain period of time. Preparing a cash-flow budget involves: • preparing a sales forecast • projecting our anticipated cash inflows • projecting our anticipated cash outflows • putting the projections together for our cash-flow bottom line • identifying surpluses and the opportunity to place short-term money on deposit to earn interest 17 . or looking to outside sources of cash. This will allow us to take steps to ensure that the gaps are closed.rating agency. Use an agency with a complete database and a fast response.
demand. More commonly. late-paying or slow-paying customers will create cash shortages. That is. the payment of accounts receivable is likely to be the most important source of cash inflows. spoiling its reputation and upsetting its suppliers. etc. repaying loans. Any forecast will include some uncertainty and will be subject to many variables: the economy. or expanding our business. then our projected cash receipts will equal the amount of sales predicted in the sales forecast. A longer average collection period represents a higher investment in accounts receivable and less cash available to cover cash outflows such as for purchases 18 . unpaid accounts receivable will leave our business without the cash to pay its own bills. Accounts receivable Accounts receivable can be looked upon as an investment. Projecting cash receipts is a little more involved if the business extends credit to its customers. the money tied up in accounts receivable is not available for paying invoices.• identifying deficits and the need to accelerate cash flows or borrow short-term money • identifying longer-term surpluses to fund expansion and development • identifying longer-term needs for funds. competitive influences. either from banks or shareholders Cash inflows Forecasting our sales is key to projecting our cash receipts. At worst. we must take into account the collection period for our accounts receivable. It will also include other sources of revenue such as investment income. The payoff from an investment in accounts receivable does not occur until your customers pay our invoices. causing our business to be late in covering its own payment obligations. If our business only accepts cash sales. In this case. The following analysis tools can be used to help determine the effect our business’s accounts receivable is having on our cash flow: • Average collection period measurement • Accounts receivable to sales ratio • Accounts receivable ageing schedule Average collection period The average collection period measures the length of time it takes to turn our average sales into cash. If credit is normally extended to our customers. but sales are the primary source.
19 . when compared to the previous month. If the bulk of the overdue amount in receivables is attributable to one customer. If the makeup of accounts receivable changes. The ageing schedule also identifies any recent changes in the accounts making up our total accounts receivable balance.and expenses. your credit policy. An accounts payable ageing schedule helps to determine our cash outflows for certain expenses in the near future – 30 to 60 days. or is it caused by a billing problem? What effect will this change in accounts receivable have on next month’s cash inflows? The accounts receivable ageing schedule can sound an early warning and help us protect our business from cash-flow problems. This will give us a good estimate of the cash outflows necessary to pay our accounts payable on time. Is the change the result of a change in sales. Cash outflows Projecting cash outflows for our cash-flow budget involves projecting expenses and costs over a period of time. The average collection period in days is calculated by dividing our present accounts receivable balance by average daily sales: Average collection period = current accounts receivable balance / average daily sales where average daily sales = annual sales /365 The ageing schedule can be used to identify the customers that are extending the payment time. we should spot the change rapidly. Reducing our average collection period will reduce our investment in accounts receivable and improve our cash flow. then steps can be taken to see that this customer’s account is collected promptly. Overdue amounts attributable to a number of customers may signal that our business needs to tighten its general credit policy towards new and existing customers. The cash outflows for every business can be classified into one of four possible categories: • Costs of goods sold • Operating expenses • Major purchases • Debt payments By classifying business expenses. it will help us to ensure that all our outflows are readily identified.
can be adjusted to meet your reporting needs. We should take into account suppliers’ terms of trade – to which we already have agreed. While it is good cash-flow management to delay payment until the invoice due date.H. A typical accounts payable ageing schedule consists of six columns. then the past due amounts listed for G. Paying bills late can indicate that we are not managing our cash flow the way a successful business should.Accounts payable ageing schedule The accounts payable ageing schedule is a useful tool for analysing the makeup of our accounts payable balance. however. Unlimited was an important supplier for Technical Office Supplies Ltd. However. Projecting operating expenses Expenses tend to come under four headings: o debt payments. For instance. Looking at the schedule allows us to spot problems in the management of payables early enough to protect our business from any major trade credit problems. the payables ageing schedule is used for listing the amounts we owe to our various suppliers – a breakdown by supplier of the total amount on our accounts payable balance.the number of columns.R. o asset purchases and o operating expenses. The schedule can also be used to help manage and improve your business’s cash flow. 20 . o cost of goods sold. we might prefer listing the outstanding amounts in 15-day intervals rather than 30-day intervals. The accounts payable ageing schedule can help us determine how well we are (or are not) paying our invoices. For example. Unlimited should be paid in order to protect the trade credit established. instead of showing the amounts our customers owe to us.R. An accounts payable ageing report looks almost like an accounts receivable ageing schedule. Most businesses prepare an accounts payable ageing schedule at the end of each month. if G.H. take care not to rely too heavily on our trade credit and stretch our goodwill with suppliers.
will be variable by nature. is fairly fixed. Rent. Mortgage payments and lease hire payments will follow the schedule agreed with the lender. weekly or even daily basis: • Opening cash balance plus Projected cash inflows • Cash sales • Accounts receivable • Investment interest less Projected cash outflows 21 .Operating expenses include payroll and payroll taxes. being the same amount each month. payroll or utilities may vary in line with our sales projections and have a seasonal aspect. utilities. Only payment against an overdraft. for example. will be in line with the sales projection after allowing for our production cycle. for example. Cash outflow in this area is generally large and irregular. Projecting cost of goods sold Outflows for the cost of goods sold. Projecting major purchases Purchasing new assets for the company tend to occur when the business is expanding. purchases of materials. rent. However. changes in the level of inventory and our payment terms. computers. Putting the projections together The completed cash-flow budget combines the following information on a monthly. i. Examples of fixed asset expenditure would be on new company cars.e. or improving its cash-flow position. Projecting for debt payments Projecting for debt payments is the easiest category to predict when preparing the cashflow budget. vans and machinery. Operating expenses can be fixed or variable. or the result of machinery needing to be replaced. insurance and repairs and maintenance.
However. If a cash-flow gap is predicted early enough. i. or at least narrowed in order to protect our business for the future. we can take cash-flow management steps to ensure that our cashflow gap is closed. A negative cash-flow bottom line indicates that our business has a cash-flow gap. but we also need to control stocks effectively to avoid theft. The second period’s closing balance is determined by combining the opening balance with the second period’s anticipated cash inflows and cash outflows. We have already mentioned the importance of managing debtors. or fund capital investment for longer-term expansion and development.e. The closing balance for the second period then becomes the third month’s opening cash balance and so on until the last period of the cash-flow budget is completed. These steps might include: • increasing sales • Increasing margins. care must be taken not to compromise on quality or to lose customers because our prices are too high • Preventing leakage from the cycle. deterioration. We can plan to place money on short-term deposit to earn interest. A positive cash-flow bottom line indicates your business has a cash surplus at the end of the period. maximize the difference between costs and prices by cutting costs and/or raising selling price. etc. • Increasing our anticipated cash inflows from accounts receivable collections • Decreasing our anticipated cash outflows by cutting back on inventory purchases or cutting certain operating expenses • Postponing a major purchase • Rolling over a debt repayment • Looking to outside sources of cash. such as a short-term loan 22 .• Operating expenses • Purchases • Capital investment • Debt payment equals • cash-flow bottom line (the closing cash balance) The closing cash balance for the first period becomes the second period’s opening cash balance.
Second. either overnight or on term deposit with a bank or with a proprietary money fund. establish a short-term borrowing facility with the bank whereby. Third. either to meet short-term shortages or for Longer-term development. The interest on a short-term facility may be more favourable than for an overdraft. These are outlined. in brief. we can advance payments to creditors and by so doing enhance our credit credentials for the future. then we can pay out money to stakeholders • Finally. It 23 . if the funds truly are surplus to current and future requirements. we can put the surplus to work by placing the surplus on short-term deposit. you can draw down a specific amount to be repaid in a specified number of days. haggle the premium. We should negotiate with the bank to agree acceptable limits to the facility and agree competitive interest rates. we will have an overdraft facility with our relationship bank. The facility will enable us to make withdrawals at short notice. We’ll be paying a premium over the base rate. then there are considerations of whether there is a premium to be paid for early repayment and whether it restricts our future flexibility unduly. as a natural extension of the two sources above. the repayment periods and the interest rates will be negotiated with the bank. The limits to the facility. at short notice. Similarly. we can pay down debt to improve our balance sheet gearing ratio and make the payment profile for future principal and interest payments more manageable. we can use the money to fund capital investment for development and expansion in line with our longer-term corporate plan • Third. First.Cash-flow surpluses and shortages Surpluses • First. to earn interest until we are ready to put the money to other uses • Second. below. Sources of finance If there is a requirement for additional funds. If we choose this route. there are several sources of new funds that can be considered. establish a revolving credit facility with the bank.
which we turn to in some detail below. It is simply good business to take the time to establish fresh links to some of these. for longer-term needs. It requires consideration of the time. In a recourse agreement. Although we want to maintain a good relationship with our bank. This is an important source of funds and can be essential if the debtequity ratio is to be maintained at acceptable levels. The interest rate can be fixed or variable. the factoring company bears the burden of collecting the accounts receivable. getting cash immediately for our sales with a cut being taken by the factoring company. • Discount rate – The discount rate is the fee charged by the factoring company for the financing. The finance can be loan debt or bond issue and can be general company debt or project specific. That is. Finally. non-recourse – In a non-recourse agreement. effort and cost required for set-up. Factoring involves ‘selling’ our accounts receivable to a factoring company at a discount.will also enable us to make unscheduled repayments whenever we have a cash surplus: the saving on interest owed may outweigh the interest that could have been earned from a separate investment. depending on the accounts receivable payment terms • Recourse vs. The typical range is 1 per cent to 7 per cent of our accounts receivable. Factoring A possible solution to short-term cash-flow problems is factoring. either from a private placing of shares or a public offering. we can raise fixed-term finance from the bank or other institutions. Fourth. 70 per cent and then will pay us the balance once the receivables are collected. there are now many competing sources of sound finance in the market. source of finance is factoring. The typical range is 60 per cent to 90 per cent of our account receivables. Factoring contracts all have the following elements in common: • Advance rate – The advance rate is the percentage of accounts receivable that companies will advance to us. Others will advance say. Beyond that we can raise further equity. especially since the de-mutualisation of many of the building societies. Some companies will advance us the full 100 per cent up front. the small 24 . an excellent and sometimes overlooked.
lenders. we can only spend cash. That said. Cash Flow Cash is ready money in the bank or in the business.business owner bears the burden of bad debts (in other words. Always shop around before we make a decision. rent. Cash flow refers to the movement of cash into and out of a business. suppliers. the non-recourse agreement is preferred. Over time. Before we commit to factoring. they will be charged back to us). We can't spend profit. if they are uncollectible. Profit growth does not necessarily mean more cash on hand. Bank fees will typically be much lower than factoring fees and we should definitely pursue that option if it is available to us. The Importance of Cash Management Understanding the basic concepts of cash flow will help to plan for the unforeseen eventualities that nearly every business faces. and investors. Obviously for a small business owner. Small businesses with higher sales volumes or with what are viewed as stronger account debtors get better rates than those with small sales volumes or more questionable account debtors. but can't be used to pay suppliers. 25 . It is not inventory. the terms and rates offered to us will depend upon our credit (or debtor) worthiness. we must approach our bank first for a loan using the accounts receivables as collateral. or employees. and creditors. Cash vs. the worse the terms. a company's profits are of little value if they are not accompanied by positive net cash flow. and it is not property. The inflow includes the cash we receive from customers. although the rates we’ll get will not be as good as with a recourse agreement. The outflow of cash includes those checks we write each month to pay salaries. Smaller the business. The terms will vary from one factoring company to another. Watching the cash inflows and outflows is one of the most pressing management tasks for any business. These can potentially be converted to cash. it is not accounts receivable (what we owe). while cash is what we must have on hand to keep our business running. Profit is the amount of money we expect to make over a given period of time.
investors and shareholders. A new loan. and because it is generated internally. and the payment of dividend are some of the activities that would be included in this section of the cash flow statement. a company has a positive cash flow. Components of cash flow A "Cash Flow Statement" shows the sources and uses of cash and is typically divided into three components: Operating Cash Flow: .Investing cash flow is generated internally from non-operating activities.Financing cash flow is the cash to and from external sources.Operating cash flow. but is by no means the only one. Cash Flow Statement A cash flow statement shows where an institution’s cash is coming from and how it is being used over a period of time. it may be in serious trouble. Negative Cash Flow If its cash outflow exceeds the inflow. is the cash flow generated from internal operations. such as lenders. it is under your control. 26 . Investing Cash Flow: . If the company can't borrow additional cash at this point. or other sources and uses of cash outside of normal operations. the issuance of stock. This includes investments in plant and equipment or other fixed assets. a company has a negative cash flow. A positive cash flow is a good sign of financial health. the repayment of a loan. nonrecurring gains or losses. Financing Cash Flow :. Reasons for negative cash flow include too much or obsolete inventory and poor collections on accounts receivable (what your customers owe you). It comes from sales of the product or service of your business. often referred to as working capital.Positive Cash Flow If its cash inflow exceeds the outflow.
Can use either The direct method. works back from net profit or loss. 27 . No one ratio tells it all. adding or deducting noncash transactions. Investing activities: expenditures that have been made for resources intended to generate future income and cash flows. o Senior management needs institution-level portfolio quality. by which major classes of gross cash receipts and gross cash payments are shown to arrive at net cash flow (recommended by IAS) The indirect method. o Regulators need capital adequacy and liquidity. Operating activities: services provided (income-earning activities). Ratios must be analyzed together. Financing activities: resources obtained from and resources returned to the owners. and branch level profitability. liquidity. and other operations of the institution. It is the trend in these ratios which is critically important. investing and financing activities. Frequent measurement can help identify problems which need to be solved before they fundamentally threaten the MFI.A cash flow statement classifies the cash flows into operating. resources obtained through borrowings (short-term or long-term) as well as donor funds. and ratios tell you more when consistently tracked over a period of time. Different levels of users will require a set of different indicators and analysis. Trend analysis also helps moderate the influence of seasonality or exceptional factors. Taken together. deferrals or accruals of past or future operating cash receipts or payments. outreach. efficiency ratios. o Donors/investors need institution-level portfolio quality. thus enabling correction. There are no values for any specific ratio that is necessarily correct. They might be summarized as follows: o Operations staff needs portfolio quality. efficiency profitability. and items of income or expense associated with investing or financing cash flows to arrive at net cash flow. the ratios in the framework provide a perspective on the financial health of the lending/savings. and leverage. leverage and profitability.
Take a look at what they are as a starting guide and some of the funding options available for start-ups and growing enterprises. are not as liquid as cash. there are a few key factors that need to be taken into consideration. are obligations that you must meet during the same relatively short time period that defines your current assets. and convert accounts receivable into cash when you take payment. and salaries are examples of current liabilities. convert those goods into accounts receivable by selling them. are helpful when preparing financial projections. The accrual basis more accurately estimates income. How does your company create income? If you manufacture a product. Factors to Consider At what stage is our business right now? How risky is our business proposition? Prioritize our funding needs: Do we require short-term or long term financing? How much funds do we intend to raise? How would the funds be utilized? What is the money used for – Is it for operational needs or for capital outlay (for assets like machinery. Working Capital So far. Current liabilities. accounts payable. one year) as a result of your normal business operations. you use funds to purchase inventory. Funding a Business Before making a choice of how we intend to fund the business. Inventory and accounts receivable. such as an asset that you can convert into cash in a relatively short period (usually. A broader and more useful way of looking at the availability of funds involves the concept of working capital. the process is basically the same. for example. although you probably purchase finished goods instead of producing them. Each of the components in this process is a current asset. If you are a merchandising firm. equipment)? 28 . in conjunction with policy decisions. Cash vs. we have discussed funds in terms of cash only.In addition to analyzing past trends. produce goods with that inventory. on the other hand. ratios. but not always. Notes payable. but your business expects to convert both to cash before too long.
and therefore becomes a shareholder. Normally. you would need to be able to succinctly convince investors of your growth and revenue potential. The investors will then have a stake or ownership of your company. they are looking for capital returns over a period of time and as an entrepreneur. A mixture of both debt and equity are considered good. Bank loan is a common example. How long do we think the money can last? We need to work out some cash flow projections. cross-sectional analysis. Another type of ratio analysis. Do we need the entire required amount at one go or can it be raised in stages over a period of time? What type of financing form would we be willing to consider –borrowing. Trend analysis works best with three to five years of ratios. debt-financing tends to be interest bearing loans. Types of analysis In trend analysis. typically years. we will still need to repay the amount. which means we need to plan how and when we can pay it back or selling a certain percentage of the business ownership to an interested and willing investor? Funding Options Choosing the right financing is critical to a business. As investors. Year-to-year comparisons can highlight trends and point up the need for action. ratios are compared over time. Whether or not we succeed in your business. Sources of funding can be broadly categorized into two types: Debt-financing – Typically refers to borrowing or taking a loan from an external party (the lender). This means that we borrow or owe the money and we agree to pay it back over a period of time. One of the most popular forms of cross- 29 . Equity Financing – This form of financing refers to selling a portion of your company to interested investors in exchange for cash capital. compares the ratios of two or more companies in similar lines of business. Bank borrowings alone may not be suitable or sufficient for all companies.
we can also detect certain relationships between the different types of information. want to judge credit worthiness. It gives us a quick indication of the firm's performance in the areas of liquidity. and over time. Present and potential investors can therefore quickly assess whether the company is a good investment or not. By computing the financial ratios. A "one off" ratio is often useless . they simply indicate by exceptions where further study may improve company performance. Financial ratio analysis is helpful in assessing an organisation's internal strengths and weaknesses. Often the same ratios of like firms are used to compare the performance of one firm with another. Which areas are used for analysis Four key areas are generally used for analysis: Profitability Liquidity Leverage (capital structure) 30 . The great volume of statistics made available in the annual accounts of companies must be simplified in some way. Other factors should also be considered such as a company's products. for example. in the form of a ratio or percentage. profitability.trends need to be established by company ratios over a number of years. Potential suppliers will. capital structure as well as the financial position and potential risk involved. The interpretation of company accounts-ratio analysis Why ratios: Ratios are the means of presenting information. Management can compare current performance with previous periods and competing companies. Financial ratios can also give mixed signals about a company's financial health and can vary significantly among companies. industries. management.sectional analysis compares a company's ratios to industry averages. Ratios by themselves provide no information. These averages are developed by statistical services and trade associations and are updated annually. which enables a comparison to be made between one significant figure and another. competitors and vision for the future.
is it clear why? Are profits and losses on sales of fixed assets: -treated as adjustments of depreciation charges? -disclosed separately "above the line" in the profit and loss account? -treated as "below the line" items in the profit and loss account? -transferred directly to reserves? What has been included in Extraordinary Items? Should any of these items be regarded as part of the ordinary business of the company? Do any items tend to recur year after year? 31 . "profit maximisation" entails the most efficient allocation of resources by management and "profitability ratios" when compared to others in the industry will indicate how well management has performed this task. for the maintenance of the business and to provide for growth? How are sales and trading profit split among the major activities? To what extent are changes due to price change? To what extent does volume change? Does inter-company transfer pricing policy distort the analysis? Has the appropriate proportion of profit been taken in tax charged? What deferred taxation policy is being followed? Has the share of profit (or loss) attributable to minority interests in subsidiaries changed? If so. Activity or management effectiveness (efficiency). Key questions to be identified in profitability analysis include: Does the company make a profit? Is the profit reasonable in relation to the capital employed in the business? Are the profits adequate to meet the returns required by the providers of capital. Therefore. a) Profitability In most organisations profits are limited by the cost of production and by the marketability of the product.
because most short term assets do not produce any return. A sufficient amount of cash and other short-term assets must be available when needed. Is it clear which items have been transferred directly to reserves without going through the profit and loss account? Is such treatment appropriate in each case? b) Liquidity "Liquidity measures" are based on the notion that a business cannot operate if it is unable to pay its bills. creditors payable within one year? Has the business sufficient resource to meet the demands of its fixed asset replacement programme and its commitments to providers of long-term capital falling due for repayment in say.e. the leverage of an organisation has to be considered with respect both to its profitability and the volatility of the industry. On the other hand. Key questions to be identified in leverage analysis include: What sort of capital has the company issued? Who owns the capital? What is the cost of capital in terms of interest or dividend? 32 . Thus. management must try to keep the firm's liquidity as low as possible whilst ensuring that short term obligations will be met. the next five years? c) Leverage "Leverage ratios" show how a company's operations are financed. This means that industries with stable and predictable conditions will generally require smaller current ratios than will more volatile industries. Key questions to be identified in liquidity analysis include: Has the business sufficient liquid resource to meet immediate demands from creditors? Has the business sufficient resources to meet the requirements of creditors due for payment in the next 12 months i. On the other hand. outside financing will become more expensive as the debt-to-equity ratio increases. Therefore. a strong liquidity position will be damaging to profits. Too much equity in a firm often means the management is not taking advantage of the leverage available with long-term debt.
should it be treated as a current liability? Are there significant borrowings in foreign currencies? Are they matched by foreign assets? How are exchange losses and gains thereon treated? Is there any preference capital? Is short term borrowing included in capital employed? Should it be? Is the treatment of pensions appropriate? Is information revealed? Would capita lising leases significantly affect long term debt and gearing ratios? d) Activity "Activity ratios" are used to measure the productivity and efficiency of a firm. 33 . for example. When compared to the industry average. Similarly. Rights issue? Bonus (scrip) issue? Acquisition? Are “per share” figures calculated using appropriately weighted numbers of shares? Are prior years' figures comparable? What individual items have caused significant movements on Reserves? Do any of them really belong in the profit and loss account? Is any long term debt convertible into ordinary shares? On what terms? Is any long term debt repayable within a short period? If so. why? E. will show how well the company is using its productive capacity.g. the inventory turnover ratio will indicate whether the company used too much inventory in generating sales and whether the company may be carrying obsolete inventory. can return on capital be calculated for each class? Has issued Ordinary share capital increased during the period? If so. What proportions of the capital have a financed return (gearing or leverage)? Is the mix of capital optimum for the company? Is further capital available if required? Is total capital employed analysed among different classes of business? If so. the fixed-asset turnover ratio.
thus reducing or improving apparent profitability? Does management control the investment in assets well? Are fixed assets sufficient for the current level of activity? Are they replaced on a regular basis and adequately maintained? Are the stock levels adequate for the level of activity. or excessive? Are debts collected promptly? Are creditors paid within a reasonable period of time? Are surplus cash resources invested to increase overall returns? How variable are the profits before interest and tax? How many times can the interest be paid from the available profit? How many times can the existing dividend be paid from the available profit? e) Other Other questions can be asked in interpreting final accounts. if any.g. Long-term trends in the business Are profits increasing or decreasing? Is the size of the business growing faster or slower than inflation? How has past growth been financed? Are the levels of stocks. debtors and creditors consistent with the long-term growth of the business? Are dividends increasing? Have any radical changes occurred in the past. These may relate to long-term trends in the business or to fixed assets. have changed significantly. e. giving rise to major changes in the business? Fixed assets When fixed assets are shown "at historical cost": 34 .Key questions to be identified in activity analysis are: Does management control the costs of the business well? Which costs.
stability and profitability of a business. and on what basis? -How have values changed since that date? -Might the assets be more valuable if used for other purposes? What method of depreciation is used for valuation? What asset lives are used? Are different lives used for Current Cost Accounting? Has adequate provision been made for technological obsolescence? Are any assets leased? What is their value? How much are the annual rentals? How long is the commitment? Is goodwill: -Shown as an asset? -Written off against reserves? -Being amortised by charges against profit? How does the book value of goodwill compare with the estimated surplus of the current value of fixed assets over their net book value? Has the status of any investments changed during the period? Subsidiaries? Associated companies? Trade investments? Non-consolidated subsidiaries? Are investments in associated companies shown by the "cost" method or by the "equity" method? What is the difference between cost and market value of quoted investments? Is market value used if it is lower than cost? Are there any long-term debtors? How have they been treated in the balance sheet? FINANCIAL ANALYSIS Financial analysis refers to an assessment of the viability. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other 35 . sub-business or project.-How old are they? What is their estimated current value? -How would revaluation affect the depreciation charge? Where fixed assets are shown "at valuation": -When was the valuation made.
as well as other financial and non-financial indicators. Acquire or rent/lease certain machineries and equipments in the production of its goods. Assessing a company's stability requires the use of both the income statement and the balance sheet. which indicates the financial condition of a business as of a given point in time. 2. Other decisions that allow management to make an informed selection on various alternatives in the conduct of its business. while satisfying immediate obligations. Profitability. Make or purchase certain materials in the manufacture of its product. Based on these reports.its ability to maintain positive cash flow. management may: Continue or discontinue its main operation or part of its business. Issue stocks or negotiate for a bank loan to increase its working capital. These reports are usually presented to top management as one of their basis in making business decisions. 3. Goals Financial analysts often assess the firm's: 1. without having to sustain significant losses in the conduct of its business.its ability to earn income and sustain growth in both short-term and long-term.its ability to pay its obligation to debtors and other third parties in the longterm. Their insights about relative performance require a reference point from other time periods or similar firms. A company's degree of profitability is usually based on the income statement. 4.the firm's ability to remain in business in the long run. Liquidity. Both 2 and 3 are based on the company's balance sheet. Solvency. 36 .reports. which reports on the company's results of operations. Drawbacks Financial ratios face several theoretical challenges: • They say little about the firm's prospects in an absolute sense. Stability.
Ratio analysis can reveal much about a company and its operations. ratios can be logically interpreted in at least two ways. a ratio is just one number divided by another. The basic source for these ratios is the company's financial statements that contain figures on assets. For example. there are several points to keep in mind about ratios. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm's performance. ratios help to understand their company’s performance relative to that of competitors and are often used to trace performance over time. • First. Financial Ratios What they mean ? In assessing the significance of various financial data. A ratio's values may be distorted as account balances change from the beginning to the end of an accounting period. and losses. However. • Seasonal factors may prevent year-end values from being representative.• One ratio holds little meaning. A financial ratio indicates a relationship between a company's activities. Changes in accounting policies or choices can yield drastically different ratio values. One or even several ratios might be 37 . Since they are often compared with industry data. Use average values for such accounts whenever possible. liabilities. • • Financial ratios are no more objective than the accounting methods employed. As indicators. the ratio between the company's current assets and current liabilities or between its accounts receivable and its annual sales. profits. Financial ratios allow a business owner to analyze and assess the firm's financial performance and position over a period of time. They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy. managers often use ratio analysis. Financial ratios are only "flags" indicating areas of strength or weakness. Ratios are only meaningful when compared with other information. the process of determining and evaluating financial ratios.
by looking at ratios rather than just dollar amounts. the age of the business. "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management." Financial ratios are determined by dividing one number by another. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future. leverage. but of the proportions in which such items occur in relation to one another. too low. we use the current. but they will make a good manager better. liabilities. We analyze a company. Determining which ratios to compute depends on the type of business. For assessing company's liquidity. such as an industry trend. therefore. and are usually expressed as a percentage. • Third. quick. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. The current ratio can be defined as Current Assets / Current Liabilities. and liquidity ratios." Gill noted. a financial ratio is meaningful only when it is compared with some standard. There are a few general ratios that can be very useful in an overall financial analysis. and provide a wealth of information that cannot be gotten anywhere else. or just right depends on the perspective of the analyst and on the company's competitive strategy. The observation that the value of a particular ratio is too high. ratio analysis can tell much about a corporation. there is no single correct value for a ratio. easy to use.misleading. and profitability of a company is not a matter of how many dollars in assets. or a stated management objective. It measures the ability of an entity to pay its near-term obligations. "They are simple to calculate. ratio trend. and equity it has. and any specific information sought. For example. if a small business depends on a large number of fixed assets. he added. ratios that measure how efficiently these assets are being used may be the most significant." Virtually any financial statistics can be compared using a ratio. • Second. but when combined with other knowledge of a company's management and economic circumstances. PERFORMING ANALYSES WITH FINANCIAL RATIOS "Measuring the liquidity. a ratio trend for the specific company being analyzed. But. Though the ideal current ratio depends to some 38 . the point in the business cycle.
the company may keep too much cash on hand or have a poor collection program for accounts receivable. This ratio indicates how well the company is utilizing its equity investment. also known as the "acid test.40:1. recommend using the debt/equity ratio. The quick ratio. Ideally.extent on the type of business. which can be defined as Net Income / Owners' Equity. If it is lower. This ratio provides a stricter definition of the company's ability to make payments on current obligations. ROE is considered to be one of the best indicators of profitability. also known as the cash ratio. It is also a good figure to compare against competitors or an industry average. A lower current ratio means that the company may not be able to pay its bills on time. The liquidity ratio. Finally. This measure eliminates all current assets except cash from the calculation of liquidity. it may indicate that the company relies too heavily on inventory to meet its obligations. If this ratio is too low. marketable securities. while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business. a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. If it is higher. or that the firm is undercapitalized. debt should be between 50 and 80 percent of equity. Ideally. this ratio indicates the relative mix of the company's investorsupplied capital. can be defined as Cash / Current Liabilities. A company is generally considered safer if it has a low debt to equity ratio—that is. When performed regularly over 39 . On the other hand. In general. recommend using the return on equity (ROE) ratio. a general rule of thumb is that it should be at least 2:1. financial analysis can be an important tool for small business owners and managers to measure their progress toward reaching company goals. to measure a company's level of profitability. and receivables) / Current Liabilities. To measure a company's leverage." can be defined as Quick Assets (cash. a high ROE can mean that management is doing a good job. Defined as Debt / Owners' Equity. it can indicate poor management performance or a highly conservative business approach. as well as toward competing with larger companies within an industry. this ratio should be 1:1. Experts suggest that companies usually need at least 10-14 percent ROE in order to fund future growth. In conclusion. the ratio should be approximately .
the risk (or volatility in performance). the annual dividend.Ability to pay current debts = Current Assets -------------------Current Liabilities Current ratio measures the ability of the firm to pay its short-term debts obligations (current liabilities) from its current assets when payment is due. the quality of management. the day's trading volume. The most common is the price earnings (P/E) ratio. the price/earnings ratio. and a number of other factors.time. It represents a multiplier applied to current earnings to determine the value of a share of the stock in the market. A company's P/E ratio should be compared to those of other companies in the same industry. These quotations show not only the most recent price but also the highest and lowest price paid for the stock during the previous fifty-two weeks.The price to earnings (P/E) ratio is calculated by dividing the current market price per share by current earnings per share. investors. the dividend policy. American Stock Exchange. Framework for linking financial business objectives There are many different ratios and models used today to analyze companies. the debt-equity structure of the company. The price-earnings ratio is influenced by the earnings and sales growth of the company. and outside analysts. high and low prices for the day. Current ratio :. It is published daily with the transactions of the New York Stock Exchange. It is also important for small business owners to understand and use financial analysis because it provides one of the main measures of a company's success from the perspective of bankers. and NASDAQ. Current assets are those 40 . financial analysis can also help small businesses recognize and adapt to trends affecting their operations. the dividend yield. and the changes from the previous day's closing price. Other ratios useful in analyzing a company's balance sheet and income statement are as follows: LIQUIDITY RATIOS Liquidity ratios help to analyze a company's ability to meet short-term financial obligations.
the more liquid the company is.Current Liabilities It measures the flow of cash in the company. The higher the net profit. Return on Equity (ROE) = Net Income ---------------------------------Average Stockholders' Equity PAT -----------------Total equity Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2 Net Profit Ratio = Net profit ratio on the other hand measures the net profitability of OR = business in relation to revenues. 41 . The higher the ratio. PROFITABILITY ANALYSIS RATIOS Return on Assets (ROA) = Net Income ----------------------------Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Overall effectiveness to generate profits from total investment in assets.is a crucial test of the firm's liquidity Net Working Capital Ratio = Net Working Capital -------------------------Total Assets Net Working Capital = Current Assets . it indicates how effective the company is at managing costs and converting revenue to actual profit= Net Profit after Tax / Sales Revenue This measures the profitability of a business or the operating ratio. which reflects what is left from sales revenue after taking into account the costs of goods sold. Called the acid-test -.items owned by the firm with the intention to generate profits or other assets that can be converted to cash within one year. Quick Ratio /Acid-test ratio = Quick Assets ---------------------Current Liabilities Quick Assets = Current Assets – Inventories Ability to convert current assets to cash for the purpose of meeting current liabilities. Gross profit margin or profit margin on sales: Profitability of a company's sales after the cost of sales has been deducted.
and equipment to generate sales. Debt to Equity Ratio = Total Liabilities --------------------------Total Stockholders' Equity Interest Coverage Ratio = Income Before Interest and Income Tax Expenses ------------------------------------------------------Interest Expense 42 . plant. = Sales / fixed assets CAPITAL STRUCTURE ANALYSIS RATIOS Debt Management ratios helps to analyze the degree and effect of a company's use of borrowed funds (debt) to finance its operations.Sales – cost of goods sold Sales ACTIVITY ANALYSIS RATIOS Asset Management ratios help analyze how quickly a company's resources can be converted to cash or sales Assets Turnover Ratio = Sales ---------------------------Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Accounts Receivable Turnover Ratio = Sales ---------------------------Average Accounts Receivable Average Accounts Receivable= (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 Inventory Turnover Ratio = Cost of Goods Sold -------------------------Average Inventories Average Inventories = (Beginning Inventories + Ending Inventories) / 2 g) Average collection period: Serves as a basis for determining how rapidly a company's credit accounts are being collected = Accounts receivable Average daily credit sales h) Fixed asset turnover: Extent to which company is utilizing existing property.
The best way to look at current assets and current liabilities is by combining them into something called Working Capital. and produce shareholder value. it also measures the profitability for equity investors. then it is in good shape. especially for a public listed company. That is. INTRODUCTION The term working capital refers to the amount of capital which is readily available to an organization. Thus. with plenty of cash 43 . If a company has ample positive working capital. Working capital is basically an expression of how much in liquid assets the company currently has to build its business. fund its growth.Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense CAPITAL MARKET ANALYSIS RATIOS Price Earnings (PE) Ratio = Market Price of Common Stock Per Share ----------------------------------------------------Earnings Per Share Market to Book Ratio = Market Price of Common Stock Per Share ------------------------------------------------------Book Value of Equity Per Common Share Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Yield = Annual Dividends Per Common Share -------------------------------------------------Market Price of Common Stock Per Share Dividend Payout Ratio = Cash Dividends ------------------Net Income Earnings per share = Net Profit after Tax / Number of shares issued This is a measure of how much profits have been made for each share issues. working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). This would potentially impact the market price of the share.
Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business" Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business". It is therefore obvious that in this entire process a cycle is involved wherein we start with cash and end at cash.building the business. About 99% of the reason that the company probably came public in the first place had to do with getting working capital for whatever reasons -. This cycle is shown below: 44 . If a company runs out of working capital and still has bills to pay and products to develop. funding acquisitions or developing new products. a company with positive working capital will always outperform a company with negative working capital.CURRENT LIABILITIES Working capital cycle and various components of working capital Any business we start with cash is converted into various kinds of current assets during production process and finally it is converted back to cash once the goods are sold and money paid by customers.on hand to pay for everything it might need to buy. so the company lacks the ability to spend with the same aggressive nature as a working capital positive peer. All other things being equal. If a company has negative working capital. This cycle is called “working capital cycle”. Thus: WORKING CAPITAL = CURRENT ASSETS . Anything good that comes from a company springs out of working capital. it has big problems. then its current liabilities are actually greater than their current assets. Working capital is the absolute lifeblood of a company.
Prepaid expenses . there are many more components of working capital.Advances given to suppliers . however. Current assets Inventory .raw material -work in progress -consumables -spares -finished goods Receivables (debtors) Loans and advances .Short term advances given to other corporates.Export incentives receivable .Advance tax paid Cash & bank balances .Interest recoverable on bills discounting .The above picture reflects the working capital cycle in most elementary fashion. In business. 45 .Security deposits given .Money kept in fixed deposit receipts .Balances in current accounts . generally. a detailed list of various items of working capital cycle is being given below.Claims recoverable .Loans given to staff and workers . In order to understand them more closely.
This requires that business must be run both efficiently and profitably.. Every running business needs working capital. which remain in use for a longer period. Every business needs investment to procure fixed assets. Investment in short term assets like cash. too much focus on liquidity will be at the expense of profitability Thus. The ‘Working Capital’ can be categorized. an asset-liability mismatch may occur which may increase firm’s profitability in the short run but at a risk of its insolvency. Business also needs funds for short-term purposes to finance current operations. The management of the working capital is equally important as the management of long-term financial investment. Even a business which is fully equipped with all types of fixed assets required is bound to collapse without 46 . is called ‘Short-term Funds’ or ‘Working Capital’. inventories. Money invested in these assets is called ‘Long term Funds’ or ‘Fixed Capital’. In the process. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. debtors etc. On the other hand. as the manager of a business entity we are into a dilemma of achieving desired tradeoff between liquidity and profitability in order to maximize the value of a firm. A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. as funds needed for carrying out day-to-day operations of the business smoothly.Current liabilities bank borrowings sundry creditors provision for gratuity an dividend ILC/FLC payable Interest accrued but not due Term loans installments falling due within one year Provision for income tax Sales tax payable Provision for expenses. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture.
(i) (ii) (iii) (iv)
Adequate supply of raw materials for processing; Cash to pay for wages, power and other costs; Creating a stock of finished goods to feed the market demand regularly; and, The ability to grant credit to its customers.
All these require working capital. Working capital is thus like the lifeblood of a business. The business will not be able to carry on day-to-day activities without the availability of adequate working capital. Working capital cycle involves conversions and rotation of various constituents/ components of the working capital. Initially ‘cash’ is converted into raw materials. Subsequently, with the usage of fixed assets resulting in value additions, the raw materials get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus ‘cash’ assumes its original form again at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition. As a result,
they rotate and business operations continue. Thus, the working capital cycle involves rotation of various constituents of the working capital. Current Assets
The first major component of the balance sheet is Current Assets, which are assets that a company has at its disposal that can be easily converted into cash within one operating cycle. An operating cycle is the time that it takes to sell a product and collect cash from the sale. It can last anywhere from 60 to 180 days. Current assets are important because it is from current assets that a company funds its ongoing, day-to-day operations. If there is a shortfall in current assets, then the company is going to have to dig around to find some other form of short-term funding, which normally results in interest payments or dilution of shareholder value through the issuance of more shares of stock. There are five main kinds of current assets -- Cash & Equivalents, Short- and Long-Term Investments, Accounts Receivable, Inventories and Prepaid Expenses. Cash & Equivalents are assets that are money in the bank, literally cold, hard cash or something equivalent, like bearer bonds, money market funds. Cash and equivalents are completely liquid assets, and thus should get special respect from shareholders. This is the money that a company could immediately mail to you in the form of a fat dividend if it had nothing better to do with it. This is the money that the company could use to buy back stock, and thus enhance the value of the shares that you own. Short-Term Investments are a step above cash and equivalents. These normally come into play when a company has so much cash on hand that it can afford to tie some of it up in bonds with durations of less than one year. This money cannot be immediately liquefied without some effort, but it does earn a higher return than cash by itself. It is cash and investments that give shares immediate value and could be distributed to shareholders with minimal effort. Accounts Receivable, normally abbreviated as A/R, is the money that is currently owed to a company by its customers. The reason why the customers owe money is that the product has been delivered but has not been paid for yet. Companies routinely buy goods and services from other companies using credit. Although typically A/R is almost always turned into cash within a short amount of time, there are instances where a company will be forced to take a write-off for bad accounts receivable if it has given credit to someone
who cannot or will not pay. This is why you will see something called allowance for bad debt in parentheses beside the accounts receivable number. The allowance for bad debt is the money set aside to cover the potential for bad customers, based on the kind of receivables problems the company may or may not have had in the past. However, even given this allowance, sometimes a company will be forced to take a write-down for accounts receivable or convert a portion of it into a loan if a big customer gets in real trouble. Looking at the growth in accounts receivable relative to the growth in revenues is important -- if receivables are up more than revenues, you know that a lot of the sales for that particular quarter have not been paid for yet. Inventories are the components and finished products that a company has currently stockpiled to sell to customers. Not all companies have inventories, particularly if they are involved in advertising, consulting, services or information industries. For those that do, however, inventories are extremely important. Inventories should be viewed somewhat skeptically by investors as an asset. First, because of various accounting systems like FIFO (first in, first out) and LIFO (last in, first out) as well as real liquidation compared to accounting value, the value of inventories is often overstated on the balance sheet. Second, inventories tie up capital. Money that it is sitting in inventories cannot be used to sell it. Companies that have inventories growing faster than revenues or that are unable to move their inventories fast enough are sometimes disasters waiting to happen. Finally, Prepaid Expenses are expenditures that the company has already paid to its suppliers. This can be a lump sum given to an advertising agency or a credit for some bad merchandise issued by a supplier. Although this is not liquid in the sense that the company does not have it in the bank, having bills already paid is a definite plus. It means that these bills will not have to be paid in the future, and more of the revenues for that particular quarter will flow to the bottom line and become liquid assets. Fixed Assets Fixed assets are long-term assets.
-Tangible fixed assets are physical assets like plant. -Intangible fixed assets are the firm’s rights and claims, such as patents, copyrights, goodwill etc. -Gross block represent all tangible assets at acquisition costs. -Net block is gross block net of depreciation. The balance sheet also includes two categories of liabilities, current liabilities (debts that will come due within one year, such as accounts payable, short-term loans, and taxes) and long-term debts (debts that are due more than one year from the date of the statement). Liabilities are important to financial analysts because businesses have same obligation to pay their bills regularly as individuals, while business income tends to be less certain. Long-term liabilities are less important to analysts, since they lack the urgency of shortterm debts, though their presence does indicate that a company is strong enough to be allowed to borrow money. Current Liabilities Current Liabilities are what a company currently owes to its suppliers and creditors. These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. These are all bills that are due in less than a year. As well as simply being a bill that needs to be paid, liabilities are also a source of assets. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. There are five main categories of current liabilities: Accounts Payable, Accrued Expenses, Income Tax Payable, Short-Term Notes Payable and Portion of Long-Term Debt Payable. Accounts Payable is the money that the company currently owes to its suppliers, its partners and its employees. Basically, these are the basic costs of doing business that a company, for whatever reason, has not paid off yet. One company's accounts payable is another company's accounts receivable, which is why both terms are similarly structured. A company has the power to push out some of its accounts payable, which often produces a short-term increase in earnings and current assets.
which detail the permanent capital of the business. A specific type of accrued expense is Income Tax Payable. The company also might have a portion of its Long-Term Debt come due with the year. Capital stock is the par value of the stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of 51 . there are some taxes that simply are not accrued by the government over the course of the quarter or the year and instead are paid in lump sums whenever the bill is due. The total equity usually consists of two parts: the money that has been invested by shareholders. These are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet. This is the income tax a company accrues over the year that it does not have to pay yet according to various federal. and the money that has been retained from profits and reinvested in the business. Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within the next 12 months. In general. These are normally marketing and distribution expenses that are billed on a set schedule and have not yet come due. Although subject to withholding.Accrued Expenses are bills that the company has racked up that it has not yet paid. Stockholders or Shareholder's Equity is composed of Capital Stock and Retained Earnings. the better the ability of the business to borrow additional funds. state and local tax schedules. this is more than a little bit confusing and does not always add all that much value to the analysis. Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more than a year. Frankly. The balance sheet also commonly includes stock-holders' equity accounts. the more equity that is held by a business. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying. which is why this gets counted as a current liability even though it is called long-term debt. such as inventories.
there are five main categories -. Specifically. and extraordinary items. Capital Stock and Retained Earnings. the income statement provides information about a company's performance over a certain period of time. Much of this is actually subject to an accounting convention called depreciation for tax purposes. Essentially.the company's stock.Total Assets. Stockholder's/Shareholder's Equity. 52 . The main elements of the income statement are revenues earned. interest. and records this on the company's books. it does provide indications of its future viability. buildings. meaning that they are either assets that cannot be easily turned into cash or liabilities that will not come due for more than a year. Capital in Excess of Stock is another weird accounting convention that is pretty difficult to explain. but that are kept on a company's books for accounting purposes. less any earnings that are paid out to shareholders in the form of dividends and stock buybacks. Retained earnings is another accounting convention that basically takes the money that a company has earned. and net profit or loss. Although it does not reveal much about the company's current financial condition. property and equipment and encompasses any land. it is any additional cash that a company gets from issuing stock in excess of par value under certain financial conventions. vehicles and equipment that a company has bought in order to operate its business. The main component is plants. expenses incurred. In contrast to the balance sheet. Long-Term Notes Payable. meaning that the stated value of the total assets and the actual value or price paid might be very different. though financial analysts may also note the inclusion of royalties. Debt & Equity The remainder of the balance sheet is taken up by a hodge-podge of items that are not current. Retained earnings simply measures the amount of capital a company has generated and is best used to determine what sorts of returns on capital a company has produced. If you add together capital stock and retained earnings. Revenues consist mainly of sales. Total Assets are assets that are not liquid.the amount of equity that shareholders currently have in the company. you get shareholder's equity -.
including • Interest earned on loans to clients • Fees earned on loans to clients • Interest earned on deposits with a bank. operating expenses usually consist primarily of the cost of goods sold. An institution prepares an income statement so that it can determine it net profit or loss (the difference between revenue and expenses). Direct expenses for an MFI include • Financial costs. and • Loan loss provisions. etc Expenses Represent costs incurred for goods and services used in the process of earning revenue. Income Statement An income statement reports the organization’s financial performance over a specified period of time. It summarizes all revenue earned and expenses incurred during a specified accounting period. Net income is the "bottom line" of the income statement. • Administrative expenses. This notion leads inevitably to the accrual method of accounting. we overstate our costs and 53 . This figure is the main indicator of a company's accomplishments over the statement period. Matching Costs and Revenues Revenue should be matched with whatever expenses or assets produce that revenue. If we obtain the annual registration for a truck in January and use that truck to deliver products to our customers for 12 months. If we record the entire amount of the expense in January. we have paid for an item in January that helps us produce revenue all year long. but can also include some unusual items.Likewise. Revenue Refers to money earned by an organization for goods sold and services rendered during an accounting period.
Suppose that a person starts a new firm. in January. we are using the accrual method. or we might receive payment in a lump sum sometime after the sale. Similarly. Using the accrual method.understate our profitability for that month. They find it more convenient to record expenses and revenues when the transaction took place. the accrual method evolved. called the cash method of accounting. suppose that we sell a product to a customer on a credit basis. we would accrue 1/12th of the expense of the truck registration during each month of the year. but it is often a more accurate method for reporting purposes. The cash basis understates income when costs are not associated with revenue that they help generate. The main distinction between the two methods is that if we distribute the recording of revenues and expenses over the full time period when we earned and made use of them. Doing so enables us to measure expenses against our revenues more accurately throughout the year. phone costs. It also records 1/36th of the cost of the computer as depreciation. Largely for this reason.000 Rs. We might receive periodic payments for the product over several months. she has made 10. the office lease. Marble Designs records 1/12th of the cost of the office supplies during January. and a computer. we will misestimate our profit until the customer finishes paying us. If we record their totals during the time period that we received or made payment. the additional accuracy of the accrual method might not be worth the effort. if we wait to record that income until we have received full payment. Marble Designs. In very small businesses.554 Rs. office supplies. Again. This is a reasonable decision because they are expected to last a full year. The assumption is that the computer’s useful life is three years and that its eventual salvage or 54 . we are using the cash method. Recording all of these as expenses during the current period results in net income for the month of 1. At the end of the first month of operations. Using the accrual method. Some very small businesses—primarily sole proprietorships—use an alternative to accrual. We also understate our costs and overstate our profitability for the remaining 11 months. An accrual basis is more complicated than a cash basis and requires more effort to maintain. She was able to save 20% of the cost of office supplies by making a bulk purchase that she estimates will last the entire year. in sales and paid various operating expenses: her salary.
lease.554Rs. The need for maintaining an adequate working capital can hardly be questioned. But this analysis says nothing about how much cash Marble Designs has in the bank. Nature and Importance of working capital Working capital management (WCM) is of particular importance to the small business. The net income of 5. While the internal factors are managerial skills.283Rs. accounting systems and financial management practices. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements. competition. The net income for January is now 5. accounts receivable and inventory. so it is appropriate to record the entire expense for January.residual value will be zero. The factors categorized as external include financing (such as the availability of attractive financing).4 times the net income recorded under the cash basis. It is a trading capital.283Rs. the business can hardly prosper and survive. not retained in the business in a particular form for longer than a year. In contrast. the flow of funds is very necessary to maintain business. Just as circulation of blood is very necessary in the human body to maintain life. economic conditions. trade credit and short-term bank loans to finance their needed investment in cash. is a much more realistic estimate for January than 1. The success factors or impediments that contribute to success or failure are categorized as internal and external factors. 55 . technology and environmental factors. The success of a firm depends ultimately. the benefits of the salary. The income statement does not necessarily show whether Marble Designs will likely be able to make that payment. on its ability to generate cash receipts in excess of disbursements. and phone expenses pertain to that month only. With limited access to the long-term capital markets. Both the office supplies and the computer will contribute to the creation of revenue for much longer than one month. workforce. The working capital meets the short-term financial requirements of a business enterprise. If it becomes weak. The money invested in it changes form and substance during the normal course of business operations. Suppose that the company must pay off a major loan in the near future. these firms tend to rely more heavily on owner financing.which is 3. government regulations.
The best and simplest method of ensuring this is that the norms for all kinds of current assets and current liabilities are fixed at beginning of the year and month after month these norms are compared with actuals so as to ensure that either the actuals are falling within the norms or norms themselves are changed in case required. If resources are blocked at the different stage of the supply chain. Thus it helps firms to reduce its cash operating cycle. but if this is not translated into cash from operations within the same operating cycle. the importance of exercising tight control over working capital investment is difficult to overstate. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. instead it is often used as a short term source of finance. Both the situations when either it is on higher side than required or it is on a lower side the required are not desirable. the twin objectives of profitability and liquidity must be synchronized and one should not impinge on the other for long. Although this might increase profitability (due to increase sales). It is also necessary in view of the fact that the money invested 56 . Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers and a proper management of same should give the desired impact on either profitability or liquidity. We have already seen in the preceding paragraphs that every business requires an optimum level of net working capital. Another component of working capital is accounts payable. it may also adversely affect the profitability if the costs tied up in working capital exceed the benefits of holding more inventory and/or granting more trade credit to customers. It is therefore necessary that the business has necessary checks and balances to ensure that optimum Level of net working capital is maintained. Thus. but it is different in the sense that it does not consume resources. Given that many small businesses suffer from undercapitalization. A firm can be very profitable.The Management of Working Capital The management of working capital is important for the financial health of businesses of all sizes. the firm would need to borrow to support its continued working capital needs. but it has an implicit cost where discount is offered for early settlement of invoices. this will prolong the cash operating cycle.
budgeted Vs actual is discussed thoroughly in the meeting and all major items are covered. The variation is two i. With this effective tool we would be able to keep the working capital by and large within control thereby keeping our finances cost within the budget. are either explained or it is ensured that after discussions they fall within the agreed norms.e. dividend proposed. usance liabilities etc. The glaring example of such assets and liabilities are debtors. supplier advances and so on. Another effective instrument of monitoring net working capital is cash flow. Every month. It will always therefore be prudent policy to ensure that net working capital is falling within the agreed norms. if any. we therefore. In Minda at the beginning of every year we make a budget wherein while projecting the balance sheet. In contrast there are current assets and liabilities which have direct co relation with the production and sales that is too easy that is too say that the amount of such assets and liabilities keep on varying in relation to the increase/decrease in sales and production figures. export incentives recoverable. have to set different kinds of norms. we are making a 3 monthly rolling plan based on which a 3 monthly cash flow is prepared. inventories. as we all know. A detailed calculation is done to fix up the current assets and liabilities required per unit of output in case of those assets and liabilities which tend to vary with production and sales. Every month thereafter the comparison of budget Vs actual is drawn. At the time of making these short term projections we ensure that the planned current assets and liabilities remain with the agreed norms and variations. Norms are fixed for other assets and liabilities based on past experience. various items of current assets and liabilities are projected. 57 . At this point it will be necessary to understand that some of the current assets and liabilities are fixed in nature in the same they do not co-relate directly to production and sales of the company like pre-paid expenses.in working capital has some cost attached to it. in order to ensure that these assets and liabilities are falling within the norm. discount provision. To rectify any adverse variances action plans are chalked out and responsibilities are fixed for various departments and sections.
Furthermore. two characteristics of current assets should be kept in mind viz.Approaches to Working Capital Management The objective of working capital management is to maintain the optimum balance of each of the working capital components. Each constituent of current asset has comparatively very short life span. (i) Short life span. These characteristics have certain implications: 58 . sales and collection and degree of synchronization among them. thereby maximizing the interest earned. some departments have significant inventory levels. While managing the working capital. such cash may more appropriately be "invested" in other assets or in reducing other liabilities. Working capital management takes place on two levels: o Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management. Investment remains in a particular form of current asset for a short period. The emphasis that needs to be placed on each component varies according to department. The life span of current assets depends upon the time required in the activities of procurement. others have little if any inventory. For example. o The individual components of working capital can be effectively managed by using various techniques and strategies. and (ii) Swift transformation into other form of current asset. production. When considering these techniques and strategies. departments need to recognize that each department has a unique mix of working capital components. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance. However. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible. A very short life span of current assets results into swift transformation into other form of current assets for a running business. It is an integral part of the department's overall management. working capital management is not an end in itself.
i. book debt policies. the degree of variation is expected to be low for firms within the industry. While a manufacturing industry has a long cycle of operation of the working capital. work-inprogress and finished goods). Accordingly. an enterprise involved in production would require more working capital than a service sector enterprise. cash and bank balances. Working Capital Analysis The major components of gross working capital include stocks (raw materials.industry variation is expected to be high. inventory policies. level of operational efficiency. The composition of working capital depends on a multiple of factors. Operations 59 . technology used and nature of the industry. ii. Decision regarding management of the working capital has to be taken frequently and on a repeat basis. such as operating level. the working capital requirements vary for both of them. and others may follow the principle of 'demand-based production' in which production is based on the demand during that particular phase of time. the same would be short in an enterprise involved in providing services. some follow the policy of uniform production even if the demand varies from time to time. ii. The various components of the working capital are closely related and mismanagement of any one component adversely affects the other components too. Working capital needs of a business influenced by numerous factors. iii. iii. While inter. The amount required also varies as per the nature. Manufacturing/Production Policy Each enterprise in the manufacturing sector has its own production policy. The difference between the present value and the book value of profit is not significant. Nature of Enterprise The nature and the working capital requirements of an enterprise are interlinked. debtors. The important ones are discussed in brief as given below: i.
v. thereby reducing the working capital investment in raw material stock. it needs a larger amount of working capital. the same level of current assets needs enhanced investment. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw material and is completed with the production of finished goods. if raw material is not readily available then a large inventory/stock needs to be maintained. On the other hand. viii. if there is no competition or less competition in the market then the working capital requirements will be low. Market Condition If there is high competition in the chosen product category. So for correct assessment of the 60 . immediate delivery of goods etc. iv. rising price level requires a higher investment in the working capital. Normally. Price Level Changes Generally. the need for working capital would be more. The assessment of working capital requirement is made keeping these factors in view. while in winters the sales are negligible.The requirement of working capital fluctuates for seasonal business. vi. At times. With increasing prices. business needs to estimate the requirement of working capital in advance for proper control and management. Ice creams and cold drinks have a great demand during summers. The working capital needs of such businesses may increase considerably during the busy season and decrease during the slack season. for which the working capital requirement will be high. If the manufacturing cycle involves a longer period. the need for increased working capital funds precedes growth in business activities. vii. As business grows and expands. The factors discussed above influence the quantum of working capital in the business. then one shall need to offer sops like credit. Growth and Expansion Growth and expansion in the volume of business results in enhancement of the working capital requirement. Availability of Raw Material If raw material is readily available then one need not maintain a large stock of the same. Otherwise. thereby calling for substantial investment in the same. Each constituent of working capital retains its form for a certain period and that holding period is determined by the factors discussed above.
o Implementation of operating plans may become difficult and consequently the profit goals may not be achieved. o Cash crisis may emerge due to paucity of working funds. 61 . This situation may lead to business closure. Thereafter. Negligence in proper assessment of the working capital.working capital requirement. An inaccurate assessment of the working capital may cause either under-assessment or over-assessment of the working capital and both of them are dangerous. therefore. thereby adversely affecting its credibility. Consequences of under assessment of working capital o Growth may be stunted. It may become difficult for the enterprise to undertake profitable projects due to non-availability of working capital. proper value is assigned to the respective current assets. The total of all such valuation becomes the total estimated working capital requirement. We know that working capital has a very close relationship with day-to-day operations of a business. The basis for assigning value to each component is given below: Components of working capital i Stock of raw material ii Stock of work in process iii Stock of finished goods iv Debtors v Cash Basis of valuation Purchase cost of raw materials At cost or market value whichever is lower Cost of sales Cost of sales or sales value Working expenses Each constituent of the working capital is valued on the basis of valuation enumerated above for the holding period estimated. It may lead to cash crisis and ultimately to liquidation. o Optimum capacity utilization of fixed assets may not be achieved due to nonavailability of the working capital. depending on its level of completion. can affect the day-to-day operations severely. the duration at various stages of the working capital cycle is estimated. o The business may fail to honour its commitment in time.
o While underassessment of working capital has disastrous implications on business. Supplier’s Credit At times. o Over-investment in working capital makes capital less productive and may reduce return on investment. Working capital or current assets are those assets.o The business may be compelled to buy raw materials on credit and sell finished goods on cash. upon completion of the credit period. The credit given by the suppliers of raw materials is for a short period and 62 . over assessment of working capital also has its own dangers. In the process it may end up with increasing cost of purchases and reducing selling prices by offering discounts. business gets raw material on credit from the suppliers. Both these situations would affect profitability adversely. The cost of raw material is paid after some time. therefore. they need to be financed through short-term funds. Consequences of over assessment of working capital o Excess of working capital may result in unnecessary accumulation of inventories. needs efficient management and control. o It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management. i. The following are the major sources of raising short-term funds: i. Each of the components of the working capital needs proper management to optimize profit.e. without having an outflow of cash the business is in a position to use raw material and continue the activities. Due to this nature. Thus. o It may make management complacent leading to its inefficiency. which unlike fixed assets change their forms rapidly. Short-term funds are also called current liabilities. Financing Working Capital Now let us understand the means to finance the working capital. o Non-availability of stocks due to non-availability of funds may result in production stoppage. Working capital is very essential for success of a business and.
the promoters bring in some money of their own and the rest they borrow from various banks and financial institutions. The loans are available for creating the following current assets: o Stock of Raw Materials o Stock of Work in Process o Stock of Finished Goods o Debtors Banks give short-term loans against these assets.is considered current liabilities. Thus bank loans for creation of current assets are also current liabilities. as we are already aware. Further besides fixed liabilities some of the current assets are financed by current liabilities also. work in process. They are long-term funds and. every balance sheet has 2 sides namely assets and liabilities. iii. ii. Promoter’s Fund It is advisable to finance a portion of current assets from the promoter’s funds. keeping some security margin. Bank Loan for Working Capital This is a major source for raising short-term funds. therefore do not require immediate repayment. Banks extend loans to businesses to help them create necessary current assets so as to achieve the required business level. The assets again can be bifurcated into fixed assets and current assets and similarly liabilities into fixed and current liabilities. At the inception of any business. How is working capital reflected in balance sheet As we are aware. This money is invested both in current and fixed assets. The pictorial presentation of all these assets and liabilities is given below in a very simple form: Balance sheet as on 63 . finished goods. The advances given by banks against current assets are short-term in nature and banks have the right to ask for immediate repayment if they consider doing so. These funds increase the liquidity of the business. These funds should be used for creating current assets like stock of raw material. These. are called fixed liabilities of the business. etc.
Current assets -Inventories .WIP . spares.sundry creditors .loans & advances . Raw material inventory therefore becomes the second item of current assets. Let us further presume that a portion of money raised by promoters is available for buying raw material.cash & bank balances Why is it necessary to invest in working capital? Let us presume a situation where business has just been started.receivables . As this material will be sent on processing 64 .bank borrowings . gratuity etc. is lying in bank.spares . for making day to day payments. This is first item of current assets. Since the supplier of raw material will take some lead time to manufacture the goods and there is some lead time involved in transporting the goods to our factory.provision for dividend. it becomes necessary to buy raw material for those many days which are equivalent to supplier’s manufacturing and transporting time.finished goods .raw materials .Fixed liabilities shareholders fund long term loans unsecured loans Fixed assets plant & machinery factory/non-factory buildings furniture & fixture motor vehicles office equipments Current liabilities . as a logical step.
As a measure of short term financial liquidity. it is necessary to do so as there is some time gap between the purchase of raw material and realization of money from customers after sale of finished goods. They are converted in debtors. Working capital ratios Since the money invested in current assets is blocked money. would not like to invest any money in current assets. it indicates the rupees of current assets available form each rupee of current liability. The higher the 65 . In order to optimize. it will get distributed to various stages of production and some quantity will always remain blocked at all processes of production in semi finished form. some quantity of finished goods therefore will always be required to be maintained at plant. Since some time is required to transport the finished goods to customer and he also buys them in lots depending upon his selling capacity. it is considered as some kind of necessary evil which is required to run the business. they are either bring in cash or they are converted in debtors. Once the raw material has various stages of process it is converted into finished goods. therefore. The current ratio of a business measures its short term inventory i. The formula is: Current ratio = current assets/current liabilities = inventories + debtors + loans&advances + cash&bank balances Bank borrowings + other current liabilities + term loans installments falling in due next one year. These ratios help in determining the working capital position of business in a very rational manner. The most important working capital ratios are explained below:a) Current ratio The current ratio measures the ratio of current assets to current liabilities. be appreciated that ideally speaking although a businessman. the money will be arise only after the credit period given to customers is over. its ability to meet short term obligations. One of the best methods of calculating the adequacy or inadequacy of net working capital in business is by calculating the various working capital ratios. Once the gods are sold. This is called work in progress.line. however. The management. it is necessary to know the correct requirement of net working capital. It is therefore.e. always aims at optimizing the money required to be invested in net working capital.
In other words of all the current assets some can be realized immediately if required while some other will take some more time to realize. thereby increasing risk. it may not be really true. The increase in profitability will be due to the corresponding increase in fixed assets which are likely to generate higher returns.e. a current ratio which is neither higher nor low. another ratio is sometimes used which is called acid test / quick ratio. This is because an unreasonably higher current ratio indicates higher amount of money invested in current assets than desired. A second effect of the increase in the ratio will be that the risk of technical insolvency would also decrease because the increase in current assets. Effect of changes in current assets of company minda Initial value (1) Ratio of current to total assets Profits on total assets Net working capital (2) ----------------value after increase (+) (3) ------------------value after decrease (-) (4) ------------------ Normally a current ratio of 2:1 is considered very good.33:1 as reasonable.current ratio the larger the amount of rupees available per rupee of current liability and greater the safety of funds of short term creditors. Not all current assets can be realized in similar time. Therefore in order to know the immediate current solvency of the business. the better it is. The formula is:66 . Banks however. consider a current ratio of 1. An increase in the ratio of current assets to total assets will lead to a decline in profitability because current assets are assumed to be less profitable than fixed assets. Similarly a decrease in the ratio of current assets to total assets will result in an increase in profitability as well as risk. Since the current assets decreases without a corresponding reduction in liabilities. Form the above discussion although it might seem that higher the current ratio. b) Acid test or quick ratio. The formula for calculating this ratio is almost same except the exclusion of some current assets which are not very liquid in nature like inventories and other current assets like loans and advances. the amount of NWC will decrease. assuming no change in current liabilities will decrease NWC. An organization therefore has to always maintain a reasonable current ratio i.
This essentially means that every one of us is touching the working capital cycle of business in one way or the other. Similarly to judge whether we are investing reasonable amount of money in debtors and whether we are getting reasonable credit from our creditors. Effect the working capital cycle: a) A person who is handling banking has to make that no money is kept in current accounts of banks as it is totally idle money.e. it checks that money invested in various current assets like inventory is not more than desired. The inventory turnover ratio therefore helps a business in ensuring that it is not carrying nay excess inventory. the better it is. it is properly invested in some short term assets. following two ratios are used: • Debtors turnover ratio = net credit sales Average debtors • Creditors turnover ratio = net credit purchases Average creditors All of us in our day to day life in office are dealing with one or the other current assets or current liabilities. The formula for calculating inventory turnover ratio is: Inventory turnover ratio = cost of goods sold Average inventory The money so saved can be invested in some other better uses. 67 . Given below are some examples of how people working in different sections of finance deptt. The turnover ratios actually check the other extreme side of current ratio i. The higher the ratio. Similarly he has to make sure that if there is some surplus money available. c) Inventory turnover ratio Another way of examining the liquidity of a firm is to determine how quickly certain current assets are converted into cash.Acid test or quick ratio = debtors + cash & bank balances + short term marketable Securities Current liabilities.
Further in case of bills negotiated under L/C the money is paid by L/C opening banks on the due date. If this is not done. 68 . e) Similarly a person working in exports has to make sure that export incentives are realized on time and a person working in imports has to make sure that claims of overseas suppliers are settled on time or minimum balances of clearing agents are maintained. chorea committee to point out various methods of assessing working capital needs of the borrower. neither too early nor too late. They are called Ist IInd and IIIrd method of lending. it will disturb the working capital cycle. Any advances given to staff and workers are being recovered on time etc. c) A person involved in sales accounting has to make sure that money which is recoverable from is recoverable on due date. In all the above examples it can be appreciated that operating person has to make sure that some item of current assets is converted in cash or its equivalent within agreed time frame or a liability is paid on time. Earlier before this system was introduced different banks had different system of assessing the working capital needs of the borrower.e.b) A person handling suppliers payments has to make sure that advances given to suppliers are squared off in time. The mechanism of assessing the working capital requirements of the company is governed by the methods prescribed by RBI from time to time. leading to liquidity crisis and may even pose a question mark on the very survival of business in short run. However. In our context and in case of all those clients. Assessment of working capital needs by bank One of the major sources of financing current assets is bank borrowings. d) A person working in journal accounting section has to make sure that money is not blocked in unawarded current assets like security deposits if possible. However in certain cases. The banks. Over a period of time 3 months of lending time have been evolved. they also meet the long term requirements of the company. RBI appointed various committees like tandon committee. Further suppliers are being paid for their dues in time i. after nationalization of banks. in general meet the requirement of working capital.
various information is taken by the banks from their borrowers from time to time during the year. This information can be divided into the following:i) CMA form (annual renewal of limits) 69 . From these gross current assets. The calculation of MPBF is explained below with the help of an illustration: MPBF calculation Rs. than the bank borrowing which is also called maximum permissible bank finance (MPBF) is reduced to that extent. Monitoring the utilization of credit facilities given by banks In order to ensure that the credit given by the bank is properly utilized. the banks also stipulate a condition that in case the business has funds in view of their desired contribution of 25% of gross current assets.whose borrowings are more than 1 crores the most prevalent method is IInd method of lending. It’ll therefore be appropriate to discuss this method in detail. However. From this figure a margin of 25% of gross current assets is further reduced. The rational of reducing this 25% of current assets is that the promoter of business also has to participate in the financing of gross current assets to the extent of 25%. This is called net working capital. a business estimate the requirement of various current assets. The balancing figure is financed by the bank in the shape of bank borrowings. the estimated current liabilities (other than bank borrowing ) are then reduced. In this method lending. Lacs Project current assets Less: current liabilities (including term liability falling Due within 1 year but excluding bank borrowing) Working capital gap Less: 25% of current assets (margin) Maximum permissible bank finance (MPBF) ---------------------------- It is necessary to note here that norms for various assets and liabilities are agreed to by the bank and the borrower based on past experience of the borrower and the norms prevalent in the industry in which borrower operates.
This also provides the estimates in similar format for next six months. banks have a system of working quarterly information from borrower. balance sheet projections and detailed projections of current assets and liabilities. QIS-III This form gives details of actual profitability and balance sheet figures for last six months.) Drawing power statement CMA (credit monitoring arrangement) After having established limits initially the banks do an annual review of the limits wherein the projections for next 2 years are given and the limits are accordingly reassessed. Last date for filing form-III is within 60 days from the end of six months.ii) iii) iv) v) QIS form-I(projections for next quarter as against projections) QIS form-II( actuals for the quarter) QIS form-III (actuals for the last six months and projection for the next few months. in order to asses the actual requirement. QIS-I Although the limits are established every year. This is done with the help of QIS form-I wherein the projections of key items of current assets and liabilities are given before the beginning of every quarter. The date for submission of this form is one week before the beginning of the quarter. The last date for filling this form is within 45days after the end of the quarter. For this purpose the borrower has to fill up CMA forms (there are about 7-8 forms) giving details of profitability projections. D. QIS-II This form gives the actual figures as against the figures projected in form-I after the end of the quarter.P statement 70 .
a company following a conservative approach is subjected to a lower degree of risk than the one following an aggressive approach. the smaller will be the amount available for investment in other profitable avenues at hand with the company. FLC payable etc. sudden spurts in sales demand etc. The security actually is in the shape of actual current assets like inventories. The quantum of investment in current assets has to be made in manner that it not only meets the needs of the forecasted sales but also provides a built in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delays in arrival of raw materials.The banks although sanction the working capital limits based on the working capital requirements of the borrower at the beginning of the year. Needless to say that while giving credit on monthly basis the bank applies certain margin on these current assets in order to account for any shrinkage which may occur at the time of actual realization of the assets. The question then arises as to the determination of the quantum of investment in working capital that can be regarded as ‘adequate’. held by the borrower reduced for current liabilities like creditors. it actually gives credit based on the security possessed by the customers on a month to month basis. profitability The basic objective of working capital is to provide adequate support for the smooth functioning of the normal business operations of a company. debtors etc. the larger the amount of investment in current assets. In the former situation the high amount of investment in current assets imparts greater liquidity to the company than under the latter situation wherin the quantum of investment in current assets is less. The aspect considers exclusively the liquidity dimension of working capital. Since current assets will be more for a given level of sales 71 . Once we recognized the fact that the total amount of financial issues at disposal of company is limited and these resources can be put to alternative uses. A conservative attitude in respect of investment in current assets leaves less amount for other investment than an aggressive approach does. The rational behind this exercise is that in case there is a problem with the borrower. the actual current assets held by the client’s can be sold/realized in the market as bank has first charge over these assets. Objective of Working Capital Management Liquidity vs. ILC.
for example. A broader and more useful way of looking at the availability of funds involves the concept of working capital. 72 . produce goods with that inventory. accounts payable. one year) as a result of your normal business operations. Notes payable. but your business expects to convert both to cash before too long. and salaries are examples of current liabilities. are obligations that you must meet during the same relatively short time period that defines your current assets. Even if we assume the same level of sales revenue. Current liabilities. and convert accounts receivable into cash when you take payment. The accrual basis more accurately estimates income. we have discussed funds in terms of cash only. such as an asset that you can convert into cash in a relatively short period (usually. are not as liquid as cash. Cash vs. convert those goods into accounts receivable by selling them. How does your company create income? If you manufacture a product. you use funds to purchase inventory. operating profit before interest and tax and net (operating) fixed assets. the process is basically the same.forecast under the conservative approach. the company following a conservative policy will have a low percentage of operating profitability compared to its counterpart following an aggressive approach. Inventory and accounts receivable. Working Capital So far. on the other hand. although you probably purchase finished goods instead of producing them. If you are a merchandising firm. the turnover of current assets will be less than what they would they be under the aggressive approach. Each of the components in this process is a current asset. but not always.
are items such as copier paper. when low items should be replenished.items are those items whose demand is determined by other items. :. The items used in the production of that car (the independent demand item) are the dependent demand items. they are unreliable. Unless inventories are controlled. Basic types of inventory o Independent demand: . inefficient and costly. goods in process and finished goods all represent various forms of inventory.Particulars April May June July INTRODUCTION "Inventory" is one of the more visible and tangible aspects of doing business. merchandise stocks in a retail store contribute to profits only when their sale puts money into the cash register. Demand for a car translates into demand for four tires. Each type represents money tied up until the inventory leaves the company as purchased products. An inventory system is a set of policies that monitors and controls inventory. o Dependent demand: . Inventory refers to stocks of anything necessary to do business. many small businesses cannot absorb the types of losses arising from poor inventory management. The term inventory refers to the stockpile Inventory is the set of items that an organization holds for later use by the organization. These stocks represent a large portion of the business investment and must be well managed in order to maximize profits. o Supplies. one transmission. one engine. and so on. Raw materials.items are those items that we sell to customers. Likewise. and pens that are not used directly in the production of independent demand items Why hold Inventory? 73 . It determines how much of each item should be kept. cleaning materials. In fact. and how many items should be ordered or made when replenishment is needed.
2. and 5. Why We Want to Hold Inventories? o Improve customer service o Reduce certain costs such as -ordering costs -stockout costs -acquisition costs -start-up quality costs o Contribute to the efficient and effective operation of the production system. To get a lower price. The cost of Inventory o Holding costs. 4. o Ordering costs. To decouple work centers. o Setup costs. 3. and o Shortage costs. To meet variations in demand. As a safeguard against variations in delivery time. o Finished Goods Essential in produce-to-stock positioning strategies Necessary in level aggregate capacity plans Products can be displayed to customers o Work-in-Process Necessary in process-focused production 74 . To allow flexible production schedules. Opposing Views of Inventory o Why we want to hold inventories o Why we donot want to hold inventories.1.
the demand for raw materials and components can be calculated from the demand for finished goods 75 . Independent Demand Inventory Systems o Demand for an item carried in inventory is independent of the demand for any other item in inventory o Finished goods inventory is an example o Demands are estimated from forecasts and/or customer orders Dependent Demand Inventory Systems o Items whose demand depends on the demands for other items o For example. Two Fundamental Inventory Decisions o How much to order of each material when orders are placed with either outside suppliers or production departments within organizations o When to place the orders. May reduce material-handling & production costs o Raw Material Suppliers may produce/ship materials in batches Quantity discounts and freight/handling and savings Why We Do Not Want to Hold Inventories? o Certain costs increase such as • carrying costs • cost of customer responsiveness • cost of coordinating production • reduced-capacity costs • large-lot quality cost • cost of production problems.
The amount ordered each time an order is placed is fixed or constant. as one increases the other decreases . Goods arrive the same day they are ordered. the order point. 3. Inventories smooth out time gap between demand and supply. When the inventory level drops to a critical point. EOQ assumptions o o o single product with a constant and known demand rate. Inventories provide a way of “storing” labor (make more now free up labor later). i. the ordering process is triggered. This cost behavior is the basis for how much to order and this is known as the economic order quantity (EOQ). the inventory level increases.The sum of the two costs is the total stocking cost (TSC) When plotted against order quantity. inventory can provide quick customer service(convenience). 2. No shortages allowed : we must reorder when inventory reaches zero. A perpetual inventory accounting system is usually associated with this type of system Why use inventories? 1. Successful inventory management 76 .. An application of this type system is the two-bin system.e. These costs are opposing costs. When the ordered quantity is received. 4. the inventory level drops. Behavior of EOQ Systems As demand for the inventoried item occurs. the TSC decreases to a minimum cost and then increases. Holding inventory may contribute to lower production costs.o The systems used to manage these inventories (Chapter 15) are different from those used to manage independent demand items Inventory Costs Costs associated with ordering too much (represented by carrying costs) and Costs associated with ordering too little (represented by ordering costs).
Many small business owners fail to appreciate fully the true costs of carrying inventory. Others include: • Maintaining a wide assortment of stock -.but not getting caught with obsolete items. • Obtaining lower prices by making volume purchases -. planning ahead is very crucial. The degree of success in addressing these concerns is easier to gauge for some than for others.but not sacrificing service or performance. many 77 . This fine line between keeping too much inventory and not enough is not the manager's only concern. • Keeping stock low -. This includes going into the market to buy the goods early enough to ensure delivery at the proper time. The purchasing plan One of the most important aspects of inventory control is to have the items in stock at the moment they are needed. Average inventory turnover ratios for individual industries can be obtained from trade associations. but it must be realized that the turnover rate varies with the function of inventory. buying requires advance planning to determine inventory needs for each time period and then making the commitments without procrastination. For example.but not spreading the rapidly moving ones too thin. which include not only direct costs of storage. computing the inventory turnover ratio is a simple measure of managerial performance. Thus. but also the cost of money tied up in inventory. For example. The main reason for this early offering for sale of new items is that the retailer regards the calendar date for the beginning of the new season as the merchandise date for the end of the old season. and • Having an adequate inventory on hand -. For retailers. insurance and taxes.but not ending up with slowmoving inventory. • Increasing inventory turnover -.Successful inventory management involves balancing the costs of inventory with the benefits of inventory. the type of business and how the ratio is calculated (whether on sales or cost of goods sold). This value gives a rough guideline by which managers can set goals and evaluate performance. Since they offer new items for sale months before the actual calendar date for the beginning of the new season. it is imperative that buying plans be formulated early enough to allow for intelligent buying without any last minute panic purchases.but not sacrificing the service level.
In very small businesses where this method is used. a manufacturing business must formulate a plan to ensure enough inventory is on hand for production of a finished product. and • When the item should no longer be in stock. a retail firm must formulate a plan to ensure the sale of the greatest number of units. • Stub control (used by retailers) enables the manager to retain a portion of the price ticket when the item is sold. In summary. There are several proven methods for inventory control. Tickler control enables the manager to physically count a small portion of the inventory each day so that each segment of the inventory is counted every so many days on a regular basis. delivery and availability of products for sale. June 21 as the end of summer and December 21 as the end of winter. Controlling inventory To maintain an in-stock position of wanted items and to dispose of unwanted items. • When the inventory should be peaked. Well planned purchases affect the price. The manager can then use the stub to record the item that 78 . • Visual control enables the manager to examine the inventory visually to determine if additional inventory is required. records may not be needed at all or only for slow moving or expensive items. from simplest to most complex. you must determine how long the inventory you have in stock will last. Part of your purchasing plan must include accounting for the depletion of the inventory. • When reorders should no longer be placed. Before a decision can be made as to the level of inventory to order. They are listed below. the purchasing plan details: • When commitments should be placed. it is necessary to establish adequate controls over inventory on order and inventory in stock. • Click sheet control enables the manager to record the item as it is used on a sheet of paper. • When the first delivery should be received. Likewise.retailers view March 21 as the end of the spring season. Such information is then used for reorder purposes. For instance.
The EOQ computation takes into account the cost of placing an order. Often the justification for such a computer-based system is enhanced by the fact that company accounting and billing procedures can also be handled on the computer. it may find a need for a more sophisticated and technical form of inventory control. the use of computer systems to control inventory is far more feasible for small business than ever before. As a business grows. Their application is primarily within manufacturing but suppliers might find new requirements placed on them and sometimes buyers of manufactured items will experience a difference in delivery. takes the stock count and writes the reorder. The final method for inventory control is done by an outside agency. the minimum stock level at which additional quantities are ordered. 79 . authorized procedure. the unit cost. that is. that is. and the cost of carrying inventory.was sold. two approaches have had a major impact on inventory management: Material Requirements Planning (MRP) and Just-In-Time (JIT and Kanban). A manufacturer's representative visits the large retailer on a scheduled basis. the size and frequency of orders. • Off-line point-of-sale terminals relay information directly to the supplier's computer who uses the information to ship additional items automatically to the buyer/inventory manager. Unwanted merchandise is removed from stock and returned to the manufacturer through a predetermined. A principal goal for many of the methods described above is to determine the minimum possible annual cost of ordering and stocking each item. • Point-of-sale terminals relay information on each item used or sold. Developments in inventory management In recent years. Two major control values are used: 1) the order quantity. The manager receives information printouts at regular intervals for review and action. Today. both through the widespread existence of computer service organizations and the decreasing cost of small-sized computers. the annual sales rate. and 2) the reorder point. The Economic Order Quantity (EOQ) formula is one widely used method of computing the minimum annual cost for ordering and stocking each item.
taking one to three years to develop. This is accomplished by reducing set-up times and lead times so that small lots may be ordered. MRP systems are practical for smaller firms.All damaged materials must be held at the point received.If damage is visible. Tips for better inventory management At time of delivery • Verify count -. Just-in-time inventory management is an approach which works to eliminate inventories rather than optimize them. • After delivery. • After carrier/inspector prepares damage report. Call carrier to report damage and request inspection. Have all damaged items in the receiving area -Make certain the damaged items have not moved from the receiving area prior to inspection by carrier. Suppliers may have to make several deliveries a day or move close to the user plants to support this plan. and delivery times become shorter and more predictable. Materials are scheduled more closely. The computer system is only one part of the total project which is usually long-term. immediately open all cartons and inspect for merchandise damage. • Carefully examine each carton for visible damage -. Confirm call in writing--This is not mandatory but it is one way to protect yourself. note it on the delivery receipt and have the driver sign your copy. Its primary use is with products composed of many components. The inventory of raw materials and work-in-process falls to that needed in a single day. • Carrier inspection of damaged items.Make sure you are receiving as many cartons as are listed on the delivery receipt. carefully read before signing. Special tips for manufacturers 80 . thereby reducing inventories.Material requirements planning is basically an information system in which sales are converted directly into loads on the facility by sub-unit and time period. When damage is discovered Retain damaged items -.
• A reduction in unit prices due to negotiations. • Quantity savings due to large volume. specifications play a very important role. • Initiating make-or-buy studies. • Include procedures for adding optional items. 81 . • Include full descriptions of any testing to be performed. • Do not request features or quality that are not necessary for the items' intended use. • !Improvement in quality or changes in specifications that would lead to savings in process time or other operating savings. the following elements should be considered. • Greater use of bulk shipments. service and delivery when making the purchase selection decision. • Developing new sources of supply. In writing specifications. through consideration of economic order quantity. • Application of new purchasing techniques. • Using competition along with price.If you are in the business of bidding. The following actions can help save money when you are stocking inventory: • Substitution of less costly materials without impairing required quality. • Describe the quality of the items in clear terms.
Current Assets A balance sheet item. requiring long-term planning and financing. Convertible Preference Shares 82 . cash equivalents and other cash equivalents. Convertible Loans A loan with a provision allowing it to be converted to equity within a specific time frame. account receivables. current assets are those items owned by the firm with the intention to generate profits or other assets that can be converted to cash within one year. Capital Budgeting The process of managing capital assets and planning future expenditure on capital assets. It includes cash. Capital Investments Funds invested by a business in its capital assets that are anticipated to be used before being replaced.BASIC FINANCE TOOLS & TERMS Glossary of Financial Terms along with Definition Bonds A certificate of debt issued to raise funds. Bonds typically pay a fixed rate of interest and are repayable at a fixed date. inventory. Capital investments are generally significant business expenses.
taxes. Factoring helps a company speeds up its cash flow so that it can more readily pay its current obligations and grow. depreciation and amortization. Default Risk or Risk of Default The risk of loss due to non-payment by the borrower. Factoring Selling the interest in the accounts receivable or invoices to a financial institution at a small discount. It is calculated by dividing EBITDA by sales and is usually expressed as a percentage. usually for services or goods supplied. It is the net cash inflow from operating activities. Customers who owe the company money. Fixed Assets 83 . EBITDA Margin A measure of operating performance.Preference equity shares issued by a business that include a provision allowing them to be converted to ordinary equity shares after a specific time frame. usually for services or goods supplied. before working capital requirements are taken into account. Creditors or Accounts Payable Suppliers the company owes money to. Debtors' Turnnover Rate A short-term liquidity measure used to quantify the rate at which a business receives payment from customers. Creditors' Turnover Rate A short-term liquidity measure used to quantify the rate at which a business pays off its suppliers. Equity Financing The issuance of ordinary shares to raise money for a business. EBITDA The earnings before interest. Debt Financing Debtors or Accounts Receivable The money that you borrow to finance a business. It is sometimes called "accounts receivable financing".
The advance is generally for a certain period. Examples include. given to a seller at the request and on the instruction of the buyer.Fixed assets are those long-term tangible assets that the business has acquired for use to earn income over more than one year. Letter of Credit A written undertaking by a bank. Trust Receipt A financing facility for imports where a bank makes an advance to the buyer to settle an import sight bill. These assets normally must have a useful life over a few years and not expected to be converted to cash in the current financial year. It is calculated by dividing income before interest and taxes by interest paid. Interest Coverage Ratio An indication of the ability of a business to cover interest expenses with its income. Stock Turnover A measure of inventory performance to show how fast stock is converted from purchases to sales. It is calculated by dividing stock level by cost of sales x 365 days Term Loan A loan for a fixed period of more than one year and repayable by regular installments. Return on Equity (ROE) A measure of the return on each dollar of shareholder investment. 84 . to pay up. warehouse. factory. Initial Public Offering (IPO) The sale of a company's shares to the public on a stock exchange for the first time. Profit Margin A measure of a company's profitability. It is calculated by dividing net profit by equity and is usually expressed as a percentage. at sight or at a future date. On the due date. fixtures and etc. the buyer is required to settle the bill with interest at an agreed rate. equipment. It is calculated by dividing net profit by sales and is usually expressed as a percentage. up to a stated sum of money within a prescribed time limit.
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