Working Capital Management

INDEX
S.No. Topic Page No.

WEEK- 1
1 Introduction 1
2 Introduction 8
3 Nature of Working Capital Management 15
4 Approaches of Working Capital Management - 1 18
5 Approaches of Working Capital Management – II 20
6 22
Trade-off between Profitability and Risk - I
WEEK- 2
7 26
Trade-off between Profitability and Risk - II
8 Working Capital Management in Indian Business 37
9 Working Capital Management in Indian Business - II 45
10 Operating Cycle 48
11 Weighted Operating Cycle 49
12 Working Capital Requirement Assessment - I 54
WEEK- 3
13 Working Capital Requirement Assessment - II 59

14 Assessing Working Capital Requirements – 64
Problems 2 & 5
15 Working Capital Requirement –The Conclusion 69
16 Working Capital Leverage 74
17 Risk and Cost of Holding Inventory 79
18 Inventory Costs 82
WEEK- 4
19 Inventory Behaviour 87
20 Inventory Management-Methods and Strategies 92
21 EOQ Technique of Inventory Management 99
22 Stockouts Cause Walkouts 103
23 Rationing of Working Capital -1 110
24 Rationing of Working Capital -II 118
WEEK-5
25 Different Modes of Bank Finance 124
26 Incremental Inventory- I 130
27 Incremental Inventory-II 135
28 Management of Accounts Receivables-I 141
29 Management of Accounts Receivables-II 148
30 Management of Accounts Receivables-III 153
WEEK- 6
31 Motives of Credit Sale-I 161

32 Motives of Credit Sale-II 166
33 Limitations of Credit Time Period 173
34 Written Credit Policy-I 178
35 Written Credit Policy-II 182
36 Goals and Functions of Accounts Receivables 191
Management
WEEK- 7
37 Valuation of Receivables at Cost or Sales Value 196

38 Credit Policy Changes-I 202
39 Credit Policy Changes-II 207
40 Credit Policy Changes-III 220
41 Optimum credit policy 233
42 Credit Risk Analysis-I 235
WEEK- 8
43 Credit Risk Analysis-II 239

44 Credit Risk Analysis-III 248
45 Credit policy Variables 251
46 Cash Management 254
47 Cash Flow Presentation 267
48 Models of Cash Management-Certainty Model by 273
Baumol
WEEK- 9
49 Certainly Model by Baumol Contd… 279

50 Uncertainty Model by Miller and Orr 291
51 Miller and Orr Model contd. and Cash Management 298
Techniques
52 Measures of Liquidity 304
53 Window Dressing & Management of Current 311
Liabilities
WEEK- 10
54 Management of Accounts Payable 317
55 Cost of Stretching Accounts Payable-I 323
56 Cost of Stretching Accounts Payable-II 330
57 Other Accruals and Overtrading 317

58 Bank Finance-Introduction 323
59 Recommendations of Tondon and Chore 330
Committees
60 Deciding a Suitable Mix 317
Working Capital Management
Dr. Anil K. Sharma
Department of Management Studies
Indian Institute of Technology-Roorkee
Lecture - 01
Introduction
Welcome students. So in this course that is on Working Capital Management we will be talking
about that how to manage the working capital in the business organizations. Working capital if
you understand means working capital is the short term finance. You must be knowing that in
any business organization, in any business in any form there are different sources of finance,
different types of the sources of finance and we largely divide them into 3 categories right.
You must have heard there are 2 categories but actually there are the 3 categories of the sources
of the funds and we will learn how to manage the 2 sources under the working capital. So when
you talk about the different sources of the finance in any business, we have long term sources of
the funds, we have short term sources of the funds and the third one is the spontaneous sources
of the finance.
So one is the long term finance, second is the short term finance, and third is the spontaneous
finance. You must not have heard about the spontaneous finance which is called as self-adjusting
source of finance. So when we talk about the long term sources of the funds, in the long term
sources of the funds we include the share capital, we include the debentures or bonds, we include
the long term loans and so on and so forth.
But in the short term sources of the funds, first we talk about the spontaneous finance and once
the spontaneous source of the finance is exhausted then we move to the next level that is the
short term sources of the finance. So if both these sources are not sufficient to fulfill the
organization’s need or the firm’s financial needs then we resort to the long term sources of the
funds to fulfill the short term requirements.
Otherwise the requirement, the focus and the need of the hour is that the short term requirements
or the current requirements of any firms or that is specially relating to the finance or the financial
short term financial requirements, this should be fulfilled from the spontaneous finance as well
as from the short term financial sources. So in this subject, in this particular area as we call it as
working capital management, we call it as working capital management.
In the working capital management we will be studying about that how to manage the working
capital of any organization, any business undertaking in the best possible manner. Now, you
must be wondering that why there is a need or a special need to focus upon the short term
sources of the finance as well as the spontaneous sources of finance as the management of the
say or the financial management of any firm or any businesses concerned.
I would share with you here that what is the need, what is the requirement, what is the urge to
learn about specifically to manage the short term sources of the funds. See when we talk about
the long term investment decisions of the firms right, they are called as the capital budgeting
decisions. In the other way the other name of these decisions is capital budgeting decisions. We
want to venture into a new project. We want to have say a another plant.
We want to have say add new products or services into our existing portfolio of the products or
services or we want to do something which you call it as, term it as, as a new project. Now in this
case, new project means a long term investment, big investment and this investment is also
called as strategic investment. When any firm makes or takes a decisions regarding the long term
investment, it is not a simple decision. It is not a decisions to be taken very quickly.
We have to take our own time. We have to think a lot. We have to conduct the surveys of the
market that whether if we increase the manufacturing capacity of the firm, if we add a new plant,
new additional manufacturing unit in that case whether we will be able to sell the additional
production in the market or not; so many things have to be taken into account and finally the
decision is based upon something which is called as the DPR or the DPFR you can call it as
Detailed Project Feasibility Report.
Detailed Project Feasibility Report, under that report we study everything. We study the
marketability of the product, acceptability of the product in the market, marketability of the
product or service we are going to create or generate then is called as the market and demand
analysis. Then we go for the technical analysis whether we will be able to manufacture the
product in the best possible manner means the best quality product at the lowest price.
Then we go for the say financial analysis. Then we go for the say networking technique analysis
everything we try to do. When it is a long term investment decision many people are involved
and we take the decision after thorough consideration. We means within the firm and outside the
firm. The environment inside the firm, environment outside the firm both are properly analyzed
and if need arises the help of the experts in that area is also taken.
Normally, the firm refers this kind of decisions to the experts, market experts so which you can
call it the consultants in the market and once they approve that yes your long term investment
decision is going to deliver the results, you can add the capacity to the existing production
capacity, you can introduce a new product in the market or you can go for say you can call it as
the vertical growth of the company or the horizontal growth of the company whatever you want
to do that is going to be quite feasible and that is going to be a wise decision.
So it means it is a multi-people decision where so many people are involved in taking that
decision. But in case of short term finance working capital management, not large number of the
people are involved; only 1 or 2 people are involved. Ultimately, it is the sole responsibility of
the CFO of the company, Chief Finance Officer of the company to manage and arrange for the
short term sources of the funds and fulfill the short term requirements.
Now, in case of the long term investment decisions if for example decision goes well. We
invested say for example 100 crores. In the say new additional capacity or maybe adding a new
product line or maybe say in the new project which the company started maybe whether it was it
is in the same existing field of the business or it was altogether a new area.
So company invested 100 crores and the project did very well and the product which came out of
that project was finally acceptable to the people in the market and means finally the project is
successful so it means everybody will take the credit. But on the other side if the project fails, if
the project does not do well and ultimately that 100 crores investment which is made by the
company goes down in the drain, who is responsible?
Because it is a multi-people decision again so it means everybody has to take the responsibility
and in that case everybody’s responsibility is nobody’s responsibility. So it means nobody will
be fired, nobody will be solely held responsible and nobody will be say paying the price for
taking a wrong decision because it was not a one-man decision. It was a team decision and if the
team’s assessment has gone wrong in that case you cannot do anything.
But in case of the short term finance or the working capital finance, as I told you that it is the
sole responsibility of the CFO, Chief Financial Officer of the company and he has to provide the
short term finance to the firm as and when it is required. When you require the short term finance
now, when you require the working capital, what is the need of the working capital in any firm,
where the working capital is used?
Now for example we are a manufacturing firm. We are manufacturing some product and when
we are manufacturing that product we need raw material and to buy the raw material you need to
have funds. If you are paying to the suppliers on time they will continue to supply the raw
material to the firm. Otherwise, they will stop. So if we default in making the payment to the
supplier on the due date then what will happen?
Suppliers will see once or twice. After that they will stop doing the business with the firm and
the onus will be of the CFO. Similarly, we hire employees, we hire plant workers, we hire office
employees and everybody has to be paid after 30 days. Normally, in Indian system, we have to
pay after 1 month. So you need to have sufficient working capital, short term finance to make the
payment of wages as well as salaries to the people.
Similarly, you have so many utilities, power, water, lubricants, similar other kinds of the small
size and the you can call it as the small quantity materials. All these materials, all this power
supplies, water supplies, we need to pay after certain period of time and the Indian say payment
system is for 1 month. After 1 month you have to make the payment to the all these utility
suppliers and if you are not able to make the payment on the due date I think they will not
tolerate anymore. We do not have any liberty to delay the payments.
So in that case you have to have the finance, you have to have the funds for your day to day
expenses. You should have material, you should have all other inputs, you should have
employees, you should have workers on the plant, everybody. And for that you need to make the
payments, not on daily basis, sometime not on weekly basis, even not on the fortnightly basis.
But you have to make the payment on the monthly basis.
So here arises a need of working capital. So it means we are going to learn many things here that
what is there to manage in the short term funds. The important point to learn here is that the short
term finance should be available in any business organization in the quantity in the amount as
much it is required in the firm. If you keep more than that, the cost of funds will go up and return
will not be there. So the loses will increase.
Again, the responsibility will be on the finance department. You are over capitalized as far as the
working capital is concerned, is bad. If you are not able to meet your obligations, not able to
make the payments on the due date it means we would not be able to honor the commitment of
the firm and because the reason is there is a no availability of the short term finance. We do not
have the easy finance, we do not have the cash, we do not have the bank balance, sufficient bank
balances I would say and you are defaulting in making the payments.
It will spoil the reputation of the firm and sometimes your suppliers, your say other input
providers will stop providing the supplies to the firm. So whose fault it would be considered as,
of the finance department. Everybody would say, purchase department would say we requested
for this much of the funds from the finance people they did not provide it.
All other means if the workers are not being paid on time, if employees are not being paid on
time so what will happen? They will say that we asked for the funds. Personal department will
say we asked for the funds from the finance but they have not provided. So ultimately the onus
will be on the finance department or on the CEO of the firm. So it means in that case who is
responsible, only one person. Only one department, not even person, only one department.
Because it is a day-to-day decision and we have to be very efficient. So if you keep more than
the required amount of funds your cost of keeping the funds will increase, your returns will go
down and profitability will be affected. Contrary to this, if you keep the funds means the lesser
than the requirements so as to increase the profitability of the firm. So what will happen?
We would default in making the payments because we do not have the required amount of the
finance with us and in that situation what could be the problem, that there is a situation of the
technical insolvency of the firm. Technical insolvency of the firm means, firm would not be able
to meet its obligation, payment obligations on the due date at the due time. So it means this is
called as the state of technical insolvency.
So it means we have to avoid both the situations. We should neither be over capitalized, we
should not be undercapitalized. We should be optimally capitalized as far as the management of
the or as far as the short term funds are concerned so it means how to have optimum level of the
working capital finance short term finance from the sources like spontaneous finance like short
term finance that we are going to learn in this subject.
So we will start just with the introductory part and then we will build up the story. With the
passage of time we would learn about managing the total, all the current assets in any firm and
the current liabilities in the firm. So it means you must have heard about because this course you
must have heard about something about the basic finance or the financial management earlier
then you would be able to have interest in this particular area in this source of finance or in the
management of short term funds or the working capital.
So I expect that you know the financial management and you have learnt something about it in
the past. So when we talk about any firm and any business organization its financial statements
include say a profit and loss account, cash flow statement, and third one is called as balance
sheet. In the balance sheet we have 2 important components; one is the asset and other is the
liabilities.
Liabilities provide the funds to the firm for running its business, for running its show and assets
are technically the properties of the firm which help the firm to go for the desired production,
then selling that production in the market and then continuing the production process all the
times. So you talk about these assets and liabilities. When you talk about these two, you have
long term assets called as fixed assets and current assets.
On the other side, in the liabilities, you have long term liabilities that is called as the long term
liabilities and the short term liabilities or the current liabilities. So this makes the balance sheet
of the firm. If you talk about the total balance sheet of the firm, we would say that there are 2
important parts of the balance sheet and in this case I would say that here is the balance sheet of
a company.
(Refer Slide Time: 16:05)
If you look at the balance sheet of a company you have on the one side liabilities and capital, on
the other side you have assets and we have normally we have divided this balance sheet into 2
parts. One part is dealing with the, this upper part of the balance sheet deals with the long term
part and the lower part of the balance sheet talks about the current or the short term part. Long
term part when you talk about, on the liability side you have long term sources of the funds that
is it is starting with the share capital.
Then it is the debentures and bonds, long term loans and other things. On the asset side you have
long term assets which you call them as fixed assets and these are the fixed assets. Fixed assets
where you start with the land, buildings, plant, machinery, furniture, and then we have something
like intangible assets but again a long term asset which is called as goodwill. So this is the upper
part of the balance sheet.
If you prepare the balance sheet in the order of permanence then on the upper part of the balance
sheet you have the long term liabilities on the one side and the long term or the fixed assets on
the other side. We are not going to talk about the upper part of the balance sheet in this subject.
Because if you are going to talk about both the components of balance sheet that is the long term
liabilities, short term liabilities, long term assets, short term assets in that case what is going to
happen. You are going to talk about the subject called as financial management.
I am not going to talk about both the things. Financial management means complete, nothing.
We are going to talk about the, in this subject we are going to learn how to manage the lower
part of the balance sheet. Lower part of the balance sheet where you talk about current liabilities
and current assets. Short term liabilities and short term assets.
Here if you are able to manage the lower part of the balance sheet properly, to a larger extent
upper part of the balance sheet will be managed automatically or to a larger extent. But still I told
you that when we take the long term investment decision, say for example we borrowed money
from financial institutions or we issued debentures in the market or we issued additional shares
in the market and that long term funds were invested into a say strategic investment decision
under strategic investment decision into a new project and the project does not say work well. It
is not viable, it fails.
Then I say that I told you that responsibility is not with the one person or the one department
because it is a multi-angle activity, multiple people are involved. Lastly products gets succeeded
but sometime once in a while they get failed also. So it means ultimately it will be considered as
a firm level decision. Nobody individually is held responsible but in the management of the
lower part of the balance sheet that is the current liabilities and current assets here only is the
responsibility of the one department that is finance department of the firm and the one largely the
one person that is the Chief Financial Officer of the company.
So we have to here learn that in this balance sheet how to manage the lower part of the balance
sheet where we talk about the current liabilities and we talk about the current assets. Now you
must have heard about the working capital. We have 2 concepts of working capital. One concept
is of gross working capital and second concept is of networking capital. In the gross working
capital, gross working capital is basically the total of the current assets in the balance sheet.
Total of the current assets in the balance sheet is called as the gross working capital. But when
you subtract the current liabilities from gross current assets then that difference is that is the
current assets minus the current liabilities is the net working capital. It means the total current
assets, inventory, receivables, debtors, cash, bank balances, marketable securities or any other
prepaid expenses, any other current assets first they have to be financed from or by current
liabilities.
And if current liabilities are fully exhausted we have fully utilized the current liabilities available
with the firm then we have to move to the long term sources of the funds and when you talk
about the current liabilities it include both the sources of funds that is the spontaneous finance as
well as the short term finance.
Once these 2 sources are fully exhausted and still if there is a need to finance the current assets,
we need to build up the level of current assets which is not possible to be financed from the say
short term funds and spontaneous sources of the funds, then you have to resort to the third source
that is the long term sources of the finance. Now why I am saying that this priority is required
because what happens.
Finance or the financial resources, they are not free they have a cost and in India we have term
structure of interest rates, term structure of interest rates. When you talk about the term structure
of interest rates I would say that term structure of interest rate is like the rate of interest of any on
any loan is related directly to the duration of that loan. Longer the maturity period or duration of
the loan, higher would be the interest rate and shorter is the duration of the loan or the maturity
period of that loan, lesser will be the interest rate.
So as I am talking to you that the long term funds to be used for the short term purposes, long
term funds are more costly, more expensive because they are borrowed for a longer period of
time and with the time period, time horizon cost of the funds increases. So if the cost of funds is
high and the returns available from the asset in which they are invested in the that is the current
assets, if the return is lesser from those assets in that case there will be a mismatch between the
cost and the revenue available.
So it means there is a cost is higher and the income is lesser so there is a mismatch and when
there is a mismatch so what will happen it will directly add to the losses of the firm or minimize
the profits because financial cost nowadays is a very important component. So you cannot think
of means afford largely or maybe beyond a extent to invest long term sources of the funds to
meet the short term requirements beyond a level.
If it is a marginal difference you can use the long term sources for the short term requirements or
funding the current assets or short term assets but if it is a regular habit more say the magnitude
is bigger of the funding the current assets with the long term funds then it is not going to be in
the interest of the firm because cost of the funds is higher because of the term structure of
interest rates. Returns available on the assets in which they are invested is lesser.
In that case what is going to happen? There is going to be a mismatch between the cost and
revenue and finally the ultimately this will be a situation of the loss, not of the profit and not of
the no profit no loss. So we have to avoid that situation. So we are going to learn here that how
to make maximum possible use of the spontaneous finance and short term finance to finance the
current assets and the investment of the long term sources of the funds to fulfill the current assets
the investment requirements is minimized or it is done to a minimum possible extent.
Now in this case I would say that I am saying that current assets are less productive or less say
profitable as compared to the long term assets and investment of the expensive funds that is the
long term funds into the assets which are either not productive, not profitable, or least productive
or least profitable should be as low as possible. Now, we would come to a discussion that how
current assets are least productive, least profitable, or sometime not at all productive, not at all
profitable.
See when you talk about the assets, you must be knowing about the definition of asset. Asset
means the property, whether is of an individual, any business organization whether is a sole
proprietorship it is the partnership firm or a company form of organization. If anybody has the
assets, it indicates he, she or that firm or that organization has this much amount of the properties
and when you talk about anything is the asset anything is the property means it will give you
some return.
If you have a extra house, if you have two houses, one in which you stay a second is rented out it
means that property is giving you a monthly rental income and that is the income from that
property. If you have surplus funds which are more than your say monthly requirements you
invest them outside somewhere in the market and if you invest them for the longer duration 4, 5
years means go for the minimum safest mod is the fixed deposits in the banks you will earn a
higher rate of interest.
So it means or any other assets you talk about, any assets which is generating income for you
that is called as asset or that is called as the property. Here when you talk about the long term
assets, land, plant, building, machinery there are certainly going to generate a sufficient revenue,
sufficient income for us or the owners of those assets but as with the short term assets are
concerned current assets are concerned they do not generate any income.
They facilitate the business process but they do not help or they do not contribute directly into
the say income maximization or the wealth maximization of the firm which is the ultimate
objective of any and every business. Now how would means how can I say that current assets are
not at all productive?
I would say that if given a chance to do the business to me or to anybody in this world without
keeping means or by not even by keeping a iota of the level of current assets if anybody is
allowed to do the business in this world I think that business would be the best running business.
But because as I told you that these assets are facilitated to the business, support to the business
though they do not earn any interest or sorry any income or profit themselves.
But without these assets you cannot generate more than a level of profits and you cannot go
beyond a level of the business so we are bound to have the current assets. Without current assets
we cannot think of running the business but if it is possible to do the business without current
assets I think your profit would be maximum and your say return on the investment would also
be maximum. So how do I say that current asset do not generate any returns.
First of all I would say, let us take one by one. First one is the inventory. Inventory is the stock,
stock of anything. It may be stock of raw material. It may be stock of finished goods. It may be
stock of the halfly processed material which is called as the work in progress. It is a stock, it is
the inventory and inventory we call as current assets, current property of the firm. And property
is expected to generate the return.
But you tell me these inventories do they generate any kind of the return to the firm? If cannot
you imagine a situation like let us state a truck load of raw material is coming from the suppliers
place going directly to the plant of the firm being converted directly into the finished product and
that finished product being kept in the warehouse for some period of time is directly from the
plant is going to the market and that to earn cash.
Entire production is going to the market and that to earn the cash. You are in between you are not
generating any current assets. There is no inventory, there is no credit sales means sundry
debtors. Will that not will be a best kind of the business situation? Raw material coming, going
to the plant, and from the plant the finished product is going to the market and entire production
from the plant is going to the market on cash.
Where is the current asset? Where is the need of the current assets? You do not require any
inventory. You do not require any debtors which come up in the balance sheet after making the
credit sales or selling your product on credit in the market. So inventory, you are keeping
inventory but returns just generating to you. What returns is generating to any firm any business
organization. It is not generating any return, it has only cost.
When you keep inventory you have to have space and space has a cost, building cost and if it is a
perishable product you have to have the cold storage, it has a cost. You have to have human
resources to manage your storing facility, it has a cost. You have to have power, water, so many
other things, it has a cost. Ultimately you are going to sell that inventory in the market at the
price which is called as a selling price.
And selling price who determines, market determines the selling price. We do not determine the
selling price. It does not mean that if my because by keeping inventory my cost of say my
investment has gone up so or my cost has increased so I would be increasing the selling price.
You cannot do that because selling price is decided by the market forces, the market situation.
You have to sell the product at the same price as you are selling it today.
After 6 months also you have to sell the price, if the price increases in the market it is fine. If it
does not increase in the sometime it goes down so you have to pay the means that case you have
to pay the price. So it means inventory is a current asset. Inventory is a property but who would
like to have inventory in the business. We would like to have a situation where directly your
material comes, goes to the plant.
From the plant finished production goes to the market. No way you are generating any inventory.
You are keeping inventory. You are storing your production in the market even for a day an hour
or maybe a moment not at all. No cost nothing and everything is say just in time but it is not
possible. We cannot do business without keeping an inventory.
We cannot do business and especially in the Indian conditions if you talk about the Indian
conditions the supply chain situation is so bad that you think that for example from suppliers
place to the production facility the travel time for a truckload of raw material is say 3 hours but
you cannot be sure that certainly the truck will start from there and will reach at the plant at the
manufacturing facility within 3 hours or at the end of the third hour.
On the way there can be anything, traffic jam, accidents anything is possible and the truckload of
material get can get delayed. When it gets delayed in that case plant’s material level will come
down to zero inventory level of raw material will come to zero and plant will come to a standstill
situation of the standstill. So it means just to avoid that situation you have to keep the inventory
of raw material.
Similarly, when the production process is getting stuck or halted, in that case your finished
production going to the market will also be getting affected and you cannot say that as and when
there is a demand in the market you would be supplying the finished product in the market.
There might be the orders from the market but we are out of stock and out of stock itself has a
cost. And in between you have to keep the inventory of WIP which is called as work in process.
So everywhere at all the stages, raw material stage, WIP stage, finished goods stage you are
bound to keep inventory but this inventory is not adding any value to the firm. It is increasing
our cost and affecting your profitability because you cannot change the selling price so in that
case inventory is an asset but it is such kind of the asset which only you can say is facilitated to
the business process, is not earning anything directly for us.
It means if given a chance to do the business without inventory or even by keeping an iota of
inventory I would not like means that would be the happiest situation for me, for any firm, any
business organization but doing the business without inventory is you can say just not possible.
Even under just in time which is a technique say came from Japan. Under just in time also you
are not keeping zero level of inventory.
You are keeping minimum level of inventory so it means everywhere you have to keep the
inventory. You only can manage with the stock level of inventory. Sometimes very high level,
sometime it is a low level, sometime it is in between. So you have to sometime you can keep a
low level of inventory but you have to keep inventory which will increase the cost, will not earn
anything for us. So it means inventory is a asset but a current asset.
So I have to finance it. I need the funds for it and if you invest more funds into inventory, keep a
high level of inventory your cost will increase, your returns will be getting affected, profitability
will be getting affected. So you have to keep the optimum level of inventory that we will learn
how to maintain the optimum level of inventory in the firms. Similarly, we talk about the second
asset which is the second asset in the say overall priority level which is called as sundry debtors.
Sundry debtors appear in the balance sheet when, sundry debtors appear in the balance sheet by
selling your finished production in the market on credit not on cash. You have 2 ways to sell
your production in the market. You can sell your production in the market either on cash or on
credit. Your first choice would be that I would be selling maximum of my production in the
market on cash but sometimes it is not possible.
If you want to do the business only on the cash basis the volume of your business will be
seriously affected and it will come down. So what you have to do is you will have to do the
business on credit also. But you see when you do the business on the credit again it is going to
increase your cost not the returns. You are going to charge the selling price almost the same
selling price but you are going to sell him on the credit.
So any if I am selling on cash today immediately I am passing on the product to the buyer and I
am getting the cash back. But under the credit system, I am passing on the product today and I
am getting the cash back after the credit period which maybe 1 month, 2 month, or 3 months or
sometimes it is more than that. So what would you like to do? Would you like to have the
payment today or you would like to have the payment after 30 days or 60 days or 90 days?
If given a chance to me to do the business on cash I would be the happiest person. Any firm
would be the happiest organization but it is not possible. You have to do the business on credit.
You have to sell on the credit and when you sell on the credit sundry debtors appear which is a
next asset current asset in the balance sheet sundry debtor they appear in the balance sheet and
you have to manage those sundry debtors those credit sales.
So it means this is a second current assets. We call it as current asset but this asset is also not
generating any returns for you, rather it has a cost. But you cannot do the business simply by
doing the business on cash. You have to do the business partly on credit also and when you do
the business on credit it means sundry debtors appear in the balance sheet and we have to bear
those sundry debtors and we will have to do the business by selling on the credit.
Everything cannot be on cash but if my choice would be that I should be selling everything on
cash but I cannot do that. So we should manage under this subject by studying the working
capital management how to manage all these current assets. We just discussed about inventory,
we discussed about say sundry debtors that is the credit sales. Similarly, we will be discussing
about the other current assets but I would again say all these current assets have the cost.
Now say returns means returns only come when they are sold in the market and sold on cash in
the market. So that would be possible even today when you are able to sell everything on cash
and that too today in the market but that is not possible. So it means if it is not possible so
inventory also appear in the balance sheets, sundry debtors also appear in the balance sheet and
some other current assets also appear in the balance sheet.
And we to finance those current assets you need the funds which come from the spontaneous
sources, short term sources and once these two sources are fully exhausted then partly the funds
can be supplied from the long term sources also. About the other current assets and other
discussion on this particular area I will be talking to you in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 10
Operating Cycle
Welcome students. So now we will carry forward the discussion on this subject working capital
management and in this class we will try to understand that how to estimate the working capital
requirements of a company. Of any firm, of any manufacturing company how to assess the
working capital requirements. How much working capital they require say to carry on their
operations successfully.
This is the process and with the help of certain techniques or certain processes we can easily
estimate the working capital requirements of the company and here we talk about the different
techniques and ways how to calculate or how to work out the working capital requirement of the
company.
We can follow either of the 3 methods. So first is here is the current asset holding period method
which is in a way called as the operating cycle approach. Second is the ratio of sales method and
third one is the ratio of fixed investment method. So current assets holding period method or the
operating cycle method or the operating cycle approach, this is very popular approach.
This is the very useful approach and say in most of the firms this approach, this technique is used
to estimate the working capital requirements of the firm. So this is in nutshell or in the say
simpler way it is called as the operating cycle approach. What is the operating cycle, how to
calculate the operating cycle and the entire concept of the operating cycle I will discuss with you
maybe in the following part.
But before that the second method is ratio of sales method. When you talk about the ratio of sales
method, is very simple that we can take we could decide certain percentage of the sales that how
much sales we are expecting to make for the for the whole of the year and as a percentage of that
as a ratio of that we can decide that this much will be the working capital requirement. Now this
can be done?
This can be done mostly on the basis of the existing firms and their working capital
requirements. So for example if we are talking about a new company which is coming into
existence for the first time, they are starting the manufacturing process for the first time so they
want to assess the working capital requirement how much working capital they require so one
method is that they follow the operating cycle approach.
But if they are not means interested to follow this approach then they take the ratio of the sales
method from the firms which are already existing in the market. We can see that what is the size
of different firms, what is the size of their sales in the market and as a percentage or as a ratio of
the sales what is the level of the working capital the existing firms are using, the new firm can
also start using the same proportion or the same percentage or little more or less than that and
third method is the ratio of the fixed investment method.
Similarly, if sales we do not want to use then we can say we can use the ratio of the fixed
investment. How much fixed investment the company is planning to make or how much fixed
investment the other firms in the same industry have made in the fixed assets. So as a ratio of the
fixed investment we can work out the say the percentage of the working capital required or the
short term funds required. So if you talk about these 3 methods the method number 2 and 3 they
are not very scientific. They are only give us as a percentage, as a proportion which maybe not
correct to some extent or to a large extent because ratio of sales method sometimes is very
difficult to forecast the sales with the precision or maybe with the say true estimates.
Similarly, sometimes some firms as a ratio of the fixed assets it maybe some percentage in the
one firm. It could be some percentage in the other firm. So these two are not very scientific
techniques. So mostly that is why I told you, most of the firms resort to the first technique that is
the operating cycle approach or the current asset holding period method. So now we will discuss
in detail what is the operating cycle.
Say in nutshell before say discussing it formally, I would like to share with you that operating
cycle in the simpler terms is that you see that you assume that when we have to manufacture a
finished product anything you want to manufacture say for example this is the pen. This is the,
we want to manufacture this pen, this is the finished product. Now this pen is requiring certain
inputs.
First input is the raw material that is the steel, that is the plastic part, that is the ink and that is
some other things. So this is the one thing is that we need to make investment in the raw material
and then the other expenses like when you manufacture this pen so we have to have that people
working on the plant so their wages will be important. Their salaries, people working in the
offices will be important and say the total other inputs are also required.
Like we need power, we need water, we need other inputs, lubricants, oils for the say smooth
running of the machinery plant and other manufacturing processes. So the cost of material means
the total input. So what will happen? The total input when we are working out larger chunk of
that input cost is on the material which is 50-60%. So first we will buy the raw material. So what
will happen? We have, before buying the raw material we have the cash in our hands.
So we are investing that cash or converting that cash into the raw material. When the raw
material comes to us that goes to the store and from the store slowly and steadily as per the
requirement of manufacturing process. The raw material is issued to the manufacturing process
so when we start manufacturing it we do not directly convert the raw material into finished
product but it is converted through stages.
So we convert the raw material into the work in process and from the work in process after
further processing we convert that into the finished product. So it means first it was the cash.
Cash was converted into raw material. Raw material was converted into the say inventory stage
and from inventory it was issued to the manufacturing process. It was half processed. So when it
was half processed it was work in process.
And then from the work in process we converted that to the finished product and now their
finished product has to go to the market. So part of the finished product goes to the market on
cash. So when we sell part of the production on cash in the market so it means we are we
invested the cash and we got the cash back right. But part of the production will go to the market
on credit.
And that production which is going to market on credit that will be known for some period of
time as the accounts receivables or sundry debtors. Because till the time we are selling it on the
credit in the market they will be called as the sundry debtors or the accounts receivables and after
that when you collect the accounts receivables or sundry debtors then after the collection we will
be getting the total cash back.
So it means operating cycle is the total time period which is say taken for investment of the cash
and converting the means receiving the cash back. So it means we invest the cash means we
make investment in the form of cash. Cash is converted to raw material, raw material to the
inventory, inventory to work in process, work in process to finished goods, finished goods to
sales on cash as well as on credit.
Cash means cash is with us but the credit sales which are sundry debtors, sundry debtors will be
in the market for some period of time and after that we will also collect that cash on account of
the sundry debtors also. So it means if we invested 100 Rs of cash our objective should be that
not more at least 100 Rs should come back to us. So that time period which is taken for
investment of 100 Rs and then collection receipt of that 100 Rs back that total time duration is
called as the operating cycle.
So if you look at this say ppt if you look at the slide what we have written here is that operating
cycle refers to the average time elapses between the acquisition of raw material and the final cash
realization. This is just what I told u. this concept more precisely measures the working capital
fund requirements, traces its changes and determines the optimum level of working capital
requirements.
That is the working capital fund requirement, traces its changes and determines the optimum
level of the working capital requirements. So in nutshell it is the total time period which elapses
that how much time it takes for conversion of inventory into cash. So first we invest cash and
then we recover the cash back. So that time, total time period is called as the operating cycle.
This is the operating cycle. If you see the operating cycle this is the operating cycle and we are in
the first stage we are starting with the cash.
Cash is used to purchase the raw material and then that raw material goes to the store and it is
called as the raw material inventory. Then we issue that raw material to the production process
and along with the raw material and other expenses we start processing that material . So it is
converted to the taken to the next stage which is called as the WIP stage or the work in process
stage. Then that is finally processed and reaches at the next stage that is the finished goods stage.
And then if you look at the next part then those finished goods have to go to the market and we
have to sell these finished goods. So if you have to sell these finished goods it means that will be
converted into the cash and partly into the accounts receivables and accounts receivables means
total sales have to be collected, partly we have collected which we sold on cash and partly which
we sold as accounts receivables we will be collecting in the due course.
So it means we invested cash and we got the cash back. This is the say something which is called
as operating cycle. So how much time it takes, how much time it takes when cash goes out of the
say the account of the company and comes back to the account of the company that total time
period is called as the operating cycle. Now you see the stages of the operating cycle. We have
the 4 stages of the operating cycle.
Raw material and inventory stores stage. When we buy the raw material we convert the cash into
raw material and raw material becomes the inventory which is stored in the warehouse or in the
store or in the godown and till the time it is stored it is at the inventory stage. Then we keep on
issuing or we will start issuing the raw material to the manufacturing process and by adding up
other expenses we convert that into the say semi-finished stage, semi-finished process.
And that is called as WIP work in process stage and then when we further process it then it
becomes the finished goods. So third stage is the finished goods inventory stage and that finished
goods inventory goes to the market so what happens. Say for example out of the total production
50% we are selling on cash. So 50% we immediately recovered. But remaining 50% will be
converted into from the finished goods to the receivables or sundry debtors.
So that will remain receivable or sundry debtor for some period of time or maybe the time period
given for say for the collection of the debtors or time period allowed to the buyers on credit that
is to the sundry debtors and once on the expiry of the credit period when they make the payment
to the company so it means the total cash which we invested we have to recover that plus profit
on that.
So that time period is called as the operating cycle which is having the 4 stages and 4 stages
means first stage begins with investment of cash and the last stage ends up with the recovery of
the cash.
So it means when you call it the operating cycle we have 2 kinds of the operating cycles, gross
operating cycle and net operating cycle. We have gross operating cycle and net operating cycle.
So first it is the gross that is gross operating cycle is GOC and then we have the net operating
cycle. This is NOC net operating cycle. So what is the net operating cycle that is GOC minus
PDP and here what is this. This is the sum total of the 4 stages which we saw in the previous
slide. We have the 4 stages of say total investment of cash and recovery of the cash.
First stage is raw material conversion period that is called as RMCP, raw material conversion
period plus WIPCP work in process conversion period then is the FGCP finished goods
conversion period and then last stage is the BDP. BDP is what we call BDP? BDP means book
debt period. The credit period allowed to the buyers who want to buy it on credit.
So sum total if this is the raw material conversion period plus working process conversion
period, finished goods conversion period and book debts. So it means for example raw material
conversion period is 10 days plus here it is 5 days plus it is again 5 days and then is the 10 days.
So it means the length of operating cycle is how much that is 30 days. In total 30 days we will be
converting the cash back into the cash.
We will be converting back cash into the cash so this is the duration of the operating cycle. Now
we call it as net operating cycle. Gross operating cycle minus PDP. What is PDP? PDP means
the payment deferral period, time period which is allowed by the suppliers of raw materials to
the firm that you buy the raw material on credit and after the expiry of say 2 months or 45 days
you can make the payment to us.
So that is called as the credit period allowed by the suppliers or in the other terms we call it as
the payment deferral period, whether you are allowed any payment deferral period or not. if no
period is allowed it means we are buying the raw material on cash. But if the payment deferral
period is allowed then that is called as the PDP. So it means how many days PDP is allowed by
the suppliers.
So for example we have calculated here the gross operating cycle is say 30days and PDP is
allowed say 20 days. So it means net operating cycle is 10 days. This is 10 days. It means you
only are investing the cash only for a period of 10days because out of this total period of 30days
we not need to pay anything to the suppliers of raw materials. They are allowing us the credit
period of say 20 days.
So we will pay them after 20 days and after next 10 more days we will convert the total
investment back into the cash. So actual duration of the operating cycle is what? That is only 10
days. That is only 10 days. It can be now the question arises. Can net operating cycle be negative
also? Yes, net operating cycle can be negative also. So for example the firms who have a very
good credit rating in the market who are the bulk buyers of different kinds of the raw materials.
Their raw material come from say different suppliers and one supplier who is a not a very big
size supplier, he supplies his total production to the one single buyer. So in that case he is also
very means comfortable that whatever he is producing 100% of his output is going as a raw
material to the another company and he is not required to look for the other customers.
It means he is safe, he is peaceful and he is also very happy to do the business with the big buyer
who is buying from that supplier and maybe from the many other suppliers. So in that case the
only requirement of that big company the large company is that they want a longer credit period.
They want a longer credit period. Now for example you talk about the car industries in India and
we take the example of Suzuki Motors, so Maruti Suzuki Motors.
So it means when you talk about the Suzuki Motors case, Suzuki Motors is manufacturing cars in
India, is a very say well-known name, means cars in India is synonymous to the Suzuki Motors
of the Maruti Suzuki so it means that is a very big company. Now this company is only
manufacturing themselves they are manufacturing is the gearbox of the car. Other all inputs are
coming from the small suppliers or different suppliers.
For example for manufacturing a car we need steel, we need rubber parts, we need glass, we
need say seat covers, we need wheels, we need say tyres. So everything is required and they do
not manufacture tyre. Somebody else is manufacturing wheel. Somebody else is manufacturing
steel. Somebody else is manufacturing rubber parts. Somebody else is manufacturing glass.
Somebody else is manufacturing so it means Maruti Suzuki is buying all these inputs from the
different suppliers. Now for example there is one supplier who is manufacturing the say rubber
parts which you can call it as the rubber gaskets which are used to to fix up the window panes.
So for fixing up so that it remains stuck and they are also used for say say on the doors also so
that door properly shuts and the car can people can be comfortable inside the car.
There is no air coming in and going out. So rubber parts for example some company is
manufacturing and they are supplying their 100% production to the Maruti. So in that case
Maruti may say that yes your product is acceptable to us but only condition is that we want a
credit period of say say 2 months, 60 days, 60 days credit period. We will pay you after 60 days.
It is no the problem.
You can sell to us for 60 days credit period and your 60 days interest cost you can add up into
the price which we will pay to you. So after 60 days when we will make you the payment of your
bill or your invoice we will make the payment. We will pay you that is for the principle plus
interest. So you add up it in the total price which you are quoting to us. Now total payment
deferral period in this case to the Maruti is 60 days.
And for example in this case they get say nod from all the suppliers; steel, then your glass, your
rubber parts, your wheels, your tyres everybody is ready to give the credit period to Maruti of
say 60 days. Now in return Maruti gives a credit period to its suppliers 60 days. So in the case
total for example you can say the total gross operating cycle for the Maruti works out, the GOC
for the Maruti works out as 50 days.
And they are able to take the PDP payment deferral period of 60 days from the all input
suppliers. So it means in that case the net operating cycle or NOC for the Maruti will be minus
10 days. It means they are starting the manufacturing process. A lot of car they are
manufacturing and that lot is going to market. They are converting that into cash into 50days.
Whereas to their all suppliers they are paying after 60 days.
So it means the total payment which they are investing at the beginning of starting of the
manufacturing process of say 100 cars it is only taking 50 days and they are selling in the market
recovering the total funds within 50 days everything is done and they have to make the payment
after 2 months to their all suppliers. So it means the net operating cycle for the Maruti is
negative. So it means operating cycle can be negative also, that is the net operating cycle.
But the gross operating cycle can never be negative. Only net operating cycle can be negative
when the payment deferral period is more than the total duration of the GOC.
So we have the equation here the last equation that is R t minus C t. R t is what is R t? R t is the
raw material conversion period and C t is the payment deferral period because normally the raw
material suppliers give the credit. Large credit comes from the raw material and raw material is
the major chunk of the total cost of production also. So R t minus C t plus the WIP duration that
is WIPCP plus F t is the FGCP plus D t is the book debt period.
So it means total of this makes the operating cycle and this is the equation for the net operating
cycle because we have already subtracted the payment deferral period as C t from the R t which
is the raw material conversion period; so gross operating cycle and the net operating cycle. For
our use and the finally for the final use we are more concerned about the net operating cycle not
about the gross operating cycle.
But you cannot calculate the net operating cycle directly until and unless you calculate the gross
operating cycle. So this way we can calculate the operating cycles. For example you see that we
have material wages and overheads. These are the 3 major inputs required for converting the raw
material into the finished product right.
So we have seen we have calculated the period in weeks. So one is the raw material conversion
period is that is say is taking 1 week in total for material, wages, and overheads. WIPCP is taking
2 weeks that is the working process conversion period, 2 weeks .There is the finished goods
conversion period is 1 week. Then is the book debt conversion period is again 1 week. So total
length of the gross operating cycle is how much that is 5 weeks and less PDP payment deferral
period say for example it is allowed to this company is 1 week.
So it means net operating cycle for this company is the 4 weeks. So this way we can calculate the
operating cycle which is an important concept.
Now we will talk about say how to shorten the operating cycle. Because approach of every
company should be that their operating cycle should be as short as possible. Because in one year
we have how many number of days, 365. So in 365 for example if some company’s operating
cycle is of say 36.5 days. So in a year how many operating cycles the company would be able to
complete that is 10 operating cycles, 10 operating cycle, 10 OCs.
And for example if the company’s some company’s operating cycle is comes down to 18 days,
so it means how many operating cycle? Roughly the company would be able to complete the 20
operating cycles in a year. So ultimately we have to shorten the operating cycle. We have to
fasten the manufacturing process and shorten the operating cycle so that the company is able to
do the maximum business, maximum production and market sales in the market.
But the length of operating cycle depends on many factors. It is not always in the hands of the
company. Sometimes manufacturing process is so that minimum time is required to be given. If
you are not using the minimum time, if you are not taking the minimum time the product quality
cannot be assured. So for making the product as a quality product or converting the raw material
into finished quality product we have to spend minimum time because ripening of that say
finished unit takes time and nobody can do anything.
We have different kind of technologies. We have different kind of processes but minimum time
is required. Only thing is we can save up on the wastages. We can save upon the say availability
of or we can ensure the regular supply of inputs like electricity is the limiting factor. Sometimes
your water is the limiting factor. Sometime your labour is the limiting factor. Sometime a
specific type of the raw material are limiting factors.
If these are the limiting factors then nobody can help it out. Even despite the fact that we could
have shortened the operating cycle but we are not able to do that because of certain reasons. So
in this case say first here we have identified the reasons which prolonged the operating cycle.
Say what are the reasons? Purchase of material in excess or short of requirements. Similarly,
buying inferior or defective materials. Then failure to get trade or cash discounts.
Inability to purchase during seasons. Defective inventory policy. Lack of production planning
coordination and control. Mismatch between production policy and demand. Use of outdated
machinery, technology. Poor maintenance and upkeep of plant, equipments and infrastructural
facilities. Then defective credit policy and slack collection policy. Inability to get credit from
suppliers or employees. These are some reasons which have been identified.
If we want to shorten the operating cycle what we have to do is that we have to remove these
reasons and we will have to or if we cannot fully remove these reasons we can minimize the
effect of these reasons. For example purchase of raw material in short requirement. We should
have sufficient production and the purchase process should be like that raw material we are
buying but not too much, not less.
We are buying a optimum quantity of raw material so that the continuity of the production
process can be assured. Similarly, if you are buying a defective raw material or inferior raw
material naturally the say processes will take more time and it will be say very difficult to
convert that raw material into finished products as quickly as possible.
Similarly, when you are not able to get the cash or trade discounts where we are ending up
paying more price, it will become expensive purchase for us and if you are investing more
amount you have to recover that more amount from the market. So it may take some time. So we
have to remove these reasons and if we are not fully removing but even minimizing the effect of
these reasons even then we will be able to shorten the duration of the operating cycle. And then
say finally how to reduce it. Proper purchase management.
We should properly identify that where is the raw material available. How much time it takes
from the place of raw material to the place of use that is the manufacturing unit and if it
agricultural based product or the raw material is say based upon the agriculture product is a kind
of agricultural product in that case it is better to buy during seasons because it is very cheap at
that time and a good quality of the material can be purchased.
For example you talk about we take the example of say your this multinational companies like
Pepsi and others who manufacture the potato chips. They buy is a agricultural based product,
potato. They buy the potato from the place where the best potato is available and they buy during
season they store it and then they finally convert into the finished product. Similarly, you talk
about the ITC.
ITC that Indian tobacco company which manufactures many products which are based upon the
agriculture raw material or raw material coming from the agriculture sector. So they buy in bulk.
They have permanent supplier. They have permanent say growers of their raw material maybe
say tobacco, maybe it is say wheat or maybe it is anything. So they are buying during season.
They are buying it from permanent sources.
They are helping them to grow the good quality of the output. So it means their operating cycle
will be under control and as short as possible. Say production management is also important,
marketing is also important. Because if you are selling more on cash rather than on credit so it
means finally we would be say ending up shortening the operating cycle. Similarly, sound credit
and collection policies, proper monitoring of the external environment, HR management.
Efficient human resources if we have, trained human resources if we have and then is the regular
maintenance of plant and machinery and other equipments. So these are some ways and means
how we can shorten the duration of operating cycle and if we are taking care of all these factors
and all these things so what will happen that ultimately that time period will be in our hands and
that it can be shortened.
So it means some factors which have to be borne in mind are the seasonal variations, accuracy of
sales forecast, investment cost, variability in sales, length of operating cycle, and credit and the
collection policies. They are some important factors which are affecting the length of the
operating cycle. So if reasons are identified and removed if some important steps are taken
seasonal variations are taken care of.
And if the demand forecasting is correct then there is no doubt that we cannot shorten the
operating cycle or we cannot bring it down to the optimum level where we can say that yes
operating cycle is the as short as possible is the optimum operating cycle and our investment of
cash we are able to convert that back into cash in the minimum possible time. So this is the just
the beginning of the concept of operating cycle, what the operating cycle is and how it helps in
the estimation of the working capital requirements.
Many other things regarding the operating cycle and how to calculate the operating cycle we will
discuss in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 11
Weighted Operating Cycle
Welcome students. So in the last part of discussion we were talking about the concept of
operating cycle which is very useful tool in assessing the or estimating the working capital
requirements of a firm. So we saw that how the operating cycle works and what are the different
stages of the operating cycle.
And the objective under the operating cycle is that the cash invested in buying of the raw
material and converting that into finished product should be converted back into the cash. So
there as I told you in the last class also the objective of the firm should be to minimize the
duration of the operating cycle and to complete maximum operating cycles in a year, in a period
of 360 or 365 days.
So that will depend upon that how you manage your operating cycle and that depends upon some
external factors also which are uncontrollable but to a larger extent the factors remain
controllable and if we take a proper care of everything then I think the duration of the operating
cycle can be kept under control. So in that part we discussed that we have 2 types of the
operating cycle.
One was the gross operating cycle GOC and the other one was the net operating cycle NOC and
we learnt that how to calculate the gross operating cycle and how to calculate the net operating
cycle.
Now we will learn about that in case of the GOC we saw that the different stages which we work
that is the raw material conversion period plus the WIP conversion period plus finished goods
conversion period and then plus the BDP that is the book debts period. So how to calculate these
periods how to calculate these durations.
For calculation of these periods or for calculation of these durations means conversion period at
the stage of raw material, at the stage of WIP, at the stage of finished goods, and at the stage of
book debt how to calculate these conversion periods that is now we are going to learn and then is
the similarly we have to calculate the PDP also that is payment deferral period and that P also
has to be calculated.
And how to calculate this payment deferral period that is also another important point to learn so
that we can quantify it and we can convert the total information given to us into number of days
and then we sum up the 4 periods. We calculate the GOC - PDP is the net operating cycle. So it
means for calculation of these periods we have certain formulas or certain systems and we can
use these formulas and we can with the help of these formulas we can calculate this duration.
So now for example we are now going to talk about say first thing is that is the raw material
RMCP raw material conversion period or in a way we call them as the DRM duration of raw
material. This is called as under the other name also duration of raw material that is raw material
duration at that for how much time raw material remains as raw material. So you can calculate
this duration with the help of this formula.
That is average stock of raw material, average stock of raw material divided by raw material
average raw material converted or committed per day. Average raw material committed per day.
How much raw material we have committed per day that is average raw material committed per
day. How much raw material we are say buying or we are using that is committed per day. This
is the formula for calculating the DRM or RMCP.
That is the average stock of raw material and divided by the average raw material committed per
day. So it means this is the way we can calculate the duration of the raw material. Now we have
to calculate the second that is the WIPCP. WIPCP or you can call it as it is the DWIP duration of
the work in process and for calculating this duration of work in process what you have to do is
average WIP inventory average WIP inventory divided by average divided by average WIP
value average WIP value committed per day.
How much per day how much WIP work in process we are having with us. So that is the WIP
average WIP committed per day. This is how we can calculate the work in process conversion
period or duration of the WIP and then we have to calculate the DFG duration of the finished
goods. How long the finished goods remain as finished goods and how much time they take to
stay in the firm.
So it called as the FGCP, FGCP or you can call it as the DFG duration of the finished goods.
Finished goods staying at the finished goods stage that is average stock of finished goods divided
by average stock of finished goods divided by average cost of average cost of goods sold,
average cost of goods sold per day, average cost of goods sold per day. So this is how we can
calculate the say duration of the finished goods.
That is the DFG duration of the finished goods or the finished goods conversion period and then
we have next thing is that is the BDP book debt period or in other words you can call it as the
DAR duration of the accounts receivables. So duration of the accounts receivables can be
calculated how that is average sundry debtors average sundry debtors divided by average sundry
debtors divided by average credit average credit sales per day.
So this is the way we calculate the book debt period or the duration of the accounts receivables
and lastly we will learn how to calculate the duration of the that is the PDP payment deferral
period or the duration of the accounts payable which is called as DAP duration of the accounts
payable that is DAP.
So it means PDP payment deferral period or duration of accounts payable and for calculating that
what we have to do is that is average sundry creditors divided by average credit purchase average
credit purchase per day average credit purchase per day so we can calculate this duration that is
PDP or the DAP that is average sundry creditors we have and then average credit purchase we
are making per day. So this way we can calculate this duration.
So if we have this durations with us, all the 5 durations with us, we can easily calculate the gross
operating cycle and the net operating cycle and that duration that length of the operating cycle
will be known to easily known to us. So now let us say use these formulas and these methods to
calculate the duration of our operating cycle. And for this purpose we have some problems we
have prepared some problems.
And these problems the some information which is available with us, we will use this
information and by using this information we will try to calculate the duration of operating cycle.
We will try to calculate the duration of operating cycle. So if we see the problems are given.
There if you look at the slides the problems are given there and in those problems we are given
say for example first problem is that the relevant information are given here as under and in this
case average stock of raw material is or for a say average stock of the raw material and the
consumable stores and spares we are given that information. Average work in process we are
given. Average stock of finished good we are given.
Average sundry debtors we are given. Average sundry creditors we are given. We are already
given. Average debtors means how we can calculate the average debtors, opening debtors and
closing debtors. For example in any year what were the opening debtors, opening balance of the
debtors and what was the closing balance of the debtors of that year. If you take the sum of these
2 and divide by 2 you can calculate the average debtors. Similarly, the average creditors.
Then average raw material consumption per day. And committed or consumed per day. Then is
the average WIP committed per day. Then average cost of goods sold per day. Average credit
sales per day which is given to us is 18000. Average credit purchase per day is 11000. So on the
basis of the aforesaid information we will have to calculate the operating cycle and the net there
is a gross operating cycle and the net operating cycle.
Gross operating cycle is called as operating cycle. But the net operating cycle’s another name is
cash cycle. The other name is cash cycle. So net operating cycle or cash cycle is the same and
operating cycle or the gross operating cycle is the same. So now let us calculate the say operating
cycle, the duration, different durations and then we calculate the duration of the operating cycle
and then we calculate the duration of the cash cycle from this information which is available with
us.
So now as we know the formulas already so now we will calculate the DRM or RMCP, duration
of raw material right.
For calculating the duration of raw material what information is given to us, average stock of raw
material. Average stock of raw material is say average stock. The formula requires average stock
of raw material divided by average raw material consumed per day and you are also given the
average raw material consumed per day and that is the say 10000 kgs are given to us. So it means
you can say that DRM is 240 divided by 10.
So this duration works out as how many days 24 days. This is 24 days. Now we will calculate the
DWIP or you can say it is the WIPCP. You are given the say the formula says that is the average
WIP inventory we have divided by the average WIP value committed per day. So it means WIP
we are given information about the WIPs that is 330 tons, 330 tons divided by average WIP
value committed per day which is given to us that is 15000 kgs.
So it means 330 divided by 15000 kgs. This works out as how much. This is 22 days. This is 22
days and then we have to go for the next duration, for calculation of the next duration, which is
called as FGCP or we call it as DFG and DFG here is that is the requirement of DFG is how to
calculate it average stock of finished goods divided by the average cost of goods sold per day. So
what is average stock of the finished goods, say for 2 lakh rupees.
That is for 2 lakh rupees the average stock of finished goods that is 2 lakh rupees and what is the
denominator requirement of the denominator that is the average cost of goods sold per day.
Average cost of goods sold per day is 20000. So it means it is 20000. So this is you call it as how
much duration this is 10 days. The duration we have calculated here is 10 days. Then we have to
calculate now the DAR duration of accounts receivables or the book debt BDP book debt period.
So in this case the accounts receivables here the requirement is average sundry debtors divided
by the average credit sales per day. So what is the average sundry debtors that is the 36000
divided by the average credit sales per day and average credit sales per day how much that is
18000. This is 18000. So look at the information given there in these problems, first problem we
are dealing with. So this is the information we are taking and if we calculate this. So what is the
duration here. This works out as how much that is 20 days.
This is 20 days and now we have to calculate the last duration, 5th duration which is DAP
duration of accounts payable and if you calculate the duration of accounts payable what is the
requirement? The requirement is average credit sales divided by the average sorry average
sundry creditors not credit sales but average sundry creditors divided by the average credit
purchased per day. So what is the sundry creditors?
Sundry creditor average sundry creditors are 220000 2 lakh twenty thousands divided by the
average credit purchased per day. How much is average credit purchased per day. This is 11000.
It means what is the total duration this is 20 days. This duration is 20 days. So now we have
calculated all the 5 durations and easily we can calculate the duration of the operating cycle so
we would say that duration of operating cycle is that is DOC.
Duration of the operating cycle is DOC and DOC is how DRM+ DWIP+ DFG+ DAR right.
These are the 4 durations and we have already calculated these durations 24 then is 22 then it is
10 then it is 20 days. So how much it is total. This works out as 46 then 56 and then it is 76 days.
Total is 76 days. This is 76 days duration of the operating cycle or you can call it as the gross
operating cycle that is GOC.
And now we have to calculate the net operating cycle and net operating cycle’s other name is the
cash cycle. So DCC is equal to how much 76 - 20. So this works out as how many 56 days. This
is the 56 days. So it means in this case in this company’s case if you talk about this company or
this company’s case you can say that their operating cycle is of 56 days.
Means the day when they purchased the raw material and when that raw material is converted
into the finished product and finished production to sales and then cash is again converted back
into cash this time period, total time period taken in case of this company is 56 days. So this is
the duration of the net operating cycle. Actually the duration of the operating cycle was 76 days
but since for 20 days the suppliers are allowing the credit or the credit period which is allowed
by the suppliers is 20 days.
So it means finally the company’s cash, company’s cash is blocked for how many days?
Company’s cash is converted into cash in how many days that is 56 days. For 20 days company
did not invest any cash on account of raw material and raw material is the larger chunk so it
means that company only invested for a period of 56 days larger chunk of the cash and this is the
duration or this is the length of the operating cycle.
So you can easily understand that in a year how many operating cycle the company can complete
and one operating cycle is requiring how much capital that will be for us the next stage to learn.
For us that will be the next stage to learn but first we are learning how to calculate the duration
of the operating cycle. So we have learnt the simple operating cycle and which has 2 components
gross operating cycle and the net operating cycle.
Now the limitation of this operating cycle is which is a simple operating cycle, the limitation of
this operating cycle is that it gives the equal importance to all the level. It gives the equal
importance at all the levels. Maybe it is a raw material conversion stage or whether it is the WIP
conversion stage or whether it is the finished goods conversion stage or accounts receivables it
gives equal importance to all.
Whereas if you talk about the total selling price or the total cost of goods sold in that total cost of
goods sold the composition of raw material is much larger as compared to the other input cost.
So some people say that we should calculate the operating cycle or duration of the operating
cycle by keeping into consideration the importance of different stages of the operating cycle.
Raw material because it requires the largest amount of investment, biggest amount of
investment.
So what we should do here that we should try to give more importance to the raw material stage
because more investment, blocked for more number of days. So more importance should be
given for that. Then at WIP stage our major chunk is the raw material. Other components are
small so that should be given comparatively lesser importance or proportionate importance
should be given to the different stages while calculating the duration of operating cycle.
So there is a concept of calculating weighted operating cycle. There is a concept of calculating

weight operating cycle. Now what is the concept of weighted operating cycle? The weighted
operating cycle requires that when you are calculating this duration of 24, 22, 10, and 20 days it
is the simple duration that how much time it takes to convert the cash into raw material and raw
material into WIP.
WIP into finished goods, finished goods into accounts receivable and accounts receivables into
cash. But if you want to calculate the weighted operating cycle so what we have to do here is you
have to multiply this duration with something which is called as W or that is called as weight.
We have to calculate some weights or to these durations on the basis of the importance of these
durations we should calculate some weights and multiply these durations with the weights.
So that we can calculate more appropriate more meaningful operating cycle which is called as
the weighted operating cycle. So there is a concept of the weighted operating cycle and we will
learn how to calculate the weighted operating cycle. That is W weighted operating cycle means
WOC. It is not a simple operating cycle but the weighted operating cycle. So in this case what
we will do now. We will have to require 2 things.
One thing is the duration or number of days at the different stages that is called as duration that is
the DRM, DWIP, DFG, AND DAP. Similarly, DAR also DAR and DAP and second information
we require is that that duration has to be multiplied with the weight. So, so far we have learnt
how to calculate those durations, 5 durations but we have not learnt how to calculate the their
respective weights.
For learning the respective weights we will be now using certain formulas and we will be
learning how to calculate these weights so that we can easily calculate the weighted operating
cycle. So for calculating the weighted operating cycle we will have to calculate the weights so
how to calculate the weights?
Here we write here as the stage or the stages and then we write here as weights. These are the
stages and these are the weights. So we know or we will learn how to calculate the weights are
different stages; stages and weights. So we have different stages. First stage for us in the
operating cycle is the DRM duration of the raw material or raw material duration. This is called
as DRM. This is DRM right. We know how to calculate DRM.
Now we will learn how to calculate something which is called as WRM. WRM is the raw
material, weight of the raw material. Weight of the raw material. So weight of the raw material
will be, how to calculate it? Cost of raw material, cost of raw material per unit. Cost of raw
material per unit. Cost of raw material per unit divided by selling price per unit, selling price per
unit. Because we are taking at the weights that is the selling price.
Selling price will be the common denominator while calculating the weights. Weights are
required people say experts say that see that different inputs are different in their weights and
volumes. So when you talk about the raw material, cost of raw material it is 50-60% of the total
selling price or total cost of the product you can say, not selling price, the cost of the product. So
it should be given a different weight.
Then the WIP, raw material is already weighted and then some expenses which we are utilizing
like power, water, other inputs for processing that to the first stage then those expenses should be
added. So we should calculate the proportionate weight of the WIP. Then weight of the FG
finished goods and then the weight of accounts receivable and then the weight of accounts
payable.
So we are learning that we know how to calculate this duration and now we are learning how to
calculate the WRM that is the weight at the raw material stage and weight of the raw material
stage can be calculated that is cost of raw material per unit divided by selling price per unit.
Second stage is DWIP. Second stage is DWIP and the weight of this stage is WWIP. It is the
weight of this stage or the weight at this stage will be WWIP, WWIP.
And for calculating this what we have to do is cost of WIP cost of WIP per unit divided by
selling price per unit. Cost of work in process per unit divided by the selling price per unit. Here
while calculating the cost of WIP we use certain say pre-decided proportions. Then how to
calculate the WIP? WIP means work in process. So in this we will take the 100% cost of raw
material, 100% cost of raw material plus 50% of the other processing expenses OPE, 50% of the
other processing expenses.
Because finished goods requires raw material plus the processing expenses. Water we need,
power we need, other inputs we need. So the WIP stage we count them for only 50%. If nothing
else is given in the problem, only we will take into account is that is the cost of raw material per
unit full plus half of the processing cost per unit we will have to add to calculate the cost of WIP
per unit. Then we have to go for the DFG duration of the finished goods.
And for DFG we have to calculate the WFG. Weight of finished goods, and the weight of
finished goods is cost of goods sold per unit, cost of goods sold per unit divided by selling price
per unit, selling price per unit. COGS cost of goods sold per unit divided by the selling price per
unit. We do not add up the profit. We do not call it as the selling price. Cost of finished goods is
that we are taking only the cost part not the profit part so that is why it is called as the COGS.
While calculating COGS what you will take here that is 100% of raw material plus 100% of
processing other processing expenses OPE, other processing expenses 100% now. We have
taken 50% at the WIP stage. At this stage we will take the 100%. So this is how we calculate the
weight that is the WFG that is the weight of the finished goods and then we have the 2 more
weights.
So for calculating 2 more weights that is the next stage is the DAP duration of accounts
receivables, DAR. So in this case you have to calculate the weight of WAR weight of accounts
receivable and for calculating the weight of accounts receivable what we do is selling price per
unit divided by selling price per unit. This weight is always 1. So accounts receivable we assume
at the selling price not at the cost price.
So it is the selling price per unit divided by the selling price per unit. So weight is always 1 and
the last weight we have to calculate is that is for the DAP that is the duration of accounts payable
stage and the weight has to be WAP. So this is basically accounts payable. Normally come into a
distance because of what. It is only because of the raw material. Only because of the raw
material.
Because we buy raw material on credit or we have supplied the raw material on credit by
suppliers. So because of that the accounts payables exist in the balance sheet. So that weight will
be same. That is how to calculate that weight that is same that is cost of raw material cost of raw
material because your accounts payable are going to be same, what is the amount of your raw
material.
So cost of raw material per unit, cost of raw material per unit divided by selling price per unit,
selling price per unit. Cost of raw material divided by the selling price per unit so you can easily
find out the weight for this. So it means weight for the raw material stage, raw material duration
and for the accounts payable will be the same and for the others proportionately the weights keep
on changing and the total weights for all the 5 durations we can calculate.
So for calculating the weight operating cycle, for calculating the weight operating cycle how
would we calculate the weighted operating cycle? D that is called as the D weighted operating
cycle duration of the weighted operating cycle that you can calculate with the help of this
formula like WRM(DRM)+WWIP(DWIP)+WFG(DFG)+WAR(DAR). This duration of accounts
receivable you are multiplying with each other.
So this will give you the duration of the weighted operating cycle. Now simple change we have
made here is earlier this was only there. Now we have multiplied with this at all the 4 stages and
then for calculating the weighted, duration of the weighted cash cycle, you can use you can do
how you can do is that is the duration of the weighted operating cycle minus that is the WAP into
DAP, WAP into DAP. So this way we can calculate the weighted cash cycle.
So we are multiplying by the weights. So we are calculating the duration of the weighted
operating cycle and the duration of the weighted cash cycle. So how to calculate now the
weighted operating cycle, how to calculate the weighted cash cycle for that we will be using the
information given in the second problem and with the help of this information we will try to
calculate the weighted operating cycle, the information given in the second and third problem
and then we will be clear about that how to calculate the weighted operating cycle. That we will
do in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 12
Working Capital Requirement Assessment - I
Welcome students. So in the previous class we were talking about the operating cycle and that
too about the weighted operating cycle. So weighted operating cycle we learnt about that as
compared to the simple operating cycle or the non-weighted operating cycle it is better to
calculate or to work out the weighted operating cycle or the duration of the weighted operating
cycle because we should give the relative importance to the say different stages of the production
process or at the different stages of the production process.
Raw material because it constitutes the largest part of your total cost of production so it should
be say assigned more importance than work in process say only constitutes the raw material as
well as half of the processing expenses so comparatively the same importance and then to the
other stages. So just to make improvement over the simple or the non-weighted operating cycle
in the theory experts have dwelt the operating cycle which is far more improved.
More scientific and more supportive of the say assessment of the working capital requirement the
concept of the weighted operating cycle has been developed as I told you in the last class that it
is better to use the weighted operating cycle as compared to the non-weighted operating cycle.
We discussed in the class, in the previous class that how to calculate the weighted operating
cycle.
I discussed with you theoretically even some formulas also that how what is the way to calculate
the weighted operating cycle so what we have to do as we have seen in the class, in the previous
class that you have to multiply the duration at the different level or the different durations maybe
Drm that is duration of raw material or Dwip or duration of the finished goods or duration of the
accounts receivables as well as accounts payable with the weights with the respective weights
and how to calculate the weights we have already discussed that.
And I have say explained to you that how to calculate the weights. So we have seen there that for
calculating the weights we take the selling price as the common denominator and then against
the selling price we calculate the respective weights for the different stages.
So in that case when we were talking about the selling price as the common denominator we
have seen that say accounts receivable accounts payable as well as the weight of the say your
raw material stage is concerned that is the weight to be given to the Drm is the same with the
weight to be given to the say at the accounts payable because accounts payable appear in the
balance sheet of any company because of the purchase of the raw material.
When we purchase the raw material on credit so we have the accounts payable. So it means the
what is the amount of the accounts payable and what is the raw material if the say the total raw
material is purchased on the credit. Normally companies purchase the raw material, they do not
pay in cash for the purchase of raw material. So when they buy it on the credit we have to see
that how much material is purchased and how much accounts payable have appeared in the
balance sheet.
Because it maybe the time period which may defer. If the company is not having a very good
rating in the market so the credit period allowed may be less. But if the company has acceptable
rating in the market then the credit period can be as per the market say average or the as it is
being given to the other firms in the industry it will be given to all the firms. So we assume that
the raw material is being purchased on the credit.
And accounts payable appear in the balance sheet because of the raw material so in that case we
have to give the same weight to the raw material stage that is Drm and to the Dap. So we have
learnt in the class that how to calculate the weights for the different durations. Now we will do a
problem and with the help of that problem we will understand that what is the way to calculate
the weighted operating cycle or what is the length of calculating the weighted operating cycle.
So if you look at his problem which is we are now at the problem number 2. Problem number 1
we have done in the previous class and it is the problem of the simple operating cycle. It was not
a weighted operating cycle but now if you talk about the say problem it is the problem of the
weighted operating cycle and we know it that we need 2 informations. One is the information
about the duration and second information we require is about the weights.
So if you look at this problem problem number 2 say it is written here that calculate the weighted
operating cycle of RCW Limited from the following information or the information given here as
under. So we are given 2 kind of information here. One part is done. We are not to do this part. It
is already given to us. Say that is the duration part. See we are given the duration of the Drm that
is given.
The raw material duration is given to us means time period required to convert the raw material.
Raw material remains as raw material in the warehouse. So that is the duration which is already
given to us. We are not to calculate this duration which is 36 days. Then WIP duration or the
time period for how much time work in process remains as the work in process that is also given
to us that is Dwip that is 28 days.
And duration of the finished goods is also given that is 12 days. Duration of the say accounts
receivables is also given to us and that is 36 days and duration of accounts payable is 24 days. So
it means first part is given to us. We are not to calculate these durations our self and we have to
go for the second part and second part is the calculation of the weights. So we know that how to
calculate the weights and for calculation of the weights we have to now use the information
given here.
So we are given the information like the cost and the price structure of the company are cost of
raw materials and stores etc. per unit is Rs. 60 and processing cost per unit is Rs. 36 and selling
and administrative and financial cost per unit is Rs. 12 and selling price per unit is 120 Rs. So
this is the total.
So what is the total cost it works out as this works out as 60 + 36, 96 then 90 means 108 is the
cost. So we are selling the product at 120 Rs. It means the remaining is the margin of the firm.
This is the estimated cost. now we have to take the weights against the selling price so we have
seen the formulas and the way the process how to calculate the weights in the previous class and
now we will calculate the weights here.
So we are doing it that how to calculate the weights so let us say start doing it. Say for example
we talk about the information which is given to us and we have to now calculate the first way
that is called as W this we have to talk here as that say Wrm, weight at the raw material stage.
So this is, how to calculate this? What is the cost of raw material that is given to us was. If you
look at the cost of raw material that was given to us is that is say 60 Rs. the cost of raw material
processing cost is per unit is 36. So here I would like to remind you that when we calculate the
weight at the raw material stage that is Wrm, we take the raw material as to be divided by the
selling price being a common denominator.
But for calculating the WIP work in process you have to take the total cost of raw material but
the processing cost has to be taken as half because at the WIP stage the product is not fully
finished. It is half finished and it will be taken to the next stage or stages and then by incurring
some more expenses it will become the finished product. So in the normal case if nothing is
given to you in the question or maybe tomorrow in the real life.
So the standard rule of thumb is that we have to take the out of the total processing cost we have
to take the half of the processing cost not the full. So here for example we have the 60 Rs raw
material cost for calculating Wrm we will take this 60. But for calculating the WIP we will take
that is 60 plus half of this is 18 that is 60 + 18 to be divided by the common denominator that is
the selling price that is 120.
And then when you calculate the weight at the next stage that is the Wfg weight for the finished
goods so at that level you have to take the processing cost as full. So it will become that is your
108 and to be divided again by the selling price as the common denominator. So let us calculate
these weights and when we calculate these weights so we have to start with the first weight and
the first weight is that is Wrm weight of raw material.
So what is the cost of raw material, we have seen here is that is 60 divided by the here the selling
price is 120 so weight is that is 0.50. This is the weight of raw material. Then we go for the
second weight. WWIP and at this stage as I told you, you have to take the 60 + 18 is the half
means the half the processing cost and then is the 120 so you will be now calculating this. So this
works out as how much that is 65%.
Means 65% of the selling price is at the WIP stage we have already incurred and then we
calculate the next weight that weight is Wfg duration of the or weight of the finished goods. So
in this case when you calculate the weight of the finished goods this is 108 divided by the 120.
So now we have taken the total finished cost processing cost that is raw material and what is the
total finished cost is that was taken as if you look at the problem here we have taken the finished
goods.
Cost is 108 so let us go back and see here how we have taken the 108. I have taken the raw
material is 60, processing cost is processing cost is 36. So we have taken 60 + 18 at the WIP
stage that is say you can say 78 to be divided by the 120 so it works out as 65% or 0.65 and
finished goods stage is we have taken the 108. Now you will be wondering why I have taken the
108 here to be divided by the selling price.
See processing cost we have to take here is that is full processing cost 60 + 36 that is 96 and after
that the next set of expense is selling, administration, and financial cost per unit. So if you take
this head normally, normally see selling and financial cost is not the cost of finishing the goods.
It is not required. It is the other cost.
If you recall the cost sheet when we prepare the cost sheet for calculating the cost of production
cost of goods sold or cost of production we take into account your direct overheads that is the
material, labour, and direct expenses and then we take the other overheads and the other
overheads are say your administrative overheads, only administrative overheads because we need
the support of the administration for going for the production process.
Because if the purchase of the raw material has to be there office people are also involved. So we
account this cost as the part of the cost of production but not the selling and the financial cost.
Selling cost is after the cost of production that maybe the part of the cost of sales but not cost of
production. So we should normally while calculating the say weight at the finished goods we
should take only the processing cost as full and the administrative cost again as full.
But since in this case, in this problem this cost is not given to us as a separate component. We are
given selling, administration, and the financial cost per unit. So it is very difficult to segregate
this into 3 parts. So we do not know that how much is the selling, how much is the
administration, and how much is the financial cost. So what I am doing here, I am taking this
total cost as the administrative cost because it is not a very big amount.
And looking at the importance of the problem as well as the working out of the weighted
operating cycle we are taking this cost as the administrative cost or as full. So I have added up
the marginal cost, then the processing cost, and the administration cost which should be taken in
principle as administration cost and if you are given separately for example all the 3 costs are
given to us very clearly separately that you are given the administrative cost, you are given the
selling cost and you are given selling distribution cost, and you are given the financial cost.
So only take the administrative cost and you simply exclude the selling as well as the financial
cost that is not to be the part of the cost of production. So administration we are taking and in
this problem we are assuming that entire cost is the administrative cost maybe the selection of
selling and the financial cost is very small so which will not impact your say calculating the
weights.
So when we are calculating this the weight of your finished goods so we will be taking into
account here that is the Wrm we have calculated that is half that is 0.50, Wwip is 60 plus your 18
that is 0.65. At Wfg stage we have taken 108 divided by 120 and the weight works out here is
that is the say how much this is 90%. This weight will be 90%. So it means this is the 0.90.
We have taken this weight here and now we have to calculate the next weight that is the weight
ar that is the weight for the accounts receivable. If you calculate the weight for accounts
receivable so we are taking accounts receivable yes. Now when you calculate the accounts
receivable we will be taking here at the selling price. So we have seen in the previous class that
what is the formula of calculating the weight of accounts receivable?
We will be calculating this as the selling price divided by the selling price. Because accounts
receivables include the profit also. Accounts receivables include the profit also. Now here I
would like to say add something that see when we are talking about the here assessment of the
working capital requirement. One school of thought in the theory you will find is some people
will say that profit is not going to be invested by the firm.
Profit is not going to be invested by the firm. So why should we take into account the profit
while calculating the accounts receivables. Why should we take the profit as a cost while
calculating the accounts receivables. Because accounts receivable, because firm’s funds are
blocked to what extent. They are blocked on account of material. They are blocked on account of
processing cost. They are blocked on account of the administrative cost. Our profit is not
blocked.
And we are assessing the assessment is this assessment of the working capital requirement means
how much investment we have to make. So profit we are not investing so why should we include
this while calculating the accounts receivable. But see there is a another school of thought that
accounts receivable or the profit when you talk about the profit that is also going to be the
earning to the firm.
So it is treated or it should be treated like that though the profit is the result of the business
operations, manufacturing and selling in the market but you assume that profit we are also going
to receive the profit so you assume that profit is also invested in the business and when we are
doing the business so profit is also the part of the total investment. Profit though it is a result of
the business but it is a it is considered here as the part of the as a part of the total investment we
are making here.
So for example if you recall when we prepared the balance sheet. In the balance sheet we show 1
item as say sundry debtors and sundry debtors are we are showing the sundry debtors at the
selling price. We are not showing it at the cost price. Sundry debtors include the profit also. So it
means if any debtor becomes a bad debt it is not only that we are not recovering the cost of
investment or the total funds we have invested in the business, we are not recovering the profit
also.
So loss is the of both, cost as well as of the profit. So here for calculating the accounts
receivable, for calculating the accounts receivable especially I am talking here is that we have to
keep the difference in mind that when you are calculating the weights you will have to say take
the weight that is the War for calculating War you have to divide the selling price by selling
price and the weight will be 1.
However, when tomorrow in the real life when we will calculate the assessment of working
capital requirement if we are given certain information which we will discuss in the next class so
in that case what we will do? We will take the for calculating the investment we will calculate
the accounts receivables at cost not at the selling price. But for the weight sake here only for the
weight sake we are taking the say accounts receivable we are calculating.
Because accounts receivable we are not only while selling that product in the market we are not
recovering the cost, we are recovering the profit also. So accounts receivables normally in the
balance sheet are also taken at the selling price. So here also it has to be taken at the selling price.
However, while calculating the investment part in the real life tomorrow we will take the
accounts receivable at the cost price.
So it means here we will take the accounts receivable at the selling price and the selling price
here is that if you talk about the selling price, selling price here is your 120. So 120 to be divided
by 120 and it is going to the weight of the accounts receivable is going to be the 1. This is the the
weight is 1. And now we have to go for the next weight that is the weight of accounts payable.
For calculating the weight of accounts payable we will have to take the same weight that is the
say we have taken the weight for this thing that is the raw material weight and that is 0.50. So
this will be again 60 divided by 120 and this weight will be again 0.50. This is how we are
calculating the weights. So only for calculating the weights accounts receivables will be at the
selling price.
But working out the accounts means investment on account of say working capital investment in
the accounts receivables we will calculate that at the we will calculate that at the cost price. Here
one more thing I would add here. For example you are asked that you have to assess the working
capital requirement for a firm depending upon the different information given to us that is the
duration given to us, investment to be made at the different duration, the total operating cycle
duration is also with us, everything is with us.
So while calculating and means sorry and at the same time you are asked 2 things. One thing you
are asked is that is to calculate the working capital investment requirements and second thing is
to prepare the balance sheet also. So what we will do? While calculating the working capital
investment requirements we will count the accounts receivables at the cost price. But while
preparing the balance sheet while showing it in the balance sheet we will be showing it at the
selling price.
Because in the balance sheet accounts receivables include the profit also. So some changes are
here. So we are calculating the weight. Weights are available with us. Wrm is half that is 0.50.
Wwip is 0.65. Wfg is 0.90. War is 1. Then Wap is the 0.50 right. so in this case we have learnt
that how to calculate the weights and now we will move the next step to calculate the weighted
operating cycle. For calculating the weighted operating cycle we will now that is what we are
going to do here is that we are calculating the duration of the weighted operating cycle and this is
duration of weighted operating cycle.
So it is Dwoc that is the duration of the weighted operating cycle. So we know the formula that is
how to calculate it Wrm multiplied by the Drm then plus Wwip, Wwip multiplied by the Dwip
duration at the weighted operating cycle. Then it is the plus Dwfg multiplied by the Dfg duration
at the finished goods stage and then we have to go for the say duration W. We are multiplying
with the way so W accounts receivable, War multiplied by the Dar.
So this is going to give us the total duration of the weighted operating cycle. So we know it that
how much information we have and if you look at the information we have got the weights. So
weight at the raw material stage was 0.50 and to be multiplied by the duration and duration is
given to you and that duration is 36 then plus War is that is 0.65. We have calculated the weight
0.65 multiplied by the duration of Wwip. This is the 24 days.
For 24 days the material remains at the processed stage. Then is the next thing is the finished
goods. Finished goods was 90. So it means it is 90%. So it is 0.90 multiplied by how much is the
duration of the finished goods 12 days. It remains at the finished goods stage for the 12 days and
then we have to go for it plus 1 multiplied by this is 36. So we are taking the duration of the
accounts receivable is 36. It means this firm is giving the say time to the credit buyers 36 days.
So if you take this duration as 36 days it means this is worked out. So how much is the duration
here we take 18 then we take here is the that is 15.6. Then we take it here as the 108 that is 10.8.
Then next is the plus 36. So we are taking the total amount. So how much it works out as total
duration is 18 and that is 33.6. Then it is 30, 43.6 and 44.4 and then is 44 and 36, 80.4. So total
duration of the weighted operating cycle is how much, 80.4 days.
This is the total duration of the weighted operating cycle. This is the this is how we calculate the
weighted operating cycle. Now we calculate the duration of the weighted cash cycle. So for
calculating the duration of the weighted cash cycle so we have the duration of the weighted
operating cycle minus we have the we have to subtract here something that is the Wap and
multiplied by the duration of the accounts payable. So you have to subtract this.
If you subtract this from this so it means we have got this duration of the weighted operating
cycle is 80.4 minus how much is the weight of the accounts payable. This is the same weight that
is 0 point you can say 0.50, 0.50 multiplied by what was the duration of the accounts payable it
was given to us was 24. If you take this and solve this so this works out as how much? 80.4
minus this is 12. So this will be how much 68.4 days.
This is the duration of the weighted cash cycle. Means your total funds will be blocked in the say
process right from the cash to be converted into cash, the whole process will be requiring the
total period of 68.4 days or you can say 68 days or 69 days or something around this. So 68.4
days we have calculated here. So this is how we calculate the weighted operating cycle and this
is more you can call it as scientific or acceptable or useful.
Because we are say providing the weights at the different stages. Half of the weight we are
giving at the raw material stage because it is a bigger chunk of the total cost of production or
maybe in the total selling price you talk about your major component is the raw material. Then if
you talk about the weight of the work in process it is 65%. We are giving the weight as 65%
because we are adding more cost at this stage Wip and weight becomes 90%.
Because the finished goods at the finished goods stage total investment increases. Means at these
3 stages or even the fourth stage that the weight is 1. All the 4 stages there is outflow of the
funds. There is no inflow. So we are investing the funds now. So we have to calculate that
duration that for how much time we are investing the funds so we are taking this so weight is
50% in this case 65, then 90 and then 101 that is 100% .
That is at the accounts receivable stage and for the accounts payable we have given the same
weight as in case of the raw material because accounts payable appear in the balance sheet
because of the raw material purchase of the raw material. So in this case you will be knowing
that how to calculate the weighted operating cycle. So we should normally use the weighted
operating cycle which is more useful, more scientific, and it is going to give us the better results.
Here one point of caution I would like to give you that this duration of the operating cycle, this
duration of the operating cycle is only indicative. This is not perfect. Only we are getting a broad
estimate that the weighted operating cycle if the accounts payable are allowed for 24 days in that
case can be of the order of or of the duration of 68 days. But this is indicative I am telling you. In
the real sense this operating cycle maybe of 70 days. It may be of 60 days.
But it will revolve around this 68. So you do not consider it as a 100% true results that the
certainly it is going to be 65. After getting this figure with the help of this weighted operating
cycle process we will have to make the internal adjustments. For example we are assuming that
raw material we are assuming here that the duration at the raw material stage is 36 days but we
can actually we can reduce this duration also or it can go up also.
Similarly, work in process normally it is the duration is 24 days but that will happen only if the
power is regularly available or the water is regularly available, all other inputs are regularly
available. Then it is fine. But if these inputs are not easily available or sometimes there is a
disruption, there is a unforeseen situation. Sometime there is a power cut and we are expecting
that the power cut will be only for say 6 hours. We will have the power for 18 hours.
Maybe because of change of season, in summer the power cut is more. So firm is getting the
power only for 12. So in that case this time period will increase. Raw material we are expecting
it will be easily available. But sometime there is a shortage of the raw material. So if the raw
material is not available or if the power is not available. Similarly, the other finishing or the say
other expenses processing expenses are not or the items are not available.
In that case this operating cycle maybe of the more duration. So this this how we are calculating
here with the help of this formula or this process this is only indicative. For finally arriving at the
duration of the operating cycle what you have to do is or what the firms normally do is they
make the internal adjustments after getting this figure. So it is very important to get the to do the
internal adjustment after getting this figure.
Now finally, for say once we get the duration of the operating cycle how to now make the say
how to assess the working capital requirement the simple and the best way to do that is that we
have a formula here that finally the say working capital requirement assessment, that is working
capital requirement assessment.
Working capital requirement assessment. So if you have to say assess the working capital
requirement so working capital requirement can be assessed with the help of this formula say
working capital requirement is equal to what is the formula here? Formula is that is COGS cost
of goods sold per day, cost of goods sold per day multiplied by we have to have something here
that is multiplied by the weighted operating cycle WOC weighted operating cycle.
And in that case we have to close the bracket plus the amount of the cash and bank balances.
Cash and bank balances, cash and bank balances. This is the formula here. So now with the help
of this cost of goods sold per day multiplied by the weighted operating cycle and cash and bank
balances. If you look at this formula what we have to find out here is we going to find out the
working capital requirement. So we need the cost of goods sold per day.
That will be easily available to us that what is the annual cost of goods sold divided by 365 so
per day cost you will be able to find out and then weighted operating cycle duration we are able
to find out that is how we have just calculated and plus cash and bank balances. Apart from the
investment we are making in the raw material in the work in process or in the finished goods or
in the say accounts receivable firms keep some amount of cash as cash and bank balance right.
So we have to add up some margin for that and while adding up the margin for that what you
have to do here is that you have to say add some amount of the cash and bank balance which the
firms will be requiring to keep in the form of the cash not to invest in the raw material in the
processing cost or in the accounts receivable. So for example we assume some figures here. Say
your for example cost of goods sold per day is how much is 40000 right.
Cost of goods sold per day is 40000. So it is cost of goods sold per day is 40000. So we take it as
40000 and multiplied by weighted operating cycle. We take the duration of. We assume the
weighted or duration of weighted operating cycle is 64 days. So this is going to be some amount
and plus cash and bank balances. So if you talk about the cash and balances, bank balance we
need to keep say for example 40000 as a cash.
So what is going to be now the final working capital requirement if you are multiplying the
40000 by 64 days. This is the cost of goods sold per day. Cost of goods sold per day is for
example your cost of goods sold is whatever the total amount annual divided by the 65, 365 or
360 days and multiplied with the weighted operating cycle. So if you work it out this works out
how much.
This is 25 lakhs and 60 thousands plus cash at bank balance requirement is how much? This is
the, the requirement is 40000. This is our total requirement 40000. So total requirement, working
capital requirement for thif firm is going to be how much that is 26 that is 26 lakhs. So we have
worked out the total requirement is that is 26 lakhs rupees, 26 lakhs this is our total requirement
which we have worked out.
So you have to have certain information means till now what we discussed? For calculating the
working capital requirement or assessing the working capital requirement first of all you should
have the duration of the different levels of your material will be raw material, then WIP, then
finished goods, and then accounts receivables and accounts payable. After that you should have
the information of the cost that what is the cost of raw material, what is the cost of processing.
What is the say cost of you see the other administrative overheads. So this information and then
the total selling price. So with the help of this we will be able to calculate the duration. We will
be able to multiply the duration with the weights and once you calculate the this weighted
operating cycle then the total annual cost will be available to us and that will be divided by 365.
So it means we will be able to find out the COGS.
So COGS multiplied by the weighted operating cycle and the cash requirement which we want to
keep as cash if it is available with us so in that case the total working capital requirement can be
assessed which works out as 2560000 + 40000 we want to keep as cash. So total requirement is
26 lakhs. So this is how we assess the working capital requirement and we will be say calculating
in the real life also the industries the firms in the real life also they also calculate the working
capital requirement this way.
So it means it is a very simple process, quantitative process. But the caution here is the duration
of the operating cycle which we have calculated that is the weighted operating cycle you have to
adjust accordingly because the number given by this formula is not the final. Internal
adjustments are required and if other information is available with us then the total working
capital investment requirements can be worked out and the firm can be more smooth, more
comfortable.
They would not be keeping high amount of current assets, not a low amount of current assets. So
firm will be avoiding the risk also because of the optimum liquidity and they will be having the
optimum level of current assets also. So the profits will also be as per the estimates or as per the
requirements of the firm and means overall a balanced scenario can be expected. So this is all
about how to assess the working capital requirements.
So I will stop here in this class. In the next class we will do some problems, some problems
where we will learn how to calculate the working capital requirement of the firms if some
information with regard to duration and the financial investment part is also given to us then how
to work out the working capital requirement of the different firms. Thank you very much.
Dr. Anil K. Sharma
Lecture - 13
Working Capital Requirement Assessment - II
Welcome students. So in the previous class we were discussing the estimation of working capital
requirement the process of estimation of the working capital requirement and we saw that based
upon the length of the operating cycle that to the weighted operating cycle how to access the
working capital requirements of a company and finally we tried to learn that with the help of a
formula we can assess the total working capital required over a period of time or in the 1
operating cycle.
So we saw that, that was a cost of goods sold per day multiplied by the weighted operating cycle
that the duration of the weighted operating cycle plus cash and bank balances. If you use that
formula you can assess that for a firm for which we are working or anybody is working and he is
in the finance department he want to assess the working capital requirements of that company.
So that way he can assess or he or she can assess that this much is the working capital
requirement of the company in the given one operating cycle. So multiplying by the number of
operating cycle in a year you can see you can easily calculate how much working capital how
much short term finance will be required.
So carrying the process forward in the same direction we will be now discussing some problems
that how to assess the working capital requirement by using the duration of the operating cycle or
different stages of the operating cycle like raw material, work in process, finished goods, debtors,
accounts payable all these durations if you are if you are able to successfully work out these
durations.
Then we can estimate that in the one operating cycle how much raw material is required, how
much manufacturing expenses are required, how much selling administration and financial
expenses are required or how much will be the say selling price. So we will be able to easily find
out. We will be able to assess it. But the base of this estimation is also the operating cycle.
That if we have correctly estimated the duration under the operating cycle that is the duration of
raw material or the work in process or finished goods or debtors then I think it will not be
difficult for the firm but again it is a point of caution. I am cautioning again that this is only
going to give us a broad estimate of the working capital requirement of the firm. This is not the
final figure.
That figure is that we are going to arrive at the say figure nearest to the accurate figure but
accuracy has to be achieved by internally adjusting these figures we are going to work out and
then finally we can make out that something more or something else as compared to this we have
worked out will be the actual requirement of the firm. So let us discuss the problems. Here I have
say uploaded 5 problems.
Out of this I will solve 3 and remaining 2 you can do yourself and then you can refer to different
books where these problems available are given and then you can be clear about the concept of
say estimation of the working capital requirement by following the concept of operating cycle.
So let us discuss the problems. This is the first problem with us and this problem says that.
the different components of the say manufacturing process are available with us that is raw
material, manufacturing expenses, selling, administration and financial expenses. Then we have
selling price that is given to us and then we are given the different durations of the operating
cycle that raw material remains as a raw material for a period of how many months, 2 months.
Work in process remains in the stage of work in progress for a period of 1 month.
Finished goods take half month to say convert into sales and finally sales partly maybe on the
cash but partly around the credit and the credit period allowed is 1 month. So if you look at the
duration of this operating cycle given in this problem this works out as how much 4 and half
months. So total duration is raw material stage, work in progress stage, then finished goods
stage, then is the debtor stage.
So cash we are for example if we are investing cash today then after 4 and half months this
company will be able to recover the total cash back so it means it does not happen that one
operating cycle will start after the another means second operating cycle will start once the first
is finished. That does not happen. Many operating cycles simultaneously start and the production
process being a continuous process so what happens?
That when the first stage of raw material when it moves from the warehouse to the plant then we
replace that material with the new material which is coming from the supplier’s place to our
warehouse and when it moves from the one say process and the manufacturing process from the
one process to the next process then the previous process is also replaced by the material coming
from the warehouse.
When it moves from the first process to the second or the final process then that first step is also
replaced by the new material coming from the beginning of the process. So that it is a continuous
process. It does not mean that if the operating cycle’s length is 4 and a half months it means in a
year firm will be able to complete somewhere around say 2.5 or maybe around 3 operating cycle
that does not happen.
Because it is a continuous process so 4 and a half we are not going to wait for one operating
cycle to complete in 4 and a half month then only the second will start. It is a continuous process
but normally we can say that one lot of production which we will start on any date in a year that
will take that the cash invested in that that will take to again come back to you in 4 and a half
months.
So we can understand that how much working capital can be required by the firm. So in this case
we are given the figures and we are given on the basis of say raw material, work in process stage,
finished goods stage and the debtor stage. So if you calculate I think it is written here also that
assuming the monthly sales level of 2500 units estimate the working capital requirements if the
desired cash balance is 5% of the gross working capital requirements and work in process is 25%
with respect to the manufacturing expenses. So it is a point of say to be noted.
It is important point say I told you in the previous class that normally while calculating the value
of the work in process we take full cost of the material whereas the manufacturing expenses or
the processing expenses are taken as half if nothing is given to us. But say for example in this
problem it is clearly given that manufacturing expenses will be 25% means 25% will be only
required at the work in progress stage.
And remaining 75 will be say after when it moves to the final stage then remaining 75 this 75%
manufacturing expenses will be required. So it means it is clearly given. If nothing is given then
we have to take the manufacturing expenses is half 50% but in this case it is clearly given it is
25%.
Similarly, the desired cash level is cash balance level is in the previous class also we saw that say
when we are calculating the working capital requirement we are say having cost of goods sold
per day multiplying by the length of operating cycle it was 64 days and then whatever the figure
comes into that we are adding the cash balance. So here also we will do that first of all we will
see that at the raw material stage how much capital will be required.
At the work in progress stage how much capital will be required looking at the cost of the raw
material manufacturing expenses and other processing expenses and the duration of the say
different durations of the operating cycle. So how much investment will be required in the raw
material stage. How much will be required at the work in process stage. How much will be
required at the finished goods level.
And how much will be required for the say selling on credit and as debtors supporting the
debtors or the credit sales how much capital we require. So it means when we calculate the
working capital we assume that in a given period of time we create current assets right and those
current assets are partly funded by the current liabilities and the different between the current
assets minus current liabilities comes from the long term sources.
Because that is the only net working capital. In this problem when we will solve this problem we
are given the information in such a way that only it is requiring the creation of the assets current
assets but not even a single penny is coming from the current liabilities. That is why it is clearly
written assuming the monthly sales level of 2500 units, estimate the gross working capital
requirements, gross working capital requirements is clearly given.
So gross working capital requirement means otherwise it would have been written as net working
capital requirement. So it means no penny is coming from the current liabilities. So it means we
are to create the current assets. But nothing will be coming from the current liabilities as
spontaneous or short term finance so it means this is a gross working capital requirement and
entire amount, entire amount which we will work out now will come from the long term sources.
So gross current assets means funding of the total gross current assets will be from the long term
sources so entire amount is a gross working capital or you can say it is nothing coming from the
current liabilities so it means total investment has to come from the sources other than the current
liabilities. So let us now work out the say this process we will follow a process and we will work
out that how much investment is required at the raw material stage.
Because raw material is remaining as a raw material. Say when we purchase the raw material
when it comes to the firm or the warehouse of the firm it stays there but remains as a raw
material or we have to keep the stock of the raw material for a period of 2 months. So when you
are keeping the material for 2 months you have to support it with the financial investment. So it
means for 2 months your funds will be blocked in the form of material.
Then it will move to the next stage to work in progress stage so it will be blocked for 1 more
month. And then it will be material cost plus the 25% of the processing expenses and then when
you move to the next stage that is the finished goods stage then half month will be means 15
more days will be required to block it or it will be blocked for 15 more days and then when we
sell it in the market the part of the production which we sell on credit that will be blocked for 1
more month.
So it means total investment which we are making in creation of these current assets will be
blocked in 1 operating cycle for a period of 4 and half months and then we will be able to
liquidate it or to convert or get the cash back what we have invested that we will be able to get
back so it is a normal period of the 4 and half months. That is the duration of the operating cycle.
So now taking the or making the use of this say cost information as well as the operating cycle
information we will now work out the say working capital requirement.
And as I told you since nothing is coming from the current liabilities so total funds will be
calculated in the form of the gross working capital requirements and they will come from the
long term sources. So now we will prepare a statement of the working capital requirements and
in this case we will prepare a statement which is called as a statement of working capital
requirements. So let us prepare the statement.
This is the statement of working capital requirements. So we are going to prepare this statement
and for this we have to have the we have to work out the total investment at the different stages
and when you work out this total investment at different stages so it means number one is the
investment at raw material stage. Investment at raw material stage. So we will have to work out
this investment. How much investment we are going to make?
Now let us see back if you if you see here raw material is raw material is say 100 Rs per unit and
how much is going to be the total production? Total production is going to be 13000 units per
year and it is written here that 2500 units are expected to be produced uniformly every month. So
it means monthly production is 2500 units. One unit’s raw material requirement is 100. So let us
see and the it is going to be blocked for a period of 2 months.
So let us see how much investment is required here and for this if we work out this requirement
so how to calculate this requirement? It will be something like this. How many units we are
going to produce 2500 units and what is the period for which it will be blocked. It will be
blocked for a period of 2 months and what is the cost of 1 unit of raw material that is 100. So it
means this is going to be something going to be the cost of raw material and here it is the cost of
raw material is Rs 5 lakh.
Now the second stage is investment at WIP stage, investment at WIP stage. So how much
investment we are going to make at the WIP stage. It is written here as that we have to take
100% of the raw material cost and the manufacturing expenses will be 25% only. So let us see
how much it works out. We will calculate here as number 1 is that is raw material. Raw material
is how much? We are producing 2500 units. Raw material is 100.
So how much it works out as this is total requirement is going to be 250000. This is one
component of the WIP cost and second component of the WIP cost is the manufacturing
expenses. So manufacturing expenses are how much. We will have to calculate manufacturing
expenses are you can say that is 25% of 25% of something like 25 into what is the manufacturing
expenses, let us see the manufacturing expenses here.
We have the manufacturing expense is 30. So it means 30, 25% of 25 into 30. So how much is
going to be this amount. This is going to be 18750. This is going to be the amount of 18750. So it
means how much is the requirement at this stage? 2 lakh rupees, 268750. This will be this much
investment will be required at the WIP stage and then we go for the third stage. Third stage is the
finished goods stage. Investment at finished goods stage.
So we will have to calculate now this investment rupees something which will work out. We will
see that how it is calculated. So raw material will be how much? Raw material investment will be
if you see this is going to be how much, 2500 units and at the rate of Rs. 100 and for how much
or half a month. So it means if you calculate this, this works out as we will keep it in the inner
column and this works out as 125000. This is the investment in the raw material.
We are going to have this investment in the raw material. So we will have to go for this
investment. So to say 125000 is for the raw material and then now see manufacturing expenses.
Manufacturing expenses at this stage are going to be how much, 2500 and into 30. We have to
take the total now here 30 and that is for a period of how much half a month. So we will take half
of it. So it works out as 37500. This is 37500.
So total amount we have worked out here is how much? That is 125000 and 37500. This works
out here as sorry we will have to make one change here that say finished expenses. So in the
finished expenses we have given something else also. If you look at the finished expenses total is
the manufacturing expense we have 30 and then selling and administrative expenses are 20. So
we will be taking here as the total amount is manufacturing expense is 25.
And we have one more head here. So one more head is the administrative expenses. So we will
take the administrative expenses also. So third head is add into this we will have to add in the
administrative expenses. Because administrative expenses are also required to be included in the
finished goods. So 25 into 20 into one and a half again. So this works out as how much? This
will be somewhere the total amount will be 25 into 25 into 20 that is 50.
So again this amount will come out as 25000. So total amount will be this is 25000. This amount
is 25000. So we will take the total cost. Now how much is the total cost here. This is the if you
calculate the total cost of the finished goods, total investment required at the finished goods stage
this is 0, this is 0 this is 5, and this is say this 7 and then this is going to be how much 0. This is
going to be 0. Then we have taken the 5.
Then we have taken 7 and 12 and then it is 5. If we calculate this works out as 17; 17, 1 and then
it is 4 then it is 5, 2. This total amount is going to be 5, 2, 7, and 8. So this is 187000. Total
investment required at this stage is 187500. This is the total requirement at the this stage and then
we go for the investment at investment at this is the investment at debtor’s stage. So investment
at sundry debtors stage.
How much is going to be the investment at sundry debtor’s stage? That is going to be say total
units are 2500 multiplied by 150. We will take the sundry debtors here for calculating the
investment requirements. We will take it as 150 not that at the selling price but at the cost price.
So this will work out as some amount and this is the say 375000, 375000 is going to be the cost
here. So this is the investment in the sundry debtors.
Now we will have to calculate something means total requirement we have calculated so far is
before the cash balance is if you take the total investment requirements before cash, how much is
going to be this investment requirement that is 500000; 2,68,750; 1,87,500; 3,75,000. So this
total investment works out as how much 13,31,250. This is the total requirement. But this is not
the working capital requirement, final working capital requirement.
Into this you have to add some amount as cash. So what is the cash requirement here? So say
requirement our next requirement is one that is we have calculated 4. So this is going to be the
5th requirement cash and bank balances, cash and bank balances we are going to keep.
And how much is the cash and bank balances required. We had the total amount. We have to
calculate it, how we can calculate? You can calculate it like this for example the investment
requirement before cash was how much 13,31, 250 and it is the it is written clearly. What is
written in the problem is that estimate the gross working capital requirements if the desired cash
balance is 5% of the gross working capital requirement.
So gross working capital requirement will be worked out after adding the cash. So we have
calculated the investment at the 4 stages. Fifth stage is keeping the cash and bank balances. So
that will be gross. So it means without cash it is only 95%. So up till this stage we have
calculated, this is only 95%. So it means for making it 100% we have to add the cash and bank
balances and for adding the cash and bank balances here how much it will be that 13,31, 250 and
we will take it as 5%.
So 5 divided by this 100 - 5. So it will be the total amount which we will work out here is that
amount will be something like that 70065 Rs. 70065 Rs you will add into this. So what was the
balance till date? This balance was if you take the balance forward so that balance was
13,31,250. 13,31,250 is the balance till now and in this you have to add something that is 70065.
70065 if you add so it means finally your gross working capital requirement will be how much?
Your gross working capital requirements, your gross working capital requirements will be
something like this. Your gross working capital, gross working capital requirements will be 14
lakhs one hundred and 14,01,316. So this works out as the total amount here. If you calculate the
total amount this will be say this is the amount not as finally if you take the final figure if you
round it off then what can you do here is that this is the not 65 but it is 66.
So this is going to be the 66 so that is why it is 6. Then it is 1, then it is 3, then it is again the this
1, and then it is 4, and this is this. So it is going to be 14,01,316 is going to be the gross working
capital requirement of the firm on the basis of this information given to us. So this is gross
working capital requirement. Why we are calling it as the gross working capital requirement.
Because this is the total amount which we require to create the current assets at the different
levels say for example investment at the raw material stage will be this much, at the WIP stage
will be this much and then the investment at finished goods stage will be this much and the
sundry debtor stage will be this much. This is the investment requirement means the creation of
current assets. But how much will come from the current liabilities that is 0.
Nothing is coming from the current liabilities from the short term or the spontaneous finance
nothing is coming. So in this case the gross working capital requirement is 14,01,316. So entire
amount has to come form the sources other than the spontaneous or the short term finance which
is we know it that it is going to be the long term finance. Total short term investment has to be
created or to be made from the long term sources.
Which is going to be a very expensive affair which is going to be a very costly affair for the firm.
But if they are not able to generate any funds from the spontaneous or short term sources in that
case they will have to arrange the funds from the long term sources and for the time being they
have to compromise with the profitability. However, firm will have the good or the sufficient
amount of the liquidity.
Because their entire amount is called as the net working capital. If this is the gross working
capital this is the net working capital because current liabilities are 0. So it means the say final
amount which is coming from the long term sources so there is no risk of liquidity if the firm is
able to manage the funds from the long term sources but because there is no risk so ultimately
firm has to pay a very high cost. So high cost will be affecting the profitability of the firm.
So this is how we can invest the or we can estimate the working capital requirements of the
different firms or different companies. So this is the first problem we could do and we could
understand that if no current liabilities are there then how much is the investment in the current
assets total requirement has to be fulfilled from the long term sources. So now we will move to
the next step further.
And that step will be that to do a problem out of these 5 where we have both the things, current
assets also current liabilities also and we can say that we will have to work out the net working
capital requirement that how much net working capital is required we have to estimate that.
Again we have to use the information given in terms of investment, in terms of duration, in terms
of the funds going to be available from the short term or the spontaneous sources.
So total investment we will work out like this as we worked out in this problem. Then we will
assess that how much funds will be available from the current liabilities and then what will be
the difference. That difference will be called as the net working capital which will come from the
long term sources. So we will move to the next problem here and for that in that problem we will
have to think that which problem is more useful for us to do.
If you see the problems here you can say that first we have done and then in this case second one
is also not very typical you can easily do it yourself. Probably we do the things to some extent
here and then we will move to the next level that is the problem number 3 and then problem
number 4 and then we have the problem number 5.
So in this case we will be taking about the problems here like say number 2 and problem number
3.
So if you talk about the problem number 2, I think it is better for us to do the problem number 2
because it is going to create a different situation as compared to the problem number 1 we did so
we can find out that how to calculate the working capital requirement of a company where we
have both the information’s about the current assets also, current liabilities also and how to
calculate the say net working capital.
So just go through this problem first of all before moving into or doing it practically. Let us
move to the problem that what is the problem and how to do it. So if you see this problem here.
General Electric sells its products at gross profit of 20%. It is a gross profit of 20% not the net
profit. It includes depreciation as part of cost of production. The following information for 12
months ending on 31st December 2017 are given to enable you to ascertain the requirement of
working capital of a company on cash cost basis.
Now it is a important question, cash cost basis. What is a cash cost? Because we have 2 kinds of
the cost. One cost is the cash cost and another is a non-cash cost. Because you are studying here
the working capital management so I assume that you already have the knowledge of financial
accounting and in the financial accounting say for example when you prepare the profit and loss
account there we include certain cost means which are cash cost.
For example raw material cost is a cash cost. Manufacturing expenses is the cash cost.
Overheads, other overheads power, water, electricity all these are the cash cost. Because you are
paying the cost in cash but there are certain cost like say you can say that is the depreciation.
Depreciation is a cost. You are going to add up in the total cost of production in the profit and
loss account maybe not in the trading account but that cost you are not going to pay to anybody.
Only it is a provision we are making in the profit and loss account and we are recovering the cost
which we have already made in the form of the fixed assets. So not counting about the non-cash
cost here we will have to only count about the cash cost and the cash cost is only the material
cost, manufacturing cost, overheads cost. That cost we have to take into account. So on the basis
of the cash cost we will have to prepare the working capital requirements of this company.
So it means the requirement is furthermore here that you will have to first calculate the cash cost
and then means cash manufacturing cost and then the cash administrative cost. Means the cost of
goods sold and cost of sales. Both the cost we will have to work. That is on the cash basis we
have to ignore the depreciation and further it is given in your working you are required to assume
that a safety margin of 15% of the net working capital will be maintained.
A safety margin of the 15% of the net working capital will be maintained. Cash is to be held to
the extent of 50% of current liabilities that is the 50% of the current liabilities, cash to be held to
the extent of 50% of the current liabilities. So it means for that purpose you must be knowing the
amount of the current liabilities first. The cash balance has to be added in the assets because cash
is the asset it is not a liability but how much cash and bank balance we have to keep is it is given
here that, that should be 50% of the current liabilities.
So you cannot calculate the total amount of current assets until and unless you have the value of
the total current liabilities. So you will calculate the current assets without cash first and then you
will calculate the current liabilities which will be available or the sources available and then you
will take the 50% of those current liabilities, you will add up those say that 50% amount into the
current assets so that way the total current assets the list will be complete.
From that total list you will subtract the current liabilities and then we will see that how much net
working capital is required and here it is written as the first point a safety margin of 15% of the
net working capital will be maintained. It means 15% net safety margin of 15% of net working
capital. So net working capital which we will work out that is the current assets minus current
liabilities 15% of that we will have to further work out.
And we will have to add up into that net working capital. So the net working capital will now be
here that is the current assets minus current liabilities plus 15% of the net working capital that
will be the total working capital requirements of this company on the cash cost basis. Further
information is given to, given here that there is no work in progress text to be ignored and then
stock of raw material and finished goods are kept at 1 month’s requirement.
Sales information is given. Material is given. Total wages and manufacturing expenses. Then
administrative expenses. Sales promotion expenses. Every information is given to us and from
this we can easily assess the working capital requirements of this company called as GE
Electricals. So how to do this and how to assess the working capital requirements of this
company that I will discuss with you in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 14
Assessing Working Capital Requirements – Problems 2 & 5
Welcome students. So let us do now this problem this is problem number 2 which is requiring
the assessment of working capital on the basis of current assets, current liabilities and then the
difference of these 2 will be the will be called as the net working capital which will be required
by the firm coming from the long term sources of finance and this we have to calculate on the
cash cost basis.
So when you calculate on the cash cost basis so we are clear that cash cost is the cost which is
without the non-cash cost. Total cost of production includes the cash as well as the non-cash cost
so like depreciation, amortization. These are some of the heads which are the say including the
cost which are non-cash cost. So we will not talk about those cost here. We will take only the
cash cost.
So before calculating the level of current assets and current liabilities, let us first work out what
is the cash cost. So we will calculate first the cash cost and then we will do the other things. So
in this case what is going to be the cash cost like say manufacturing, calculate the manufacturing
cost on the basis of the cash cost.
So we are going to calculate something like say calculation of manufacturing cost on cash cost
basis. Cash cost basis. So if you are going to calculate this on the cash cost basis, manufacturing
cost on the basis of the cash cost basis so what is the material consumed. First component is the
material consumed. How much is the material consumed? Material consumed is Rs.6,75,000
worth of the material has been used.
And then we talk about the wages, number 2 is wages. What is the total amount of wages paid?
This total amount of the wages is 5,40,000 right and then we have the cash manufacturing
expenses. Third component is the cash manufacturing expenses, cash manufacturing expenses.
So what is the cash manufacturing expenses if we see we have seen the material is 6,75,000.
Wages are 5,40,000 and manufacturing expenses, outstanding at the end of the year that is
60,000 Rs.
But it is written in the bracket these expenses are paid 1 month in arrears. It means this expense,
manufacturing expenses, this figure 60,000 is not only not for the whole of the year but only for
the 1 month. This is the one part which is outstanding that is only for a period of 1 month. It
means for the whole of the year the figure will be something different and that figure will be how
much? If we take this figure that figure will be Rs. 7,20,000.
This is the this figure is 7,20,000. So total, we will have to calculate how much is the cash cost
now. The cash cost is, this is 7,20,000. So what is the total cash cost here, cash manufacturing
cost I would say. The cash manufacturing cost is how much 6,75,000; 5,40,000; and 7,20,000.
How much this works out as? Total will work out as 19,35,000. This is the cash manufacturing
cost. But this is not the final cost.
We will have to calculate now the cost of sales. So into this you have to add something. Number
4 add administrative cost. So what is the administrative cost here? Administrative cost is given to
us. Let us check the administrative cost given. The administrative cost here is total administrative
cost paid as above. So total administrative cost is paid in the 1 month period but the total cost is
given to us is 1,80,000.
And then the second head of expense which is the indirect expense that is called as sales
promotion expense paid quarterly in advance. So this is 90,000 Rs. This is the total sales
promotion expense. So in this case we have to take the administrative cost. Administrative cost is
how much here? Total administrative cost is 1,80,000. This is 1,80,000 and then add sales
promotion expense. Sales promotion expense was how much?
We have seen it is total is 90,000 for the whole of the year. So this cost works out as how much
now? This is the final cost of sales. You can say cash cost of sales, cash cost of sales. This is
total is 2,205,000 is the total cost here. So this is the cost 22 lakhs and 5000 or in other way
around you can say it is 2 millions and 205,000. So this is the total cash cost we have calculated.
So here we have not taken here the any cost which you call it as the depreciation or anything say
non-cash cost.
Here raw material is also a cash cost component. Then the wages are also the cash cost
component. Cash manufacturing expense we have taken as cash. So we have calculated the cash
manufacturing cost first which works out as 19,35,000. Then it is the administrative expenses we
have added. Then we have added the sales promotion expenses. So this becomes the cash cost of
sales. So this is the manufacturing cost and this is the say cost of sales, final cost which is on the
cash basis.
Nothing on the sort of non-cash basis we have calculated here. Now we calculate now the say we
prepare the statement of working capital requirement.
Statement of, statement of working capital requirement. Statement of working capital

requirements we are going to prepare now this statement. So we will take here now the first
investment in the current assets. Investment in current assets. This is the investment in current
assets. So we have to take now the different current assets and if you take the different current
assets, first current asset is raw material or the investment in the say raw material stock.
Investment in the raw material stocks. If you take the investment in the raw material stock so
what is the your say raw material stock is how much. Let us check the raw material cost. The
cost of raw material is how much? Raw material consumed, supplier’s is for 2 months that is
6,75,000 and time period is how much? Raw material remains in the raw material stage is for
how period of time? Stock of raw material and finished goods is the first line, read the first line.
Stock of raw material and finished goods are kept at 1 month’s requirement. So it means raw
material remains as raw material for the equal to the 1 month’s requirement. So it means how
much it is going to be. This is the 6,75,000 is the cost of raw material which is say requirement is
material consumed supplier’s credit is for 2 months. So material consumed is that is 6,75,000 and
is only kept as a stock for 1 month.
So we will have to calculate it as a stock for 1 month. So it means 6,75,000 is for the whole of
the year. So it means we have to take it as divided by 12. So we will be calculating for 1 month.
So it means it is rupees how much? 56,250 Rs worth of raw materials investment will be
required. This is the one part. Then second requirement is the finished goods. There is no work in
process. It is written here that there is no work in progress. It is clearly given.
There will be no work in progress. It means we keep the raw material as raw material and that
raw material is then finally converted into the finished goods. So it means finished goods stock,
finished goods stock this is the finished goods stock. So finished goods stock is going to be how
much? What is the cash cost. here we will take the cash cost which we have calculated. Cash
manufacturing cost we have taken the calculated the cash manufacturing cost which is how
much, how much was that cost, 19,35,000. This is the cash manufacturing cost.
This is the required for the finished goods and the stock of finished goods we are keeping it for
how many time. Finished goods are kept for 1 month’s requirements. It means we are keeping it
for 1 month requirement. So total annual cost is 19,35,000. So we will be dividing it again by 12.
So it means monthly requirement here will be monthly investment requirement here will be
19,35,000 and that will work out as 1,61,250.
1,61,250 is the requirement, investment requirement for the finished goods. Then we go for the
third item that is the debtors, sundry debtors. Sundry debtors we are keeping the debtors as
sundry debtors and sundry debtors will be of what that is of the at the this we will be taking into
consideration the total sundry debtors will be including all the cost here but not the profit. So
cost is administrative cost and then we will be taking here as the sales and promotion cost also.
That too on the cash cost basis. So if you take this cost how much is this? This is 2 million
205,000. 22 lakh and 5000. 22,05,000 we have calculated this cost already and it is for how
much period of time? For 2 months. 2 by 12 if you calculate this cost works out as 2 by 12. How
much is this? This is 3,67,500. This is the investment in the debtors. And then next item given to
us is that is the we have taken the material.
We have taken now the manufacturing expenses means the finished goods stage there is no work
in process stage. So raw material stage, finished goods stage, sundry debtor stage because it is
written here that total time period is given sales at the 2 month’s credit. That is total sales we
have made this much. So material consumed we have already taken and finished goods we have
already taken.
So now one thing which was required here is cash to be held to the extent of 50% of the current
liabilities. So we will be able to calculate the volume of the cash once we calculate the amount of
the current liabilities and after we calculate the net working capital we will add 15% of that. So
in this case now we will have to calculate the something like say 1 item more. One more current
asset here is sales promotion expenses paid quarterly and in advance.
Sales promotion expenses paid quarterly and in advance. So it means we will have to go for here
before we talk about the cash we will write here sales promotion expenses paid in advance. It
means this is a prepaid expense and prepaid expenses are also assets. So once you have to make
the pre-payments so it means you will have to make this investment also. Total is 90,000 given
in the problem.
So we are taking it for the 1 quarter and that works out as how much 22,500 and we will go for
the fifth requirement that is the cash and bank balance. Cash and bank balance. That we will
calculate after we calculate the current liabilities level. Now we go to the next stage and that
stage is the current liabilities. Current liabilities how much funds are going to be available from
the current liabilities.
So current liabilities are first, we will see the number one is the sundry creditors. Sundry
creditors. Sundry creditors you can see here that material consumed supplier’s credit is for 2
months. So that is for a period of 2 months. So how much is the total material we are using? We
are using the total material of say Rs. 6,75,000 and for a period of 2 months we are getting a
credit.
So it means this much of the funds will come from this much of the funds will come from how
much funds will come from 112,000 will come from 112,500 this will come from the sundry
creditors and the next item is the say outstanding wages. Wages we are also paying after the lag
of some time so outstanding wages will be how much? Outstanding wages will be something like
here how much is the outstanding wages? Total wages paid at the beginning of the next month.
It means at least for a period of how much 1 month we are getting the credit of the wages.
Normally we get the credit of wages for a period of 1 month. So it means this total amount of the
wages is how much? 540,000 and we are getting the credit for 1 month so it means this is for 1
month we need not to worry about paying for the wages. So this amount works out as how much
45,000. So this is the amount, 45,000.
This much credit is available to us and then we will be talking about the manufacturing cost. here
next thing is the if you look at the problem here manufacturing expenses outstanding at the end
of the year is 60,000 and these are paid 1 month in arrears. So it means cash manufacturing
expenses. These are the manufacturing expenses. So cash manufacturing expenses which we can
pay in arrears. Cash manufacturing expenses these expenses we can pay in 1 month in arrears.
So it means their outstanding 60,000 is so total we have seen is that is the total amount was how
much total amount was say 720,000. So we are taking here as 60,000 which is outstanding for a
period of 1 month and then what else is there? We have to see now the something like anything
which we can pay total administrative expense is paid as above, 1 month in arrears. So
administrative expenses we also pay in arrears.
It means total expenses are how much 180,000. So out of 180,000 1 month is paid in arrears. So
it means administrative expenses you can say outstanding, administrative expenses they will be
paid in arrears. Total is how much? 180,000 and divided by 12. So we are getting here 15,000.
This much of the credit will come for a period of 1 month from the outstanding administrative
expenses which we can delay the payment.
Then we have how much we have taken the 4 items here. Current liabilities 112,000 is the
sundry creditors 112,500 is the sundry creditors. Wage credit is available for the amount of
45,000. Cash manufacturing cost is available as 60,000 and then we have the administrative
expenses which we also can pay at the arrears of 1 month. So that is 15,000. How much this
works out if you calculate this.
Total current liabilities, you will say here as the total, total current liabilities. Total current
liabilities are how much? Here we have to see, this will be 0. Then it is 0. Then it is how much?
This is 5. And then we will have to take this is 232,500. 232,500 is the total amount of the
current liabilities. Now we have got the figure of current liabilities 232,500. So it means now we
can fill this column that is the cash and bank balance required.
Cash and bank balance required will be half of this. 50% of the current liabilities. So it means it
is 116,250. 116,250. So the total amount of the current assets is going to be how much? If you
take the total amount of the current assets now, we write here total current assets. Total current
assets will be how much. That amount will be if you total these figures that is 56,250, 1,61,250
then 3,67,250; 22,500; 116,250. This amount works as how much? 7,23,750 Rs.
This is the total current assets. This is the balance of the total current assets. These are the total
current liabilities. Now let us see the say excess of current assets over current liabilities. Excess
of current assets to current liabilities. This is going to be the excess. It means this much of the
level of the investment we require. 723,750 worth of rupees of the current assets we will have to
build up over a period of 1 year.
And this much of the funds will be available from the current liabilities over a period of time. So
it means this is how much? That is 232,500 will be available from the current liabilities. So what
is the excess of current asset to current liabilities or current asset over current liabilities that
amount will work out as 491,250. This is the total excess and in this excess in this excess
amount.
So this is the total excess and against this excess it is written here something like this if you look
at a safety margin of 15% of net working capital will be maintained. So it means a safety margin
of this is actually a net working capital current excess of current asset to current liabilities is net
working capital. So it means we have to maintain a margin of 15%. So it means add here add
safety margin, safety margin at the rate of 15%.
This will be how much if you take the 15% of this, this will be something like 73,687. So if you
take this and then we will move to next sheet so here the total working capital requirement.
Total net working capital requirement on cash cost basis, cash cost basis we have worked out is
that is 564,937. This is the total requirement. 564,937 is the total requirement that is the total net
working capital requirement on the cash cost basis we have worked out worked out is this. so in
this if you look at the whole process, investment first we have to calculate the say cash cost.
Cash cost we have manufacturing cost we calculated 19,35,000.
Then we calculated the total cash cost, cost of sales on the cash basis which was 2,205,000 or
22,05,000. These 2 costs we worked out and then we assessed the level of the current assets
requirement and while assessing the level of the current asset how much current assets we have
to build over a period of time in a period of 1 year. So we saw that this much is required in the
raw material. This much is required in the at the finished goods stage.
This much is required to invest it at the sundry debtor stage. This much is required to support the
sale promotion expenses which have to be paid in advance. These are the prepaid expenses. Then
we have the cash and bank balances. All the times we have to keep the cash and bank balance
because minimum asset as a cash or the bank balance has to be maintained which was 50% of the
current liabilities figure here.
And then we saw that for this funding of the total investment in the current asset that is 7,23,750
this is the total size of the current assets we are going to have for the whole of the year. So for
this 112,500 will come from the sundry creditors. It means suppliers are going to give us this
much of the credit. Wages we are going to pay at the lag of 1 month. So it means 45,000 we need
not to worry. This will be all the times available to us.
Cash manufacturing cost is going to be 60,000 so it means this is the this was the manufacturing
expenses, 60,000 we are paying in the arrear of 1 month. Similarly, administrative expenses are
also being paid at the arrear of say 1 month and the amount was 15,000. So in total the total
funds available to us from the spontaneous finance was 2,32,500 Rs. This much was available.
So it means when we calculated the excess of current, this is not the net working capital.
So we are calling it as a current, excess of current asset and current liabilities. This is net
working capital but at this stage we have to add something more. That is why I am not calling it
as the net working capital I am calling it as the excess of current asset to current liability. This is
491,250 is the excess of the current assets over current liabilities and in this we have to add the
safety margin, at the rate of 15% so that works out as 73,687.
So when you are adding this safety margin also into the excess of current asset over current
liabilities so investment requirement is further going up and then total investment net working
capital requirement becomes on the cash cost basis 564,937. So what is the difference between
this problem and the previous problem? In the previous problem you have seen that we have only
calculated the this part that is the current assets part.
We have not got any funds from the current liabilities. So it means the total investment up to this
level has to come from the long term sources. If there is no spontaneous or short term finance
available then total investment has to come from the long term sources but in this problem we
have seen that we require this much total current assets and this much of the funds are coming
from the current liabilities.
So it means some part is coming from spontaneous sources of the finance. Then we will see that
now we have got this much further requirement of current assets which are more than the current
liabilities so we will fund it from the short term sources first that is borrowing from the bank or
financial institutions or factoring or maybe other sources and still if there is a requirement then
that requirement will be fulfilled from the long term sources.
So the total requirement we have worked out here is that is the 564,937 Rs of the working capital
is required. This is the total working capital requirement assessment of the total working capital
requirement for this company. Now after this problem we will move to the next problem and out
of these 5 problems I am moving to the last problem now, problem number 5 and in the problem
number 5 we will have something more say additional information.
In that problem what you have to do is you will have to you have to say prepare number one is
the working capital statement like this what we did in the problem number 2. So you will have to
assess the current assets requirement and the current liabilities, funds available from the current
liabilities and then you have to see that how much net working capital is required. Apart from
that you will have to calculate the net profit also and prepare the balance sheet also.
So it is a comprehensive problem, interesting but comprehensive problem where you have to do

3 things. First thing you have to do is you have to assess the working capital requirement by
assessing the requirement of current assets and current liabilities and then you have to go to
prepare the profit and loss account on the basis of the information available and then you have to
prepare the balance sheet.
So 3 things are required to be done in the problem number 5 and remaining 2 problems that is
problem number 3 and 4 because I am doing first, second, and fifth; problem number 3 and 4 you
can try at your level yourself and if you have any problem or any doubt you can raise your
queries during when the course will run and then we can discuss these problems. You do it or
sometime you can send these problems after solving it through mail to me.
And then I will see to it that if there is any problem or if there is any issue then we will discuss
jointly mutually on mail or maybe while addressing your queries but I would like that you try to
do these 2 problems yourself and assess the working capital requirement net working capital
requirements of these companies which are given in the problem number 3 and 4. Now let us talk
about the problem number 5.
This is the last problem for this particular topic for us that how to assess the working capital
requirements of different companies. So this will be the last problem and remaining problems
you can find in the books, number of books are there. I will tell you in the next class the number
of books you can refer to and but the basic book which you have to follow for this subject is that
is the Working Capital Management by Hrishikes Bhattacharya.
That is a PHI Publication and that is Working Capital Management by Hrishikes Bhattacharya.
That is little complex book but if you read that book you will be more clear about the many
aspects of the working capital management. Apart from the Hrishikes Bhattacharya’s book there
are many books say all the books on financial management.
One say section of any book on financial management whether it is written by Prasanna Chandra,
I.M. Pandey, or J. C. Van Horne one section is say devoted to the working capital management.
So you can refer to any of the financial management books also but that is the as a reference
books. Basic text book I would request you is that you should follow the Hrishikes Bhattacharya
working capital management by Hrishikes Bhattacharya that is a PHI Prentice Hall of India
Publication.
But these problems will not be available in that book. These problems are taken from different
books and you will be finding these problems in the different books like any book on the
financial management. So let us first try to understand this problem, problem number 5 and then
we will try to solve this. See here it is written that on 1st January 2018 right board of directors of
Dwell Max Limited wishes to know the amount of working capital that will be required to meet
the program of activity they have planned for the year.
The following information are available. The following information are available. Issued and
paid up capital. So it means just I had told you that you will have to prepare the balance sheet
also. You do not require this paid up issued and paid up capital information anywhere in the
assessment of working capital requirement statement but you require that in the balance sheet.
Then you have got the debentures, 5% debentures secured on assets and the amount is 50,000.
And then you call it whether it is in the rupees or dollars. Then you have the fixed assets valued
at 125,000 on 31st December 2017. Then we have production during the year 2017 was 60,000
units. It is planned that level of activity should be maintained during the same level of activity
should be planned be maintained during the year 2018. The ratios of the cost to selling prices are
raw material 60%, labor is 10%, overheads are 20%.
Raw materials are expected to remain in store for an average period of 2 months before these are
issued for production. Each unit of production is expected to be in process for 1 month. It means
work in process is for 1 month. Finished goods will stay in warehouse for about 3 months.
Finished goods will stay in warehouse for about 3 months. It means finished goods conversion
period is 3 months.
Creditors allow credit for 2 months from the date of delivery of raw material so it means
suppliers credit is available for 2 months. Credit allowed by this firm to their own buyers,
debtors is 3 months from the date of dispatch.
And selling price is also given to us that is 5 Rs or dollars we call it as and production and sales
cycle is continuous and regular. Production and sales cycle is regular. It means all through the
year the production is going on.
So it means preparation of working capital what is required to be done here. Preparation of the
working capital forecast statement and second requirement is then an estimated profit and loss
account and balance sheet at the end of the year also have to be prepared. So we will be
preparing all the 3 statement that is the working capital forecast statement, profit and loss
account, and balance sheet.
And then we will try to see that how this assessment of working capital requirement helps us to
prepare the profit and loss account and balance sheet and that we will do in the next class. Thank
you very much.
Dr. Anil K. Sharma
Lecture - 15
Working Capital Requirement –The Conclusion
Welcome students. So let us move to the next level that is doing the problem number 5 out of the
total problems 5 here as I told you earlier that problem 3 and 4 you will try yourself and then
keep in touch with me through mail or thorough this discussion forum when the course will run.
So in this problem as I told you in the previous class that we will have to prepare 3 statements.
One is the working capital requirement assessment, the assessment of the working capital
requirements for this company that is Dwell Max and profit and loss account, estimated profit
and loss account and then the forecasted balance sheet. So now let us move to the first part that is
the preparation of your working capital statement for this company. So this is not on the cash
cost basis or something like that.
This is the normal statement and here we will have to assess first the level of current assets then
the level of current liabilities and then the net working capital, prepare the profit and loss account
and then the balance sheet. So we will prepare now the statement of working capital
requirements.
So it is statement of working capital requirements, statement of working capital requirements and
as we are doing in the past 2 problems we have been doing, first thing is the say current assets.
Assessment of or the say estimation of current assets, estimation of current assets and while
estimating the current assets you will have to see here first current assets we are going to have is
the raw material. First current asset is the raw material and this raw material is how much?
It is given in the problem is that total production is going to be how much? That we will have to
find out here. The total production the company is going to have in this period is that is
production during the year, point number 4, production during 2017 was 60,000 units and what is
the say cost of selling price of 1 unit is 5, Rs. 5. So it means total is the 3 lakh rupees. The total
production we have gone is for worth Rs. 3 lakhs.
And out of this 3 lakhs, the percentage of raw material is 60%, labour is 10%, overheads are
20%. So this works out as how much this is 60, 70, and 80 or 90. So 60, 70, and 90. 90% is the
cost. Out of 3 lakhs 90% means 270,000 is the cost and remaining 30,000 is the profit. So we are
given the ratios. So we will have to find out here out of 3 lakh rupees of the sales we will have to
see that what is the material cost. We know that 60% of 3 lakhs is the 180,000.
So we will take here as the raw material cost is how much? This is going to be something like
say this is the how much 180,000. This is the cost total. Cost for the whole of the year and for
how much time it remains in the form of raw material? It is given to us raw material is expected
to remain in store on an average for a period of how much time, 2 months before these are issued
for production. So it means for a period of 2 months it is remaining in the store. So it means 180
multiplied by 2/12. So this is how much? This works out as rupees. Say total amount is going to
be 30,000. So raw material investment is how much 30,000 worth of rupees we are going to
make here.
That is 30,000 rupees worth of investment we are going to make here. Then we will go to the
next stage that work in progress stage and for that we will have to calculate the amount of work
in progress first. I have calculated here the amount of work in progress which is say something
like total amount which we are going to have here investment in the work in progress here that
we have to see that how much time the it is written here.
It is given to us is that raw material expected to remain in store on an average for a period of 2
months and each unit of production is expected to be in process for 1 month right. so we have to
see that each unit is in process for 1 month. So we will have to calculate now the WIP cost. So if
you see the WIP work in process we have calculated it as say 18,750 this investment is at the
work in process stage.
The investment we have worked out here is that is 18,000 Rs directly that we have calculated
here is that is this investment we have calculated here is that is 30,000 that is in the raw material.
Work in process we have calculated here is Rs. 18,750. How this 18,750 has been worked out.
You can see find out that we have to take the 50% of your manufacturing expenses. So it means
say let us calculate here and then I will rub it off WIP for example.
For calculating the WIP we have to take the raw material and stages 1 month. So it means raw
material is total raw material is how much we have to take here is that is total material cost is
180,000 and for a period of 1 month the cost works out as 15,000. So this is the raw material
cost. Then we have the next head we have to add up here is wages. So wages are how much?
Wages of total are 30,000 and it remains in process.
We have to take the half of this because at the WIP stage we take half. So we are going to take it
as 15,000. Total we are going to take this as 15,000 and 15,000 is going to remain in this store.
So if you multiply this total amount this works out as divided by 12. So this works out as how
much 1250. So and third is overheads. Overheads are going to be how much? Overhead cost is
going to be 60,000 and period is how much is 12.
So this is divided by 12 this works out as how much 5000. So this is 5000 we have taken 5000.
We have to take half of this. This is 2500. Similarly, you can take this as divide by 12. In this
case you can take the this component also you can take it like say 30,000 divided by 12. So this
will be how much? This will look like this will be somewhere 2500 and we have to take the half
of it so it is 1250. So what you have to take is this is 1, this is 2, and this is 3.
So these are the 3 costs. So this works out as how much? 16250 and this is 18750. So this works
out as 18750 is the WIP cost. This is how we have calculated the WIP cost. So it means we will
have to take this amount that investment in the work in process here is that is 18,750. Now we go
for the next stage that is the investment in the finished goods.
So for calculating the investment in the finished goods, finished goods and for the finished goods
stage how much investment we are going to make here? Total cost was how much? Finished
goods we have take it at the cost price. So we have seen that how much was the total sales are of
3 lakh rupees, 300,000 total sales and 90% is the say cost of production. So finished goods will
be taken as 90% of 3 lakhs that will work out as how much? That is 270,000.
This is 270,000 and something we will have to calculate here. So for calculating that the actual
for how much time finished goods remain as finished goods? We will have to see that and
finished goods are here, ratio of this. Finished goods will stay in the warehouse for about 3
months. Finished goods will stay in the warehouse for a period of 3 months so you can say
multiply it by 3/12. So this will be 1/4. So this will be how much?
If you see the investment in the finished goods this will work out as 67,500 rupees worth of the
investment you have to make in the finished goods. Fourth is now the sundry debtors. So sundry
debtors was given here as creditors allow the credit for 2 months and credit allowed to the
debtors is 3 months from the date of dispatch. It means 3 months we are giving the credit period
to the debtors also. So it means sundry debtors stage, sundry debtors stage is again 270.
We will take sundry debtors here while calculating the investment part is at the cost. So this will
be how much? Again 3/12. So this will work out as the same amount 67,500. 67,500 is the final
amount here we are calculating. So I think these are the total 4 current assets we are going to
build. These are requirement of the firm, raw material requirement is say 30,000. WIP
requirement is say 18,750.
Finished goods requirement, investment requirement is 67,500 and sundry debtors investment
requirement is 67,500. So this is the total current assets, total current assets is going to be the
total requirement which is how much if you calculate this sum it up it will work out as 183,750
Rs. 183,750 Rs worth of the current assets are to be built up. Now let us estimate the current
liabilities, current liabilities.
We have to now calculate the current liabilities, the total level of the current liabilities. How
much funds will be available from the current liabilities. So we will have to take the total current
liabilities. Estimation of the total current liabilities will be how much? So that is the now the next
thing we are going to do here. So it means total current assets minus total current liabilities we
will be taking. So estimation of it is better to write like this.
Estimation of current liabilities, estimation of the current liabilities is going to be how much? It
is written here that say if you look at the problem, creditors allow credit for a period of 2 months
from the date of delivery of raw materials. So it means sundry creditors. First is the sundry
creditors, sundry creditors. How much credit will they be providing? They will be providing the
for the period of 3 months.
So it means how much total purchase of the raw material we are making. 18000 and the credit is
available for a period of how much 3 months. For a period of they will be not requiring the funds
for a period of less than 2 months or 3 months. Let us check. Creditors credit allowed. Creditors
allow the credit for 2 months, not 3 months but 2 months. So 2 months is 2/12. So this amount is
Rs. 30000.
So it means this much of the funds will be available from the current liabilities that is the sundry
creditors and no other you can say the other credit is available to us in this case if you look at
raw material, then each of production, finished goods, creditors nothing is there. So it means
only the credit available is from the sundry creditors and that is 30,000 worth of rupees. So it
means now you can see that the what is the net working capital NWC.
We will see the net working capital and this is 1,53,750. This is the net working capital
requirement of the firm which is very simple to calculate that these are the 4 current assets
required to be built up. Total investment requirements are 183,750 and then we look at the
current liabilities. So this much of the funds are going to be available from the spontaneous
finance that is the current liabilities sundry creditors 30,000.
It means at least there is nothing to worry about this this raw material. This raw material we are
going to get on the credit. Say same is the amount of the raw material. So raw material part we
are not going to worry about that from where this investment will come. We will have to worry
about the investment of this 18,750; 67,500 and again the 67,500 of the remaining 3 heads. One
head is we are going to have from the sundry creditors.
And this investment is coming from the spontaneous finance. So total working capital
requirement of this company is 1,53,750 right, clear, simple, good. So now we will move to the
next requirement and that next requirement was preparation of the profit and loss account. So we
will prepare now the profit and loss account, profit and loss account. I assume that you know the
financial accounting and you know the format of the profit and loss account which is something
like this. It is the T form of the profit and loss account.
And in this we will prepare the profit and loss account here. This is the debit side, this is the
credit side and here we write particulars. Here it is amount. This is the debit side. Here it is
particulars. Here it is amount and this is the credit side right, two sides. First we prepare, the
upper part is called as a trading account. Lower part is called as the profit and loss account. So
let us prepare the trading account now which we take only the 3 direct expenses.
That is material, labour, and other overheads. And then we take the sales on the credit side and
the difference between the sales and these 3 expenses is called as the gross profit. So let us start
with the first two 3 items. What is the raw material, to raw material. To raw material. How much
is the raw material cost. It is 1,80,000 is the raw material cost. To wages. How much is required
on account of wages?
The wages requirement is or the labour requirement is how much 30,000 right. This is 30,000.
Then we have other head of expenses to overheads. Overheads are how much. If you look at the
overheads they are 60,000 right. Then we take here as sales by sales. How much is the sales
amount? It is 3,00,000 lakhs nothing else. So this is the total income we are going to have. This
is direct income 3 lakh sales and this is 3 lakhs sales. This difference is gross profit.
How much is the gross profit now to GP. We call it as gross profit. So how much is the gross
profit here? If you calculate the gross profit here this works out as 30,000. This is 30,000, 3
lakhs. So this is 180, then 210, 270. 270,000 is the cost. 3 lakhs or 300,000 is the income from
the sales. So the difference is the gross profit that is called as gross profit 30,000 Rs. Now here
we take it as by gross profit.
This is 30,000 will come here and now what is the indirect expenses. Here we have to take now
the indirect expenses and if you look at the problem the indirect expense is I think only one. 5%
debentures which are bonds and the amount is Rs.50,000. So 5% means it is the rate of interest.
So you have to calculate now the 5% debentures. The rate of interest is 5%. So 5% of 50,000 is
going to be how much? To interest on debentures is 2500 right.
So there is no other income, source of income it means this side is 30,000 closed. This is again
30,000 and account is balanced. So it is the to net profit which is 27,500. So this is the profit and
loss account. We have prepared by calculating the sales value. By calculating the raw material
cost, wages cost, overheads cost, wages or the labour cost, overhead cost. Then we calculated the
GP first and then we are given the debentures. We have calculated the interest on that.
So it means against 30,000 of gross profit we have calculated the interest expense. This is 2500
and it means the net profit we have calculated here is that is 27,500. So this is the second
requirement we have fulfilled. Now next go to the third requirement and that is the balance sheet.
Let us prepare the balance sheet for this company.
Same format, T format. So in this format we will be taking say balance sheet. This is the we are
going to have now the balance sheet sorry. This is the balance sheet of next this Dwell Max
Company. So balance sheet we have to take here. This is the liabilities and capital and capital
here it is assets and it is here amount here. It is the amount here. No debit, no credit. No to no
buy. Straightaway we have take all the assets, liabilities, and capital and balance both the sides.
Let us start with the say liabilities and capital side. So what is the capital given to you here is
issued and paid up capital is 200,000 right. So we will take here as share capital, share capital
this amount is how much. We can directly take to the outer column. If you take to the outer
column this statement or this amount of the balance sheet we can take to the outer column. So
this is 2 lakh Rs. 200,000 is the share capital right.
Then we take net profit. Net profit which we earned just now in the profit and loss account we
have calculated. That amount was how much 27,500. I will just widen the column here so you
can widen the column here so if you take this column this is going to be the bigger column for
us. So this is going to be the say balance sheet now. So we are going to have 2 lakhs. So it means
the share capital is 2 lakhs. Net profit is 27,500.
Then we have next thing is the debentures. Debentures are for how much 50,000. These are the
debentures here we have taken for the 50,000. Anything else, yes sundry creditors. We are now
going to have after this capital and long term liabilities we are going to take the now the current
liabilities sundry creditors. We have calculated the sundry creditors and the level of sundry
creditors is something like this. We have to take the level of sundry creditors.
So in this case how much is the amount of sundry creditors? We have calculated the amount of
sundry creditors as 30,000. Suppliers credit 30,000 we have calculated from the working capital
statement. So this is the figure. So we have taken 2 lakhs as share capital; 27,500 as the profit,
net profit. Then we have taken debentures as given to us. Then we have calculated the sundry
creditors 30,000.
Then see if there is anything is any other item is there or not but first let us move to the asset
side. If you move to the asset side we will take the fixed assets first. We take the fixed assets and
we are given the fixed assets here. How much is the fixed assets given to us. Fixed asset given to
us are here like say 125,000. 125,000 worth of rupees fixed assets are given to us. Others are
current assets. So current assets are like say we say current assets.
We have calculated from the working capital statement current assets are how much? First is raw
material. What is the raw material figure we have already calculated is 30,000. Then we have the
other current asset is finished goods. Finished goods, that is 67,500. Then we have sorry we have
the work in process also. So work in process should come first. So work in process should come
first before finished goods we have to take the work in process.
So we will take the work in process here. So work in process is WIP is how much? 18,750 we
have already calculated. This is the work in process and then the finished goods. Finished goods
we had calculated here is 67,500. Finished goods are 67,500 and last current asset is the sundry
debtors. Like sundry creditors we have sundry debtors. So it means the sundry debtors are sundry
debtors here we have. How much is the level of sundry debtors?
If you calculate the sundry debtors total amount of the sundry debtors is with us that is 67,500 or
it has to be something else it is 75,000. 67,500 or 75,000. We have to take here the 75,000. I will
just tell you that why we have taken 75,000 here and I think there is no other asset available so if
you take this and total it up this side I think seems to be bigger than this side. Let us total this
side so this works out as how much? 3,16,250. This is the total of the asset side.
And if you look at this side is how much 200,000; 27,000; 227,000 then 277,000. This side is
shorter than this side. So it means let us put this balance here 3,16,250. Out balance sheet is this
side. But now this side is shorter. So if the asset side is more than the current say liability side, so
what is the balance called as, as the profit and loss account. Profit and loss account. This is the
profit and loss account.
That is excess of current asset over current liabilities and this amount will come out as 8750.
This amount will work out as 8750. So if you look at this side now and look at this side now so
this difference is 8750 we have calculated. Just we see this is the balance because of the asset
side being more than the liability side by this amount 8750. So now this side is equal to 3,16,250.
This side is already 3,16,250.
So we have been able to balance the balance sheet and you see say other than share capital and
debentures and fixed assets most of the other items have come from the working capital
statement. Your raw material has come from the working capital statement. Your WIP has come
from the working capital statement. Your finished goods have come from the working capital
statement and similarly, your sundry debtors have also come from the sundry debtors sorry
working capital statement.
Your sundry creditors have come from the working capital statement. So if you are not preparing
the working capital statement I think we would not be able to prepare the profit and loss account
and balance sheet. Profit has come from the profit and loss account here. So we will not be able
to prepare because we would not be knowing the level of current assets. How much current
assets we are going to build over this period of 1 year.
How much raw material we will have. How much WIP we will have. How much finished goods
we will have. How much sundry debtors we will have. We would not have this level of the
current assets with us. So in this case we are able to have it from the working capital statement
and sundry creditors also we are going to have from the working capital statement. So if you are
seeing here this balance sheet or maybe the profit and loss account in the previous sheet here
most of the items have come from the working capital statement.
In the balance sheet also most of the items have come from the working capital statement and we
are able to tell you the balance sheet also. We are able to prepare the profit and loss account and
we are already we have prepared the working capital requirements statement. So we are able to
find out that the working capital requirement of this company is how much that is 1,53,750 and
the profit they will be earning will be to the tune of 27,500.
This is the profit before tax and for example if the tax rate is 0 in that case entire tax profit if no
dividend is also paid, no tax is due on that entire profit if it is transferred to the balance sheet
then this balance sheet will look like that the balance of the balance sheet will be 3,162,50. Here
also 3,16,250 and the positive part of this balance sheet is that the assets side is more by 8750
and that we have put this balance on the liability side to make both the sides are equal.
So this is the superior balance say very healthy balance sheet and the firm’s overall financial
position is very good. Here now I will discuss just for a 30 seconds this point that is 75. If you
look at the sundry debtors I have taken here at 75,000 but if you look at the working capital
statement there we have taken it at that 67,500. So why the difference in these 2 figures is there?
See in the working capital statement we are calculating the investment to be made. We are not
taking into account the profit right? Whereas both the rules of thumb or both the rules are
possible. Some people say that in the working capital also we should calculate it on the selling
price basis, not on the cost basis. Or some people say that it should be on the cost basis because
we are only going to calculate the investment we are going to make here.
We are not going to say talk about the profits. So either way is good. But normally it is better to
take as the at the investment level at the cost. So we have taken in this working capital statement
at cost. So the cost of the sundry debtors is 67,500. But in the balance sheet it has to be taken at
the selling price so in the balance sheet I have taken at the selling price because sundry debtors in
the balance sheet are always shown with the profit.
Because we are not going to recover the investment from the credit buyers or buyers on credit.
We are going to recover the cost that is 67,500 plus profit on that. So total amount which we
have to lent out is not the investment only. We have lent out the profit also. So that is why in the
balance sheet we take sundry debtors as 75,000 but in the working capital statement it is always
advisable that rather than inflating your investment requirements factitiously it is better always to
take it on the cost.
So that is why I have taken it at the cost and here I have taken it at the selling price and finally
we are able to prepare the working capital statement also, profit and loss account also and the
balance sheet also for this company called as Dwell Max Limited and finally the balance sheet is
balanced and we are seeing here that balance sheet is not balanced but the assets are more that
the liabilities.
So it is a very healthy balance sheet which depicts a very good very healthy financial position of
this company. So this is how we assess the working capital requirements of the different
company and we have to assess both the current assets and current liabilities and then we see the
difference and that is the net working capital requirement. So it means the requirement which is
not going to be fulfilled from the spontaneous and short term finance that will be fulfilled from
the long term sources of the funds.
So at this level we have learnt is that how to assess the working capital requirements of the
company provided we are given the total financial information, total financial information as
well as the duration of the operating cycle or different stages of the operating cycle. So I will
stop here and next time or in the next class we will start the next topic. Thank you very much.
Dr. Anil K. Sharma
Lecture - 16
Working Capital Leverage
Welcome students. So in the last part of discussion we were talking about the operating cycle
and the working out the investment, working capital investment requirements that how to work
out the investment requirements of the working capital in a firm where we saw that if we are
given the say requirement of the current assets and the funds available from the current liabilities
and if their duration is already given to us.
So how to work out the working capital requirement or investment in the current assets. So we
have seen that under the operating cycle we learnt that how to calculate the duration of different
levels of say operating cycle that is from the cash to the inventory stage and then to the WIP and
then to the finished goods stage and then to the book debts or the receivables stage and once we
are given the duration or once the duration is already worked out.
And if we are also given the requirement of the current assets and the funds available from the
current liabilities then how to work out the working capital investment requirements. So we saw
that in the previous discussion or the discussion till now we had. Now we will be talking about
the say different current assets means the management of the different current assets that we
have important current assets which we learn to manage under the working capital are inventory
is the first and the foremost asset.
Second is the receivables management and third one is the cash management. So these are the 3
important current assets which we will be learning how to manage these 3 current assets and then
we will see that if we have to build up these 3 current assets like inventory, receivables, and the
cash as well as the other current assets also. So how much investment is required.
And once we learn or we have already learnt about these 3 assets management current assets
management then we will try to see that to fund these current assets what are the different
sources of funds available. I told you some time in the past also that we have 9, 10 sources. So
we will be starting with the say trade receivables. Then we will be moving to the other sources of
funds.
And finally we will be knowing more in detail about the bank finance or role of the bank finance
in the managing the working capital or arranging the funds for the short term sources. But before
talking about the investment management or the other current assets I would like to introduce
you with the concept of working capital leverage. This is a very important concept, working
capital leverage and we would first like to understand what is the working capital leverage.
And how it helps to understand the say means overall level of the current assets and how it helps
us to understand the relationship between the current assets, existence of the current assets in a
firm as well as the return on investment. Because we have discussed sometime in the past that
the level of current assets impacts the return on investment right. We have the higher level of the
current assets in a firm the overall ROI goes down because current assets are least productive.
You have seen it, we have proven it also as inventory is not at all productive or the receivables
are not at all productive. They only need funds to be invested but there is no ROI available or
there is no return on investment on these funds is available. So we have already concluded and
we have already understood that larger the amount of the current assets in the firm more
inefficient it is treated as.
Because current assets are only requiring investment they do not produce any kind of the returns
and if there is no return available on this investment then we should try to minimize the
investment in the current assets. Now we cannot run the show without the current assets but
anyhow we have to learn about that what should be the level of current assets and if we keep the
level of current assets as low as possible or I would say low but you would use the word that is
optimum level of the current assets, neither too high nor too low.
So if we increase the level of current assets it means it is going to impact the ROI, return on
investment. Higher the level of current assets lower is going to be the ROI and vice versa or
reverse is going to happen when you are running the show with the low current assets then the
return on the investment will be as compared to the say first situation will be higher. So and we
have seen the concept of we have learnt and understood the concept of the negative working
capital also.
So in the negative working capital we have seen that the firms are running the show where the
current liabilities are more than the current assets. So in that case the level of current assets is
very low. Level of the current liabilities is very high so cost of funds invested in the current asset
is very low and the funds being generated from the current liabilities or we would say from the
spontaneous finance is high.
So it means the cost of funds is low so it means when the financial cost goes down and the
minimum funds are invested in the current assets so it means ultimately managing your financial
cost in a very efficient manner leads to the overall increased profitability. So we have already say
concluded that the level of current asset in any firm should not be very high and we should try to
keep it at the optimum level.
And the firms who are running the show with the negative working capital they are par
excellence and they are able to say minimize the financial cost because most of the funds are
coming from the short term sources or from the spontaneous finance which is almost you can call
it as free of cost and means indirectly it is free of cost though there is a cost to the spontaneous
finance also but directly there is no cost as such like interest or anything.
There is no cost. That is not appearing in the profit and loss account. So we can think about that
more funds coming from the current liabilities and lesser investment in the current assets and
having the situation of the negative working capital is the best situation. But since it is not
possible for all the firms to run the show with a negative working capital so at least if you want
to have the positive working capital keep the level of current assets at the optimum level, neither
too high nor too low.
So it means let us see now what is the working capital leverage and if the working capital
leverage we try to understand in the simpler terms you would say that working capital leverage
measures the sensitivity of return on investment.
Sensitivity of ROI means that is the earning power to the changes in the level of current assets.
Means sensitivity of ROI to the level to the changes in the level of the current assets and this can
easily be determined in the following manner. So what is the working capital leverage?
Percentage change in ROI divided by the percentage change in the current assets.
So if you have a given level of current assets in your firm or in any firm if you work for if you
have the given level of the current assets if you decrease the level of current assets from the
given level in the firm so it means what will happen? Keeping the total assets same when the
level of current assets will go down certainly the level of long term asset or the fixed assets will
go up.
So it means long term assets or the fixed assets being more productive as compared to the current
assets so what will happen? The firm’s ROI will improve. And if vice versa is going to happen
that if keeping the level of total asset is same if the say fixed assets or the long term assets are
going to be replaced with the current assets so in that case what is happening current assets being
least productive ROI of the firm is going to be impacted negatively.
So we have to think about that what is the relationship between the ROI and the current assets.
So it is measured in terms of working capital leverage. That what is the level of say ROI
percentage change in ROI as compared to the percentage change in the current assets. So we will
have to see it and we will have to understand it in terms of this situation. So let us now measure
the working capital leverage or try to understand the concept of working capital leverage with
the help of say a situation or a small example that how we can understand it.
So will go for it. First of all how to say show it. What is the formula of measuring the working
capital leverage?
So working capital leverage you can say you can say working capital leverage is current assets
divided by total assets minus change in the current assets. This is the concept of the leverage or
the working capital leverage which you can say that current assets divided by the total assets
minus change in the current asset. So what will happen that if you have the current assets level,
some level of the current asset is given to us.
And if there is a change in the current assets that is say delta change. So it means current assets
are being decreased. So what will happen in this case that this formula we are going to use in
case of decrease in current assets. In case of decrease in the current assets we are going to use
this formula. So we would say that working capital leverage can be worked out with the help of
current assets divided by the total assets minus change in the current assets.
This is in case of the decrease in the current assets and second is the working capital leverage in
case of the when you are going to increase the increase in current assets. So in this case what is
going to happen? This is current assets divided by total assets plus change in the current assets.
So it means if there is a increase in the current assets we will use this formula and if there is a
decrease in the current assets we will use the above formula.
That is total assets minus change in the current assets and then we will see that how it impacts
the ROI or what is the relationship between the current assets level and the ROI level. So in this
case how to measure it and how to make use of it let us see a situation of the 2 companies. So I
would give you the say particulars here. So this is the particulars and then we have 2 companies.
First one is the ABC Limited and second company we have the XYZ Limited.
Second company is XYZ Limited and these are the particulars. So in this case we would see that
the situation is like current assets. Current assets are Rs. 200 lakhs in ABC Limited and only 80
lakhs in XYZ Limited. Then we talk about the net fixed assets. Net fixed assets means fixed
assets after depreciation. So this is 80 and here it is 200. So what is the level of total assets? If
you see the total assets here, total assets are 280, Rs. 280 lakhs. In this case also, 280 lakhs.
This is the level of the total assets. Now you see that there is a complete say different story in the
2 firms. In ABC Limited the level of current assets is very high. Out of the 280 lakh rupees of the
total assets largely means the 200 lakhs of the rupees of the assets are current assets, short term
assets and only 80 lakhs of the assets are fixed assets or the long term assets. Whereas in the
other firm XYZ Limited the situation is reverse.
That only we have the current assets of 80 lakhs and the 200 lakhs of the assets are of the net
fixed assets or the fixed assets after depreciation. So if we look at go by the say approaches of
the working capital and we see that smaller the amount of current assets more profitable the firm
will be and higher the amount of current asset lesser the lesser profitable the firm will be.
If you go by that situation you will easily be able to conclude that the firm XYZ Limited seems
to be more profitable because level of the current asset is just 80 lakhs as compared to 200 lakhs
in this firm as compared to the firm ABC where the level of current assets is just reverse that is
200 lakhs and the net fixed asset is 80 lakhs. So this is a simple conclusion we can draw by
looking at the assets but in terms of the working capital leverage how to measure it.
So let us now assume that we will have to now compute the working capital leverage and first
situation we have to say we call it as compute working capital leverage if current assets are
reduced by 20%. If the current assets are reduced by 20% and that too in both the firms that too
in 2 firms. So if you are reducing the current assets in both the firms by 20% how the working
capital leverage is going to be there.
So in that case we will see first of all the working capital leverage in case of ABC. So we will
calculate the working capital leverage for ABC and that is going to be how much? What is the
formula here? Working capital leverage in case of the say this is the formula we are going to use
that is in the decrease in the current asset. So compute working capital leverage if current assets
if the current assets are reduced by 20% in 2 firms.
So the working capital leverage in ABC is going to be how much? We have the current assets
level and that is given, already given level is 200 right? And the total assets level is how much,
280 minus now delta current assets that is total assets minus change in the current assets. So
change in the current asset is how much. That change in the current assets is 0.2 into 200. So this
is the reduction by this amount.
And if you calculate this reduction in this amount so this works out as 200 divided by how much
280 and this becomes how much, 40. So it means finally the new situation emerges as 200/240
and what is this percentage. This is called as 83.33%. This situation is 83.33%. Now what is this
percentage, I will discuss with you later on but first we will understand the situation in the other
firm and then we will see that we interpret in terms of the working capital leverage.
So first of all you calculate this first percentage that is 83.33. Now we calculate the working
capital leverage in case of the XYZ Limited and in this case we have again the same situation.
Total assets are 200 here and now we have the sorry current assets are 200 and total assets are
280 and now we have the level of current assets in XYZ Limited is how much? The level of
current assets is this much. So this is say what we have to do is minus that is 0.2 into 80.
So it will work out as how much. This will be something like 200/280 - 16. So if you find out
this amount, so this will be how much? That is 200/264 and that amount will be how much
30.30%. So this is the second percentage that is 83.33 and this is the 30.30 we have calculated in
the say 2 companies in case there is a reduction in the current assets by 20%. So we have
calculated it. Now how do we interpret it?
We see that this percentage 83.33 percentage percent is in ABC and 30.30 percent is in this case.
So it means this these 2 percentages are the working capital leverage in the 2 companies. So
83.33 and 30.33. So it means because the percentage of working capital leverage that is 83% is
much higher as compared to 30.30 in the other company.
So working capital leverage can be interpreted in terms of that with the change in the level of
current assets in the company ABC Limited or in the firm ABC Limited there will be a higher
change in the profitability or in the ROI as compared to the change in the ROI in the company
XYZ Limited. This percentage indicates that the magnitude of change, the quantum of change in
the return on investment in the 2 companies.
So because the working capital leverage is very high in the first company as compared to the
second company so you can say that a minor change in the level of current assets in the 2
companies if there is a minor change in the level of current or any change in the level of current
assets in the 2 companies ROI in the company A will be affected at a much higher level as
compared to the at a much higher say level in company ABC as compared to XYZ Limited
because of the magnitude of the working capital leverage being very high that is 83%.
And it is clear also because we have the level of current assets is 200 lakhs as compared to the
fixed assets that is only 80 lakhs. So if you are going to reduce the current assets by 20% it
means how much assets we are going to reduce? That is 40 lakhs worth of the assets we are
going to reduce and the total say assets we are not saying the total asset we are keeping same. So
it means what is happening that the in the total process that level of the total asset is going to go
down.
And we are saying here that the total assets are coming down that is change in the current assets
so it means the 200 level of the current assets and we are going to reduce the level of current
assets from the total assets. So it means finally what will happen? Your percentage is 83.33% of
the working capital leverage as compared to the company XYZ Limited.
So any change because of very high level of current assets is impacting the return on investment
of the company ABC negatively because the level of current assets is very high as compared to
the level of current assets in the XYZ Limited. So if you reduce the level of current assets in
ABC it will impact the profitability or return on investment on the of the company at a much
higher level or in a much bigger way as compared to the company XYZ Limited because there
the magnitude or the level of current assets is already very low.
So invent is already 80,000 or 80 lakhs. From the 80 lakhs if you reduce it by 20 so how much is
going to impact and from the 200 lakhs if you are going to reduce it by 20% how much is going
to impact it so larger the amount of the current assets in the firm, more impact upon the ROI of
the firm is going to be there if there is any change in the level of current assets.
And if the smaller the level of current assets in the firm smaller is going to be the change in the
return on investment of any firm if we are going to change the level of current assets in that firm
by any level or in any way or in any mean. So this is how we interpret this percentage that how
higher the percentage of working capital leverage higher is going to be the change in the profits
of the firm if there is a change in the current assets.
And lower the level of working capital leverage percentage lower is going to be the change or
the change in the ROI as we change the level of current assets. So now we will see that if we
increase the level of current assets what is going to happen. We have reduced it currently we
have seen we reduced the level of current assets but for example if we increase the level of
current assets what is going to happen in the 2 firms. So again the balance sheets are same.
Current assets are 200 lakhs and the fixed assets are 80 lakhs and in the other firm the current
assets are 80 lakhs and the fixed asset net fixed assets are 200 lakhs. So it means if there is a
increase in the current assets in the 2 firms by again the same percentage that is the 20% so what
will be the working capital leverage in this case.
So what will happen? The formula now will become is current asset divided by the total assets
minus sorry plus 0.2 of the current assets. Now working capital leverage of working capital
leverage of ABC. Working capital leverage of ABC. Current assets are how much? 200 and what
is the level of the fixed assets 200 plus we are going to increase the current assets plus 40. So it
means in this case what is going to happen?
This is 200/320 and this is going to be, the percentage is going to be 62.5%. In the second case if
you calculate, working capital leverage of XYZ Limited, in this case what is going to happen?
Again the level of sorry current assets level is how much? The current assets level is current
assets level we have here is 80 and we have 280 plus how much is going to be there 16. So we
are going to add up the 16 lakhs of the current assets more.
So we will compare it with the adjusting level. It means this is going to be 80/296. So this is
going to be again the same percentage that is 27.03%. So now the situation remains the same. In
this case also when we are adding up the more current assets so it means the 62% is the working
capital leverage in ABC and 27.03% is the leverage in the XYZ Limited.
Now you see that first we say when you interpret the working capital leverage you say that
higher the percentage of the working capital leverage, higher is going to be the impact upon the
profitability of the firm as compared to the firm having the lower percentage of the working
capital leverage out of the 2 firms. So in this case we are seeing that level of current assets was
already very high, 280.
So it means now we are going to add up more current assets so this is going to further increase.
Total assets will become 320 and if you see the working capital leverage that will be 62.5% and
in the other firm we are going to add up the current assets but the level is going to move up from
the 80 lakhs to 96 lakhs. So the percentage of the working capital leverage is going to be
27.03%. Now in this case we will see that again the same interpretation will come here.
What do we mean by the working capital leverage if there is a increase in the current assets of
the level of the current assets and we will see that higher will be the change more sensitive will
be the ROI or change in the ROI in the company as compared to the company B. In the ABC
change in the return on investment will be more sensitive to the change in the current assets as
compared to the company XYZ Limited.
Because working capital leverage percentage is low that is 27.03%. Now, in what direction ROI
will move? Because we are seeing that in the previous case we have seen that in this situation
what we have done is we have reduced the level of current assets. So ROI is means sensitivity of
the ROI to the change in the level of the current assets. That is the definition of the working
capital leverage. Sensitivity of ROI to the change in the level of current assets in the firm.
So in the first case what we have seen? We have reduced the current assets from the existing
level, whatever the level is 280, we have reduced it by 20% in both the firms. We have seen that
this working capital leverage is much more higher in the ABC Limited as compared to the
second firm XYZ Limited. We will see that profitability or the ROI in the firm ABC will be
changed at a much faster rate or in a much bigger magnitude as compared to the second firm.
Now, we are understanding that change will be bigger in first firm as compared to the second
firm. So what will be the movement of the ROI. That movement in the ROI will be positive or
negative. The movement in the ROI will be positive. Because you are reducing the level of 20%.
So it means current assets are being reduced by the 40 lakh rupees. So it means out of 200 they
are being reduced by 40 lakh rupees.
So it means ROI will be going up because as say it is already proven fact that if you reduce the
level of current assets there is going to be a positive change in the ROI so ROI of the firm ABC
will improve much faster or at a bigger level as compared with the ROI of the firm XYZ Limited
by reducing the current assets by 20% because current assets being less productive if we reduce
the level of current assets from the existing level they add up more towards the profitability or
the return on investment of the firm.
So we are seeing that working capital leverage percentage is very high. There is going to be more
change in the ROI of the firm ABC as compared to XYZ Limited and more change means that
current asset level is going to come down so there will be higher change in the profitability or
return on investment of the company ABC as compared to the company XYZ Limited where the
percentage of working capital leverage is just 30.30.
So it means the change in the return on investment will be low as compared with the first firm
but that low will be means a positive change. The ROI will improve because here in this firm
also we are reducing the level of current assets from the existing level of 80 lakhs to say by 16.
So it means total assets level is coming down to 264. It means finally in this firm also the level of
current assets is coming down.
But the profitability or ROI will not be impacted in the same way as it is being impacted in the
first firm but it will also be impacted in the second firm too and that too the profitability or ROI
of second firm will also improve. Now, in this case in the next case if you look at we have seen
here that again there is a working capital leverage when we increase the level of current assets
and we have seen here also that there is a higher percentage of working capital leverage in ABC
as compared to the firm XYZ Limited.
So in this situation also there will be a much higher impact on the ROI of the firm ABC as
compared to the firm XYZ Limited. So what kind of the impact will be there? Increase or
decrease in ROI. ROI will decrease because we are increasing the level of current assets now by
same percentage as we were reducing in the previous case. So when you are increasing the level
of current assets, percentage of working capital leverage being higher the profitability of the firm
A will be negatively impacted.
ROI of the firm A will be negatively impacted at a higher level as compared to the ROI in the
firm B where the working capital leverage is just 27.03%. So this is the concept of the working
capital leverage which explains the relationship between the change in ROI as there is a change
in the current assets. When you increase the current assets level if the current assets level is
already very high as we have seen in case of ABC Limited.
And you further add up more current assets in the same firm so what is going to happen? Your
profitability is already low and is further going to go down and that reduction is going to be at a
much faster rate. Similarly, if the level of current assets is very low but if you are going to add up
more assets so that is going to reduce the profitability but not at the same pace and in the same
magnitude as it is going to happen in the first firm.
So we have to ultimately here also with the help of working capital leverage also we understand
that the level of current assets should be kept as low as possible or you can say optimum level of
current assets so that neither we are into the situation of the technical insolvency nor we are into
the situation of the extra or the higher level of current assets. So in both the ways it should not
impact up the profitability of the firm negatively.
We should have the current assets also and we should have the technical solvency also and we
should have the desired level of the profitability also. So working capital leverage is a very
important concept. This concept indicates that the level of current assets and the impact of those
current assets on the ROI of the firm. So it means finally the working capital leverage measures
the sensitivity of change in the ROI as there is a change in the current assets.
So because in these 2 firms we have seen with the reduction of the current assets by 20% we
have seen that the sensitivity of the ROI is very high in case of the ABC Limited that is the
percentage we have calculated the working capital leverage percentage is 83% because higher
level of current assets if you are going to reduce that your profitability is going to increase at a
faster pace as compared to the firm where it is already very low 80 lakhs. And if you reduce it by
16 more lakhs profitability is going to improve but not at the same pace as it is going to happen
in the firm ABC Limited.
So this is the concept of the working capital leverage we can understand. So again we conclude
here that in any firm to be the efficient say manager of the working capital or the finance
department in any firm the people in the finance department to call them as the experts or the
efficient managers of finance they should try to keep the level of current assets at the optimum
level where there is no situation like that we do not have the minimum level of current assets.
So the production process is getting affected. But we should not increase the level of current
assets beyond a level where it is impacting the profitability of the firm though we are not taking
much risk but we are reducing the profitability also on the name of reducing the risk. So this is
we will say stop here in this discussion and we have learnt in this present class that is about the
working capital leverage and we have seen that how it is related to the say how it explains the
sensitivity of ROI with the change in the current assets. Thank you very much.
Dr. Anil K. Sharma
Lecture - 17
Risk and Cost of Holding Inventory
Welcome students. So in this class we will start learning and talking about the inventory
management. One important current asset or the most important you can say like this, most
important current asset in the series of the current assets which we talk say in the working capital
management, different current assets or the level of different current assets we have to build up.
First asset is the inventory.
As we have talked many times in the past also that what is the inventory, what is the importance
of the inventory, what is the need of the inventory and how it impacts the overall profitability of
the firm. If you do not keep inventory it may impact the production process. If you keep
inventory it will increase the cost right or if you talk about the inventory of finished goods
because we have the different kind of inventories.
One is inventory of raw material. Second is inventory of work in process, and third is the
inventory of finished goods. If you do not have the sufficient inventory of the, if you do not keep
the sufficient inventory of the raw material what will happen? Your production process may get
affected. To keep the level of inventory at the lowest level, in Japan manufacturing firms
invented a technique which we call as just in time.
People misunderstand this concept that under JIT the level of inventory is 0. But it is not true.
Level of inventory is not 0 in the JIT also. We keep the minimum level of inventory under the
JIT also. So that depends upon the type of the supply chain arrangements we have in and around
our production unit. The source of raw material and the usage of that raw material.
The firm who has to make use of that raw material and the firm who has to supply that raw
material, the distance between the 2 firms, the supply chain arrangements between the 2 firms,
the logistics between the 2 firms and the means of transportation in between the 2 firms are
important factors. If we keep the level of inventory maybe 0 or maybe we create a situation that
we will not keep the inventory of raw material.
We will have a situation like that straightaway the raw material will start from the supplier’s
place as and when we place the order and by the time the material goes at the lowest level in the
manufacturing process at the plant we receive the another truckload of the material and it directly
goes to the plant, we use that at the plant and then we order the another truckload of material and
straightaway that also goes to the plant. So that way we are creating that situation.
But see that is possible in the economies like US and Japan where the logistics are very efficient,
road condition is very good. Railways condition is very good excellent. So we cannot compare
those economies with our economy. Still in those economies also level of inventory of raw
material is never allowed to come down to 0. That is also not allowed to come down to 0.
They also keep some inventory but yes you can say the level of inventory can be the lowest as
compared to the inventory we are keeping in India. The inventory keeping means those firms
keeping in their economy is much lower. That is a one part of the story. But you cannot run the
show with the 0 inventory because anytime we can be in the situation of the stock outs and stock
outs has a very serious impact upon all levels or at all levels.
First if there is a no inventory of raw material and whatever the inventory we had we have
already exhausted it on the plant and truckload of material which was expected to reach at one
particular point of time that could not reach because of the obstacles maybe you call it as a traffic
jam or maybe because of the bad road conditions or anything else it could not reach on the plant
on the time. So what happened? Their production process got stuck.
It got interrupted. It got hampered and what will happen? Your plant is idle. Your workers are
idle. Your entire production facility is idle and we are paying the cost but we are not using that
facility to the extent we could have done that. Similarly, in the WIP stage also work in process
stage also material moves from the one stage to the other stage. So if the there is no material on
the first stage certainly the situation will also arrive at the WIP stage also, at the work in process
stage also.
And we have to face the same situation as we have the situation at the opening inventory level or
maybe at the beginning stage of the manufacturing process. Because there is no regular supply of
inventory so there is no availability of material at the beginning of the process, in the middle of
the process, nowhere and finally entire your plant and workers are lying or sitting idle. Third is
type of the inventory is the inventory of finished goods.
We keep some inventory of finished goods at the desired level. Because we do not know the
demand from the market. Though we have already calculated that how much units of our product
we sell in a week or in a fortnight or in a month in the market, who are our distributors, what are
their average monthly orders, how much we are going to supply to them and how much they are
going to demand from the firm.
So we try to maintain a proper synchronization between the supplier, as a supplier, the firm as a
supplier and the different distributors in the market. But beyond that also sometimes the firms
receive the unforeseen orders which are not from the regular distributors or the channels of
distribution. Sometimes some there can be some you can call it as once in a while orders also.
For example any say we are at IIT Roorkee and IIT Roorkee for example has decided that in all
the classrooms we will provide the colour TVs right and we decided that these colour TVs will
be purchased from Samsung. So normally Samsung knows that their monthly consumption of
their colour TVs or sale of colour TVs by their distribution process or their distributor dealers in
the market is say 500 units.
And if they are only manufacturing that 500 units it means the level of inventory in the
warehouse of the finished goods, finished colour TVs is 0. They are not keeping any inventory.
Straightaway their raw material is coming to plant, being process, converted into finished
product and from the plant itself it is going to the market to the distributors. Nothing is going to
the warehouse and warehouse is empty.
Now IIT Roorkee want to buy 100, 200 colour TVs and they say they means plan it this way that
we will directly buy from the company because we are going to buy in bulk so rather than buying
it from some distributor we will buy it from the company directly or even from the distributor
also. When any distributor receive an order of 200 colour TVs from IIT Roorkee, he does not
have the stock.
He will ask the company that I want to sell 200 colour TVs to IIT Roorkee which is not a regular
buyer. They have placed the order once in a while. Please supply me 200 additional colour TVs.
So even the Samsung at the company level itself they would not be able to serve the order. So it
means they have lost the order. They have missed the bus. Maybe IIT Roorkee can shift to Sony
or maybe they can go to LG or some other company because we quickly want the supply.
So it means that also has a cost means not being inventory not being available also has a cost and
that cost is called as the stock out cost. Stock out cost is one that we could not make that order,
we could not serve that order, we could not serve the market with that order and number one we
lost the sales, we lost the revenue, we lost the profits. This is one, material effect you can say,
material loss and the other loss which is you can call it as invisible loss.
And that loss is called as the loss in the goodwill, the loss in the reputation and that is a very
serious and the big loss. So it means the moral of the story is that despite the fact inventory has a
cost only. It does not earn anything for us. No company in the world can run the show by not
keeping certain level of inventory at all the 3 levels. If they assume a situation straightaway a
truckload is coming from the supplier, going to the plant, being converted to work in process.
From the work in process it being converted to finished goods and straightaway the finished
goods are going to the market. Nothing is in the godown of the warehouse of the sorry of the
inventory. Nothing is there in the godown as raw material inventory. Nothing is in the warehouse
as the finished goods inventory. So it means we have that situation which seems to be very you
can call it as interesting situation and every company would like to have that situation.
But along with the positives of that situation there are certain negatives also and negatives we
have seen that it may interrupt the production process because of the lack of the availability of
the raw material or it can have the stock out cost also that has we have received some unusual
order from the market. We are not able to serve the market because we do not keep any
inventory of the finished goods in the warehouse and ultimately we have lost that opportunity.
We have to pay the big price for that as the stock out cost. So it means we have to keep the
inventory. Finally we have decided we have understood it every firm is supposed to keep the
inventory and inventory is the important current asset. First asset, inventory is the first important
current asset because it constitutes the highest amount of the total inventory of the working
capital in as compared to the all the current assets.
And another limitation you can call it as or demerit of inventory also is that it is least liquid asset.
You cannot convert that inventory into cash as and when you want it or as and when the firms
want it right. This is the biggest most limitation of the inventory. If you keep an inventory and
the level of inventory is not optimum nor too high, neither too low and if have the very high level
of inventory and if want to convert that inventory into cash, can you do that? You cannot do it.
Because inventory cannot be sold as and when the buyer seller wants to sell it in the market.
Inventory will go to the market, will be possible to be sold in the market if the buyer wants to
buy it means there is a demand for the company’s product in the market. So it means if there is a
demand only then the inventory can go to the market. Otherwise, it cannot go to the market.
So if it cannot go to the market we are keeping a high amount of inventory rather than earning a
good revenue or profits for us is only causing a larger amount of the cost. So we will have to
learn how to manage the inventory as a important current asset.
So first of all decide that looking at the manufacturing process, looking at the product we are
manufacturing, type of the product we are or the products we are manufacturing, looking at the
demand supply situation in the market we will have to decide what is the optimum level of raw
material as inventory, WIP as inventory, finished goods as inventory right.
After that we will see that if you are keeping the optimum level of inventory at all the 3 levels in
that case we can assume neither it will impact the profitability negatively nor the firm has to pay
the cost which are called as the stock out cost and nor the plant or the production process has to
be say interrupted or get stuck with for the want of raw material. So we will have to think about
it.
Since it is least liquid, since it is least liquid so when we study the liquidity profile of a firm,
when we build up the liquidity profile of any firm while studying the working capital
management you see we calculate 3 ratios, 3 most important ratios which are called as the
liquidity ratios. First ratio is the current ratio, second is the quick ratio and third one is the super
quick ratio or the cash ratio.
So in the difference in the current ratio and the quick ratio is what? In the current ratio we take
current asset divided by current liabilities. And we calculate the current ratio which we say that if
this ratio is 1.33:1 it is appropriate. More than that is bad. Lesser than that is risky. When we
calculate the quick ratio, acid test ratio, quick ratio what is the difference in that ratio?
We take current assets in the numerator, current assets minus inventory divided by current
liabilities. So we are subtracting the inventory from the current assets while calculating the quick
ratio or the acid test ratio. Why we are subtracting inventory from the current assets because
inventory is the least liquid asset. You cannot convert inventory into the cash as and when you
want it. It is not true in case of the current assets.
Like you see talk about the accounts receivables. Accounts receivables can be to some extent,
not to the fullest extent but to some extent can be converted into cash as and when we want it if
they are good quality receivables. If they are bad quality receivables I do not say anything about
that. If they are the good quality receivables they can be converted into cash as and when we
want it and if we talk about the third asset that is cash.
It is already cash so again we have to learn the management of cash because keeping too high
level of the cash is also not good. It is also bad. So we will have to learn about these 2 assets
also. But I have been saying that say converting receivables or accounts receivables or trade
receivables into cash or the credit sales into cash is quite possible or easier as compared to
inventory, how? See that credit sales or accounts receivables appear in the balance sheet when?
When we sell on credit we have sold the material, passed on the material to the buyer but we
have not received the proceeds or the selling price which is due to be received from the buyer
and he has bought the material from the firm on credit. That amount will be received at the later
date and there is a pre-specified credit period. Firms sell for the for the pre-specified credit
periods.
In India their credit period ranges between 45-60 days so we have to think about that period. Say
for example we have sold to somebody for a credit period of 45 days. It means from the date of
sales we the seller has to wait for 45 days. On the 45th day the buyer is supposed to make the
payment to the seller, one. Similarly, the buyer is also not bound to make the payment prior to
that credit period because that credit period has been given by the seller to the buyer.
So it means the question arises how the cash can be received from those receivables which are
going to be collected or going to be available in cash after 45 days. Say for example any firm
sells on any date and after selling means the credit period is 45 days but after selling means after
5 days after selling the material on a credit period of 45 days from the seller, the selling firm
needs the funds right.
Now since they have sold it for 45 days of the credit period to the buyer they cannot force the
buyer to make the payment immediately that is just 5 days after the sales. Because still there is
40 more days credit period is to go. Only after 45 days the buyer can be compelled to make the
payment as the credit period has come to an end. But if the selling firm needs the funds adjust
after 5 days they can they have 2 options to get the cash.
They can request the buyer that if you prepone your payment by 40 days, we will give you the
huge discount maybe 2, 3, 4% discount we will give u. So if you are want to make the payment
after 45 days okay we will you will have to pay this much amount to us but if you can make the
payment today that is 40 days prior to the due date we will give you 5% discount. Say for
example in that case say if somebody has to make the payment of 1 lakh rupees to the firm.
So in that case how much he has to pay that by paying 95,000 Rs or maybe if the discount is 10%
by paying 90,000 Rs the buyer is set free from his obligation and the seller is also getting the
funds though 10,000 Rs lesser he is getting, firm is getting. But they are getting 90,000 Rs at the
time when they want it. If that happens perfect. So it means at least you could get the liquid cash
against the expected payment of 1 lakh rupees you could get the 90,000 Rs as the liquid cash.
So the receivables can be converted into cash as and when we want it if the other party also
agrees. But for example the situation arises that the other party does not agree. They say that we
do not have the liquid cash and we have got the credit period from you as the seller for a period
of 45 days so certainly on the 45th day we will be making you the payment of 1 lakh rupees.
Before that we do not want to make the payment and we do not have the funds to pay.
The seller cannot compel because they have entered into an agreement contract of sale that yes
45 days credit period, this much is the invoice, this much is the sales. This is the date of sale.
This is the date of purchase and this is the due date of the making the payment by the buyer to
the seller, finished. What option, second option then the seller has to get those funds back? The
second option is the bank.
The seller can go with that invoice with those bills of credit sales which they have sold to the
other firm and the credit period is 45 days; 5 days immediately means 5 days after the sales if the
seller needs the funds, seller can go to the bank and they can request the bank that look we have
sold for this much of amount on credit to this second firm XYZ Limited. This payment is due to
be received by us after 45 days; 5 days have already lapsed. Still we have to wait for the 40 days.
But we need the funds today. So you keep these bills with you. Give us some amount against this
and on the due date after 45 days total period either the buyer will directly make the payment to
you, we will instruct him or if he will make the payment to us we will return it back to you with
interest. Now the bank will analyze and see the quality of that buyer or the quality of those
accounts receivables, what is the quality of those accounts receivable.
If the quality of the accounts receivables is very good, if the buyer is enjoying a very good credit
rating in the market, very good financial reputation in the market, bank will certainly know about
it. So bank would say that if I discount these bills today we are going to get sufficient financial
benefit because bank charges in 2 ways. Number one is the administrative charges or the
discount charges you can call it as.
And the second thing is they charge the interest for the period for which the funds are being lent
by the bank to the seller. So now the total time period is 40 days and invoice value is 1 lakh
rupees. So what will happen? Bank would say that yes. Normally the rule in India is if the bank
finds the quality of the receivables is good, the buyers quality, buyers financial reputation is
good and there is no possibility of the default from the buyer’s side after the end of the credit
period.
So bank would agree that it is a good investment. So bank would say that yes. Normally in India
the percentage rate is 80%. Banks discount the bills, credit sale bills to the extent of 80% if they
accept the financial reputation, the credibility of the buyer to the desired level. So they will
immediately agree that okay we will discount these bills. We will keep the invoice with us as a
say you can call it as guarantee and we will immediately we can give you 80,000 against this
invoice of the 1 lakh rupees. So firm will get immediately. At least 80,000 is is available as cash.
For remaining 20,000 on the due date when the payment will be made by the buyer either
directly to the bank or to the seller and seller will deposit it in the bank. Bank would get entire 1
lakh rupees. And out of that 1 lakh rupees, bank has already paid 80,000 Rs to the seller so bank
will adjust for that advance and now for the 20,000 Rs bank first will calculate the interest of on
that 80,000 Rs which were given to the seller by the bank 40 days before.
And the interest on that on the pre agreed date plus the administrative charges plus some
commission banks charge for giving this kind of the services. So for example the total interest
plus the commission, administrative charges of the bank works out as 10,000 Rs. So bank out of
the remaining 20,000 Rs Still we have to wait for the 40 days, bank will deduct 10,000 Rs and
10,000 more rupees will be given to the selling firms.
So this way also as we were talking about that the firm is giving the selling firm is giving a
discount or proposing to give the discount to the buying firm at the rate of 10%. So in that case
also the seller was going to get 90,000 Rs. In this case also the seller in total has 90,000 Rs. So it
means banks come to the rescue of the firm, the selling firms as and when they want or they want
to convert their accounts receivables into cash.
So there is a quite sufficient or the good possibility of say liquidating the current assets which are
in the form of the credit sales or the accounts receivables. So accounts receivables are also
convertible into cash if there are they are of the good quality, current assets. Cash is already cash.
But this facility is not available in case of the inventory.
Inventory has to be kept as inventory and maximum we can do is that if we are able we want to
sell this inventory in the market and if the firm does not enjoy the good reputation in the market
or the firm’s product is not a welcome product in the market. So what will happen? Some buyer
will buy the product from the firm but on the credit. So what maximum the firm can do is, selling
firm in that case is converting the one asset that is inventory into the credit sales into the
accounts receivables but not in the cash or not into the cash.
So inventory is converted into credit sales into accounts receivables. One asset into another asset
but not into the cash. So liquidity, liquidity of the inventory is the least most. So we will have to
be very careful while learning to manage the inventory. How to manage the inventory is very
important concept because it is the first asset , is the largest asset, is the biggest asset and we will
have to think that how to keep the inventory.
How much inventory to keep it, all the 3 levels and how to manage it so that the firms do not
block more funds into the inventory. Similarly, cost of managing inventory also remains as low
as possible. Production process is also facilitated. That also goes on and market is also served as
and when there is a demand for the firm’s product in the market. So we will have to keep all
these things in mind while managing the inventory.
So in the 3 assets, important current assets, we talk about the management of 3 important current
assets, inventory is the most serious kind of the assets we will have to think about because larger
chunk of the funds is going to be blocked in the inventory if you keep the inventory beyond the
stipulated level. Receivables are convertible into cash either by giving discount to the buyers for
preponing the payments or by discounting those credit sale bills with the bank.
In the process, I just I told you and that process is called as the bill discounting facility given by
the banks in India and it is a very popular facility make use of this facility very frequently and at
the very say you can call it as increased level. So in case of inventory we will have to be very
careful because investment locked in the inventory is very high and we will have to think about
that if this inventory is not managed properly firm can means can be under a big financial stress.
And you take about the other way around the situation in another way round that we are
manufacturing and we are storing expecting that there will be a demand in the market. Lot of
costs are there. Carrying cost is there, holding cost is there. Maintenance cost is there and the
biggest cost in storing the finished goods inventory is of the obsolescence cost. We are
manufacturing today in anticipation of the demand 3 months down the line.
But 3 months later on we saw that there is no demand for your product because of the
competitors, other products in the market; change of the in the taste of the people. There is some
new products or some new alternatives are available in the market. So what will happen? The
adjusting inventory which is there with us that will become obsolete. So the threat of
obsolescence is the very big threat or that is very big risk.
So we will have to think about that also. So in overall we would say that management of
inventory is very important concept and we will have to learn all these assets management one
by one but we are moving first with the inventory process and first we learn with the inventory
then we will talk about the other assets. So it means finally what we want to say here.
We would say here is that inventory is which may be classified as raw material, work in process,
finished goods and supplies are an essential part of virtually all business operations, essential
part of all business operations. You cannot avoid inventories. You have to bear the inventories.
Inventory levels depend heavily upon sales as is the case with the accounts receivable. Inventory
levels depend heavily upon sales as is the case with the accounts receivables.
Because if you are going to sell more in the market you would have low level of inventory
because there is a inventory but it is fastly moving. If our product is selling like hot cakes in the
market there is a inventory but that is fastly moving. But if there is a say lack of sales for any
company’s product in the market in that case what will happen? Inventory will not move. So you
cannot stop the production process but here what is happening?
You are manufacturing and it is going to the warehouse. So what is happening? Your inventory
is mounting. And when the inventory is mounting rather than going to the market if it is going to
the warehouse it is a very pathetic situation. We should try to avoid this situation as is the so and
it happens with the receivables also because when the sales are there in the market.
So we create another asset also that is accounts receivable but at that time partly we sell it on
credit and partly we sell on cash. So it means that is not that bad as it is in case of inventory if
you are producing but you are not able to sell it in the market at the same pace then inventory
will start mounting and that mounting inventory is going to cause a big threat to the existence of
the or the continuance of the firm.
However, whereas receivables built up after the sales have been made. Inventories must be
acquired ahead of the sales. So they are the two means a peculiar situation. First you have to
estimate how much you are going to sell in the market in the period to come. Accordingly you
have to acquire the inventory. So you acquire the inventory as per the expected sales in the
market but sales figure got means somewhere misplaced.
That we have exaggerated the sales or because of the availability of alternative to the people we
lost the sales or whatever we expected or thought of that will happen in the market that did not
happen like that in the market. So what will happen? Your acquired inventory of raw material
will be converted into finished product but that finished product rather than converting it to sales
or accounts receivables will be converted into the inventory of finished goods.
That is more challenging a situation. So that should not be allowed to come up in the firm. This
is a critical difference and the necessity of forecasting sales before establishing target inventory
levels which makes inventory management a difficult task. So sales forecasting is important.
Selling finally is important and storing also depends upon the sales forecasting and our selling or
sales activity in the market. So this is a continuous process.
We first follow the backward process that first we forecast the sales we are going to make. Then
we come backward that we buy the raw material. Then we go for the manufacturing process.
Then from the manufacturing process it goes to the market and part of the inventory goes to the
warehouse and finally our objective is that the total production which we have made of the
finished products that should go to the market. We expect that it should go on cash but partly
when if it goes on the credit also it is a big shy of relief to the firm because finally we are able to
sell it in the market.
Cash sales are cash sales but even the credit sales are also good sales and they will also be
recovered at the later date but storing the inventory should not be the situation and the firm
should not be compelled to store the inventories. So this is just beginning of the management of
inventory process and more about it that how to manage inventory, what is the importance of
managing inventory, how to go ahead about say management of inventory I will discuss with you
all these things in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 18
Inventory Costs
Welcome students. So we are in the process of learning the inventory management under the
working capital management. When we talk about the management of inventory it has different
perspectives. When you simply learn the inventory management we have different techniques
like economic order quantity EOQ and then JIT and different techniques of inventory
management. That is a different perspective in which we learn the inventory management.
For the working capital part when we learn the inventory management we learn that how to keep
the level of inventory at the optimum level and what are the different techniques, methods to
minimize the level of investment in the inventory so that it continues the production process also,
serves the market also and we are not to be at the extra cost of investment in the inventory also.
So we were talking, I was, we were discussing.
I was talking to you the importance, the rationale of the inventory management that it is a
difficult task to manage the inventory because the mismanagement of inventory I would tell you.
The mismanagement of inventory can make a well-functioning organization a sick organization.
It can bring the firm under distress, under the stress, under the sickness and it can spoil the
overall running flow of the firm. How it happens?
I have shared with you a story, a case, a real life case that happened recently in India. You have
heard about the Steel Authority of India Limited. You know this is a very big company in the
public sector. Till 1991 when India was a closed economy, not a globalized economy, it was a
closed economy; Steel Authority of India was the steelmaker to the nation. We had only 2
companies who were manufacturing and supplying steel in India.
And larger market share was with the SAIL and some part of the total India’s market was with
the TISCO also. SAIL was called as the steelmaker to the nation. Now what happened? After
1991 when the steel sector was opened for the private sector participation and private sector
firms were allowed to manufacture and sell steel in India or serve the Indian market with steel. In
that situation in the western part of the country many private sector firms came up manufacturing
and selling steel in the private sector and 2 important firms were Lloyd Steel and Essar Steel.
In the southern market of the country Jindal Vijayanagar Steel Plant, Asia’s first hi-tech plant
came up in the steel sector. So it means it gave a very stiff competition to the SAIL. Earlier when
the SAIL was the only single largest entity in this country manufacturing and selling steel to the
people of this country and serving the 90 more than 90% market of this country, now they had to
face a stiff competition from the private sector firms in the western part of the country from the
Lloyd and Essar Steel.
And in the southern part of the country they had to face a competition from the JVSL Jindal
Vijayanagar Steel Plant which is now called as JSW Jindal Steel Works. It is renamed as Jindal
Steel Works at the Vijayanagar which is Asia’s first hi-tech plant which came up as JVSL Jindal
Vijayanagar Steel Plant. Now as a result of this privatization and coming up of the private sector
players in the market Steel Authority of India Limited lost major chunk of their market.
Because the quality of the steel they were manufacturing and the price of the steel they were
charging from this market or from the users in this market when there was a private sector
participation and competition from the private sector firms in the market when people found the
better product at the lesser price they opted out to the new product from the new suppliers and
SAIL had to lose the market. They lost the market in the western part of the country.
They lost the market in the southern part of the country. Now they are left with the northern
India, Central India, part of the Eastern India. Larger chunk of the market is lost. Now that
happened and when that happened the immediate effect of the company, this change in the
market and the market dynamics was and the loss of the market to Steel Authority of India
Limited that the inventory started, their inventory started mounting.
Because it is a big company, it is a large company having many plants, Bokaro, Rourkela, Bhilai,
all these plants they have Jamshedpur sorry Bokaro, Rourkela, Bhilai, all these plants they had.
They are manufacturing steel continuously; the production process is going on. When the
production process cannot be stopped you cannot stop the selling process. But selling depends
upon the demand in the market.
So continuous production process when the demand is not there in the market or the demand had
just say been divided by half or that has just remained come down to half or maybe little more
than half because of the loss of the major chunk of the market. So what will happen? What
started happening with the SAIL that major chunk of their sales or their production started going
to the warehouse.
And when it started going to the warehouse the inventory started mounting. Now what is
happening? You are buying raw material or raw material is coming. It is going to the production
process, being converted into the finished product. Earlier the finished product was going to the
market because entire market was with SAIL but now the market is lost to the private sector
players.
So part of the product is going to the market but part of the product is going to the warehouse
and you are not able to sell that product in the market. At that time the SAIL had a very huge,
large manpower, 1.47 lakh people and they almost because it is a public sector company they are
the permanent employees. Their salaries card was stopped. They cannot be say asked to leave the
firm and you cannot afford to stop the production process because there is no demand in the
market so production should be stopped. That also cannot happen.
So it means when the production process is continuous but when the selling but at the same time
selling process is hampered, it is stuck, it is interrupted so what happened? By the end of 90s, by
the end of 90s, maybe 98, 99 Steel Authority of India started reporting loses. It became a profit
well-functioning organization; a profitmaking firm immediately became the lossmaking firm.
And when the loss is sustained or continued to increase or to grow, loses continued to grow then
a profitmaking firm became a lossmaking firm because of the loss of the market, because of the
increased inventories and because of the less demand for the company’s product in the market.
So one single factor, other factors remaining the same; production is same, your processes are
same, your entire thing is same.
But because there is no sale in the market or the sale of the product in the market has been
significantly reduced so what happened? That it affected the overall inventory process of the
company and a well-functioning profit making organization suddenly became a loss making
firm. And it continued to be a loss making firm and government tried different ways and means
to restructure the company or to bring it back on the wheels.
Or maybe to sometimes to say bring it or to make it back as a profit making company but when
the government failed to achieve the say profitability of the firm or the company itself failed,
company’s management itself failed to bring it back on the wheels and to say make it a profit
making company from a loss making company then finally government thought of say
disinvesting or selling it to the private sector.
And for that global tenders were issued in the market but because of the very large size of the
company because of prevailing inefficiency in the company and because of very large size of the
permanent human resources in the company the disinvestment process could not deliver the
desired results. So government finally dropped the idea of disinvesting the company because
there is no buyer not in India but around the globe of this company called as SAIL.
So then the government thought of continuing with the process and running the company under
the public sector and for that purpose the company’s overall structure or the company’s say this
company was referred to the a consulting firm called as the McKinsey and McKinsey was asked
to study the Steel Authority of India Limited and suggest some its revitalizing strategies. So
McKinsey gave many suggestions that first of all your large human resources which are 1.47
lakh people it has to be brought down.
Anyhow you have to bring it down because you cannot sustain this much of the large human
resources are not required in SAIL so first you have to bring them down. Second suggestion they
gave that you have lost significant market in India and you are not, now it is not possible to
regain it back because private sector players are more efficient, they are more expert in the
market, they are more accepted in the market so do not expect that you will regain the market
within India, it is lost, it is lost forever.
So you have the option is that you look to go out of India and think of selling your product in
those markets where is it possible to sell and they suggested that Middle East could be a market
for the steel of the SAIL and for that you have to look for the long term say contracts with the
buyers in those countries and if you can make up some loss means loss market share in India
with the new market share in those countries then you can think of that the sales that inventory
level which is mounting that can be thought of say that can be brought down.
So then company worked on it. That company offered some VRS to the its adjusting employees.
Then some other say incentives were given the employees so that they can leave the firm, they
can leave the organization and then the strength of the company was significantly, human
resource strength was significantly brought down and then company opened a long term contract
channelizing agency or office in Dubai.
So that from Dubai the Middle East countries can be served or their market can be served and the
lost market share in India can be regained by selling the product in those markets where there is a
possibility. Third suggestion which was given by the McKinsey to the SAIL was that they have
to modernize the technology of their 4 plants; Bokaro, Rourkela, Bhilai, and Durgapur. It has to
be modernized and for that there was a requirement of the 50,000 crores.
So government thought of helping the company and that process was also followed. So you can
see that as a result of that now the SAIL is again to some extent back on the wheels but it had
become a sick company from a well-functioning or profitmaking organization and largely the
factor was inventory, inventory of the finished goods and that inventory of the finished goods
came in the balance sheet or appeared in the balance sheet of the company because of the lost
sale in the market.
So you think about the importance of inventory management because your funds are blocked in
the inventory and short term funds which are say so scarce which are so say precious which are
so expensive if they are blocked into asset which is which has become now the least productive
asset in that case what will happen? The profitmaking company will become a lossmaking
company.
It has already happened in case of SAIL and it can happen in many other companies. When the
companies become sick it only happens when they are not able to sell their product in the market.
So if they are able to say readjust the manufacturing process then it is fine. But if it is not
possible to readjust the manufacturing process and if the production goes on with the same pace
but the sales do not pick up so what happens?
Slowly and steadily the company becomes sick and it goes out of the market. So we will have to
think about that inventory management is very important as far as it is called as a current asset,
short term assets, and funds are blocked in this asset. Short term funds are blocked in this asset.
So as we have seen here in this case that this is a critical difference and the necessity of
forecasting sales before establishing target inventory levels which makes inventory management
a difficult task. So sales forecasting is very important. So if we are say for example in case of
SAIL we have seen that if they have lost the market in India they should have forecasted it.
That if we are losing sales in India what are the other markets out of India or outside India which
we can use or we can say supplement with the existing market or whatever the market is left with
us so that lost sale in India can be regained from the market outside. So it could not be done at
their own level but McKinsey then suggested them to go to Middle East. They found the market
and then they improved the situation. So it is a bit say difficult task, is a challenging task.
Also, since errors in the establishment of inventory levels quickly lead either to lost sales or to
excessive carrying costs, inventory management is an important as it is difficult. It means if you
have mismanaged or if you have mis-assessed the inventory requirement so sometime what will
happen. We will have plenty of inventory with us so we have the large stock of inventory and it
will increase the carrying cost right?
And sometime the obsolescence cost also and if there is a again you can call it as the forecasting
of the sale is lesser than the say actual level which we can attain in the market so what will
happen? They will be facing the cost of out of stock or stock-out cost. So that is again a very
important. So appropriate or the proper forecasting of the sales or the say you can call it as the
desired forecasting of the sales is a very important requirement.
If you are able to forecast the sales properly that what we are going to do in the market how
much we are going to sell in the market then it is fine. Otherwise it is very difficult. And
profitmaking company can become a lossmaking company. Financial managers in corporates
have a responsibility both for raising the capital needed to carry inventory and for the firm’s
overall profitability right.
You have to on the one side raise the investment or you have to make the investment. So if you
make investment more than the required level so what will happen? Cost will increase, returns
will go down so profitability will be negatively impacted and contrary to this if we make lesser
investment and if we face the stock-out cost we will be losing the sales. We will be losing the
revenue. We will be losing the profits.
So ultimately profitability will be again negatively affected by not selling in the market and by
not earning the profits which could have been possible if we could have sold in the market.
Hence it is important for them to understand the financial aspects and issues involved in the
inventory management. It is very important for the financial manager. It is important for the
production manager because inventory is related to the production process.
But here as a student of working capital management it is very important for us to understand the
inventory management from the financial perspective. For the financial manager also he also has
to understand that how much investment is required to be made in the inventory and from where
to arrange this investment, how to manage this investment and how to generate maximum returns
on this investment so that it does not become a wasteful investment or it does not remain short of
the requirements. Effective inventory management.
Now let us talk about certain important points here. Ensure a continuous supply of raw material
as I have been talking to you. Continuous supply of raw material. So to avoid the excessive
investment into the inventory what we do is we ensure a continuous supply of raw material
maybe by adopting the JIT just in time arrangement but we will have to make sure that yes
sufficient inventory is available with us.
Now these days what is happening that to ensure the proper or the continuous supply of
inventory to the firms there are 2 ways. One thing is either you have just in time process but
since we have very rough logistic situation in India so adopting or following even just in time is
also not possible. So what is the need of the plants or the manufacturers that they have to store
the inventory the minimum or the desired or the optimum level of inventory they will have to
store.
But when they store their inventory their inventory cost goes up. Maybe the inventory cost of the
raw material it goes up. So what they do? Most of the manufacturers especially in electronics
sector, in the automobile sector what they have started doing is their strategy is they identify the
suppliers because for example if you talk about the car manufacturing company, a car
manufacturing company in its own plant manufactures largely it manufactures the gearbox.
Other parts you talk about the steel, you talk about the rubber parts, you talk about the glass part,
you talk about the say tyres, tubes everything they are supplied by the other manufacturers. They
are called as end sellers. So now what is the strategy inventory strategy so that minimum
investment is made in the inventory and continuous supply is ensured, continuous supply of the
raw material is ensured to the company or to the manufacturing process.
When the company has designed the layout of their plant they provide the space to the suppliers
of different inputs or different raw materials. They provide the space to the tyre suppliers. They
provide the space to the tube suppliers. They provide the space to the glass suppliers. They
provide the space to the rubber part supplier and to some extent they provide the space to the
suppliers of the steel also.
So within the premises of the factory or the manufacturing process the plant one area is the
manufacturing process manufacturing plant on the other side the storage area and that storage
area is allotted to the suppliers of the different inputs. So those suppliers of different inputs are
supposed or are required to keep a sufficient level of the inventory with them within the plant
area of the company.
So inventory is being managed by the supplier but since it is a just a ways length so it means as
and when it is required it is available to the manufacturing process. If it is not being done by the
company what will happen in that case? The company itself has to manage its own inventory. So
in that case the company the main manufacturer they will have to bear the inventory cost also. So
they are passing on the inventory cost to the suppliers.
And suppliers rather than locating them outside the plant and then again facing the supply chain
problems, they are located within the plant, space is provided by the company, sometime free of
cost or sometime on some say normal renting. Rental charges are, normal rental charges are
taken from the suppliers.
Suppliers store their products for the company so as and when the manufacturing process, car
requires, cars manufacturing requires glass, part or the rubber parts or the seats or the seat covers
or the say tyre then tubes and anything that is available within the plant, the inventory is being
managed by the supplier. Cost is being borne by the supplier. So company without even
maintaining any level of inventory they get the continuous supply.
This is an normal model which is being followed by all the manufactures in India. For example
you visit the Maruti Plant maybe in Gurgaon or any other place you will find that the inventory
place or say end sellers are storing their inventory within the plant only. They have been
provided the space by Maruti and Maruti without maintaining any kind of inventory they are
getting or they have ensured the regular supply of the material.
This is the one strategy. But in certain cases what happens that say for example a company which
is manufacturing the agricultural product or agriculture means they are say raw material is
agriculture based products. So they are processing it. For example you talk about the ITC. ITC
when they manufacture different agriculture based products. So they have, you must have heard
about the e-Choupal.
So they had the long term agreement or arrangement with the farmers and they have the
arrangements like that whatever the total crop maybe the wheat crop or maybe the any other crop
it comes up we will buy it in total from you and partly you will store the inventory and partly we
will store the inventory. Or sometimes if it is a seasonal product so if it is a seasonal product so
in some cases if the farmer is unable to store the product company has to buy the total product at
the time of the season and they have to store it.
So there is no other way out. You cannot ask the end seller or you cannot ask the supplier
because farmer’s financial position is not that good. Farmer’s say facilities are not means farmer
is not able to have the facilities like of the cold storage and other kind of things. So in that case
what will be there? Company will, ITC will ensure the supply of the good quality inputs. They
have to be bought in the season when they come up, when the crop comes up.
That have to be properly stored and sometime the cold storage facilities we will have to use and
the cost has to be borne by the company because farmer is not able to bear that cost. So in that
case that is a different process. So in that case the inventory cost goes up or managing the
inventory goes up but they manage the inventory cost in a way because they buy during the time
at the time of season and they buy in bulk so overall purchase price per unit goes down.
That remains optimum for the farmer also and for the company also. Farmer is able to sell the
product in bulk and the company is able to buy the product input in bulk and both have the
agreement that your entire crop is ours. We will pay you the in full. So farmer has not to look for
the market. He is also assured of the sale of his product and company is also not to look for the
raw material but they have to store the raw material.
So cost is say acceptable to the company as well as the price is also acceptable to the farmers and
both are having the win-win situation. So it means managing the inventory means we have to on
the one side ensure the supply also and second side is we have to keep the cost under control
also. Investment also has to be optimum and supply has to be regular and we have to avoid the
stock-out situation also.
Second thing is maintains sufficient stock of raw material, whether it is by the end seller or
whether it is by the company as in the case of the agricultural products it has to be made means it
has to be assured that material is available in the sufficient supply in the desired supply and it is
all the times available as and when it is required so that production process is continuous.
Maintains sufficient finished goods inventory because we have to avoid the stock-out cost also.
So if you have to have sufficient finished goods inventory also as I told you that we have the
regular distribution channels, distribution process but sometimes what happens that we have
some extra or unforeseen orders, unexpected orders and firm should be able to meet all those
requirements of every buyer in the market. Otherwise, the firm has to face the stock-out
situation. So that should not be there because that will be the loss of sales, loss of revenue, loss
of profits, and loss of goodwill in the market.
So we have to make sure also that the finished products should also be sufficient in supply so
that there is no shortage of the finished goods inventory but the finished goods inventory should
not be that much like SAIL that it becomes unsellable, it becomes obsolete and firm has to pay
the cost of obsolescence and firm has to face the huge financial loses for not being able to sell its
inventory in the market. Minimizes the carrying cost and time.
Minimizes the carrying cost and time. That is also the one important requirement of inventory
management that your carrying cost should be minimum. So it means that is why we are
emphasizing upon, optimum level of inventory. Too high too low, both have the cost. if you have
too high, we have the very high carrying cost. if you have too low, sometime we have to face the
stock-out cost and stock-out cost is very high.
I will share with you a survey done by the Harvard Business School professors where they have
say interviewed 70,000 respondents across the globe or in the many countries in the world and
finally they have concluded that stock-out cost is very high cost and it should all the times be
avoided because sometimes it is not the case of the firms or companies. In our day-to-day
situation also when we go to the market and we want to buy a particular product.
We have gone up to the market with a our made-up mind that we want to buy a particular brand
of the shampoo and we want to have that bottle available with the retailer and when that
shampoo is not available and retailer says sorry I do not have the product how you feel at that
time. So sometime we feel that I will not come back to this shopkeeper or to this shop so that
shopkeeper is losing the sales forever.
Sometimes the person says I will not use this company’s product because it not available now
and I have been say denied the product. So it has a huge cost. People sometime change the
buying options. Sometime they change the product options. Sometime they go to the alternatives.
So it is a big cost. So we should not allow anything of the kind which is called as the stock-out
cost and the carrying cost. Controls investment in inventories at an optimum level.
So finally maintain the inventory which is optimum, which is acceptable, which is giving you
optimum returns optimum cost. So that is the ultimate objective of the inventory management
because we have to look at as a student of working capital management everything from the
financial angle. How much funds I should invest in this asset so that my cost of funds is also
under control and my returns are also at the accepted or acceptable level. Motives of inventory.
Why you store the inventory or why you go for the inventory management. Transaction motive.
Precautionary motive and speculative motive. Transaction motive means we need the inventory
for our manufacturing process, day-to-day process, continuous supply of raw material to the
manufacturing process and continuous supply of the finished goods to the market. So on the one
side you want to ensure that your plant is continuous working.
On the other side you want to make sure that your product is all the times available in the market.
There is no shortage of your product in the market. So it is a transaction motive. Precautionary
motive. Sometime there can be shortage of the material in the market. So we will have to face the
music. So you keep sometime inventory which is expected to be short in supply in the time to
come. We keep that more in our warehouse or in our godown.
We keep more inventory in the godown. So that we have not to face the stock-out situation in
case of the raw material also. That is the precautionary situation. Sometime what happens that
some agricultural products are like because agriculture raw material is available at the time of
season. Now you think about a firm manufacturing the say this sarson oil or the mustard seed oil.
Mustard seed is a agricultural product. It will be available at the time when the crop is there.
So if the firm who is manufacturing the mustard oil if they want to derive maximum benefit out
of their product oil they are selling in the market they have to buy the largest or the maximum
amount of the mustard seed at the time when there is a crop and from the places from the areas
from the mandis where it is available in the bulk as well as the best quality of the seed is
available.
If they do not buy at the time of season then rather than the manufacturer of the oil somebody
else will store the mustard seed. At that time if he jack up the price then what will happen? If the
mustard seed price goes up oil price will also go up and if the company is not able to sell the
product at the competitive price in the market the well-functioning organization will be sick.
Speculative purpose. Speculative purpose means buy today and sell at a higher price tomorrow.
That also happens. Everywhere it happens. There are many firms who maybe the agricultural
product itself we talk about. The entire agricultural crops or products do not go directly to the
manufacturers of the finished products. Sometime it remains with the middlemen also. Or
sometime it remains with the firms for manufacturing the finished product but sometime they
tend to sell the raw material also. So they buy in bulk. They store in bulk.
Part of the material they use in their own manufacturing process and part of the material they sell
it to the other manufacturers when the supply is short in the time to come. It is a speculative
purpose by investing more to earn more but selling the product at that time when there is a
shortage of that raw material in the market. So if that is possible and we can estimate the market,
we can forecast the sales, we can forecast the coming situation well then it is quite possible.
There is no harm in say using the inventory or the inventory management for the speculative
purposes we can do that but we should be careful that sometime speculators have to face the
huge loss also and that loss if comes then it will kill the company financially. It will affect the
financial health of the company.
Inventory costs. We all know what are the inventory costs. We have been talking since we
started talking about the inventory management. So we have the 4 kind of the cost. Number one
is the carrying cost. Major chunk of the cost is the carrying cost which is that part of the funds
which are invested in the say purchase price of the inventory. Price we pay to the farmers in case
of mustard seed, in case of potato, in case of onion, in case of other agricultural wheat, rice.
That is the main, this is the main cost, major cost. Second is handling cost. Transportation cost is
there. Storage cost is there. When you keep it in the godown, electricity cost is there. Water cost
is there. Manpower cost is there. Every cost is there. So that cost is called as the handling cost.
Ordering cost, shipping cost, receiving costs, all these are the costs. And finally the cost is the
stock-out cost, which I have been talking that stock-out cost is a very big cost.
It has been empirically proved after research that if you are not able to serve the market for the
needs of the market as and when it is required then it affects the company’s reputation and
supply chain arrangements as well as overall goodwill and reputation of the market severely. So
we should avoid the last cost also.
Because it should be firm’s objective that the optimum level of inventory means ensuring the
continuous supply of raw material to the plant or to the manufacturing process and ensuring the
continuous supply of the manufactured or finished product to the market so that all the times
when people want to buy any company’s product the product is available on the shelf. If it is not
available on the shelf, if you are not able to serve the market as and when market wants our
product then the cost is very high. So all these 4 costs are important.
So keeping these costs in mind we will have to manage the inventory in such a way that on the
one side supply is assured and the funds are also minimum investment of the funds also takes
place and the profitability is also not compromised. That is also at the desired or the expected
level. More about the inventory management I will discuss with you in the next class. Thank you
very much.
Dr. Anil K. Sharma
Lecture - 19
Inventory Behaviour
Welcome students. So we are in the process of discussing the inventory management under the
working capital management and the importance of inventory while managing the short term
funds or the working capital. We have discussed in the previous class also that the asset which is
the least liquid asset and converting inventory into cash is a difficult process so we should be
careful while making investment of short term funds in the inventory.
And if the large investment is made the funds will be blocked for the longer duration and will not
be able to convert into cash as and when we wanted. So that will create the problem. So we are in
the process of discussing all this relevance of managing inventory. So we were talking about that
say when you manage the inventory we have different motives and the different costs are
associated to the inventory.
And we saw that carrying cost, handling cost, ordering cost or reordering cost and the stock-out
costs are the 4 important costs which we should be careful about and if we are not able to
manage these costs properly then the overall cost of production will go up. The total say selling
price will also increase and the firm would not be able to sell the product in the market at that
price so that will create the problem.
So we will have to keep the cost of inventory under control. So we have to keep the investment
in the inventory also under control. So for that purpose we should learn that how to manage
inventory as far as the management of the short term funds is concerned. Now let us have a look
upon the inventory behaviour, how inventory behaves.
Just for a moment let us talk about the different costs and we are talking about the carrying cost,
handling cost, ordering cost, and the stock-out-cost. So we know what is a carrying cost, what is
a handling cost. Carrying cost means the investment made in the inventory that is the purchase
price of the inventory. Handling cost that is of the electricity, water, and then the manpower
people who are say posted on the in the godown we have to pay to them.
Similarly, we have the ordering cost also, receiving cost, shipping cost, means transportation cost
all these costs are there we all understand that these are the physical cost but the one cost which
is the stock-out cost I have discussed with you in the previous class also that is also a very
serious cost. Very important cost, very serious cost and we should try to take care of this cost
also.
That is why we talk about investment in the inventory which is the optimum investment not too
less not too high. Because if we make the investment too less in the inventory then sometime we
have to face the stock-out-cost and that will also have the its repercussions. So to avoid the
stock-out cost we should maintain sufficient inventory at all levels and what the repercussions of
the stock-out cost and how it can impact means the firm at every level.
It is not only impacting the firm the manufacture but even the distribution channels also, the
retailers also. So a detailed discussion on this kind of the cost, stock-out cost I will have with you
in the sometime later because we will see that how serious this kind of the cost is and as I
discussed in a reference I gave you the reference of a survey conducted by the Harvard
professors a team of the Harvard Business School professors.
Where they say interviewed 71,000 customers across 29 countries and what were the outcomes
of those discussions as well as what was the reaction of those consumers that if they find no
product on the shelf when they want to buy or they intend to buy or they visit the store to buy the
product. If they do not find the product on the shelf what is their reaction. So the total detailed
survey and their outcome and the say the seriousness of the stock-out cost I will discuss with you
sometime in the class later on.
But let us first move to the next part that is the understand the inventory behaviour. When you
talk about the inventory behaviour, you see that inventory behaviour moves like this.
High inventory maybe it is a inventory of raw material. It is a inventory of work in process or it

is a inventory of finished goods. Moves to the low prices right. Cut back on the production so
that opening inventory becomes low. For example any firm has a very high inventory of the
finished goods. They are not able to say it means the movement of the goods from the place of
production to the place of consumption is slow.
They are not able to pass on the production to the market at the pace as it should have been. So
there is a high inventory as I discussed with you the case of SAIL, Steel Authority of India
Limited in the previous class. We saw that why the Steel Authority of India became a sick
company. The only reason was very high level of inventory of the finished goods because
production process was continuous and selling process was affected because of the competition
from the private sector so they had the high level of inventory.
So in any firm if there is a high level of inventory what will happen? The prices will go down
because the supply side is improved. And high means very say high supply of the goods in the
market will certainly create a situation when the prices will go down and if it is possible, if it is
possible as I discussed with you that in case of the SAIL it was not possible to cut down the
production because of the heavy investment in the human resources.
Then they had the 6 plants and many things. So people cannot sit idle. They cannot be asked that
plant is shut because we are not able to sell the product in the market. So you have not to
produce today. Production process was continuous but the selling process was not continuous
that was affected because of some changes in the market. So because of that reason, company
became sick because of the mounting inventories.
But in the normal cases or maybe in the cases when it is a small firm or the firm if it is able to
adjust its production process then certainly they should do it because inventory is very high and
prices are going down so that will create a problem for the firm because they would not be able
to even sell the product at the desired price or sometime not even at the cost price. So there is no
point selling at that price in the market. So better it is that to cut down the production.
Production should be reduced and you should wait for that the adjusting inventory is sold in the
market that goes to the market and once that existing production has sufficiently or means going
to the market to the to the sufficient extent then after that we should try to say regain the
production process. So opening inventory in the coming time when we have to regain the
production should be very low, opening inventory should be very low so that we can add up the
new inventory of the finished goods.
And normally that happens also but that when any supply of any goods or services goes up in the
market the production process is readjusted if it is possible and it happens in many cases it
becomes possible so the production is readjusted and then the production is the pace of the
production is slowed down and once that adjusting inventory is fully exhausted in the market or
exhausted to the largest extent then the new production takes place.
So this is a normal behaviour of inventory so that demand and supply side remains sides remain
balanced. Next thing happens in the behaviour of inventory is that excessive inventory is due to
unavoidable circumstances or inefficient management. Sometimes because of the recessionary
situation in the market when the purchasing power of the people go down, they find it difficult to
purchase certain things. So how the people then decide or ration their say their purchases.
First of all they go for the necessities. After that they go for the comforts and then they go for the
luxury. This is the normal process. So if we are manufacturing a necessity or we are
manufacturing the product which is a necessity for the people, impact of the recession will not be
very high. It will be there but not be very high. But if it is a comfort or luxury certainly it will be
most hit. So we will have to see that in which segment we are.
What kind of the product we are manufacturing and we will have to think about that if we can
readjust the manufacturing process we should do like that otherwise the prices of the means
because of the increased supply prices will fall down and the manufacturers have to suffer the
loss. So in that case what happens?
That sometimes this inventory, excessive inventory comes up in the pipeline only because of
certain factors that sometimes we are not able to forecast the sales properly or in the right earnest
that how much we are going to sell in the market or how much is going to be the demand for the
product in the time to come in that case what happens? The production process is strengthened
and more production comes out of the industry.
Whereas the demand for the product is not there that maybe because of the recessionary
situations, maybe because of the say lack of the purchasing power of the people and this all
maybe whatever the reason you could say, we would ultimately say that all these reasons or any
of the reasons would attribute to the reduced sales reduced demand from the market and when
there is no demand in the market it means our assessment of the market in the time to come has
gone wrong.
So it means sometime inefficient management sometime some unavoidable circumstances as I

told you that in case of the SAIL the circumstances were unavoidable. You cannot stop the
production . You have a huge manpower 1.47 lakh people were there at that time with the Steel
Authority of India Limited. So they are the permanent employees. They will not say that you do
not pay us the salaries because you are not able to sell the product in the market.
So once you have to pay their salaries they are everyday coming morning to the plant office
everywhere and then all the plants, 6 plants of the company, 4 major plants that is the Rourkela,
Bhilai, Bokaro, Durgapur and 2 more plants they were continuous working and they had to so if
you stop working with the plants at the desired capacity, the other costs will go up. So it was not
possible to stop the production.
So production was continuous but the sales were affected. So I can say here that excessive
inventory takes place either due to some unavoidable circumstances that company suddenly lost
the market, production process cannot be readjusted. So inventory is mounting, company is not
able to sell the inventory in the market. Or sometime when we are not able to forecast our sale,
sales properly then also the inventory comes up.
So we should try to look forward in future that how much we are going to sell in the market.
Same way we should produce and same way we should make investment in the inventory or in
the stock of the raw material, work in process, and the finished goods so that everything remains
under control and the overall cost of production does not go up just because of the inefficient
inventory management.
Third point in the behaviour is firms draw down inventory, inventory slowly if no jump in the
prices. Again that could be the one important reason. When because of the recession it entered
the market or because when the say income of the people go down then the purchasing power of
the people is affected. For example we have seen the say subprime crisis in 2007 and that say
continued and that it became a global crisis and most of the countries in the world were affected
negatively.
So people lost jobs. When people especially people who are working in the private sector, they
will lose jobs because for the what of production and sales in the market. So when people lost
jobs their purchasing power was affected and because of that the say selling in the market was
very difficult for the firms.
But to talk of the manufacturing products when we talk about the subprime crisis that happened
in US in 2007 even the inventory of the houses or the say people who were who had borrowed
money from the banks and had purchased the houses then somehow when their purchasing
power was affected or their income was negatively affected they were not able to repay back the
EMIs on the loans which they had taken for buying the houses.
And ultimately they surrendered the houses so inventory of the housing increased with the banks
and because of the increased inventory with the banks because everybody is surrendering the
house as they are not able to pay the loan. So supply of the housing stock increased and prices
fell down. So many banks were not able to recover their loans because ultimately what the bank
can do is bank can take the charge of the house which has been purchased by the person by
borrowing money from the bank.
So if the person is not able, is not able to repay the loan he has to surrender the house but if
everybody is surrendering the house or every third person is surrendering the house the stock of
the inventory of the housing went up and suddenly the price of the housing fell down. Many
banks failed in US. Lehman Brother is the one bank that is the case that it was a dream company
for many people to work in.
But that also failed and many other banks also had to face the heat of the subprime crisis. So in
that case what happens that if the prices are not going up if the prices are not improving then
certainly the inventory level has to be readjusted so that supply side also becomes weak and
when there is a lesser supply and stable demand in the market or demand start picking up then
only the inventory level is increased, manufacturing process is readjusted, strengthened and the
more supply comes up in the market.
So if in any way when the supply goes up, demand remains stable or goes down then what
happens? That inventory is increasing, prices are falling down. Other side if the demand is
increasing, inventory is low, prices are going up. So what we have to see is we have to see we
have to forecast that how much we are going to sell in the market in the time to come. We have
to prepare the proper budgets for that.
And that will depend upon the sales forecasting that how much is going to be the total demand of
the product we have manufactured and we are selling in the market. And in the time to come for
example in the next 3 months, in 1 quarter how much is going to be the total demand for example
we talk about the colour TVs. So companies have to plan in a way that how much is going to the
demand for the colour TVs in the total Indian market.
What is the market share of the company in question and how much colour TVs they are
planning to sell. So accordingly they should go for the production and that happens also. That is
a natural inventory behaviour that happens also. And when say the inventory level starts
mounting, production process is readjusted so to bring the inventory down the efforts which are
made by the firms.
And the result of those efforts is that firms tend to sell more than whatever they produce. They
shrink the production process. They control the production process. They do not produce as they
were producing in the past. They shrinken the production process and when it is controlled
production is reduced, sales are increased. So ultimately the effect is that again the inventory also
gets readjusted.
Purpose of this all is to understand the inventory, inventory behaviour clearly and then to say
following the changes and then implementing the changes and adjusting and readjusting the
manufacturing process is that prices of the products which are in the market remain at the
acceptable level for both the sides; seller also and the buyer also. So the continuous adjustment
in the manufacturing process is required to be made.
Next point is economy seems to be the persistent industrial recession if the sales are not picking
up right. If the sales are not picking up in the market it means the industry is in the continuous
industrial or the persistent industrial recession. It will create a problem for all. It will create the
problem for the manufacturer also. It has the already means created the problem for the buyer
also.
When the buyer’s power, purchasing power is getting affected negatively, in that sense what is
happening? The seller also has to control the supply. Otherwise prices will fall down. So when
the economies are in the persistent industrial recession or the purchasing power is affected,
production processes are readjusted so ultimately it creates the problem for all. To deal with the
problem if we are not able to sell in the market better it is not to make much investment in the
inventory.
Make lesser investment in the inventory and produce less. If it is possible that is the best way to
do the things. Firms increase sales if sudden jump in the say prices occur. If there is a sudden
jump in the prices then certainly firms will increase the sales because they would like to recover
the total investment they have made in the say inventory or in the manufacturing of the goods.
Drawing from inventories with increase in production.
So then increase in the production, production picks up. Whatever is there in the inventory that is
also taken out and most of the things go to the market and when the there is a high demand in the
market certainly because it is a cyclical trend. So it means initially we started manufacturing the
production then it started rising. It is at a point but because of certain reasons there was a
industry recession so demand certainly fell down because of the negative impact upon the
purchasing power of the people and then the demand was negatively affected.
So it means the industry has to slow the production also. They have to take out from the existing
inventory and even if they are not able to get sell that inventory at the desired price then they
have to say take out the minimum finished goods from the inventory also and they should wait
for that when the market improves. If the market improves then because it is a cyclical trend so
market will improve. So when the market improves then everything will pick up.
Production process will also pick up. Taking out from the inventory existing inventory will also
pick up and that will be a win-win situation for the buyer also as well as for the seller also
because buyer purchasing power has improved and for the seller the market has improved. But
normally in case of inventory this kind of the cyclical trends are very common, they take place.
So we should be very careful that to avoid excessive investment in the inventory because we are
going to invest the short term funds and sometime what happens.
When the short term funds are not sufficient in supply then we have to invest the long term funds
and you see there is a mismatch between the cost and the return because long term funds as I
discussed with you in the past that in India today we also have the term structure of interest rates.
So as the maturity period gets longer the cost of the funds also increase, the interest rates also
increase.
So if you have borrowed the funds for the long term purpose it means for next 5, 10 years. So it
means we are paying a high rate of interest somewhere 18, 20% and we are investing those funds
in the inventory which is short term asset or current asset then there is going to be a mismatch
because the return from the inventory is very low sometime, even negligible returns from this
asset.
Whereas if the cost of the funds is very high so the firms finances, firms incomes are going to be
impacted seriously, negatively because of the increased financial cost. So we have to be very
careful that we should be able to visualize how the inventory is going to be managed by the firm
and how the market is going to behave, how the sales are going to take place in the market and
how the inventory level should be adjusted and readjusted.
Now why inventory level increases, why inventory level increases? We all know that there are
many reasons why inventory level increases. As we have seen in case of the SAIL as I discussed
with you inventory level in the SAIL, Steel Authority of India Limited increased because of the
sudden change in the economic policy of the government. Till the till 1991 the economic policy
of the government did not allow the participation of the private sector into the steel sector.
But suddenly after 1991 when the private sector participation was allowed in the steel sector
private sector firms were allowed to come up in the steel sector, in that case SAIL got unforeseen
competition from the private sector players. They lost the southern market, they lost the western
market, part of the central markets of this country, central India and then near about say 30-40%
market of the company is lost. So what happened?
Their manufacturing process as I said could not be readjusted. The production was continuous,
sales were affected negatively. So inventory started mounting. That happens if sudden change
takes place in any of the factors maybe because of economic policy, maybe because of change in
the demand of the people, maybe because of the intensification of the competition in the market,
maybe any reason could be there. So inventory can increase.
We should avoid the increase in the inventory level and we should be able to forecast or
foreseeing the future that what could be the factors that might affect the inventory policy of the
company negatively. So we should be able to visualize well in advance that if our inventory level
starts going up what should we do? Or what should we do that inventory level remains under
control, it does not go up.
So for that reason we should understand why the inventory level goes up. There are certain
reasons we have listed out here.
We have put here some reasons like first is no perfect markets. Because it is not very it is not
very easy to find out the demand and supply scenario in the market. It is not very easy to find
out. Now when there is a sudden increase in the income of the people, people start demanding
for even both services and goods which are not demanded much in the past. So what are the
factors?
We should be able to find out that is there any possibility that the income of the people is going
to increase because of any reason? Then say in the beginning of any new financial year when the
companies say announce the hike in the salary of their employees or sometimes when the
government announces the hike in the salary of its own employees we can expect that the income
of the people go up.
When the income of the people go up, goes up in that case you should expect that yes people will
start demanding for more goods and services. It may be possible that all segment or all category
of the people, all income, people belonging to all income groups; everybody’s income is not
growing. There might be different segments of the people. Say for example you talk about the
upper middle class.
If the income of the upper middle class is expected to go up we can say that people may start say
buying more cars or looking for more cars. People who are say in the lower classes or lower
income groups or maybe the lower middle income groups, they may start looking for more two-
wheelers, more colour TVs, more refrigerators. So it means we will have to see that what are the
economic factors which are going to change the demand, impact the demand.
Maybe positively, maybe negatively. So since we do not have the perfect markets, it is not very
easy to visualize how the demand and supply will behave in the market, these forces will behave
in the market. So because of sometime of imperfect prediction of demand for any product
increases the inventory level because companies strengthen the manufacturing process. But when
the income does not increase, when the people do not buy the manufactured goods which are
available in the market in that case inventory level goes up.
So since the market is imperfect we should be careful how to find out what is going to happen in
the market as far as the demand and supply situation is concerned. The companies at least the
product which they are manufacturing they can conduct the surveys, they can be more nearer to
the people, their existing buyers or maybe the potential buyers they can collect the regular
information from the market and then they can try to find out what is going to be the possibility
or what is the possibility of increasing or decreasing of the sales of their product in the market.
That is a very important requirement if you want to control the investment in the inventories.
Another reason could be no efficient production distributive system. Sometimes, normally the
firms have the proper distribution channels right; firms have proper distribution channels but say
we have 2 kind of the marketing systems in this world. Sometime we have the direct marketing
system and sometime we have the indirect marketing system.
In the direct marketing system we say that there are the companies who have their own
distribution channels, their own distribution network for example you talk about Bata right. Bata
sells in the market first they sell it directly through their own network, through their own shops
and through their exclusive stores. Similarly, we have some branded say apparels also like you
talk about the Reebok, you talk about the Nike, you talk about the Puma.
So all these products largely they have their own exclusive distribution network. So when they
are directly manufacturing and selling in the market they remain connected to the people,
existing as well as the new buyers. So they remain informed that how people like their
production, how people react about their product, and what changes people expect and if we
make the desired changes as designed as expected by the buyers then the sales of the product
may pick up.
But sometime what happens? We have the indirect distribution channels, which is a normal
process. Somebody else manufactures the product and then we have the distribution process. The
product from the manufacturer it goes to distributor. From the distributor it goes to the retailer
and from the retailer it goes to the or sometime there are the 3 people; distributor, wholesaler,
retailer, and then consumer. It is a very long chain. So in that case sometime what happens?
When the retailer is not helping the company to sell the product, when the retailer is not helping
the company to sell the products sometime what happens? Companies compete with each other
and they keep on luring the retailers by offering them different schemes, different percentages of
the margins and different other incentives. Now any retailer who is given a incentive by a
company he would like to sell more of the products of that company rather than of any other
company.
So it may be possible that the company was given the incentive and the company who has not
given the incentive, the company who has not given the incentive to the retailer might not be
knowing that the retailers preferences have changed and when the retailers preference is changed
in that case it is sometime creating the fluctuation in the demand and supply situation. Product is
not moving to the customers as at the desired pace.
Retailer is convincing the customer even though the customer has come prepared to his shop to
purchase a particular product but since retailer’s interest is with some other company so he
sometime convinces the buyer that rather than buying the product of this company you buy the
product of that company. So in that case which if it is known to the company whose inventory is
in question then this fluctuation may take place.
And we will have to think about that how to take care of such kind of the factors. Now in a
situation I would share with you a very important thing that when you talk about the relationship
between the manufacturers, retailers, and the consumers right; between the manufacturers and
the users of the product, consumers of the product there is one for example we forger the other
two, distributor and the wholesaler. We say only retailer is there. So what happens?
Retailers first are the agents of the consumers then they are the agents of the manufacturers right.
They want to give the best product to the consumer so that consumer is satisfied with the product
which he has purchased from a particular retailer and consumer keep on visiting him time and
again. To change this loyalty of the retailers from the consumer to the manufacturer some
companies give them different kind of incentives.
And for that incentive he changes his position as a say loyal to the consumer rather than being
loyal to the consumer he becomes loyal to the seller or to the manufacturer and because of that
the company who has given the incentive their sales pick up and the companies who do not give
the incentives their sales are getting affected negatively. So these fluctuations also cause some
increase in the inventory. Break-down or burn the production distributive system.
Sometime there are some mishappenings and the say productive distribution system is broken
down or it is say it is getting affected. For example there is no availability of the raw material or
very less availability of the raw material. So what will happen? Supply of that product will be
affected negatively in the market. Sometime there is a technical fault in the manufacturing
process of the firm so they are not able to pick up with the production process.
So that also affects the supply position in the market. So in that case it is not good for the
manufacturer, it is not good for the consumer also. Because in certain cases we have seen that the
prices of the essential commodities go up. We see the prices of the sugar sometime go up
sometime we see the price of the onions go up. That only happens when there is a breakdown of
the supply system.
Maybe because of the non-availability of raw material or maybe because of the not efficiently
working the plant conditions or maybe because of any other reason and inventory is affected.
Sometime we have high amount of inventory but because of the breakdown non-availability of
raw material there is a very low level of inventory or sometime no inventory available so again
the firms are affected for the stock-out cost. Inventory absorbs the shocks of fluctuations right.
So if we keep inventory and sometime if there is a unprecedented demand in the market if we

have the sufficient inventory we can fulfill the demand. It happens reverse also. That you have
huge inventory, demand has gone down, and we have to continue with the existing level of
inventory and your sales are blocked, sales are not picking up. Your funds are blocked because
of the high level of inventory. So anything is possible.
No stock-outs for finished goods, no loss of the sales. So it means if we want to maintain a
appropriate or the optimum position in the market we should take the inventory management
very seriously. We should look forward and try to find out the reasons which may affect the
inventory situation negatively. We should try to find out that how to maintain the optimum level
of inventory so that investment in the inventory is also optimum.
Sales are also optimum and ultimately the profitability of the firm is also optimum or maximized.
So these are some of the reasons why the inventory takes place, picks up and we have to
visualize these reasons and we have to try to control the effect of these reasons. Some more thing
about this inventory management we will be talking about and learning about in the next part of
discussion. Thank you very much.
Dr. Anil K. Sharma
Lecture - 02
Introduction
Welcome students. So in my previous lecture I was talking to you about the different types of the
current assets in the balance sheets of the companies and I was say sharing with you that these
assets are called as assets but in the real sense companies do not require these assets. If given a
chance to do the business without these assets I think they will be or the businesses will be the
happiest lot right.
So were talking about the 2 assets, current assets like inventories and debtors. We talked about
inventories say are there in the balance sheet because we have to keep the inventory and there is
means no possibility that without inventory we can have a complete just in time system of
inventory management that on the one side the raw material a truck load of raw material is
coming from the supplier’s place and is going to the plant.
And then from plant you are converting it into finished product and it is going to the market and
we are not keeping any say any inventory with us, that is not possible. We do not want but we
have to keep inventory because supply chain arrangements are not very good in India and second
thing is that sometime we have to keep certain things in the stock because we receive sometime
unexpected orders, so of the finished goods especially I am talking about.
So there might be that we know that we are manufacturing some product in the market maybe
any consumer durable you talk about say we are manufacturing the color TVs and we have
standard set of distributors in the market or the retailers in the market and we know that how
much they can demand over a period of time, over the different months in a year or maybe if you
set aside the festival season then what is the normal demand in the other say 9 months or 9 or 10
months in the year so that we know and that much of the production we can ensure.
But sometime what happens that we will see some say you can call it as unexpected orders which
are not very regular orders but sometime we receive it. For example we are at IIT Roorkee here
and for example IIT Roorkee decides that in every classroom we will install the color TVs so
that we can use them as a teaching aid. So it means IIT Roorkee may place an order of 300 color
TVs or 500 color TVs to one company say Samsung, Sony, or any other company.
So and if they have not assessed the demand earlier they may be forced to lose the order. So that
at that cost that will be a very heavy cost for the company and that cost is called as the stock out
cost, cost due to the product being out of stock. So that is again a cost and if that order if the
company loses in that case that will affect the profitability of the company.
So it means just because of the say interrupted or the very and not very successful supply chain
arrangements sometime because to avoid the stock out cost or sometime because of many other
reasons you have to keep the inventory so we are to have the inventory and we are keeping the
inventory but ultimately inventory has a cost and the company should be efficient enough.
The business or the firm should be efficient enough to add up their cost into the total cost of
production and to keep their margins intact. If they have a good credibility in the market so they
can already they can adjust their inventory cost. But if the price is the is a problem in that case
you can say that inventory cost is the cost which the company has to manage somehow but you
cannot run the show without keeping inventory as a current assets and you have to keep it.
Similarly, we were talking about the debtors. So they come out and they appear in the balance
sheet because of the credit sales. So it means we do not want to sell on credit but we have to sell
on credit because with only selling on cash is not possible. So next you talk about the other
current assets for example we have other current assets like bills receivables, prepaid expenses.
Bills receivable are again some sort of sundry debtors.
They also appear when we sell either on credit or we give lend money to somebody so it
becomes a bill receivable which we have to miss which is the expense incurred today and that
has to be recovered at the latter date whether it is a goods or services or cash or anything which
is given today and we have to recover it so the firm’s efficiency will be that if they are selling on
credit or they are if they are lending some cash to somebody they should be able to add up to that
the interest cost.
And if the buyer is ready to pay the interest cost in the purchase price in that case there is no
harm in selling on credit. But if the cash and the credit price is same in that case this will be a
loss to the firm. So nobody would like to sell on credit but we have to sell on credit because
everything cannot be on cash.
So because of that you have debtors you have receivables and only thing that can save the
company is that if you are selling on credit period of say for 2 months or say 45 days we should
be able to add up the interest cost at least the cost which is incurred or cost to the firm that they
should be able to add up to the total cost of production because financial cost is a very important
cost nowadays.
You cannot simply say that finance has no cost. It is a very important cost because if it is our
own money we are investing into the credit sales or manufacturing and then selling on credit it
has the opportunity cost and if it is borrowed money we have to pay the interest to the source
from where we have borrowed the funds as a firm so why not to recover that interest from the
buyer who is buying on credit and you might have seen that these prices are different.
When we buy something on cash from somebody we pay a different price but when we buy
something on credit from somebody we pay a different price so but we do not want to have any
debtors or bills receivables but we are forced to have we have to sell on credit. Similarly, you
talk about the prepaid expenses. Who would like to say make the payment in advance? Who
would like to make the payment in advance, prepaid expenses?
And why they make the prepayments because sometimes it happens that the product that we are
manufacturing the raw material of that product is scarce in supply that is short in supply. To
ensure a regular supply from the suppliers we want to make sure that yes we are making advance
payments to the suppliers so that he is not interrupting our supply.
To have uninterrupted supplies of certain kind of inputs certain kind of the raw materials we
would like to have say for example now we are a firm which is using as a raw material say coal
or we are using petroleum products, diesel as a input or as a source of fuel or source of energy.
So sometimes what happens that these things are sometime short in supply.
So if they are short in supply in that case we have to sometime make the advance payments to
the suppliers so that they are also under pressure that people or the companies who had paid
them in advance they have not to be say face any kind of the interruptions in the supply of
material so we have to make the but who would like to make the advance payments
prepayments.
Ultimately, we are compelled to make the prepayments otherwise we would like to make the
payment after the receipt of the material. But prepayment we call it as asset but I think it is not a
real asset. Similarly, you talk about the advance deposits. Like prepaid expenses we have to say
make some advance deposits with the suppliers. This is also like prepayment payments but we
are forced to do that as a firm as a business because we want to run our business smoothly,
successfully.
No interruptions we are ready to face or to bear so we want to keep the supplier happy so
sometime we make the prepayments, sometime we give the advance deposits. All these are
current assets but we are not interested or we would not like to have these assets but we are
ought to have. Similarly, we have the marketable securities. Marketable securities are very short
term investments.
Sometimes what happens and this is a the way you can say reduce the cost of your cash. We have
say cash is again a next asset I am talking to you, you can see in the balance sheet that is the
cash, cash in hand and cash at bank. So two because if you are keeping cash as a cash again it is
also asset but if given a chance to me to do the business without cash I will be the happiest
person. I would not like to have cash any cash with me. Cash in hand only has a cost, no returns.
Cash at bank only has a cost, no returns. When you keep the business cash in the bank that is
kept in the current account. That is not kept in the savings account. Businesses are supposed to
have current accounts and current accounts don’t earn any interest from the bank. Banks never
pay any interest on the current account. Banks only pay interest on the savings as well as the
fixed deposits.
So if you are keeping some part of the cash in the bank in the current account we are not getting
any interest on that but keeping that cash has a cost. Sometime what happens that bank allows
the company that in a day you are allowed to have 3 to 4 transactions as free but if you your
number of transactions increase beyond 4 or the sanctioned or the pre-agreed limit of the
transactions then you have to pay the cost per transaction.
So it means even you are keeping cash in the bank you are paying the cost to the bank when you
are say increasing the number of transactions and since we are in the business so you cannot
restrict the number of transactions from say between 3 to 4. Sometime it increases and when the
transaction increases we have to pay the cost to the bank. Similarly, cash in hand. Cash in hand,
when you are keeping cash in hand you are keeping it as a for the precautionary purpose.
We do not say all the times require the kept cash but you have to keep the cash. So if you are
keeping the cash it has a storage cost. It has the security cost. It has say number of other cost but
that cash is not earning for you. So to minimize the cash balances whether in hand or at bank
firms sometimes resort to the option of converting part of the cash into the short term
investments and those short term investments are very short term investments.
They are called as marketable securities. These days we have investments maybe even for 24
hours. If you have surplus cash and you see you do not require that whole cash till tomorrow
evening 24 hours for example if we have, we would like to invest that cash in the market. You
can make it as a call deposit. You can invest it for a very short interval of 24 hours. You can
invest it for 3 days, 1 week, 10 days, 15 days, 1 month.
If you do not require certain amount of the cash for that given period of time, it is better to invest
that in the market. We can earn some 3 to 4, 5 percent of the interest from the market. So that
very short term investments which are kept as a you can call it as in the language of working
capital management we call it as backup liquidity right. Cash is a pure liquidity.
Cash is the pure liquidity and the marketable securities are backup liquidity. Marketable
securities, why we call them marketable securities because anytime when you need the cash and
if you do not have the cash within a few hours you can convert those securities into cash. If you
know that for example we have to make a payment of to a supplier tomorrow maybe tomorrow
by maybe 10 o’clock you have to send the cheque.
So you know today at 10 o’clock you have 24 hours. You can convert some of the securities into
cash within 24 hours and by tomorrow you can if you have to make the payment of say that
payment to the supplier in cash you have the cash with you and if you want to pay a cheque then
you have to assess that if we issue a cheque tomorrow then in how many days he is going to
collect that cheque from our account so you have to keep that cash ready in the account.
So you can easily convert those marketable securities into cash or and that cash can be deposited
in the bank account so that in the next 3, 4 days when the cheque will come back in the account
for collection we have maintained that much amount of the cash in the account. So it means all
these current assets they do not earn anything for us other than marketable securities, short term
investments, very short term investments they earn some interest.
But neither inventory nor debtors nor receivables nor prepaid expenses nor even advance
deposits nor cash in hand or cash at bank earns anything any income for the business but we call
these assets as the say all these items as assets. They are in the balance sheet as current assets.
Other than the marketable securities all these assets have the cost. They do not have any kind of
the returns. So in this case given a chance to do the business without iota of these current assets I
would be happiest person but it is not possible.
So once you have to keep the current assets as a true manager of your current assets or working
capital your approach should be that you keep the level of these current assets. I would not say as
low as possible or as maximum as possible. I would use the word optimum. Optimum is neither
more nor less. It means how much inventory you keep normally you own normally so that
successfully the business operations can be done, you keep that much inventory.
Without losing anything if you are able to sell on credit, you sell that much on credit. If you are
comfortably able to make the payment in advance, you make the payment in advance. If you how
much cash you require normally for day to day operations you keep that much in hand and then
some in the bank and that cash which you do not require for say next couple of days or maybe
next week or 15 days or 1 month, you convert that cash into marketable securities.
So other than marketable securities these current assets are not going to earn anything for the
firm. So keep their level at the level of means their quantity at the level of optimum level of
current assets and then we come to the liability side.
In the liability side we have what is here that we have here the creditors. Then we have here the
bills payable. Then we have here the your short term loans and then we have the outstanding
wages and then we have the say your outstanding overheads, provisions for dividend, provision
for taxation, advance from customers, and other current liabilities right.
Now I told you in the last lecture also that when you talk about the sources of the funds for the
business, they are 3. You must have heard about only 2, that is the short term finance and the
long term finance. Short term sources of the finance and the long term sources of finance. But I
say that there is a third one also which is called the spontaneous source of finance. Spontaneous
is the self-adjusting source of finance.
Self-adjusting source of finance I would say that for example you talk about when we are saying
here we talk about that is the creditors. Now the creditors are the suppliers. When the supplier
supply to the firm on credit now they are called as the say suppliers and till the time you make
the payment to them they continue adjusting in the balance sheet. This is a current liability.
Similarly, we have bills payable.
Sometimes we have borrowed cash for short term purposes so we have to it is not a loan, it is a
you can call it as a other way around arrangement between say the two business. So they are
called as bills payable. So when you are have to create the current assets you have to fund the
current assets and funding the current assets under the working capital we learnt here that we
have 3 sources of finance and out of the 3 sources spontaneous finance is the cheapest most.
It also has a cost. I would not say that it does not have a cost. It also has a cost but as compared
to the other 2 sources it is the cheapest source. Now if you say that you have say spontaneous
finance yes the cost is minimum. Then you have once that spontaneous finance is fully exhausted
means if you want to buy the raw material then you have to keep it as a stock. Your approach
should be as a true manager means I would say that the wise student of working capital
management. Maybe you can be CFO of any company tomorrow.
You advise your purchase department that maximum purchases you make on credit. So I am
saying that spontaneous finance has a cost means that when you buy on credit supplier will not
supply you on the price which is the same when you buy it on cash. He will load that interest
factor which is paying to the his source or his opportunity cost to that the cost of the price of
those credit sales.
But as compared to your short term funds and the long term funds, spontaneous source will be
cheapest having the lowest cost. So our approach should be to invest minimum cash in the
purchases of raw material we should buy it as much as possible on the credit. So in this case the
creditors are the spontaneous source of finance. They are called as self-adjusting source of
finance.
Because suppliers, we have the long term say relationship with the supplier and supply terms are
pre-decided and supply terms are pre-decided. It means say somebody is supplying us any raw
material and the terms between the supplier and the buyer is that he will supply it on a credit
period of 2 months for a period of 60 days and the firm also knows who is buying this material
from supplier, any supplier or number of suppliers that after 60 days bills of different suppliers
will become due.
So they will make arrangement in the bank so that if they issue the cheque against the bank
account so they have a sufficient balance in the account for that because it is a routine matter.
When we are buying on credit we are supplying in the market. Partly we are supplying on cash,
partly we are selling on the with the finished product we are selling on credit. We are also
receiving from our say buyers who are buying it on cash or credit.
Then money is going to the bank account and then we have to on the due date when the
payments of the different suppliers are becoming due we are writing the cheques and then we are
making the payments. So it means some special pressure is not there in the mind of the CFO or
on the finance department that we have to make the payment of this much of the suppliers and
we do not have the money.
As compared to arranging the short term funds, short term funds are basically the bank finance or
maybe you are arranging it from the different sources, maybe say public deposits or maybe loans
from other financial institutions. There you have to make some proper arrangements. There some
extra efforts are required for arranging the short term terms. Similarly, you have to make some
efforts for the arranging the long term loans.
But in case of the spontaneous finance we have once have an agreement, the supplier and buyer
have the agreement. Supplier keep on supplying and on the due date when the due date for the
different supplies becomes comes automatically cheque from the finance department goes to
him. He presents the cheque in the bank and then the from the bank account of the buyer who is
the manufacturer of the finished product his account is debited and the payment is made.
So this is not creating a special pressure in the mind of the finance department or the purchase
department or maybe in the minds of CFO or people in the finance department, it is self-
adjusting. It is a routine decision. We are getting the material and we are making the payments
and we are keeping in mind that how much money we have in say in our in our bank account
how much payments we have to make over a period of time, that is a that becomes a routine
process. Because firms normally resort to the process of the cash budgets.
Once any firm is making the cash budget, say the time horizon is, if you want it to very efficient
cash manager then you have to reduce the time horizon of the cash budget. Say if efficient firms,
very efficient firms are keeping the time horizon of the cash budget is one week. If we do not
have, we are not that much efficient and we do not have that much of the resources we can raise
it to 15 days or maximum it can be 1 month, 30 days.
So if you have a cash budget for 30 days, in that cash budget you know it that over a period of
time in the different days in the say next 30 days, how much payments we have to make to
different suppliers. We have already made the provision and we are sure that according to that
cash budget we are maintaining the cash in the bank account and automatically we are writing
the cheques.
But in case of the short term loan, if you have to arrange the short term loan you have to make
some special arrangements for that special efforts for that and once that short term loan is
exhausted you have utilized that, you have to repay it back to the bank or maybe the source from
where we have raised and we have to go for the complete full-fledged boring agreement for the
next say amount of the loan.
For the next loan we will have to do the same thing what we did in the past. But in case of
spontaneous finance we do not do that. So our approach should be that if you have decided to
have this much level of different current assets or given level of current assets then from where
the funds will come now to fund these current assets. Now we have come to the liability side we
came.
So I told you that first of all you try to have maximum funds from the creditors, automatic
supplies. So if you are buying it on credit, we do not need to pay them immediately, we will pay
them after 2 months. So it means it is a automatic source of finance. Bills payable is something
like this that we can borrow for the short intervals from one business to other business, that can
be possible.
Once this spontaneous finance is fully adjusted, self-adjusting source of finance is fully
exhausted then you resort to the next source that is the short term loans or the short term sources
of the finance and similarly just before that short term loan I would say that creditors, bills
payable. Then you talk about these 2 important other things is the outstanding wages and salaries
and outstanding overheads. They are also the spontaneous sources of finance.
See the higher employees, maybe they are plant workers or they are office employees, we hire
them on one particular day. They work for entire period of 30 days or 1 month and we pay them
after 1 month. Do they require or do they ask for the salaries before 1 month. They are giving a
services to the firm for a period, complete period of 1 month and after 1 month you have to make
the payment to them.
So it means for 30 days you do not need to bother about the payment of labour that is the wages
and the payment of the salaries to your employees, office employees again is spontaneous source
of finance. Similarly you talk about we have number of other inputs. You have the power
requirements. You have water requirements. You have lubricants requirements.
You have some other sources of the energy or the fuel maybe the coal maybe sometime save
petroleum products in the normal course. We have supply arrangements at least for 1 month.
Electricity supply, company is not going to give you the bill every day. They bill, some
companies collect their bills in once in 2 months. Some companies have reduced the time
horizon now to 1 month.
So they are going to collect it but at least means they are going to collect it for after 30 days but
at least for 30 days they are not going to ask you to make the payment. So you got a automatic
spontaneous credit for a period of 30 days. Maybe it is a supply of electricity, it is a supply of
water, it is a supply of any other kind of a small inputs including material then you talk about the
wages, salaries.
All these sources at least, they are not going to ask you any kind of the funds for a period of 30
days or 1 month and in case of the supplies of the major inputs we can have arrangements for 2
months also. In India the credit period which is there which is existing in the manufacturing
sector in India that ranges from 45 to 60 days. If somebody is very efficient buyer he can make
the supplier agree that I will pay you after 60 days.
Every consignment for I will pay you after 60 days but if it is not that much efficient minimum
credit period you can expect for 45 days or at least for 30 days. So if we are below average it
means any firm can be given a credit period of 30 days. So it means for 30 days we do not need
to bother for the payment. So it means this is the self-adjusting or the spontaneous source of
finance.
After 30 days we have made cash budgets so it means we will have the funds for paying the
wages, salaries to the suppliers, power bills, water bills, we have that much of the provisions.
You see for example it is not a question of business. In the our say domestic affairs also at the
our household level also we normally think of that how much payments we make monthly. We
have to pay the electricity bill. We have to pay the cable TV bill. We have to pay the water bill.
We have to pay for the grocery. We have to pay for the other kind of inputs. We have to pay the
fees of the kids. We have to pay for maybe any other input which we require for a period of 1
month. We make monthly arrangements or we make the arrangement or we make the budgets for
1 full month. So it is happening at the household level, at single individual’s level. So if you talk
about a company, if you talk about the business and means if you talk about the business in that
case automatically this budgeting is there.
If in case of the one household in one family if you prepare a monthly budget then we can easily
prepare the monthly budget at the corporate level and in that case we do not means put some
extra pressure on our mind or on our head. It is automatic. It happens every month and it is a
self-liquidating or the self-adjusting source of finance.
So try to have maximum funds as a true manager, efficient manager of working capital from the
spontaneous sources of finance and then once that is fully exhausted that there is now no scope
to have any credit from the market then you resort to the short term sources of funds. We have 9,
10 short term sources of funds, I will discuss with you later on but most popular in India the
short term source of the fund is the bank loan.
And it is because of the easy availability of the bank loan to the businesses for fulfilling their
working capital requirements that the other 9, 10 sources have not been say utilized by the Indian
business or the Indian business firms to that extent to which it deserves. So in this case means if
nothing else is available bank finance is easily available. So when you borrow from the bank you
can borrow for the short term, short period and for the long period.
When you borrow for the long period it means you have to pay the higher rate of interest. If you
borrow for the short period you have to pay the lesser rate of the interest. So it means because in
India now also we have the time term structure of interest rates. Longer the maturity period,
higher is the interest rate. Shorter the maturity period of the loan, lesser is the interest rate. So it
means since we are going to invest that cash that finance to finance the short term assets or
current assets and current assets are least productive.
So our cost to fund these assets should also be as low as possible. So after spontaneous finance
resort to the short term sources and once the short term sources are fully exhausted then you can
think of utilizing the long term sources of the finance. Long term loans, when you borrow long
term loans or the money for the long term purposes in that case what happens? Part of the long
term loans or part of the long term borrowings can be used for the short term purposes.
The funding agency itself a loss that sometime remains a inbuilt clause in the borrowing
agreement that say 25% of the total loan, long term which the bank or any financial institution is
giving to the company, to the firm, 25% of that can be used for the short term purposes or for the
working capital purposes. It means that with the permission of the financial institution we are
utilizing but you see they would not reduce the rate of interest.
You have to pay the same rate of interest. Only permission is that the long term funds provided
out of that 25% can be used, maximum up to 25% can be used for the short term purposes and
remaining 75% certainly has to be used for the long term purpose for which the funds have been
provided. So in this case, but means the minimum investment should be from the long term
sources because the interest rate is very high on the long term borrowings.
So if you are going to invest very expensive long term borrowings for the short term purposes
especially in the current assets which are least productive so there is going to be a mismatch
between the financial cost and the financial returns. Cost is very high, somewhere 18-20 percent
and the return is almost very low.
Because if you sell anything on even your finished goods if you sell on credit and you feel that if
I am selling on credit I can load my credit sales with the interest which I am paying to the
financial institution and if that interest is 18-20 percent if you load your credit sales with 18 to 20
percent of the financial cost your price of that product will be very high and nobody will buy that
product even on credit.
So loading is also allowed if the cost of funds is at the acceptable level and which can be
maximum for the short term funds. Short term funds we pay in India somewhere around 10-12
percent. So if it is 10-12 percent you can increase the cost by 10-12 percent. Say for example if
you buy the cash or something on cash, I will pay you or I will sell you a pen, for example we
are manufacturing the pens. I will sell you this pen for 10 Rs.
But if you want to buy it on credit I will load it with 10 % or somewhere 15% so I will sell it to
you for 11 Rs or 11 Rs 50 paise. But if you say I will be selling it to you for 14 or somewhere 13
or somewhere 12.5 I think he will say no I do not want it because I have to sell that pen in the
market and if that pen is not saleable beyond 13, 14 or 15 Rs so what I am going to buy from you
at the price and what the price I am going to charge from the customer so they would not be able
to sell that product in the market. So loading cost has to be within control.
So it means to keep the cost of your funds under control your priority should be that you first use
the spontaneous source of finance so that you can easily bear the cost. Once that is fully
exhausted you go to the short term source and once that is also exhausted and need arises then
you have to resort to the long term sources of the funds.
So here means now we have discussed this balance sheet in the previous class and in today’s
class that if you look at this balance sheet the lower part of the balance sheet which we are going
to talk in the next say total 30 hours or next 29 hours in the 58 lectures we will be discussing
about how to manage the lower part of the balance sheet, how to manage your current assets,
how to manage the current liabilities.
And if you are able to efficiently manage your current assets and current liabilities to a larger
extent upper part of the balance sheet will be automatically managed or managed to a maximum
possible extent. So we are going to learn about that how to manage about current assets and
current liabilities in this course of discussion under the subject of working capital management.
And this total course of 30 hours would finally make you equipped with the techniques and tools
and the complete understanding with the concepts of working capital management and I am sure
that you will be clear about that how to manage the short term sources of funds or the working
capital finance. This is all for today. I will stop here and then next part we will start in the next
class. Thank you very much.
.
Dr. Anil K. Sharma
Lecture - 20
Inventory Management-Methods and Strategies
Welcome students. So we are in the process of inventory management. We are discussing the
inventory management and now we will talk about the valuation of inventory. See since we are
talking about working capital management so in that connection we are talking about or we are
discussing the inventory management because inventory being one of the important and the first
and foremost current asset.
So here is I am not going to discuss with you in any case the valuation methods of inventory that
is sometime in the other subjects in some other area you can learn or you must be knowing about
it that how to value the inventory and what are the different methods of valuing inventory. But in
the passing reference we will have to say try to find out that how different valuation methods
impact the management of inventory as far as the management of the short term funds or the
working capital is concerned.
They make a difference. They make the impact because these are the valuation methods which
sometime create the problem of excessive inventory or sometime the say shortage of the
inventory. Sometime because of the wrong valuation methods it becomes very difficult for the
firms to recover the investment they have made in the inventory. So let us talk about these
different methods or discuss these methods but not in detail, just in the passing reference.
We have different methods of valuing inventory 5, 6 method or 6, 7 methods of valuing

inventory are there.
First method is say for example FIFO method First-In-First-Out Method. Second method is Last-
In-First-Out Method. So it means in the First-In-First-Out Method means things or the materials,
maybe raw material or the finished goods which are purchased first they should go out first right
which they are purchased first they should go out first and then similarly we talk about the Last-
In-First-Out.
Sometime the goods which have been recently acquired or the inventory which has been recently
acquired that should first go out in the market that should be first sold in the market. Then we
can talk about the remaining inventory which is there with us in the warehouse or in the godown.
So FIFO is the one method, LIFO is another method. Then we have average cost method. I will
discuss with you that when in what situations these methods should be used.
And how they are impacting the working capital management. So but the third method is average
cost method. In the average cost method we take the simple average, weighted average, moving
average, different type of the averages of the different types of materials or materials acquired
are the different points in time. They are calculated and then we calculate the average price
method. Sometime we purchase the material at a high price.
Then we purchase sometime back material at the low price. So rather than following LIFO or
FIFO they calculate the average of both the prices high as well as low and then we divide it by 2
and then we calculate the simple average. Sometime we calculate the moving average, weighted
average. So different kind of averages are calculated and at that weighted say average cost
method or by following the average cost method the inventories are valued. Then we have the
say some specific identification method.
Some different types of materials like very expensive materials which are used in the small
quantity but they are very expensive or some special identification marks are there on the
inventory. So we can follow those methods also. Base stock method is there. Adjusted selling
price method is also there. Extended cost method is also there. Different methods are there. I am
not going to discuss these methods in detail.
But how these methods impact the inventory level and the funds blocked in the inventory how
they are blocked for longer duration if we are not able to manage these say inventories or the
different type of inventories properly. So it means in that case the management of because of the
poor management of inventory because of the poor valuation methods because of unsuitable
valuation methods of inventory sometime the recovery of the funds invested in the inventory
becomes difficult or at least it is delayed.
So now for example we talk about the First-In-First-Out Method, First-In-First-Out Method. Say
for example we say we are in the process of rising prices in the market. We are in the process
means currently we are feeling that the prices are rising in the market or prices are about to fall
down in the market. We see that the prices are expected to fall down in the market. We can see
that maybe because of the lack of purchasing power of the people or maybe because of very
strengthened supply side, the prices may fall down.
So in that situation, in the expected falling prices state of affairs in the market, First-In-First-Out
Method should be the method should be followed. Because for example we have acquired some
inventory at high prices in the past and currently the prices are at the acceptable level but in the
future the prices are expected to fall down. So in that case what will happen? The material which
has been purchased at the high prices by the firm we would not be able to sell that at the same
price if the price will fall down.
So it is always better and means advisable to follow the FIFO method First-In-First-Out Method
so that when we have purchased the material at the high price and the prices are expected to go
down so it is better to take it out as early as possible so that the firm’s investment is recovered
and firm’s profitability is not negatively impacted. Last-In-First-Out, in this case also when we
talk about Last-In-First-Out, so it means the, if the prices are rising now currently we are in the
state of fear that the prices are rising in the market.
Or the say prices for the finished goods are rising in the market. Similarly, the prices for the say
raw material are also very high in the market. So we have purchased the raw material today. So it
is better that you purchase the raw material, process that immediately and convert that into a
finished product and sell it immediately in the market. That is Last-In-First-Out. Latest purchase
should first go out in the market because it is a rising trend.
It is a inflationary trend in the market. If this inflationary trend gets reversed then what will
happen? We purchased the material today at the high price and if the prices fall down in that case
we would not be able to recover the investment in the made in the inventory. So different
methods are followed depending upon the market trends or the market situation or the pricing
trends or the pricing situation.
We have different kind of the trends in the market and our objective should be that whatever the
investment is made in the inventory that should be easily convertible into cash, quickly
converted into cash and convertible into a cash in a profitable proposition rather than losing
something out of that investment. So different methods we are following and we are using. Now
you see that what are the important say factors that impact the choice of the method.
Size and type of the organization. See when the organization is very large they are manufacturing
the quantity or the product in a large quantity in the bulk in that case a minor change in the
pricing of the product because of the pricing or change in the prices of the material which will
impact the change of the prices or the prices of the finished product in that case a minor change
will affect the firm seriously, negatively.
But if it is say for example if the firm is manufacturing the multiple products right firm is
manufacturing say 10 different products and the prices of material of the one product which is
not in very large supply or which is not having a very huge demand in the market it is one out of
the 10 or maybe the one or the say you can call it as having the smallest market share or smallest
performance in the overall portfolio of the product portfolio of the firm.
In that case you can choose any method because that will not impact much. But if the size of the
organization is large and if they are manufacturing one or two products only, in that case a minor
change, a negative change in the prices of the raw material if we have purchased the material at
the high price and if the prices of the finished product go down then the firm will be badly hit. So
we should try to avoid that situation.
Similarly, you talk about the state of the economy. I just discussed with you. In case of the
inflationary situation we should follow the LIFO method Last-In-First-Out because it is
inflationary trend. We are buying the raw material today at the very high price. So that should be
immediately sold in the market so that whatever the investment you have made in the inventory
by buying it at a high price that is immediately recovered.
Otherwise if the trend changes and if the economy moves from the rising trend to either
saturation or if it starts falling down moves to the declining phase of the cycle economic cycle in
that case it will be very difficult for the firm to recover the funds invested in the inventory which
is purchased from the market at the price when there was a inflationary trend and the prices were
rising; so economic state of economy is also impacting the choice of the method.
Industry practice. Sometime say there are the standard industry practices that some firms follow
the LIFO method, some firms follow the FIFO method. For example if there is a any firm who is
manufacturing the say the finished product based upon the agriculture products. The raw material
of the finished product means the finished product coming out is from a raw material which
comes from the agriculture sector and that production is seasonal.
The acquisition of the raw material is seasonal. So normally in those kind of the firms, in those
kind of the companies, in those kind of the organizations they follow the FIFO method, First-In-
First-Out. Because if they do not sell the product which has been acquired first or long back then
the quality of that product maybe even after finishing or converting that into the finished
products goes down.
So because the raw material’s nature is like that that its obsolescence is very fast, is very quick
so better it is the material which has been acquired first that should go out first in the market so
that could be the one reason. Similarly, the tax regulations and implications. See for example the
announcements in the budgets. When the budgets, when the government budget has to come,
normally it comes in the on the first February from the previous year onwards.
Now the government has started announcing the budget on the 1st of the February. So
everybody, every company, every firm expects some changes in the tax and regulations in the
prices as well as the say overall conditions changes in the tax conditions which are affecting the
industry or the firms working in a particular industry or particular area.
So they feel that if the tax level or the tax rates go up in that industry so they would like to sell
maximum with their production which is say produced in the past so that their profitability is not
taxed beyond a level. But if they are feeling that the tax is not going to have much impact upon
their performance or their product so they can follow any kind of the method of inventory. And
similarly, you talk about the tax effect and the valuation of the firm.
Certainly because if the firm is expecting the increase in the tax rates for a particular industry or
for the particular product in that case what will happen? If there is a upward change in the tax
rates is expected then firm would like to sell maximum that inventory which has been
manufactured at the low cost and is sellable at the high price so that before the tax rates change
upward or they are revised upward maximum profit is pocketed and lesser amount of the tax is
paid.
So accordingly the valuation will be done and consistency. Sometime firms remain consistent.
Once they are following LIFO, the follow LIFO. If they are FIFO, they are following FIFO they
remain consistent with the FIFO or sometime the average cost method. So any of the methods
can be chosen by the firms, by the different firms.
Sometimes some changes have to be made in the valuation methods depending upon the changes
in the economy or in the economic structures of any country but that is not a regular phenomena.
Once in a while that kind of the things can be done. So different factors like the type of the
product we are in, type of the market we are in, type of the customers the firm is serving, all
these factors impact the inventory valuation.
And finally the profitability coming out of that manufacturing their product and selling that in
the market. So accordingly the valuation methods are selected, adopted by the firms and
ultimately the objective is that the inventory should be properly managed. Funds investment in
the inventory should be recovered at the say fastest possible extent and profitability, financial
cost, and investment in the inventory is properly managed and recovered as early as possible.
Now you see that we have a table here and we have different methods of valuing inventory.
See we have LIFO, we have first method is FIFO, LIFO, simple average, weighted average, and
the moving average; 5 methods are there, we have seen here. So when you talk about the
valuation or the price of the stock or the say the stock which is shown in this balance sheet or
you can call it as in this profit and loss account not balance sheet. In this profit and loss account
if you see the valuation of the material or the inventory you see that we have opening balance of
the material.
Then add to the inventory we have added to the inventory and stock available for the sales is
given. This is 12,990. Less closing stock. Out of this total stock for the sales we are subtracting
something to be kept in the warehouse as a closing stock and you see that the depending upon the
method of valuation we have chosen the finally the cost of that material which we are showing
here or you can call it as the value of the material we are showing in our profit and loss account
credit side you see that the value is different. Under FIFO, it is 2685. Under LIFO it is 2625.
Under simple average method is 2605. Under moving average sorry weighted average method it
is 2600. Under moving average method it is 2674. So it means when you change the method of
valuation of inventory certainly there is a change in the value of the inventory and that impacts
the profitability of the firm. That impacts the future sales of the firm. And that impacts the
process of the recovery of the funds invested in the inventory.
So we have to be very careful that what kind of the product we are manufacturing. What kind of
the customer we are serving. What are the expected say economic trends in the market. And our
objective of recovering the investment made in the inventory as quickly as possible, as
efficiently as possible is achieved.
So different valuation methods are important and we should be careful that is a true manager of
finance, true manager of finance or expert in finance or CFO of the company should keep on
advising the production department, purchase department that they should buy the material in the
stocks which are optimum, neither too less nor too more and the valuation should be done
appropriately so that finally the recovery of the funds invested in the inventory is not a problem.
Now we will talk something about the it is a very interesting area next part that is the inventory
strategies. Because it is a big investment or you can call it as most illiquid investment. Most
illiquid investment you can say. We have seen that when we make any investment in the
inventory we can say that that investment becomes illiquid for some period of time because you
cannot convert it into cash as and when you wanted.
It depends upon the external factors and especially the demand in the market. If there is no
demand in the market you cannot create the artificial demand. If you can create the artificial
demand maximum you can do is you can convert the inventory into the credit sales or accounts
receivables. So it means one current asset into another current asset but not at least into cash. Out
objective is to convert the inventory into cash not into the credit sales or accounts receivables.
So if the inventory is there it should be converted into cash and should be convertible into cash
as quickly as possible. So for that purpose we should have some appropriate strategies. Now let
us look at the strategies and the requisites for building a strategy by the firm. Like see every firm
should follow a integrated approach. They should look the inventory from the place from where
the inventory is being acquired as a raw material.
Then it is going to the processes means it becomes raw material, then it becomes WIP work in
process and finally it becomes the finished product and it goes to the market. So what should be
your acquisition strategy for the inventory. It cannot be 0 inventory, not possible. So it means if 0
inventory level is not possible you cannot run the show with that. It means you have to keep the
minimum inventory.
We discussed in the past that even under JIT just in time technique of material management we
keep the minimum inventory with us so that because of any obstructions in the supply chain
arrangements if the supply of the material gets affected then whatever the material is there in the
store that can be first used. So number 1, we should look at the inventory management in the
holistic sense, in the integrated sense, and we should follow a integrated approach.
Look that when we are buying the raw material what is its state with the supplier? Is it available
in plenty? Is it available without any kind of the limitations or if it is limited in supply. Look at
the supplier side or second thing is if it is available means there is no restriction on the supply
but at least on what terms and conditions we are buying it from the suppliers. Are we buying it
on cash? Are we buying it on credit?
How much credit period the supplier is ready to give to the firm that part. How much time it is
going to take within the processes. How much time it is going to take to get it converted to
finished product and how much time it takes from the place of production to reach or to move
from the place of production to the place of consumption and how the consumers are going to
buy the products of the company.
Are they ready to buy it on cash or it is on the credit. So entire operating cycle has to be taken
into account and for that purpose to make your integrated approach most effective, most suitable,
most revenue generating and the say profitmaking we should forecast about everything. How
much sales we are going to make in the market in the time to come for which we are budgeting;
which we are planning, which we are forecasting.
How much time it is going to take to convert the raw material into the finished product and how
much time it is going to take to acquire the raw material from the place of supplier to the place of
manufacturing. Order processing will take how much time?
Production planning should be very carefully done. Machine scheduling should be very efficient.
And the vendor engagement should also be very good. Vendor in terms of suppliers of the
materials as well as the suppliers of finished product from the market to the consumers. So in
that case we have to have a integrated approach if we want to have the very effective and value
adding strategy with regard to the inventory.
So first prerequisite is that go for a complete integrated approach because we would be able to
sell the product in the market if we have the regular supply and that too in the desired quantity.
More we want, more it is available. Less we want, less it is available. We are able to adjust the
manufacturing process also depending upon the sales conditions in the market and similarly we
are able to deal with the suppliers also while increasing or decreasing of the supply of the
material. So it should be integrated approach. This is the first prerequisite.
Second prerequisite is integration of inventory functions to corporate strategy of the firm. What
is the corporate strategy of the firm? Normally see when you talk about the corporate strategy of
the firm, we can talk in terms of say for example in terms of the marketing strategies. In the
marketing strategy we follow say market skimming strategy or the market penetration strategy
right. In the market skimming strategy what we do?
We sell lesser number of the products in the market but the quality product at a high price and by
selling the lesser number of units in the market high price units in the market to the class of the
people or to the classes not to the masses we would like to earn the same amount of the revenue
as we are going to earn by selling product of masses at the low price and the maximum number
of units in the market.
Ultimate objective is to earn a given amount of the revenue and the profits. For example the
company’s objective is that the profit should be 1000 Rs per month. Now that 1000 Rs per month
you can achieve by selling 5 units in the market at 200 Rs per unit and then you can sell or
achieve that means when you call it as the revenue or the profits. For example we want to have
the revenue of 1000 Rs per month.
So you can have that revenue by selling 5 units of 200 Rs each in the market or by reverse by
selling 200 units of 5 Rs each. That is the choice of the strategy under the penetration we would
like to serve the masses and to produce in bulk. Under the skimming policy we would like to
remain selective. Our consumers are also limited and we do not want to reach up to the masses.
For example you talk about these branded products like we talk about the say Nike shoes or we
talk about the say Puma shoes or you talk about the Adidas products. Now what is the strategy of
the firm? These are very highly priced products right? They are placed, they are positioned
differently in the market. Nike shoes are not for everybody. Puma shoes are not for everybody.
Adidas products are not for everybody.
Even the seller knows who is going to buy their product. Even the buyer knows that whether I
can afford or not to buy these products. Ultimate objective of the company is that by following
this kind of the strategy, skimming market skimming strategy they ultimate focus upon that our
revenue has to be a given amount, profit has to be given amount. That you can achieve by selling
lesser number of units in the market and by following the market skimming policy.
Other way around it can be the market penetration policy. So we have to see what is the
corporate strategy and accordingly the inventory strategy has to be built up. Success of the
business strategy depends upon the operational strategy. It means you are going to achieve
because if you want to serve the masses we should have sufficient supply of the raw material.
Only then we will be able to convert that into the finished product and to serve the entire market.
Other way round we can have the limited supply, limited inputs, limited outputs, and limited
sales in the market; that is also our choice. Operation strategy guides to techniques of inventory
management. What kind of the strategy we are going to have, skimming or penetration. If it is a
penetration certainly you have to acquire in bulk. If it is skimming then even by being say
selective in buying the raw material or maybe the semi-finished products we can serve the
market so we can achieve the corporate goals or the we can work as per the corporate strategy.
Achievement of ultimate goals of sustainable competitive advantage because we have to stay in

the market. Not for today but for long and the overall say growth of the company has to be
spectacular so ultimately that to a larger extent is possible by following the appropriate inventory
strategy and that inventory strategy has to be as per the corporate strategy so that when both go
hand in hand the ultimate objective of the value maximization of the firm can be achieved.
So it means inventory is a very important component and being a most illiquid current asset we
have to carefully manage it. So it means when you talk about the strategies, we have 3 strategies.
Cost leadership strategy. Then we have differentiation strategy. Then we have focus strategy.
Cost leadership strategy, under this strategy cost leadership means when we are going to serve
the huge market. When we are going to sell our product to the masses in that case we are going
to focus upon one thing that is cost reduction and the cost reduction is possible when you acquire
the raw material in bulk.
But when you acquire the raw material in bulk you have to invest huge in the inventory, invest
huge in the manufacturing processes and invest huge in converting the finished products and
taking it to the market. So inventory strategy in case of the cost leadership strategy remains
marked to stock.
Continuously manufacturing and passing on to market and then keeping in the warehouse also so
that sometime if the market goes up or the demand in the market picks up beyond even our
existing level we have sufficient inventory for that and we are sure that since we are selling at the
lowest possible price in the market so we are able to reach up to the masses or to the maximum
or to the largest segment of the market.
So it means the inventory strategy is to acquire maximum, manufacture maximum, sell

maximum and to attain maximum revenue and the maximum profits. Second is differentiation
strategy. Under differentiation strategy we manufacture different kind of the products. We
differentiate the products and we sometime say manufacture the product for masses also and we
manufacture the product for the different type of the customers you can call them the
manufacturing the customized products.
If there is a differentiation strategy that we want to create serve the different markets different
types of the customers and sometime when the customer is choosy, selective, we have to serve
his needs also. In that case the inventory strategy has to be make to stock or assemble to order.
Number one is that you manufacture, expect that we will be serving some segment which is not
very choosy, not very selective.
So their needs can be fulfilled from the products which have already been manufactured. And
accordingly acquire the raw material, manufacture the product and sell that in the market. But at
the same time we can have some of the customers who are very selective also, who are very
choosy also. So in their case, we will have to keep the say semi-finished products ready with us
and then we have to assemble that say product to the order.
Sometimes say for example in case of the bicycle industries. In bicycle, if you go to a bicycle
shop, there are certain standard kind of the bicycles available which everybody comes and picks
up and buys and goes. But there are certain kind of the cycles which can be assembled as per the
orders. There can be some toys you talk about. Those toys can be assembled as per the order of
the people. So it means both the customers are there.
If the customers belong to a mass then you follow the first strategy, make to stock and serve his
requirements. But if he is customized or he is say for example a selective, choosy customer then
we will have to assemble the product as per the requirements of the customer and for that we
should have sufficient inventory of the semi-finished products.
And last strategy is the focus strategy means we are only serving the selective customers, limited
customers in the market and in that case we are focused upon high-class people, upper-middle
class people or maximum middle-class people. No lower-middle income groups. No low-income
groups. No below poverty line people. It means when you are serving the high-income group
people their needs you understand, their paying capacity you understand.
Accordingly you are manufacturing the products, accordingly you are pricing the products and
distributing the product in the market. So that is called as a focused strategy. For that you know
that our customers are limited. So our manufacturing process has to be adjusted accordingly. It
has to be priced, the product has to be priced accordingly and then we have to serve the needs of
those customers so that means customer is, in this segment customer is ready to pay any price.
But he does not expect any even iota of the defect in the product. So you have to be very careful.
So in that case when you buy the raw material that should be of the best quality. When you
process the raw material that should be done in a best possible way and when you sell the
product in the market that has to be very carefully done and priced carefully so there we have to
use the different inventory strategies like make to stock or assemble to order.
Largely it is assemble to order or make to order or engineer to order. Sometime we have to

design the product for the special type of the customers who are ready to pay any price but they
want the product of their choice and in many cases for example in the car industry it happens that
people want to have the cars of their choice, sports cars or SUVs, sports utility vehicles. People
want to have the special kind of the products.
In cycles, racing cycles or some sports cycles you have the say requirement of the people which
is customized, which is totally a special requirement so they do not worry about the price but
they want the product of their choice. In that case sometime you have to make to order or
sometime you have to engineer to order. So accordingly we should have the availability of the
raw material with us.
So since it is a very high-end product so the cost of the raw material will also be very high so
keep the investment limited so that it keeps on liquidating also and as the product keeps on going
to the market we keep on supplementing it with the old or with the new products and accordingly
we will have to have the inventory strategy. Here I will like to share one interesting story with
you that some time I was reading somewhere that General Motors had who is a manufacturer of
cars, American company manufacturing cars, all type of the cars.
They are into India also but I think they are closing operations from India. They said that let the
people think about or any person think about any kind of the cars that my car should have this
kind of the property, that kind of the property, this feature, that feature, everything. Let him think
according to his imagination power and give that design to us or maybe the requirements to us;
not design but their requirements to us.
And within 15 days we will hand him over hand him over the keys of the car. So it means the
company has to think in a innovative manner and those kind of the companies follow the focused
strategies that they are going to serve the classes not the masses. So the choice of raw material,
investment in raw material, conversion of raw material into finished product and converting that
finished product into cash by selling their product in the market has to be in a synchronized
manner.
So ultimately everything is interlinked. So we have to be very careful while managing inventory

from the angle of say short term funds management or the working capital management because
any investment in the inventory can be converted into cash if it is appropriately made. If it is
unplanned or if it is a say in abundance then it will be very difficult for anybody to convert that
into cash or as quickly as possible to convert into cash.
And we have already seen the story of SAIL that if they are not able to recover their investment
made in the inventory and the inventory started mounting so well-functioning a largest steel
manufacturing company which was a profitmaking company in India became the lossmaking
company and became a sick company. So let us see. We will continue the discussion on this
inventory management in the other class in the classes to come.
Also in the means say in the classes in future also and we will arrive on a some say logical
conclusion that what important factors have to be borne in mind while managing the inventory as
far as the management of the working capital is concerned. At the moment I stop here and we
will rest of the things we will discuss in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 21
EOQ Technique of Inventory Management
Welcome students. So we are in the process of discussing the management of inventory, the first
current asset and so far we discussed the importance of inventory and how important it is for the
say financial managers as well as the production managers to manage the inventory in a efficient
manner so that cost of managing inventory investment made in the inventory remains under
control.
We maintain the optimum level of inventory and say finally we recover the investment made in
the inventory well within the time so that the operating cycle remains optimum. Now taking the
process further we will be learning more about the inventory managements so that the investment
made in the inventory in the first current asset most illiquid current asset becomes possible to be
managed very efficiently and whatever the investment firms makes that can be recovered at the
faster pace.
Now we talk about the say management of inventory, the first current asset requires that it should
have optimum investment or the firms should make optimum investment in inventory while
building up this current asset as without inventory the show cannot be run, the firms cannot
perform. So we have to build up the inventory level at all the levels that is of raw material, WIP,
and the finished goods right. Now in this case, how to find out that optimum level?
You must have read sometime in the past about the techniques of inventory management or
material management and most popular technique is the EOQ technique or Economic Order
Quantity Technique. To find out the optimum investment in the inventory we take the help of the
EOQ technique and that technique helps us to find out that amount or that quantity of the raw
material to be purchased which is most economical for us right?
So we have to make use of that technique. There are number of techniques like JIT is another,
ABC is another; different techniques of inventory management. So we some people, some
experts in inventory management have started saying that EOQ has become say you can call it as
not of much use now. It has become useless technique as it is not able to give us the appropriate
quantity that should be procured, that should be purchased and that should be stored.
So we should resort to the other techniques or new techniques like JIT or the other techniques.
But I would like to emphasize here upon that even today also EOQ is that much important as it
was in the past. Maybe it is not that important in the countries like Japan, US but the supply
chain arrangements are very efficient where even by maintaining the lowest level of inventory by
following JIT and other techniques of material management or inventory management.
They are able to run the production process efficiently but in a country like India we cannot think
of abandoning the EOQ technique and since JIT is not possible to be implemented in all the
industries in all the firms in the country or in a country like India so we have to still depend upon
the EOQ.
And we will prove it empirically or by say certain models that whatever the limitations you say
or we talk about the EOQ has become an old technique or is useless technique or is a obsolete
technique but we can say prove it that EOQ is still useful for us in the companies working in
India or for the companies working in India and we will have to depend heavily upon the EOQ
technique.
So first before talking about the limitations and say how to take care of those limitations or how
the limitations of EOQ affect the management of working capital or say finding out the
investment to be made in the inventory from the financial perspective or the financial point of
view, let’s just recall quickly what the EOQ technique is. You must have read this technique
somewhere else.
Also while sometime studying about the inventory management or sometime material
management so it is a old technique, it is a very you can call it as old in the process but it is
better for us in the class to recall what this actually the technique is, what are the important
components of this technique and then if there is any criticism of the technique in the modern
world then how to take care of that and how to justify that this technique is still useful.
So I would say that to find the optimum investment in the inventory to be made in the Indian
scenario or by any manufacturing concern in India, they should depend upon or they can easily
depend upon the technique like EOQ and there is no need to think about that this technique has
become say obsolete or is not worth using now because thinking of JIT and other kind of
techniques is also not that much feasible for all the firms or the industries.
So let us recall what is JIT and how to say make use of this technique. So you see that what we
try to find out under JIT sorry this EOQ, what we try to find out under the economic order
quantity, we try to find out that quantity of material which is most you can call it as appropriate
and the cost of acquiring that much of the quantity we call it as a economic order quantity that it
is most economical to acquire that much quantity.
And once that quantity is exhausted, fully utilized in the manufacturing process then should we
replace the say old material with the new material until unless that existing order has been
exhausted we should not go for placing the new orders and we should not buy the new material.
So how it behaves you must be able to recall that saw toothed picture, the saw toothed picture is
something like this we will be going for this and we will try to learn that what is saw toothed
picture. It is some structure like this.
This is the structure of the inventory management and let us recall this structure. It is something
like this. It moves from here. It goes like this. It goes like this. It goes like this. It goes like this
and it goes like this. It comes down. It is called as a saw toothed picture and saw tooth diagram
and in this diagram we can make out that this is the level of the material which is on this side we
take the quantity or you call it as the Q.
This is the quantity of the material and here we take the time. So it means here we say that it is a
Q level of the quantity of the material we are buying and we are here, when we have bought we
have received the order of the material what we placed. We got the material and when we got the
material, this is at this level and we start using it so it comes down to this level to the last level.
When it comes down to this level then we again place a new order.
We replenish the material level to the beginning level and then we start using it comes down and
this way this picture emerges like if you divide this here from here we call it as this is the
average inventory level. This is called as average inventory level which you can say it is half of
the Q level or it is Q/2. So it means we have this level of inventory, average level of inventory
which we all the times maintain.
We say that normally this much of investment always remains so that is why it is called as the
average investment to be made in the inventory and here when we talk about a third point, that
third point is somewhere here and that third point is called as reordering level. We call it as
reordering level. As inventory reaches at this point we reorder it and if you draw a line here this
to this, so between this area this is called as the say here we have placed the order, order placed
and here it is the order received.
So we have received the order. So it means this is the time period you can call it as the cushion
period. We have got the cushion period here from this place to this place because if you allow
the inventory to come down to this level and if takes some time to receive the inventory so in
that case it may affect the production process so what we do is we decide the reordering level
that when it will reach at the lowest level or maybe the level where the placing the order is most
optimum then we will be placing the order and we know that how much is the lead time required.
This time is called as the lead time to receive the inventory. The time taken to receive the
inventory is called as the lead time. So that lead time we have to work out and accordingly we
have to decide the reordering level and as per this reordering level we place the order, we receive
the order. Again, when the inventory comes down to 0 then we replenish it with the same level
that is the Q level of inventory.
So this process keeps on moving which we call it as the saw toothed picture and this is the way
we can say that economic order quantity works. This is the average level. This is the average
inventory at the Q/2 level. So average inventory means on an average this much of investment
always remain remains in the inventory and we are not able to liquidate this investment or
convert this investment into cash. So in this case what you see is we had lines here.
Say for example if you close this level, highest level is that is the Q. If you close this level you
say this line is the you would say this line is the supply line. This line is called as supply line and
this line is called as the usage line. So supply line takes the material back to the same level from
where we have started that is to the Q level because it was 0 here. We placed the order when it
was say something say above 0 we placed the order.
After finishing the lead time we came down to 0 level and immediately we received the order. So
through supply line we again made it back to the Q level and then we started consuming it and
when it will come down it will be reaching at the reordering level. We will place the order and
this way the entire process works. So it is not a new thing. You must be knowing it. You must be
remembering it what is this picture and how this picture will work or how this structure works
and this is economic order quantity.
And when you say that how to work out the economic quantity, let us recall that also and you
must be knowing it that we take into consideration 2 cause for deciding the economic order
quantity level.
Why we call it as the economic order quantity? Because the cost of the material acquired at this
level or by deciding this much of the quantity is available at the lowest possible cost and that is
the total cost, lowest possible cost. You see that we have the 2 kind of the cost which are
associated to the inventory. So first cost is the carrying cost, which is the purchase price plus
transportation cost.
And other kind of the cost which we incur while we purchase the inventory and until unless we
convert that inventory into finished product and finished product becomes sales and sales convert
into cash that investment remains blocked. So that is called as a carrying cost. So one cost is the
carrying cost. The another is the ordering cost right setup cost or you call it as the ordering cost.
So if you keep the inventory level high right. So what will happen?
Your carrying cost will increase because you are investing more funds in the inventory.
Inventory is remaining as inventory for the longer duration and funds are blocked in the
inventory for the longer duration so it means that what will happen, your carrying cost will
increase. But if you lower down the inventory level, so what will happen? Time and again you
have to place the orders and ordering cost itself is a high cost.
And when the ordering cost will increase so it means what is happening you are lowering down
one cost. If you are lowering down the carrying cost, ordering cost is going up. When you are
lowering down the ordering cost by not ordering it frequently, very frequently your carrying cost
is going up. So it means ultimately that is not called as the economic order quantity. Economic
order quantity is the one where the total cost of acquiring the inventory is the lowest.
That is the economic order quantity. I think you will be able to recall it. So let us see how we
work that cost. Here we have the cost on the x axis and on the y axis we have the ordering
quantity. This is called as ordering quantity. This is the quantity we are going to order or this is
the quantity which is going to be there with us. So we have something like this. It moves like
this. So in this case in the ordering quantity this cost behaves like this.
This is called as the carrying cost. And this cost is called as the ordering cost. So this cost is the
carrying cost and this cost is called as the ordering cost. So what is happening? If you are
reducing the level of orders, if you are coming from this side to this side what is happening?
Your ordering cost is going up because you are keeping this much level of the inventory and
again when it comes down to 0 or maybe to the lowest level, you have to again place the order.
So the ordering cost will go up. But if you go from this side to this side and you keep more stock
of inventory with you in that case your carrying cost will increase right? So we will have to find
out the quantity that will be called as a economic order quantity and that will be something like a
point where both the cost are equal. So you say this is point where both the costs are equal.
When the carrying cost intersect with the ordering cost, that quantity will be called as the
economic order quantity.
This quantity is called as a economic order quantity and here both the costs are equal, the
ordering cost and the carrying cost are equal so this we say that this is the cost. If you draw a
curve here you will find something this is the least total cost. This is the least total cost. Here
also the cost is very high. Here also the cost is very high. So you would say at this level the least
total cost this is the least total cost.
So here if you try to find out the cost here so this is the cost and in this case this is the least total
cost and out of the total cost both the sides if you are going from this side to this side you are
here at this level and from this level to this level the cost is very high. From this level to this
level the cost is very high. At this level only the cost is lowest. So it means this will be called as
the quantity which is called as the economic order quantity.
Where your total cost is the lowest and both the costs they are equal, carrying cost is equal to the
ordering cost and vice versa so this quantity of the raw material which we are going to purchase
from this to this is called as the economic order quantity right. So it means when you say that this
curve is total variable cost right. This curve is the total variable cost so it means in this case this
is at the lowest total cost at this level.
So it means we have to acquire this much of inventory and this inventory is called as the
economic level of acquiring. We place the order and that order is keeping the cost at control at
the lowest level. But here people say that this economic order quantity process has become
obsolete and in today’s competitive scenario we should move to the other techniques like JIT,
ABC technique of material management or the other techniques of material management but that
is not correct.
Even today, as I told you just in the beginning of the class that even today it is very useful to say
use the economic order quantity process and there might be some problems. People say that to
assess the ordering cost, there are say difficulties in assessing or finding out the exact ordering
cost. Carrying cost if you try to find out there are the difficulties in finding out the carrying cost
and the total investment which we plan to make or we are going to make there is a problem to
find out that total investment we are going to make.
So if we are not able to work out the cost, total investment we are going to make how can you
think of working out the carrying cost. Agreed that it cannot be worked out with the total
precision. There is a possibility that the carrying cost we are working out in the beginning and
the carrying cost actually taking place that might be different. Similarly, if we talk about the
ordering cost because ordering cost involves many things.
And the people, the human resources who are working and dealing with the ordering of the
materials, they are not only doing this job. They are working for the other things also. So it
means the salaries they are being paid, what part of their salary should be say apportioned and
that should be attributed to this particular job, the ordering of the inventory job, that is again very
difficult.
So yes, we agree that if it is a temporary workers and doing this kind of the ordering job only
then it is fine it is easy to calculate the cost, ordering cost. But if some people who are working
on the multiple things, finding out the ordering cost will be very difficult because out of the total
their salaries cost, the salaries they are being paid, they are doing many things so how to find out
the ordering cost. So there is a problem, agreed.
But still if somehow if you are able to find out the carrying cost and the ordering cost which is
quite possible, which is quite easy, not every difficult and there can be differences also that what
is the estimated cost and what is the actual cost, there can be differences. Despite that EOQ
model or EOQ technique of inventory management is very useful even today or in the modern
scenario especially in the countries like India or the developing countries.
Because this technique even today gives us the quantity of the raw material that can be purchased
at the lowest possible cost and minimum investment of the short term funds can be made in the
inventory. Now, we would see a situation that if there is a problem in assessing the cost it means
that will cause the error. If the assessed carrying cost or the estimated carrying cost and the
estimated ordering cost are different and actual are different so there is a variance, there is a error
in calculating the cost.
So how much that error is there. Whether that error is going to make a different or that error is
not going to make a difference. Let us see about that, talk about that and try to understand that
error. I will not I will take you to the say a model which is helping us to understand that what this
technique is.
How it is possible to be say precise in calculating the cost and if there is an error in calculating
these costs because of which because of these errors this technique is called as obsolete
technique or need to be abandoned then let us see whether it is justified or not. So we can say
that let us determine the error factor.
So how to what are the important components of the two costs, carrying cost and the ordering
cost. Number one is the demand factor because how much material you will be ordering that will
depend upon the demand and people say that there is a problem in estimating or forecasting the
true demand or the actual demand for the product we are manufacturing or the different firms are
manufacturing.
So let us see that let us work out the different errors and first is the demand factor. We have
taken here estimated demand divided by actual demand and whatever the difference in the
estimated demand and actual demand is there that is called as the demand factor and let us
denote that factor with the M. This factor is denoted with the M. So this is one thing. Second
thing is now the error factor for ordering cost.
We say that ordering cost is very difficult to find out the ordering cost as I just told you that the
people who are working for ordering of the material they are not only doing this job in the firm
they are doing many other jobs also and since they are permanent employees they are getting
salaries so how to apportion attribute the part of their salaries towards this job towards this
function so it is very difficult.
So there can be the error or there can be the possibility of the errors and say we have estimated
that error also. We have tried to find out the ways and means to identify that error also to
estimate that error also and in that case ordering cost error factor is estimated ordering cost
divided by actual ordering cost. That is only going to happen, only 2 things; estimated ordering
cost and the actual ordering cost nothing else.
It means if there is a difference let us denote this error by N. Third cost is the holding cost or the
carrying cost, holding cost or the carrying cost. It is sometime difficult to identify the carrying
cost or holding cost that how much investment is required to be made, how much funds are
required to be invested in say a given amount of inventory and what will be the carrying cost or
holding cost for that.
So in this case estimated holding cost we can take for calculating this error factor for working
out this error factor or the error factor for the holding cost. Estimated holding cost divided by
actual holding cost right and we also get this error factor worked out and let us denote it by K. So
it means now we have got them order. Denote Q, Q means that is quantity that is saw tooth
picture first level that we call it as the economic order quantity.
And Q star is the order quantity with estimated errors means we identify actual EOQ level should
have been say 500 units of a given period of time or a lot of the 500 units but be estimated or as
per our estimate the economic order quantity which came of was Q star with the estimated errors
and that was say 600. It means finally if you use this model you would say that how much
variation is there. Our objective is to find out the variation.
How much variation is there? If you see the variation here then Q*- Q means estimated say
quantity minus the actual quantity means quantity which is say estimated with errors and actual
quantity which was purchased and which was called as the real quantity that is EOQ divided by
the Q and here if you look at the model which is the standard model of the Q, EOQ model that is
2DC/H.
2 multiplied by the demand annual demand multiplied by the carrying cost divided by the
holding cost and the root of this. This is standard model. No need to explain this model and if
you incorporate the errors in this, if you incorporate the errors in the demand as well as in the
carrying cost. So we have already identified here the error factor and demand is M. The error
factor in the ordering cost is N.
So if you multiply by the error factor here so Q star becomes means the economic order quantity
which is affected by the error becomes under root of 2DCmn/Hk; Hk is the holding cost and that
is also full of error. So it means one model is this model which is the original model and one
model is the another model which is the another model.
So it means if you talk about this in that case you would say that this is the one thing and another
thing is that if you want to talk about this is the another thing that Q is 2DC/H under root and Q
star is 2DCmn under root Hk sorry divided by Hk under root. So if you see Q and Q star we have
got 2 important things. One is correct and the another one is the incorrect or full of errors. Now,
let us see what happens.
Impact of the errors on the demand or on the estimated Q as we have calculated here or which
can be calculated here say the final model will become like Q star - Q/Q and if you solve this
model here finally we arrive at this particular thing which is the last thing. So if you see here this
last thing is mn/k under root - 1.
This becomes the final model and if you use this model you will be able to find out the error
factor, how much error is there in estimating the economic order quantity and that will help us to
understand whether it is worthwhile to use EOQ model or it is not worthwhile to use it has
become a model which is obsolete; we should abandon it.
So it means finally after adjusting for the error factor and differentiating between the actual
economic order quantity or the actual based upon the actual demand, actual carrying cost, actual
holding cost and estimated demand estimated carrying cost estimated holding cost, the difference
between these 2, if the difference is very high then yes the technique is obsolete. But if the
difference is too low then you can say that yes there can be some kind of errors, problems in
estimation which can be easily taken off.
But if that error is minute then the technique is still useful but if the error is big then yes certainly
we will have to look for the alternatives.
Now let us see we take a data and use this model which we will try to find out here that say
whether the technique is still useful or not. For example we have taken the parameters demand D
estimated at EOQ level is 7200 units, actual is 10,000 units means we could sell that much of the
product in the market. What is the percentage change, what is the variation in the demand for the
product in the market, 38.9% that is plus positive means we estimated the demand 7200 units.
Actual demand was 10,000 units. So here is the error in estimating the demand or forecasting the
demand. Now look at the second component ordering cost. Ordering cost is 1200 per order that is
C. Actual ordering cost was 1000. So it means again there is a error here and that is means the
estimated was estimated ordering cost was high. Actual ordering cost was low and there is a
negative variation by 16.68%. Now we talk about the holding cost.
Holding cost is also different here. Holding cost we estimated were or was Rs. 3 per unit and
actually it worked out as Rs. 4 per unit. So again there is a variation of 33.33% here right. Now
finally how the model will work. We have already estimated or known how to estimate these
error factors. That is estimated demand, error between the estimated demand and actual demand
that is m. Error between estimated ordering cost and actual ordering cost that is n.
Error between estimated holding cost and the actual holding cost k and here we have out of the
given figures here we have worked it out that is 0.72, 1.20, 0.75 right. Put all these figure now in
this model. This model which we have worked out in the previous slide here that is under root
mn/k - 1 if you use this model which will capture the error in the actual between the actual and
the estimated.
So it means finally the model is Q star – Q/Q is under root mn/k - 1 and if you put the values the
error factors we calculated here with regard to demand, with regard to the ordering cost, with
regard to the holding cost if you see here you will find out that total calculations are here
something like this that is 1.07. So - 1 means which is the difference part. The estimated part is
1.07 and the actual is 1.
So the difference between the estimated and the actual is 0.07 or finally you can say 7%. It
means the difference in estimation of demand, difference in estimation of the carrying cost,
difference in the estimation of the holding cost or if you do not want to call it as a difference you
call it as error. Error in estimating the demand, error in estimating the carrying cost, error in
estimating the holding cost; nutshell the total error or the magnitude of that error is just 7%.
It means 7% which is at the acceptable level. It is less than 10% and anywhere when we are
going for the forecasting of any demand because at the level of estimation we are forecasting we
are only estimating. So certainly there ought to be a difference between the estimated level and
the actual level. But if that difference is very high then what will happen. The that the EOQ
worked out, estimated EOQ and actual EOQ will be much different so what will happen?
If it is on the higher side, estimated economic order quantity is very high so what will happen?
We will end up making more investment than the desired investment or required investment so
wasteful investment of the funds will be made in the inventory and we will not be able to convert
that inventory into cash as quickly as possible. Or it can be vice versa that we have estimated it
wrongly so actual requirement of the inventory was high.
We estimated it lesser and we are not able to serve the market or we are facing the stock-out cost.
Now in this kind of the situation if that is the case yes certainly we will be facing the music. But
in this case there is no problem at all; 7% difference between the estimated and the actual figures
is not a big difference. So ultimately we can prove it or it has been proven say it has been proved
in the literature that economic order quantity is still a useful technique.
And in case of the working capital management also, management of the short term funds also
how to find out that magnitude or the level of the inventory, economic level of the inventory
which can be decided that we call it as the optimum investment in the inventory or that quantity
which is called as the optimum quantity of the inventory which can be acquired which can be
used which can be converted into finished product and which can be say taken to the market.
So in a country like India in all the developing economies we cannot say that we can use JIT so
we will have to depend upon the economic order quantity. So it means finding out the optimum
level of investment in the inventory or building of the current assets in the form of the inventory
we will have to depend upon the economic order quantity even today in the time to come and this
is a very useful technique.
So this is something like that we were talking about while say started discussion on the
management of inventory that we should make optimum investment in the inventory so a big
question mark was how to find out that optimum investment in the inventory and here the way
out is that with the help of EOQ we can find out that level of inventory which is optimum, which
is most appropriate.
And if you build up that much level of inventory, cost of inventory will be at control. Total cost
of inventory will also be controlled. Investment will also be under control and converting that
into cash or into sales will also not be a problem and finally all the objectives of optimum level
of maintaining inventory, optimum level of investment in inventory and optimum level of sales
and avoiding all kind of excessive cost can be achieved. So this is for today.
We will stop here and we will carry forward the discussion of management of inventory and in
the say in the classes to come also I will carry forward the discussion and we will discuss many
other things with regard to this particular current asset we will learn more how to manage the
first and the foremost current asset, most illiquid current asset called inventory so that investment
in the inventory can be kept under control and that can be converted into cash as quickly as
possible. Thank you very much.
Dr. Anil K. Sharma
Lecture - 22
Stockouts Cause Walkouts
Welcome students. So we are in the process of learning the inventory management or say
investment in the inventory deciding the amount of the inventory to be kept which will be the
optimum amount. So in the previous class I was talking to you about certain costs which are
associated to maintaining inventory or not maintaining inventory. In both the cases we have the
cost. As we know that in case of maintaining inventory we have the carrying cost, holding cost,
shipping cost.
So not holding the inventory and sometime if there is a situation comes up that there is a order
received by the retailer or maybe by the manufacturer and he is not able to serve the needs of the
consumers. Then the consumer will be it will not be a good step. It will not be a welcome step
from the consumer side. He will not like it and sometime we feel or sometime we feel that the
reaction is not very sharp as far as the consumer is concerned.
But in the mind of consumer sometime it gives a sharp reaction that this company is not the say
you can call it as the company which takes care the needs of the people or the consumers or
sometime this retailer is not the say appropriate retailer and there is a there is a shortage of the
goods on the shelf of the retailer and they do not feel like to come back to such retailers. So
stock-out cost is a very big cost.
Many people misunderstand it or sometime they do not understand the gravity of the problem
which comes up because of the stockouts. So we should not allow the situation. Like that we
have the orders. People are ready to buy the goods and services from some company or from
some retailers but we are not able to serve their needs. So that creates the problem. That situation
should also not come up.
And if that situation comes up and if the any say way maybe the retailer or the distributor or the
manufacturer is not able to serve the needs of the buyers then it creates a big problem and it has a
big cost. It leads to the lost sales, that is a direct effect. But the loss of a loss of reputation, loss of
goodwill, loss of say customer preference or customer choice. These are the some indirect costs
which are sometime very heavy.
And it gives the impression that these companies or these retailers or these people do not take
care of the needs of the people. On many times it has happened with you also when you visit a
store or any shop and you have something in your mind that I want to today buy a particular type
of the shampoo or maybe some cosmetic or maybe some other thing of daily use or some say
thing to eat like salted you can call it snacks.
So these things when we do not find on the store we feel very bad that we wanted to have
something but it is not available. So ultimately it creates a problem. First it disturbs the consumer
and the aftermath effect of it is to the distributor, to the retailer or to the company also. So we
have to take care of it. As I was talking to you that why we are talking of maintaining the
optimum level of current assets right.
Whey we are talking of maintaining the optimum level of current assets because from the current
assets we have to pay the current liabilities. We have to create that kind of symbiosis that kind of
situation in the company that it is only the current assets who would generate the cash and from
the current assets only we will have to pay for the current liabilities. Maybe it is a spontaneous
finance or whether it is say short term sources of the finance, we have to pay the current
liabilities.
So current liabilities become very say quickly due to be paid. So we have to remain say very
careful about that and at any particular point of time we are not able to make the payment of the
current liabilities as and when they become due the firm is considered as technically insolvent.
Everybody understands that the firm is good. Overall financial health of the company is good. It
is a very big company. It is a large organization.
Assets of the company, liabilities of the company, financial performance of the company,
profitability of the company, there is no doubt about that. This is a means unparallel
organization. But you see that if you are not able to make the payment at that time when it is due
to be made what impression the other side will carry.
So it means how big your company is, how profitable your company is, how high the level of
assets and liabilities is; if we are not able to serve those liabilities, if we are not able to payback
those liabilities as and when they become due in that case there comes the problem. So we
should avoid that kind of the problems. So you see we are talking about building the optimum
level of current assets especially those assets which are least liquid and one is the inventory.
Inventory is the least liquid so we should build up the optimum stock of inventory. Otherwise
what will happen? As we are talking about the stock-out cost that same way there will be the
stock out of the cash. For example we exhausted the cash, whatever the cash as a current asset
we had maybe the cash in hand or cash at bank. Similarly, we exhausted even the credit sales that
is accounts receivables also.
And now we have to depend upon the inventory and if the inventory is not saleable if it is not
convertible into cash. So what will happen? The company is not able to serve its liabilities,
current liabilities at the time when they became due. So that is considered as a technical
insolvency. That is a state of technical insolvency because firm is not insolvent. Firm is not
bankrupt.
Firm is good, having a good financial health but that is called as the technical insolvency. So
same is the case means same situation arises when we go to a shop. We want to buy a product as
a consumer but the product is not there. So we understand company is good, company’s product
is good, everything is good but at that particular point of time when the company is not able to
serve anybody’s need, any consumer’s need so consumer thinks that this company is technically
insolvent.
So that situation should not come. So we should carefully think about the stock-out situation and
we have not to worry about that. Means here with further think about that many a times you
might have seen here that when we visit a shop some distributors or some salesman from the
companies they visit the shops themselves and with the permission of the shopkeeper or maybe
the owner of the retailer store, they themselves manage the shelves.
They place their goods at a place where they are easily say is the customer can easily see can
have a look upon it. Because many a times we feel that if something is available on the shelf and
it looks attractive we do not want to purchase it but sometime we go for the unintended
purchases also.
So that is also a another skill that you are managing your company, your distributors, your
salesperson, sales force and retailer are managing the show in such a efficient manner that even
the customer does not want to buy the goods, particular type of the goods, but they are bound to
buy it they are forced to buy it because it looks so attractive because it is available on the shelf.
So that is a another part of the story. That is a another extreme.
So we have not to allow this extreme to come that we means anybody comes to the store to buy
anything and that stock is not available as and when we want to buy it right. So stock-out cost I
was just talking to you that is a very high cost. We should avoid this cost and all the times
sufficient inventory of all kind of the things should be maintained. I was referring you to a to a
survey which was conducted by the Harvard Business School professors, 2 Harvard Business
School professors and one of their another fellow.
Three of the people they conducted the survey sometimes back and the survey was conducted
across say 71,000 means on the 71,000 consumers across 29 countries right.
A survey was conducted. These 2 Harvard professors that is Daniel Corsten and then the Thomas
Gruen, they conducted a survey on 71,000 consumers across 29 countries to learn how they react
to stockouts when they cannot find the precise product they are looking for right. How they find
when the precise product they are out to purchase but the product is not available on the shelf,
how they react. Means it has many kind of reactions; mostly they are the psychological reactions.
But we have to capture as a researcher as a surveyor we have to capture those reactions and we
have to translate how the customer feels at that time. So how the customer feels.
Here is the picture they have presented and they divided their total consumers, 71,000
consumers, who they interviewed and tried to get the information from. They finally say
concluded that customer take either of the 5 decisions; either of these 5 decisions and sometime
they are not in the interest of the company. Sometime they are against the interest of retailer. So
it means whether it is retailer, whether it is company, both are negatively getting affected.
And both are going to pay the cost which is direct cost in terms of the lost sales and the indirect
cost in terms of the lost reputation, goodwill. So that kind of the situation should not arise. Now
see how the customer feels when he visits, he or she visits the store for buying a particular thing
or buying intended good and that is not available on the shelf how they feel at that time. What
kind of the decisions they take and what is their reactions.
They have captured their reactions and they divided into 5 broad categories. Number 1, do not
purchase item. They come back and they do not purchase the item. So out of that out of 71,000
consumers how many said that they do not buy the item, 9% only. Okay, if it is not available
today I will buy it later on but I will not buy any other substitute. I will not go to any store. I will
not say replace the store. I will not replace the product. I will not look for any other alternative.
I will not buy the product and he or she comes back. Still it is not that bad. If the person is not
buying the product at least you lost the sale for a moment but next time he or she goes to the
store and if the production is available, same company same retailer could make the sales in the
market and the product could be sold. Only there was a difference of time. Not bad, not that bad.
It is bad but not that bad. Now second case is delay purchases.
Sometime we forget purchase. So okay no problem. We are not going to buy it but he may buy it
later on but the second thing is delay purchases. This is also not bad. 15% of the people say that
okay if it is not available today, I will buy it later on right. So he will delay the he or she will
delay the purchase. Again he or she will not look for any alternative, not substitute the product or
the store.
And they would like to again come back and to buy the same product from the same store. So
50% or 15% of the people have said that yes we will buy it at the later date. So it means out of
the 100% consumers, 24% of the consumer say that either I will not buy it. So it means he may
again think sometimes that okay let me go out and to look for the product. But in the second
category that is 15% of the people say not today I will come tomorrow.
And they delay the purchases but they do not look for the substitutes. In both the cases 24%
consumers are not very harmful but still it is not good. That kind of situation should not arise.
Look for the third decision they take. Substitute different brands. This is a large amount of the
people; 26% of the people say that if it is not available I will buy the product of any other
company. So it means in that case what happened? Company is going to pay the price.
Company lost the sale. That you say that it does not means it does not make a difference that if
somebody does not buy it or somebody replaces X company’s product with the Y company’s
product so how does it matter? But it matters. It does not happen at one place. It happens at many
places. So the person if likes the product of the other company the substitute then he may never
like to come back to the first product so first product lost the market forever.
Lost the consumer or the potential sale forever. So it means substitute different brands, it is a
most dangerous situation for the manufacturer, for the brand. For example we want to buy a
shampoo, particular type of the shampoo. We buy Head and Shoulder, we are user of the Head
and Shoulder.
But when we went out that a particular variant of the Head and Shoulder we want to buy and if
that is not available on the say on the shelf but anyhow I see that okay if the Head and Shoulder
is not available which I normally use I will go for the next or the second brand which is available
on the shelf say for example the L'Oreal is available on the shelf. So people will replace Head
and Shoulder with the L'Oreal.
And if they like it, if they use it and if they like it maybe they will replace it forever. So Head
and Shoulder is gone out of that person’s choice and that brand of the shampoo is replaced by the
L'Oreal so you see it is a loss of the sale to the manufacturer of the Head and Shoulder. Fourth
decision they take is substitute same brands. Substitute same brands. In this case what happens?
Head and Shoulder is the one brand. But it can be from the same company there can be other
brand also.
They will use the shampoo; they know that who manufactures Head and Shoulder. So if the same
company manufacturing the other brand of the shampoo at least they will like to replace it with
the same brand. So in that case it is not loss of sale to the manufacturer. It is not of the sale to the
retailer and not a very bad decision on the part of the consumer. It is not against the interest of
the manufacturer or the retailer but still it is not a good practice.
Last decision is buy item at another store, buy item at another store. If they buy item at another
store look whose loss it is. It is a loss of the retailer. It is the loss of the store. Because that
retailer, that store could not fulfill the requirement of the consumer who is regularly visiting that
store, that day he did not find the product. He will not wait; he will not delay the decision. He
will not say say stop buying.
He will immediately go to the another store, nearby store and he will buy the same product from
that store. So it is a loss of sale to the retailer. So it means some cases there is a loss to the
manufacturer and retailer both. In some cases there is a loss to the manufacturer. In some cases
there is a loss to the retailer. So everybody is paying the cost. And we have understood that the
cost is both, direct as well as indirect.
So this kind of situation should not be allowed to come up and we should try to maintain
sufficient inventory but it does not mean that you maintain the inventory beyond a level because
otherwise what will happen that means we want to ensure the sales but we are paying the extra
financial cost by investing huge amount of the funds in the inventory maybe at the
manufacturer’s level, maybe at the retailer’s level, maybe at the distributor’s level.
That is also not good. So I am time and again emphasizing upon that we have to look for the
optimum level of inventory which serves the needs of all the stakeholders. Now what the further
have found out, the survey has found out is look at this thing. The further findings of the survey
are, what consumers really do in case of the stockouts.
Buy items at another store right. We understand. Now we have the four kind of the products
here. The survey included 4 kind of the products. First product was cosmetics. Second was
shampoos. Third was coffee and fourth one was the salted snacks. These were the 4 products and
these are largely consumer products. See the impact of stockouts is more on the consumer
products, less on the consumer durables; less on the consumer durables.
It is on the consumer durables also but less. For example if you want to buy a colour TV. We
have already decided. Because colour TV is a kind of product which we do not buy everyday.
We buy once in a while. So if we have decided in the mind that we will buy only a Samsung
colour TV or a Sony colour TV or the LG colour TV that decision is already there in the mind
right.
When we go to a retail store and go to a store, electronic store we try to find out that whether
Samsung TV is there or not right. But if the Samsung TV or that desired variant of the Samsung
TV if it is not available at that time we take two decisions. Either we visit the another store,
another electronic store or we postpone the purchase because brand in case of the consumer
durables is something which we do not want to change so frequently.
We are satisfied with the Samsung or Sony or LG so ultimately have to buy Samsung product,
Samsung colour TV. If it is available today, I will buy it today. If it is available not in one store,
in the other store, I will buy at other store. But anyhow I have to buy it, only Samsung. So it is
not a loss of sale to the Samsung but is a loss of the sale to the store at that particular point of
time. If he buys the product at another store then it is a problem to the store.
So it means in that case the impact is not that much to the company it is to the retailer. But in
case of the consumer product which we buy on daily basis right if that is not available on the one
shelf or one store we immediately go to another store. If the one company’s product is not
available we replace with the other company’s product. So we have to be very careful as a
manufacturer, as a distributor, as a seller that this type of situation does not arise.
So if you look at this, in case of the cosmetics how these 5 decisions of the consumers have
affected. Say first is 43% buy item at another store. In case of the cosmetics it is a very big chunk
near to the half of the consumers out of 71,000, they buy cosmetics at the other store. So it is a
loss of sale to the store. Then 22% people delay purchase. They delay purchase so it means at
least the store can expect this person will again come back to me and by that time I should make
the product available.
So not a very serious loss. Substitute same brand. If he substitute the same brand it means if the
one variant is not available go for the another variant or the cosmetic and same store and same
company but some loss of the reputation but not much. Substitute different brands. In this case
this is direct loss to the, it is a direct loss to the company. Say 8% of the people. Very few people
change the brands.
Because if you use a product of a one particular brand we do not tend to change the brand very
frequently especially in the cosmetics which affect your skin here and maybe your taste. So we
do not change it very frequently but sometimes we change as in this case 8% of the people, 8%
of the respondents have said that in case of the cosmetics we substitute the product we buy
normally with the another brand.
So it is a loss of sale to the brand, not to the store and do not purchase item, not at all purchase
item. So ultimately it is a loss of sale to the both that is to the store also that is to the company
also but maybe you can hope that he has not completely said not to buy the product he may come
later on but not with the within the specified period of time.
If that is the time is specified that I will come tomorrow, I will come 2 days down the line then it
is a delay purchased season but here do not purchase the item. So he will forget for a moment.
Again that thing will come up in his mind. He may visit the same store. Look for the product, if
it is available he will buy it. In case of the shampoos we have seen here that 32% of the people
buy the product at another store, again a big chunk.
Delay purchases only 21%. Substitute is 19. Substitute with a different brand is 18 and do not
purchase the product is small number that is 10%. In case of the coffee in case of the coffee we
have seen that 29% of the people buy the same brand coffee at another store. So there is a loss of
sale to that store. Delay purchase 21%, then substitute same brand 13%, substitute different
brand 20%, do not purchase the item is only 17% right but it is not a small number.
We should look for that if somebody has made up the mind to buy the product he should be
served with that product if the product should be available. Even he decided do not, not to buy
the product then it may be possible he will come tomorrow; it may be possible he will not come
even forever because he has not delayed the purchase. He has taken a decision I will not
purchase the product. Again he can think about but he may or he may not.
Think about the salted snacks, 21% because snacks many companies manufacture and sell the
snacks in the market. So it maybe mathlab it is not a big difference it does not make a big
difference that for example we use the say Lays as a chips, salted chips potato chips. If we use
Lays and we are say means habitual, we like to consume the those snacks those chips only those
salted potato chips then maybe if the Lays is not available of the blue pack of the Lays is not
available I may go with the green American taste.
Or maybe I can go with the yellow taste which is very simple you can call it as only salted, no
spice in that. 9% of the people delay purchase in case of the salted snacks. Okay today it is not
available I will come tomorrow. 20% substitute the same brand. So if the Lays is not available I
will purchase some other company chips for example say local Haldiram’s chips are available or
maybe this Bikano’s chips are available so we will buy that.
So it means in that case the Pepsi lost the sales. 25% people or say 25% people substitute with a
different brand like and do not purchase item forget I will not eat chips. I will not go to any store
I will not replace with a new product I will not eat chips and that is also a big chunk 25% of the
people. Out of 71,000 consumers if they are saying that 25% of 71,000 people if they are saying
that they are not interested it means somewhere 16, 17,000 people have responded that they do
not purchase the product.
They neither replace the brand, they do not substitute the brand, they do not change the store.
They simply take a decision. I wanted to have chips but if they are not available do not worry I
will not take it. In that case again it is a big loss to the manufacturer to the retailer to everybody.
So it is a very big cost and we will have to be careful while serving the needs of different kind of
consumers in the market.
Now I would share with you some of the other findings of the same paper, same case which was
reported by these 2 Harvard professors plus one of their associate on the basis of whose finding
we are sharing and we are learning about the stock-out cost. They have said that on their in their
survey when they visited different countries they found that out of 100% stockouts they find or
the reasons for the stockouts they found, they concluded on the basis of their research that 72%
of the stockouts were found on the store because of the inefficiency of the retailer, because of the
inefficiency of the retailer the product was not available on the shelf in the store.
It means store is careless. He does not care. Store people do not care what product is available,
what is finished which has gone off the shelf which is on the shelf and I have to replace it with
the new stock they are careless, 72%. So they are also the party to it so they are also getting
affected. They are also losing the sales if people buy the same product at the other store. 28% of
the stockouts were found because of the inefficiency of the manufacturers or the companies who
manufacture these 4 products, 28% but only.
So it means 72% was the reason that is at the store level inefficiency of the store and only 28%
reason were attributed to the manufacturer that manufacture did not bother about that in that
particular market or in that particular area we have not received the order for long so let us check
whether there is a need for our product or not or sufficient inventory is lying. So they should also
be careful in that case. So what happened? What is the solution?
Solution is what they have given the solution they have found the consumers as well as the some
of the stores in US as well as in UK they have taken some actions also and how they have
improved this situation to deal with the stockouts?
Improved IT systems may improve the stockouts situation but it is expensive to have IT have
efficient IT systems. So only important thing is that with the help of IT systems we have the
programs, information technique based programs in the systems which keep on telling, the
system keep on telling that on one particular shelf this range of the products are kept and this
product has gone out of order.
This product has gone out of order so it means say out space not order I would say but it has
gone out of shelf it is finished it is over I should replace or store should replace it with the new
product. If that is the case that can help the help to solve the problem to a larger extent and many
stores have found out that improved IT systems though they are very expensive but if the store is
very large for example we have some big chains you can say that Big Bazaar in India or Reliance
Retailers they are in India.
They can they can afford to have that kind of the softwares or that kind of the IT systems. Here
in this survey they have reported 2 important cases that there is a one big retailer who is called as
H.E. Butt grocery HEB. The small name of the grocer was, is a grocery chain in US. It is a US
food retailer you call it is a US food retailer H.E. Butt grocery which is in the short called as
HEB they have adopted this system of the means putting in place the efficient IT system.
They are the retailers and by spending money on having the efficient IT systems they have been
able to reduce the stockouts to the extent of 22.5%. up to 22.5% the stock-out problem has been
solved at the store level by this HEB distributors or the retailers. There is a another retailer, here
there is another retailer in say US largely which is called as Sainsbury. So Sainsbury also has say
put in place the very improved IT systems.
And in that case normally they have identified number of items and Sainsbury has connected
around 2000 items. It is given in the survey 2000 means largely selling items they connected to
this IT system and as a result of that improved IT systems, which is linked to the 2000 frequently
selling items, top selling items they have been able to reduce the loss of sail by 2%. It means
sales have gone up by 2%.
So these stores which are very big in say size, sales amount everything which are very big if
means they are able to gain the sales by 2% just immediately after say putting in place the
improved IT systems so you can make out that regular gain of the sales will be how much. So
that system, the cost of the system will be compensated to the company or the company will be
compensated for the cost of say putting this systems in place if we are able to deal with the
problem of the stockouts.
So we have to be careful that when we are talking about working capital management we are
talking about that on the one side when we are careful about not investing huge amount of capital
into the inventory so we should be careful on the other side also that the investment should not
be too short. Because short investment creates the problem of the stockouts whether it is a stock-
out at the level of or because of the inefficiency of the manufacturer.
Or because of the inefficiency of the retailer or any other means component of the total
distribution channel that is again a bad thing. We should avoid that. All the times shelf should be
having the product as and when the people visit the store they want to buy the product. The
product should be available. So it means not abundance of the products but sufficient desirable
amount of the supply of all kind of the product should be ensured. It is the duty of both the sides.
It is the duty of the retailer also. It is the responsibility of the company also. Company’s sales
force they should continuously keep on visiting and in many a cases companies take the
responsibility that companies take the responsibility that their salesperson visit the stores and
they know this is the area, this is the shelf where our product is normally kept by the store. So
they visit very frequently.
And they see that all variants of our product is available there all the times and if it is not
available it is their job to put the product on place. Nobody else will come. We have seen in
many cases when we visit the bookstores some good book publishing houses their representative
come to the bookstore. They see that means a one particular book is having a low sales.
So what they do is they pick up the book from somewhere put in the backside put it on the front
so that any person who visit the store or the shop they can see they can have a look upon that
book and they can just pick up the book. If they find the book useful they can buy the book. So it
can be done by the manufactures also. It can be done by the retailers also. But if retailers will not
do it then it should be the say duty of the supply chain people who are ensuring the supply chain
in the store, not the responsibility of the store people.
In many cases the retailers have realized that it should not be a responsibility of the store people
or people managing the store. It should be the responsibility of the people managing the supply
chain. So everybody has to work towards this and they have to make sure that sufficient quantity
of goods in sufficient amount sufficient supply is available all the times at all the stores all the
shelves so that the cost of stockouts can be avoided.
So look at the thing which we were thinking about it is not a big deal. If we are not able to serve
the customer’s need he will come next time. But it is not a that kind of a thing. It is a very serious
issue and companies have to think about. While managing their inventory, making investment in
the inventory they have think about that not too much investment in inventory but not too less
investment in the inventory.
So ultimately again the optimum investment in the inventory because otherwise we will have to
pay apart from the many other cost if we are going to avoid the carrying cost, we are going to
avoid the holding cost, we are going to avoid any other direct cost it has the stock-out cost. And
it is equally important cost, it should be avoided. So here I will stop for this and next time with
certain more concepts or aspects of inventory management we will discuss in the next class.
Thank you very much.
Dr. Anil K. Sharma
Lecture - 23
Rationing of Working Capital -1
Welcome students. So in the process of inventory management now we come to the question of
funding the inventory; whatever the level of inventory we have decided to build up. Million
dollar question is how to fund the inventory, from where the funds will come which will be used
to fund the inventory or the funds to be investment for building a given level of or optimum level
of inventory.
See when we talk about the different sources of the finance I will discuss with you later on after
we finish the discussion on all the assets when we will come to the liability side then we will talk
about all the sources of finance, sources of the short term finance or sources of the working
capital management.
But in case of say manufacturing sector in India when there is a need of the working capital
management for funding the different current assets maybe it is the inventory maybe it is the
credit sales, maybe keeping the cash or paying in advance as a prepaid expenses, though we have
9, 10 sources around the globe 9, 10 sources are available for funding the say inventory
requirements of the companies.
But in India the most prominent source which is used for funding the inventory or the funds
which are inventory investment in the inventory they come from one single source or largely
from the one single source that is the bank finance. See as I told you in the previous discussions
or previous classes that when you talk about the sources of funds to fulfill the working capital
requirements we have 3 sources.
Spontaneous finance, short term finance, and once these 2 sources are fully exhausted then we
have to go for the or resort to the third source which is the long term sources of the finance and
investing long term sources to fulfill the short term requirements. That is the third source but that
should be used as minimum as possible. Now spontaneous finance is the first thing which is used
to fund the inventory.
Because when we buy the inventory when we buy the raw material, we buy it from the suppliers
and suppliers are asked by the companies by the manufacturers that they should supply it on
credit because this is symbiosis. Manufacturer gets the credit from the supplier and he gives the
credit to the buyer. So once he is expecting the credit from the supplier he is bound to give the
credit to the buyer.
And if he is bound to give the credit to the buyer he is also have he also has the right to expect
the credit from the supplier. So supplier agrees because they have a long term supply
arrangements with the buyer and the between the buyer and the sellers. So seller also gets the
long term agreement, long term opportunity that yes if I am having the acceptable terms of in this
agreement.
And if I get the long term supply orders from this particular company it is good for me also and I
would be giving some credit period to the company but if my payment is safe and company is
ready to pay some interest also for the credit period how say bad it is for me. But his capacity is
also limited. So part of the funding of the inventory comes from the supplier. But the supplier’s
funding is largely about the raw material.
After that when the raw material comes and it goes to the manufacturing process you have the
inventory of WIP also and you have the inventory of the finished goods also. That inventory of
the finished goods who will fund that inventory of finished goods. So after the spontaneous
finance is over or the credit available from the supplier is over, that source is fully exhausted
then we have to resort to the short term sources of the finance.
And as I told you there are 9, 10 sources of finance around the globe, around the world which
firms use in the different countries in the different parts of the world. In India also largely now
after liberalization most of these sources are available. But only one source is used to the
maximum possible extent and that source is the bank finance. Reason for that is that it is easily
available as compared to other sources.
It is cheap also, easily available also, more regular, more secure, and comparatively cheaper
source of finance. So companies resort to this source of finance. Other sources even the bank
finance in detail I will discuss with you later on but here in the passing reference I can tell you
that funding of inventory once that source spontaneous finance is over second important source
is the bank finance.
Now when the banks fund the inventory banks not only funding the inventory, bank funds the all
working capital requirements of the companies, the manufacturers. They fund the inventory also.
They fund the credit sales means accounts receivables also. People can withdraw cash also from
the bank account or from the sanctioned amount and they fund the prepayments also to the extent
it is possible.
The total amount sanctioned by the banks for fulfilling the short term requirements of the of the
manufacturers, bank is supposed to divide that total amount sanctioned into the different assets
that this much amount out of the for example bank sanctions the say total working capital help or
assistance. I do not call the name or the mode of delivery of those funds that can be any. There
are the 3 modes of providing the funds.
One is the cash credit limit. Second is the working capital loan, and third is the discounting of the
credit sale bills. I have talked to you something about the credit sale bills in the previous class
also but I will discuss it again. So one is the CC limit, second is the working capital loan and
third one is the discounting of the credit sale bills. Now most prominent, most light preferred
source for the manufacturer or for the borrower is the CC limit.
Because the beauty of the CC limit is that when the CC limit is sanctioned by the bank to the
borrower or to any manufacturer, in that case a certain sum mutually agreed by both the sides is
sanctioned by the bank say for example 1 million, 10 lakh rupees are sanctioned as a CC limit
and an account of the borrower is opened by the bank in the said branch and an amount of 10
lakhs, 1 million is credited or provided in that account.
Now that amount 10 lakhs should be used for the different purposes means for financing
different assets in the different components like part of the 10 lakhs can be used for funding the
inventory. Part of the 10 lakhs can be used for funding the credit sales. Part of the 10 lakhs can
be used for the prepayments. Part of the 10 lakh can be used for making the payments as a cash.
Now when it is a divided sum for example out of 10 lakh rupees bank says that half of the
amount, 5 lakh rupees, half a million can be used for funding the inventory.
Half a million can be used for funding the inventory as and when you want to buy the inventory
you can withdraw money from this account and then you can make the payment. But that is true
to the suppliers. So it means 50% of the funds are available out of CC limit. Half of that 1
million rupees that is available for paying the making the payment to the suppliers and that can
be used for supporting the inventories.
Now in this case, this is the normal situation. Banks when sanction these limits this is the normal
situation. But sometimes when the credit flow squeezes with the banks when the credit supply
with the banks gets affected then the funds available with the banks to be provided as a loans or
the working capital limits or working capital loans the people gets restricted. Then those
restrictions, shortage of the funds also affects the working capital funds to be provided by the
banks to the manufacturers.
So what the banks do, that for example bank has for example 50 crores normally but because of
some credit restrictions maybe from the different sources because normally the funds come to the
banks from the deposits maybe under the different say regulations of RBI that fund which is
available with the banks to be invested in the market as loans that keeps on say fluctuating.
So because of some changes in the economic or in the monetary policy by RBI or some changes
in the CRR or some other say monetary changes, monetary policy changes by the RBI if there is
a there is a reduction of the funds available with the bank. There is a restriction on the funds or
surplus funds or the funds investible funds available with the banks then the impact of that
restriction comes on the different CC limits also.
Banks also say pass on those restrictions to the different CC limits also and they start rationing
the loans or the working capital funds or the funds provided through the cash credit limits to the
different manufacturers. So that is called as restrictions of working capital by the banks or
rationing of the working capital by the banks whatever the name you call it as but for example
earlier it was 1 million.
Now the banks can say that we are reducing your limit for the time being. It will not be now 1
lakh you can only withdraw up to 8 lakh rupees. Now what is CC limit, how it works, I will
discuss with you later on but see this is the limit that up to earlier up to 10 lakh rupees somebody
can withdraw and use the funds for fulfilling their working capital requirements but now the
restrictions are imposed.
And because of that restrictions on the availability of the funds with the banks, banks have
further passed on those restrictions to the borrowers and CC limits are restricted from the or
brought down, CC limit is brought down from the 1 million, 10 lakh to the 8 lakh rupees. It
means there is a restriction of 2 lakh rupees. The CC limit account has gone down by 2 lakh
rupees and now only 8 lakh of the funds will be available.
So it means when 8 lakhs will be available it will have the impact upon all the assets. Inventory
will also inventory funding will also be affected. Credit sales funding will also be affected.
Prepayments say financing will also be affected. Similarly, the cash position will also be
affected. So that situation is called as the say rationing or restrictions of the working capital
imposed by the banks on the different manufacturers.
So now we will discuss here that if this kind of the situation arises and any kind of the
restrictions are imposed by the banks on funding of the inventory maybe of the raw material,
maybe of the WIP, or maybe of the finished goods then how the company can deal with that
situation.
Now roughly without going further into detail you can easily make out that we discussed in the
previous class that we decide the level of inventory to be maintained at one particular point of
time that is by following a technique of inventory management which is called as EOQ,
economic order quantity and that economic order quantity we find out by taking into
consideration different cost. Largely the costs are two.
One is the carrying cost, the investment made to fund the inventory and other is the ordering cost
or the setup cost. Now what will happen? We have decided this EOQ and EOQ is that the EOQ
level of that we have seen the saw tooth picture and the Q level we are deciding that is the
economic order quantity or that is the economic quantity we wanted to buy where both the cost
are equal. But now because the restriction of the funds available so what will happen?
That Q level will go down. Now for example if you see here. Our Q level will go down and in
this case when you talk about the Q level this is the level we decided here.
Here it is our Q level in the normal course and this where this structure was going on as we have
seen in the previous classes this was working like this. This is our Q level. But when the
restriction is imposed by the banks and the funds are not available so what will happen? This Q
will come down to this place. So now our structure will come up something like this, this one
and this is now earlier structure. This structure we have to follow.
So this level of the Q, so it means from this level to this level the funds have been say restricted
by the banks. So now you have to bring it down and if it happens so what will happen? In the
next case we have decided the structure on the basis of these 2 costs. This is your carrying cost.
This is your ordering cost. So what will happen? Your carrying cost will go down because we
have we were investing say for example into our inventory we were investing earlier 4 lakh
rupees. Now only or we were investing 5 lakh rupees. Now the 4 lakhs are available.
So what will happen? Our carrying cost will come down. If the carrying cost comes down like
this so what will happen? It will increase your ordering cost. Why it is increasing the ordering
cost because our requirement is Q. But now it has been revised to Q star so now we have to buy
smaller amounts of the quantity whatever production process is continuous.
So when the production process is continuous but you are buying in the smaller quantities so
what will happen? Frequently you have to place the orders. Frequently you have to place the
orders. So it means we are keeping a small stock of inventory not that huge amount of inventory
or the EOQ level of inventory. We are keeping now inventory because of the non-availability of
the funds as the result of the restrictions imposed by the banks.
We will have now the Q star level, not the Q level. So our inventory level will go down and we
are regularly utilizing the inventory as you were utilizing it in the past when no restrictions were
there. In that case your stock will be out of we will be in the situation of out of stock or our
orders will be or our level of the stock will be exhausting at the faster rate because it is it has
come down from the EOQ level so we have to place the orders time and again.
We have to means put the orders again and again so what will happen; though you have reduced
the level of inventory to be kept as a stock so your carrying cost will go down. Investment to be
made in the inventory has gone down from the 5 lakh to 4 lakhs. So you are paying the interest
on the 4 lakhs. That cost has gone down. But because you are ordering it again and again and
again because the order size has become smaller so your ordering cost will go up.
So what will happen, in that case your EOQ level will have to be changed. We have to now come
down from the Q level to the Q star level and then we will have to see that not this level at this
level we are and then we have we will come down for example when we will come here. So at
this, this is the reordering level. So when we will come here, this is the reordering level. So when
you come here you have to place the order.
And then it will not be allowed to go up to this level. It will, replacement of the inventory will
take you to this level. Quickly it will come down to this level and we will have to place the order.
So many orders, the ordering cost will increase and the carrying cost will go down. So earlier we
saw that EOQ was when both the costs were equal. Now both the costs are not equal. One cost
has gone down, another cost has gone up so we will have to bear say bear the burn of that.
But we will have to deal with the situation. So how to deal with that situation? We will again
learn it with the help of an example that if this kind of restrictions are imposed by the banks
because we are largely depending upon the banks for funding the working capital requirements
in India so if this kind of restrictions sometime are imposed by the banks then how the
manufacturers have to deal with this situation or how they have to solve this kind of the problem
we will have to learn this today.
So we will see how it happens. So for example we take the example of a company who is using
the 3 types of items. Or for example they are buying the in their inventory 5 type of the items
they are using and these items are for example we take here as the item number.
And then we are talking about annual demand. This is the annual demand. Item number, annual
demand, and then it is the unit cost. This is the unit cost in rupees. Items we have A, we have B,
we have C, we have D, and we have E. We have the 5 types of the inventories we are using; 5
types of items are keeping in the inventory. And annual demand of these items is in terms of the
units, this is in the units. This is in terms of units is this. This is 1500 units. This is 2250 units.
This is 6000 units. This is 30,000 units and this is 45,000 units right. We are using these units of
1500 units of A, 2250 units of B, 6000 units of C, 30,000 units of product D, and say 45,000
units of product E right. So let us see now what is the unit cost. Per unit cost of these raw
material is how much. Say for example it is 7 Rs and 50 paise. It is in rupees. In this case it is 25
Rs. In this case it is 12.5 Rs. In this case it is 15 Rs. In this case it is 5 Rs.
This is the unit cost which is given to us or which is available with us. Now other costs are
ordering cost is ordering cost is Rs. 25 per order and carrying cost is 20% per annum. Carrying
cost is 20% per annum. These are the 2 costs right. Now if everything goes normal then we are
means happy with this kind of the situation. We are using 5 kind of the materials. Units required
are this much given here.
And the unit cost or the cost per unit of the different these 5 types of the materials is like this.
Now bank imposes the restrictions. You call it as bank restrictions and these are up to the amount
of 2000 Rs, up to the amount of 2000 Rs. Say whatever the capital was or the CC limit was
sanctioned by the bank to fund the inventory to buy the inventory and to use the inventory bank
was providing certain sum out of the total sum sanctioned in the CC limit.
Whatever that sum was we will find that. 2000 is now reduced by the bank. There is a restriction
of 2000 Rs. We have kept a small amount knowingly just for the sake of simplicity that there is a
restriction by the bank that whatever the amount you have been using to fund your inventory by
borrowing from us now you will be borrowing 2000 Rs less as compared to the amount we have
been borrowing in the past. Now how to deal with this kind of situation?
This is a small situation, how to deal with this. So again what we have to do is now again we
have to work out the EOQ level. Economic order quantity we have to work out. First we have to
work out the adjusting EOQ level out of this and then we will see that if the restrictions are
imposed by the bank how to work out the revised EOQ level that is the I just saw you in the in
the structure that now we have to work out this Q star level.
So how to calculate this Q star level or the revised EOQ level we will have to look for it because
now the one cost is going up and the another cost is going down so it means certainly it will
change your economic order quantity also. Now let us see what happens? How we will do it?
First of all from the existing situation, from the existing data you calculate what was our existing
EOQ. Say for example what was the Q A? If we try to find out the Q A, what was from the
existing without restrictions how much was the Q A?
That is 2 into demand is requirement is 1500 unit and then the cost per unit is say sorry ordering
cost is multiplied by the ordering cost is 25 and then we have the unit cost which is 7 Rs and 50
paisa and your carrying cost is we have to take here as the carrying cost is just 20%. The carrying
cost is 20%. If you solve this you will work out as that our EOQ is 223.6 or you can say it is 224
units. This is the level of the EOQ or the economic order quantity.
You call it as Q level in case of the unrestricted amount available which is say originally
sanctioned by the bank our EOQ level or the Q A, in case of the A was 224 units. So what we
will have to do is we will have to now find out the average inventory. It means average inventory
is how much? Average inventory is just when you calculate this like this you take here when it
goes like this you have to divide it half.
Because this much of the investment we assume always remains invested in the this much of the
funds always remain invested in the inventory. So now we will have to find out the average
inventory here and when you have to find out the average inventory in that case, what is average
inventory here now? Average inventory is 224/2 so it will be 112 units. So earlier when we had
say 224 is the total requirement.
This was the total requirement 224 and what was the our cost, annual demand is how much, 1500
units. Annual demand is this much. Q level is EOQ level is 224. So number of orders we are
having, number of orders per year, number of orders per year are going to be how much? That is
the same amount here and that will come out as 6.70 orders. This is the original case, this is the
original situation. So we are annually placing 6.70 orders.
Our ordering cost is, cost per order is 25 per order and the carrying cost was 20% and our
average inventory we are keeping here is that is 112 units. This is the original case. Now on the
basis of this all calculations you first have to work out or the firm first has to work out the EOQ
level for all the 5 items, number of orders.
And on the basis of the ordering cost and the total investment which is required to be made we
will have to create a situation that to find out what is the existing situation with us and if there is
no restriction by the bank then what will be the will be the case that how much funds are
available to us and how we are utilizing these funds. Let us work out the EOQ level, EOQ for all
5 items of inventory, all 5 items of inventory.
So we will take here the item number right. This is the item number. Then we take the unit cost.
This is the unit cost. Then we have to take the order size. This is the order size. Then we have to
take the number of orders; number of orders per year, number of orders per year. Then is the
average inventory, average inventory in units. Average inventory in units and then we have to
work out the investment in inventory rupees, investment in the inventory in rupees.
So let us take all the items here. A, then it is B, it is C, it is D, it is E. Cost per unit is given to us,
7 Rs 50 paisa; 25 Rs; then it is 12.5; then it is 15 and it is 5 right. Order size as we have seen how
to calculate it? 224 it was in case of A we just saw, 150 in the second case, 346 in the third case,
707 in the fourth and in the fifth item the order size is 1500 units. Number of orders per year 6.7
sorry. Number of units 6.7, 6.70. here it is 15, number of orders 15. Then it is 17.34.
Then it is 42.43. And then it is 30. Average inventory you can easily find out by from this
column 112. It is 75. It is 346. So it means we have 173. Here in this case it is 354. And in the
last case we have 750 this is the number of average inventory the units which are there in the
inventory. Now you can easily find out the investment in the inventory that is the number of
units you have here is this, this, this and this right. 112, 75, 173, 354, 750 units are there.
And what is the per unit cost, we have here the per unit cost, cost per unit. You can multiply this.
So it means 112 into this much. So how much it works out. This is the total investment is total
investment we have to work out so 112 units and the cost per unit is 7.5. So it means this is the
840 Rs are investment in A generally. 1875 is investment in B. Then is the 173 into 12.5. This is
2162 here and then is the next part is 354 multiplied by 15.
So it is 5310 and then it is 3750 right. So this is the total investment we have to find out and if
you total it up this works out as how much? 13,927. This is in rupees. This is the total investment
which is made in the inventory in all the 5 items before say imposing the restrictions by the bank
this much of the funds are invested by the company into the inventory by borrowing it from the
bank and now see number of orders per year is how much?
This is if you total it up it works out as this is 7, this is 4, this is 11, and then it is 18 to 20. So it
means 21. So it is say 1 and it is 1. So 111.47 are the number of orders. This is the invested
which is blocked in the inventory all the times. So we are utilizing the bank finance or the funds
provided by the banks through CC limit. From that total limit 13,927 are say blocked in the
investment or in the form of investment in the funding of inventory so it is here.
Now, this money will not be available to us, 13,927 in total will not be available to us. What will
be available to us is that is 13,927 - 2000 because this is a restriction imposed by the bank. So
now the amount available to us will be 11,927 right? 11,927 will be available to us now because
this much is going to be withdrawn by the bank so it is 11,927 amount is there. So if this amount
we have to say it is not 27 this is the this amount is not 27 I think it is 37.
So here also it is 37. It is not 27 please correct it. So it is the amount of 37 because it is 527 then
it is 11 and then it is this is 17, 18, 20 ya 3. It is 37, it is 37. Here it is 37. At all the places it is
37. So now we are available with the fund that is 11,937 because 2000 are withdrawn. So if this
money is left with us, not this but this is available with us it means now we have to run the show
with this 11,937 rather than the earlier amount we had 13,937.
So it means the production process should be smoothly going on. Availability of the material
should also be sufficiently there in the firm. The overall operation should not get affected. We
have to run the show also. We have to make sure that raw material is also available. Money has
also gone down. The funds available have also gone down by 2000 Rs. Here we are taking 2000
but in the actual situation it can be in crores.
So if it is restriction is imposed out of say 100 crore for example the bank says that you run the
show with 70 crores it means at the EOQ level, we had worked the EOQ level at the level of 100
crores. You have to now revise EOQ level with the 70 crores. So will have to see how much
difference it makes. So in this case, now available investment with us is 11,937.
So how to use it, how to run the show with this 11,937 and how to say carry on the production
process smoothly so that inventory level is also maintained production process is also smooth
and there is no impact of this as such to the extent we are able to manage it we would manage it
but how to manage it and how to say run the show with this reduced amount 11,937 where we
have the restriction of 2000 we will learn in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 24
Rationing of Working Capital -II
Welcome students. So in the previous class we were discussing about the restriction of working
capital by the banks or restrictions imposed on the working capital provided by the banks so if
there is a shortage of the working capital from the bank’s side and if any restriction is imposed
by the bank. So were learning with the help of a problem or an example that how to deal with
that in the practical situation or in the practical life, how the companies deal with that.
And that kind of the rationing of the capital or restrictions of the working capital normally takes
place and it is regular say phenomena in the market because when there is a squeeze of the credit
or there is a shortage of the credit or the funds available for the credit with the banks then
sometime banks go for the rationing of the even say their loans including the working capital
loans or the working capital limits.
So we have to deal with this problem on the say very on the very regular basis. So we should be
clear about. So were learning with the help of an example that how to deal with this kind of
situation. There we saw that how much investment the company was making earlier in the
inventory because as I told you that investment in the different current assets is done with the
permission of the bank.
And bank say categorizes clearly that this much of our funds you can invest in inventory, this
much in the receivables and this much in the say other current assets. So were dealing with that if
there is a restriction imposed by the bank and the restriction is effective on the inventory also so
how to deal with that and how to say carry on the business and say all production process in a
very smooth manner.
So were trying to learn about that. So we in the in the problem we were talking about or the
example we were discussing so we worked out with the help of certain say parameters that the
investment which was company making in the working capital to fund the inventory how to
create the current asset as an inventory that investment we worked out by following certain
parameters and certain process and that we worked out was how much that is 13,000 Rs.
That was Rs. 13,937 right. So this investment we worked out. You know the process how we
have arrived at on this figure by drawing the say information from the company’s record and
then say knowing how much material is required for different products. So we found out that this
much of the investment is required or the company is making currently making in the inventory
so now we knew that the restriction imposed was 2000.
So it means now the capital working capital available from the bank side to fund the inventory
will be say reduced to 11,937 and not as 13,937. So how we have to run the show with this
particular figure? So what we have to do is now that we have to now calculate the ratio of the of
the say restricted capital to the unrestricted capital. So restricted capital will be now this much
and the unrestricted capital was this much.
So it means because of the reduction of the say working capital limit on inventory. So if you
calculate this, this works out as 85 sorry 0.8565 or now it has come down to 85.65%. So now we
have to rework the whole process in the ratio of this restricted capital to unrestricted capital
which is 0.8565 and if you work this so what will happen? What was our order size earlier? Our
order size earlier was how much 224 units.
That was the 224 units that we called it as the economic order quantity for the product A or the
raw material A. That was 224 units which we had worked out as and we were calling it as EOQ
economic order quantity 224. So order size was 224. When we had unrestricted working capital
available so were keeping or we were buying in 1 lot that is 224 units and half of that we were
keeping as the average inventory with us right.
So investment in this component was rupees how much? Rs. 840. This much amount was
invested. Out of this particular amount this much, out of 13,937, 840 was invested in the say
inventory of or maintaining the inventory of item A or the material A. Now if there is a
restriction it means we have to see that this 224 is a economic order when there is a no restriction
on the capital. But if there is a restriction you have to work this order again.
And this you have to work that 224 multiplied by 0.8565. So this new order will be, so now it
will be 85.65% of 224 and this will work out as how much 192 units. So your what will happen
your order size has come down. Your economic order quantity which was 224 earlier when the
sufficient capital was available but now the capital is not available or there is a restriction by
2000 so the economic order quantity has to be revised.
Because we have to store less and order many times or the number of orders will increase. So
your now EOQ new EOQ if you call it as EOQ then it will become 192 units. If it is becoming
192 units so in that case what will be there? Let us now see how many orders. Total annual
requirement is how much 1500 units. And now this is the per unit we will be buying or the one
order we will be bringing in the material of A to the extent of 192 units.
So this will become that how many orders we will be having now, 7.81 orders, 7.81 orders. And
earlier the number of orders were there how much 6.70. So now the number of orders have
increased. Once the orders have increased so what will happen now, your ordering cost will go
up. So your ordering cost will be what is the ordering cost? Ordering cost here is say it is given
to us ordering cost per order cost is Rs. 25.
So what will happen now? Your ordering cost will increase and your ordering cost will go up to
190 Rs, 195.25. This is the ordering cost, 195.25 this will be the ordering cost. So what is there
we have to deal with this situation and to deal with this situation we have to run the show by
placing more orders. So in that case we have to see here that total ordering cost for this item will
become as something like 195.25.
But the effect of that will be the, the positive effect of that will be what the positive effect of this
change will be that your carrying cost that is the carrying cost will go down. How much is the
carrying cost because we are going to have the inventory of how much that is 192 units. This is
going to be now new EOQ so you will divide it by 2 and so how much it will be? This will work
out as say whatever it comes out as.
So it will be something you can say do like this that 192/2 into 7.5. This is the cost per unit and
multiplied by the carrying cost. So that is 0.20. So this will come out as Rs. 144. This will come
out as 144 for this unit. So it means in this case what will happen? The effect is that your
carrying cost is going down, your ordering cost is increasing. So the things will change to some
extent.
But net effect we will have to manage like that how much is the net effect we will have to find
the net effect. So in this case we have got the revised ordering cost. The carrying cost is this
much. We have got the ordering cost is this much and now we are seeing that we will have to
calculate this all for all the say revised orders means for all the items we will have to calculate
the revised EOQ.
And as we have done in case of the item A we have found it out in the ratio of the restricted
working capital to the unrestricted working capital. We found out the ratio that is 0.8565. In this
same ratio we revised the EOQ for the item number A and earlier it was 224 units. Now it is if
the revised is if it is multiplied by the ratio we have worked out this came up as 192 units. It
came down so you have to keep the lesser inventory and you have to frequently order.
So what will happen your carrying cost will go down because we are storing less but your
ordering cost will increase because you are ordering many times. So when we found out the
number of orders new here the number of orders we have got here is that is 1500 is the total
demand, annual demand and 192 is the size of now EOQ size of the new EOQ size of the item
number A.
So number of orders will become 7.81 and if you multiply it by the ordering cost which is 25
because ordering cost we have seen earlier is that ordering cost is 25 per order. So your ordering
cost will become now 195.25 but your carrying cost which is 20% of the inventory we are
storing or the cost of the inventory we are storing. So it will be something like 192/2. So this will
become 96 units. Average inventory will be 96 units.
Earlier how much was the average inventory, it was 112 units. So it will come down by certain
number of units it will come down so it means roughly you can say that average inventory has
come down by 16 units and if you are storing 16 units less so 16 into 7.5 is going to be the total
amount which we need not to invest now and if you are saving that investment it means your
carrying cost will also come down by 20%.
So we have seen that the carrying, new carrying cost is 144 and the ordering cost is increased a
bit that is 195.25. So in this whole process we will have to revise the entire thing and we have to
work out the new ordering cost, total ordering cost, new carrying cost and then we will have to
compare that whether the overall cost total cost we have to actually find out the total cost.
Ordering cost plus carrying cost.
So whether it has gone up or it has gone down or it has remained the same. We will have to
check for that. So let us now work out the say rework the whole thing and then try to calculate
the investment.
In this case, now we will have to say inventory position I would like to write here inventory
position and investment under restricted working capital scenario, under restricted working
capital scenario. So inventory position and the investment under restricted working capital
scenario. So here we take again the item number right. This is the item number. Then we take the
order size. Then we take the number of orders. We will have to calculate number of orders.
Number of orders and then we will have to go for the ordering cost, ordering cost and then we
will have to calculate the average inventory, average inventory. This is the average inventory and
then it is the investment in inventory, investment in inventory, investment in the inventory and
then finally we will have to calculate the carrying cost. Finally, we will have to calculate the
carrying cost. So these are the items we will have to do and this we will prepare a table again.
As we prepare the table under the under unrestricted regime. Now we will be preparing a table
under the restricted regime. So again we have the items here that is A, B, then it is C, it is D and
it is E. These are the items. Now the order size, revised order size. In first case we have
calculated is 192. In case of the B it will come out as 128. In case of the item C it will come out
as 296 and in the D case it will be 606 and in case of E it will be 1285.
So this is the revised order. Revised EOQ you can say, revised order you can say. So this is the
revised situation. Earlier what was there? A was 224. B was 150. C was 346. D was 707, now it
has become 606. And E was 1500 and now it has come down to 1285. So number of units now
we are going to order in one order is has come down. So it means we are going to say store lesser
number of units.
When you are going to store lesser number of units your investment is also going to go down.
Number of orders let us work out. In this first case we have worked out is 7.81. Here it will be
17.58. Here in this case will be 20.27. Here in this case will be 49.50. And here it will be 35.01.
So total number of orders will be how much? 130.18. What was earlier, number of orders?
111.47. So it means now there is a difference in the in the orders.
So almost there is a 19 orders have increased and when 19 orders will increase multiplying it by
25 so it means your ordering cost will increase. Number of orders per year. So we have means
this is the number of orders per year we have calculated. We have now calculated the order size.
We have calculated the number of orders and now let us calculate the ordering cost. Here the
ordering cost will be we have already calculated for A. That was 195, not 192, that is 195.
So 195. So if it is 195 in the revised case, 195.25 we had already calculated. In the previous slide
we have calculated somewhere, ya 195.25 we have already calculated. So this is the one. Then it
is 439.50. Then it is 506.75. And then it is 1237.5 and it is 875.50. So this is going to be the total
ordering cost. 195.25, 439.5, and then it is going to be 506.75, 1237.50, and then it is 875.50. So
total ordering cost becomes Rs. 3254.5, 3254.5. This is the total ordering cost.
Now let us calculate the carrying cost. For calculating the carrying cost we need the revised say
average inventory. And revised average inventory is the half of this. So it is going to be how
much, 96 units. In this case it is going to be how much 64 units. In this case it is going to be 148
units. In this case it is going to be how much 303 units. And in this case it is going to be how
much 642.50 units.
So this is going to be the average inventory or the average number of units we are going to keep;
96 units, 64 units, 148 units, 303 units, and 642.5 units. This is going to be the new average
inventory. So investment in the inventory is going to be how much? We will have to multiply by
the price. So what is the price of this per unit price is how much? Per unit price is somewhere
that is per unit cost is going to be 7.5.
So if you calculate that with the help of that so investment in the inventory is going to be how
much? 720 right? Then it is going to be 1600. Then it is 1850.00. Then it is how much 4545.00
and then it is 3512.50. This is going to be the total investment. This is 720 then 1600, 1850,
4545, 3512, sorry this is I think wrong. There is something wrong about it. So we will have to
check it again. Here we will have to see that it is not 35 it will be something else.
So it will be this will be something I think 3212.5, 3212.5. So it is 720 then it is 1600, 1850,
4545, 3212.5. So this total will become how much? This will be something like say 11927.5,
11927.25. It will be something like 11927.5. So it means what was our ratio. We have already
calculated the ratio and we have calculated the total amount that is the restricted. Now the
working capital available was 11,937 which is we have worked out here is which is nearer to this
figure and this difference of the 9.5 Rs is just because of the rounding off.
So it is exactly we have calculated the same way. So it means the new investment which is
available to us, new capital, new funds available from the bank how we are going to make use of
that is that we are dividing we are apportioning this way. So earlier if you talk about the
investment in the inventory here was 840. Now it is 720. Earlier it was 1875. Now it is 1600.
This was the investment in the inventory.
And if you talk about the next one then it was 18 sorry earlier was 2162. Now it is 1850 it is
reduced. Earlier here was 5310. Now it is 4545 and it is earlier it was 3750 now it is 3212.5. So
this is the reduction in the investment. If you total it up it works out as the same thing. But we
have calculated as the ratio of the restricted working capital to the unrestricted working capital.
Now let us finally calculate the carrying cost.
That is important for us for the analysis. So carrying cost here is we are multiplying the this
investment by the say 0 sorry 0.20 or maybe by the 20%. So 20% of this 720 is 144. Then it is
320. Here it is 320, then it is 370, then it is 909, and then it is 642. It is 642. Then it is 642. It is 6
sorry this is 642. So 642.5 right. So this is going to be the carrying cost for all the 5 items; 144,
320, 370, 909, 642.5. So this total works out as 2385.5, 2385.5.
So now what is important for us? Out of this analysis something important to us is that if you call
calculate the total cost one cost is important to us and this is another cost which is important to
us. So we will have to take these 2 cost. Because sum of these 2 costs, this is the ordering cost
which has increased, this is the carrying cost which has come down right. So we will sum it up
and see what is the total cost.
And we will find out what is the cost what was the total investment cost earlier. So we have not
calculated that cost, what was the total investment cost earlier. So we will try to find it out what
is the ordering cost or what will be the what is the ordering cost earlier. So let us see here. We
will make the analysis, here only we will make the analysis. So say we will call it as relevant
cost. We will call it as relevant cost, relevant cost.
This is the say ordering cost plus carrying cost plus carrying cost. This will be the total cost for
us. So relevant cost before. Relevant cost before I will call it as before means before the
restriction was imposed. So that relevant cost before was how much. That is 2787.75 that was the
ordering cost. Plus carrying cost was 2787. Earlier ordering cost was 2786.75 and then the
carrying cost is 2787, 2787.40.
So the total cost becomes how much? That is 5574.15, 5574.15 is the cost of maintaining
inventory or maybe the total cost of investment we are making in the inventory. Earlier cost was
before the say imposition of the restriction of the working capital by the bank or say reducing the
supply of the working capital by the bank our ordering cost was because your number of orders
were less.
So ordering cost was less and carrying cost was high because we were investing more into the
inventory because average inventory was high. So the total cost was ordering cost 2786.75 + Rs.
2787.40. So the total cost was 5574.15. Now the relevant cost after relevant cost after it is given
to you. Your ordering cost is how much, 3254.50 plus second is 2385.50. So this works out as
how much 2385.50, this works out as how much 5640.00 right.
So here find out the difference. Difference in the cost of maintaining inventory, how much? Rs.
65.85. Rs 65.85. This is the cost. So it means, now you can make out, the entire analysis in front
of you. If you look at this analysis you will find out what has happened, what is the result of
reducing the working capital available or the investment of the working capital in the inventory
and if you have reduced the investment what will happen?
This is the effect of reducing it from the EOQ level. The standard EOQ level was in case of the
unrestricted working capital requirements that was say 224 units and now when we calculated it,
it came down to 192 in case of the A and as a result of that we have found out that one cost has
gone down, another cost had gone up. So they are not equal. They are not equal at both the levels
and once they are not equal at both the levels because you see that if you find out here earlier
what was the cost? Both the costs were equal.
If you look at these 2 costs, almost they are equal; 2786.75, 2787.40 they are equal. But in this
case they are not equal. One cost is more, ordering cost has increased and carrying cost has gone
down. So this disturbance in the symbiosis or this disturbance in the say you can call it as this the
2 lines that is the carrying cost and your when we find it out that when the carrying cost is
something like this. So this has not remained now this at this level. This has been disturbed.
One cost has gone down, another cost has gone up. So we are not at this level now. We are at the
disturbed level. We are at the lesser level where the one cost is more another cost is high. You
will be wondering that how we have calculated the say before the carrying cost. So what was the
investment earlier?
We were making Rs.13,930. So we have multiplied it by 20%. So this worked out as how much?
This came up as 2787.4 and how much were the total number of orders. Number of orders we
worked out were 111.47 and multiplied by the per order cost that is 25. So that was 2786.75
right. So this was the cost how we worked it out and we have used it in here we have calculated
this cost. We have used this cost here. So you see both the costs are equal.
And that is the beauty of this model that both the costs where both the costs are equal when they
intersect with each other. So we are able to find out that this quantity is going to be my EOQ
level or this is going to be my quantity which is the standard quantity I am going to buy and
sorry this is the amount of the this material I am going to buy this is the quantity we are going to
buy. So it means what has happened? These are the costs.
This is not the quantity but this is the cost. So here it is the cost, not the quantity. So it means it is
the cost. This is the cost, this is the quantity. So your quantity when you are at this level and your
cost is this much. When you go up to this level your cost will increase. When you come out from
this level to this level so what we have we have seen the structure earlier. At this level the costs
are going up. At this level only this is the lowest, this is the minimum cost.
So that is the EOQ level that is the standard EOQ level but because we got the working capital
supply restricted so we could not have the same amount that we had earlier from the bank. So
because of that reason we are unable to maintain the same level of EOQ and because of that what
has been the result? The result was that your overall cost of maintaining the inventory has gone
up, not very seriously, that is by Rs. 65.85.
But look this is a small example we have taken the figures, small figure, small case, small
examples. But in the real life scenario you see when the when the firms are making investment
worth thousands of the crores or maybe it is a very big company and if there is a restriction
imposed by the bank. For example the existing say amount allowed in the investment of the
inventory by the bank is say 100 crores.
And now they say that it will not be 100 crores you will be having now the 70 crores. So there is
a reduction by 30 crores. So it means due to that reduction of 30 crores of the funds into
maintaining the inventory what will happen? Your total cost will means will make a day night
difference. So that is the problem. Here is not the problem. We have seen here total cost is going
up. So when the total cost is going up so what will happen? Either, you have 2 ways.
Either you you go with the same thing what we have done here and you have increased the cost
right? We have seen here the cost has gone up. This is the one outcome. If we want to avoid this
kind of situation what we have to do is we have to use the working capital provided by the bank
that is 11,937 and the remaining amount has to be arranged from the other sources so that the
cost escalation here as we have seen in this case can be taken care of, can be checked or can be
reduced.
So this is the outcome. So you think in terms of a multinational company or a very big company
who works at the national level and serves the market like India. That is a market of say millions
and billions of rupees. So in that case that makes a difference. So what we have to do is they
have to be very careful that anytime if restriction is imposed by the bank because of certain
unavoidable reasons what we will do, we will have some alternatives.
So from the internal funds or maybe from the funds borrowed from the other sources the
investment can be made. Or the third alternative can be long term funds can be diverted for some
period of time for the short term needs so that if we are going to pay the increased cost of the
long term funds we are going to save here because we are not going to allow the inventory
management cost to go up.
So that way we can see that we have to strike a balance and if it is possible either way it should
be done, it should be followed, it should be observed. So this is how we deal with the situation
that if any restriction is imposed by the banks on the supply of working capital on a particular
current asset then how to deal with that situation. Remaining some more other aspects with
regard to management of inventory the first most important current asset we will be talking in the
next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 25
Different Modes of Bank Finance
Welcome students. So before proceeding further I would like to discuss with you the concept of
you working capital provided by the banks or maybe the little some we will discuss at in detail
later on but since we talked in the previous class about the rationing of the working capital by the
banks so let us first understand that how the banks provide the working capital finance. What the
different base, modes, and say parameters taken into consideration by the banks and how that all
is done.
So that I think before proceeding further and talking about other things about inventory
management we will like to know about it. See funding of the working capital requirement as I
told you by the firms by the businesses we have normally 3 sources. One is spontaneous finance.
Once it is exhausted then it is the short term finance. Spontaneous finance includes the supplier’s
credit and the credit provided by the say your trade expenses like electricity company, water
company, by the salaries of employees.
Because all these services are available to us for at least 30 days and we have to pay after 1
month or 30 days. So that is also a sort of credit available. So supplier’s credit, then the expense
credit. These are the spontaneous sources. So we should try to take maximum advantage out of
it. Once that is over, then the next thing is to resort to the short term sources and if you talk about
the total list of the short term sources available for funding the working capital say fulfilling the
working capital requirements we have about say 9, 10 sources around the globe.
Most of these sources were not prevalent in India. They were not allowed before the opening up
of Indian economy or liberalizing the in liberalizing the Indian economy but now they are
available in India also right. So earlier till 1991, I would say only bank finance was the only
source of fulfilling the short term funding requirement of the manufacturing sector in India. And
that was considered as the obligation of the banking sector as well by the government also and
by the industry also.
So banks were compelled to provide the liberal working capital help assistance to the industry.
But after 1991 since now we are aligning with the rest of the world and the financial system is
also changing and even the sources of the investment, sources of funding are also multiplying so
we are not having only the one source that is the bank finance but we have the multiple other
sources also right.
So in that case we have now say introduced many other sources in this country but because of
easy availability of the bank finance even today these other sources are not popularizing right.
The other sources are like commercial paper right. What is commercial paper and how we make
use of it I will discuss with you later on but commercial paper is the one source, factoring. What
is the factor, what is the factoring service?
How they fulfill the working capital requirement of the industry, manufacturing industry for
fulfilling their short term requirements that is a one source. Then we have the your public
deposits right. Then we have the funding available from the institutional sources maybe the
development finance institutions or maybe the investment finance institutions. Earlier they were
not allowed. Now they are allowed. So these are the sources. Then we have derivative finance.
Then we have forfaiting. That is another source of working capital available. So apart from these
sources we have inter-corporate deposits. So in total if you talk about we have not at least means
7, 8 sources or total things goes up to the say 9, 10 sources including spontaneous, short term,
and the long term finance. And then once these sources, short term sources are fully exhausted
by the firm still there is a requirement of the working capital then we have to resort to the third
source that is the long term sources.
Long term sources are also required to be invested for the short term needs if we are going to the
bank for fulfilling our major working capital requirement. Because it is a condition, precondition
of the banks also that if you are coming to us for seeking the working capital investment then tell
us how much you are investing from your own sources.
And since banks cannot ask for any collateral, any security in the normal circumstances from the
company to provide the short term finance so they want a security in terms of that part of the
investment will come from us and part of the investment has to come from the company itself so
banks have in a way restricted that maximum of the total requirement only 75% will be provided
by the bank and remaining has to come from the other sources including long term.
That is the reason I have discussed with you sometime in the in the past that the current ratio has
to be maintained by the firms minimum that is 1.33:1 so that 1.33:1 means when you are talking
about the current ratio as 1.33:1 it means that 1.33:1 is what?
It means this is the current liability. This is the current liability or what is this 0.33. Why current
assets are supposed to be means 1.33 times of the current liabilities. This 0.33 is expected to
come from the long term sources LTS. And this is the requirement of the banks. Earlier I have
discussed with you in the past that the ratio was 2:1. So current assets are supposed to be 2 times
of the current liabilities and here 1:1 is the funding coming from the short term sources including
spontaneous but remaining 1 has to come from the long term sources.
So it was a very expensive situation but now the banks have agreed that okay if you do not want
to maintain 2:1 ratio you maintain 1.33:1 ratio. So 1 point means 0.33 is the cushion which the
banks seek that if for example if the ratio is only say current ratio is allowed as 1:1 as we know
that some of the current assets are not possible to be converted into cash as and when we want it
as we have seen in case of inventory, as we have seen in case of receivables.
As we have seen in case of the prepaid expenses. So that is not possible. So why this cushion we
keep? That if some of the assets are not convertible into cash as and when the current liabilities
become due at least we have some liquid funds available which come from the long term sources
that is one-third of the current asset that is 0.33%. So those funds can be utilized for repaying the
bank’s funds or say say liquidating or paying off or honoring any other current liability.
So this is the cushion required by the banks. This is the security in a way you can call it as. This
is a collateral, this is the security required by the bank; so the current ratio is 1.33:1 minimum
these days and earlier it was 2:1. So this requirement is of the banks, not of anybody else because
banks want some security that as and when our payment becomes due to be made then where is
the security.
And if there is a lack of liquidity with the bank, with the firm, then at least the long term funds
kept for the purpose or invested in the short term assets they can provide the liquidity to the firm.
So now even today as I told you despite we have number of sources of the funds available but we
are still depending upon the bank finance for fulfilling our working capital requirement, reason
for that is that it is very easily available, most secured, regular source of finance, and without
providing any kind of the collateral by the manufacturing unit, manufacturing firm.
No collateral is required. Bank cannot ask for any security normally and its easy availability and
mode of providing the funds by the banks to the firms for fulfilling their working capital
requirements is also most convenient to the firms. Now what are the modes? How the banks
provide the funds to these companies or these firms, we have 3 modes. When you talk about
these modes, we have 3 modes here for means how the firms take the working capital from the
banks. So let us see these 3 modes. These 3 modes are CC limit.
First mode is CC limit. CC limit is called as cash credit limit. This is the first mode. Second is
working capital loans and third mode is discounting of credit sales bills. These are the 3 ways
banks provide the working capital finance to the manufacturing sector. Now what is CC limit?
Cash credit limit it is called as CC limit. Cash credit limit means when firm has a surplus cash
available, deposit in this account and when firm needs funds to fund some current asset or to pay
for acquiring some current asset withdraw cash from this account which is called as credit.
Cash means depositing and credit means borrowing as and when there is a need. So this is a
flexible account available. Manufacturing firms after working out its working capital
requirement they move to the bank and they request the bank that our working capital, annual
working capital requirement is say 1 million, 10 lakh rupees. So you are requested to sanction a
say CC limit account or this sum through CC limit account.
And we should be helped for that. Bank would ask the company to provide the 3 previous you
call it as years’ financial statements and bank could analyze overall financial performance of the
company, liquidity performance of the company and everything and if bank feels that yes
company’s overall financial performance, liquidity position is okay, acceptable then mutually
bank and firm would arrive at an amount.
And say for example both the sides agree that yes the firm deserves 1 million from the bank side
it is approved and the firm is also able to convince the bank that yes we need 1 million rupees of
the working capital limit. So after this mutual agreement, an account will be opened by the bank
in its own branch in which the firm has requested in the name of the firm and that account will be
called as the CC limit account, cash credit limit account.
And a sum of Rs 1 million will be earmarked to that account, will be kept safe in that account.
Now you see 10 lakh rupees are available to the firm for fulfilling their short term working
capital requirements, 1 million rupees is available. If say after sanctioning the limit next day
morning firm receives a truckload of the raw material and immediately the firm has to make a
payment of 2 lakh rupees.
In the firm’s kitty or in the firm’s account there are only 50,000 Rs lying. Firm has to make the
payment of 2 lakh rupees. Firm is not at all in problem now because they have got the CC limit
account and they have that account from where they can withdraw 1.5 lakh rupees extra and
immediately complete the payment of 2 lakh rupees, 200,000 Rs payment can be made. So the
balance of that account will go down by 1.5 lakh rupees.
So it will come down to 8.5 lakh rupees now. One week after firm received 2 lakh rupees of the
payment from their buyers who have bought on credit from the firm and that 2 lakh rupees so
this is the condition of the bank that now you will not maintain 2 accounts in the same branch or
in the at the any other branch of the same bank or in any other bank. Your total cash and the
credit will be routed through this account. This is a condition. Both the sides have to agree.
So when the firm needed 1.5 lakhs, firm withdrew from the account and when the firm has got
surplus means the receipt they have got from the buyer who have bought from the firm on credit
then that 2 lakh rupees firm will deposit in the same account right. Now that account will become
when it was how much it was 10 lakh rupees. When 1.5 is withdrawn how much the balance,
8.50.
Now if 2 lakh rupees are available say if 2 lakh rupees are received by the firm in that case, 2
lakh rupees are available what will be there now; 2 lakh rupees are available. So the balance of
this account will go up to 10.50 lakhs, 10.50 lakhs right. Banks has given only 1 million, 10
lakhs. Now the account has overflown. That is by 50,000 Rs. It means firm used that 1.5 lakh
rupees for how much period?
Only for 1 week and they used only 1.5 lakhs not the entire 10 lakhs. So beauty of the account
for the manufacturer or the benefit of this account for the manufacturer is that manufacturer has
to pay the interest to the bank only for this amount of 1.5 lakh rupees and for the period of 1
week right. 1.5 lakh rupees and only for a period of 1 week because he has borrowed 1.5 lakh
rupees only, withdrawn 1.5 lakh rupees and he has used that money for 1 week only.
After that he has deposited 2 lakh rupees back in the bank so it means now the again account is
10 lakhs plus 50,000 which is extra he has deposited. On this extra 50,000 Rs firm will not get
any interest right. It is this account is considered as a current account. Normally, even if the firm
has its own money which is invested in the bank or account is open and some balance is
maintained in that account, that account is called as current account.
And no interest is paid by the bank to the firm on that account and in this case also since now it
has crossed the sanction limit of 10 lakh rupees it has become 10,50,000 Rs so for the additional
50,000 Rs bank will not pay any interest. The benefit to the firm is that firm is getting easy
liquidity and only they are bound to pay the interest on that amount which they have withdrawn
from the sanctioned limit and for the period they have utilized it.
This is called as the CC limit account. So most beautiful account, most beneficial to the most
beneficial to the manufacturer right. This is called as CC limit account. So one account is
opened. Firm can withdraw maximum up to that limit of 10 lakh rupees, less anytime and they
can use it for the given period of time. After that if they receive the funds from some source they
deposit it back and then only pay the interest for the period you were using the funds and only on
that amount which is withdrawn and utilized agreed.
Now this is the one way and this is the most convenient mode of getting the working capital
finance from the banks by the manufacturing sector in India. There is nothing better than this. In
US for example this CC limit account is not available. They call it as credit line system. If the
firm if the people withdraw money from the bank or if they want any kind of the working capital
finance from the bank in US.
That is why the bank finance is the least preferred in US and is the most preferred in India. Why
it is more preferred in India, I just told to you but why it is not preferred in US? In US what
happens? If any firm goes to the bank and seeks the credit line for fulfilling its working capital
requirements bank would say yes if its requirement is 1 million dollars, we will give you 1
million dollars. We will sanction this but that will be in the form of loan, not as a CC limit.
And against that loan you have to give the collateral also. Collateral is in the form of what will
be done? Bank will sanction a loan of 1 million dollars, open an account, sanction that loan of 1
million dollars and credit that amount in that account. Firm can at any time whenever they want
money to be paid to some supplier, they can withdraw part of that amount as and when or how
much they want and remaining will be there. Maximum they can withdraw is 1 million dollars.
But to have that facility they have to open another account in the same branch and half of that
sanctioned loan say 5 lakh dollars, 500,000 dollars they have to deposit in that account. So it
means 1 lakh sorry 1 million dollars loan and a deposit of 5, half a million, 5 lakh rupees in the
another account. Bank would charge interest on that entire 1 million dollar or the total 10 lakh
dollars. But bank would not provide on any interest on that additional that is 5 lakh rupees kept
in the same bank in the another account as a collateral.
So in fact the actual facility available they actual loan available to the firm is of the half a million
not of the 1 million because half a million is deposited by the firm in the other account, most
expensive to the firms in US the manufacturing sector firms in US. So they do not resort to the
bank finance because it is very expensive. In a very difficult scenario when they do not find any
other source then they move to the this source, they resort to this source.
Otherwise, they do not depend upon the bank finance because it is very expensive in US. But
whereas it is very you can call it as convenient and cheap or cheapest in India. Now the other
source is or other modes of providing working capital finance by the banks to the manufacturing
sector in India other 2 modes are as I have written here that is working capital loan. If you talk
about the working capital loan in that case it will be like a loan.
If 10 lakh rupees are required as a working capital by the firm and bank says that we will not
give you CC limit. We will give you loan. So in that case it will work like a normal loan account;
1 million rupees will be sanctioned by the bank, will be earmarked in the account, deposited in
the account, kept safe in the account. Firm withdraws either entire 1 million rupees or firm does
not withdraw even a single rupee out of that firm has to pay the total interest applicable on that
account or on that loan for the period for how much that loan is taken by the firm.
It means that beauty of the CC limit is absent here. In the CC limit what happens that you have
safe deposit of 1 million rupees, 10 lakh rupees. As and when you withdraw, want to withdraw it
how much you want to withdraw it, withdraw it, pay the interest on the withdrawn amount and
for the period you have used the funds. That feature is not available in the working capital loan
account.
In the loan you have to be very careful as a manufacturer while working out your requirement
that entire amount of the 1 million should be properly utilized. Otherwise you will be paying
only interest back to the bank and you may not be using the entire 1 million rupees. So this is
expensive source. Third one is discounting of the credit sale bills. I have discussed with you this
source or this mode sometime in the past also.
But again I recall discounting of the credit sale bills means when the firms sell to the people or to
their customers or to their distribution channels distributors, wholesalers, or retailers on credit
right on credit. So there is a time period for which the credit is given. And the buyer is not going
to pay the funds back to the firm if the firm require the funds before the end of the credit period.
So in that case what happens? Firms get these bills discounted from the banks.
They go the bank, say for example they have sold for say 5 lakh rupees to some XYZ Limited.
Now the credit period given is 45 days. XYZ Limited will pay to ABC Limited after 45 days or
on the 45th day but if the firm needs the funds, ABC needs the funds after 10 days they would
request XYZ but XYZ say we are unable to fulfill your request then the other source is ABC will
go to the bank and they would ask that we have sold for 5 lakh rupees to XYZ Limited.
This is a good creditworthy firm having a good financial reputation. They will pay us 5 lakh
rupees after 45 days but we need money today so please keep the bills as a security, discount
these bills and give us the money. Bank would like to know who is this XYZ Limited and if their
financial reputation, their credibility is found okay, acceptable to the bank in that case bank
would immediately agree to discount the bills.
And maximum up to the 80% amount of that credit sale bills means 80% of the 5 lakhs that is 4
lakh rupees bank would immediately give to the firm to ABC who is a seller and they will retain
the 20%. On the due date when XYZ Limited will make the payment to the bank, maybe to the
ABC or sometimes on the instruction of ABC to the bank directly sometime what happens that
the seller gives the instruction to the buyer that you directly make the payment to the bank.
We have already got your bills discounted from the bank, you make the payment to the bank. So
once the bank receives that amount maybe directly from buyer XYZ Limited or through ABC,
ABC will receive that amount and that will be credited by or that will be deposited by ABC in
the bank. So bank will then recalculate the whole thing. How much amount was given, 4 lakh
rupees. For how much period of time, say 35 days right. What was the agreed rate of interest?
They would calculate the interest on that agreed rate on that 4 lakh rupees for a period of 35
days. They will calculate that and they will take they will deduct it out of that 20% they have
because they have received now 100%. So they have given 80% to the firm but 20%. So out of
that 20% they will first adjust the interest. After that bank would deduct its own administrative
charges and commission.
Because banks also charge some administrative charges and commission on such transactions.
So they would adjust that also. After adjusting for their interest, for commission and
administrative charges if any amount is left out of that 20% means 1 lakh rupees. Then that will
be again remitted by the bank to ABC Limited maybe for example that total cost of discounting
of the bills becomes 50,000 Rs.
So bank will deduct 50,000 out of the remaining 1 lakh and remaining 50,000 will be credited
into the account of ABC Limited. So it means in that case what happened. ABC got 4.5 lakh
rupees against the total payment of 5 lakh rupees which they had to receive after 45 days from
XYZ Limited but in that case the major benefit to ABC was they could get the funds as and
when they were required.
Because funds are most useful at that time when they are required and they are easily available.
If the funds are not easily available as and when they are required so what is the purpose of that
investment that money or those funds if they come after the need is over. So the benefit to the
ABC is they could get even 4.5 lakhs against 5 lakhs, against 5 lakhs but at the time when they
needed it. So that saved the ABC’s financial reputation, credibility and overall goodwill in the
market.
And for XYZ Limited they made the payment after 45 days. So they are also safe. For the bank,
bank provided this facility to ABC but the earned in lieu of that they earned 50,000 Rs revenue
just in a period of 35 days. So this is the bill discounting facility. Now earlier till 1991 this was
the condition by the government that total working capital will be provided by the banking sector
to the manufacturing sector and largely in the form of the CC limits.
But now these conditions have been revised by RBI because banks have the pressure of this
particular say system of funding because bank has earmarked 1 lakh, 1 million rupees in the CC
limit account and they are getting interest only for that amount which is withdrawn and utilized
by the firm and for the period for which that amount is utilized. So their funds are blocked that is
10 lakh rupees, 1 million.
It may be possible that the end of the year on an average firm used 7 lakh rupees out of that 10
lakh rupees. So bank is getting the interest on the 7 lakh rupees who will pay the interest on the
remaining 3 lakh rupees. This is the depositor’s money banks work on the deposit and loans
system. This is the depositor’s money. So bank has to pay the interest on the total 10 lakh rupees
but bank is getting the interest only on the 7 lakh rupees. So this is the pressure on the banks.
So on the request of the banks RBI has now directed and issued the new policy guidelines that to
fulfill the working capital requirement of the companies banks should meet that requirement but
in the ratio of 80:20. If the requirement of the firm is the borrower’s working capital requirement
is say total requirement in all the current assets is say 10 crore and above. If any firm needs 10
crore and above to fulfill their working capital requirement in that case the ratio of 80:20 should
be observed, should be followed by the banks.
80% of the finance should be given as working capital loan plus bill discounting facility only
20% can be given as a CC limit. So if somebody’s requirement is 10 crores so only a limit of 2
crores can be given by the bank and remaining 8 crores can be given as loan and over a period of
time this threshold level is asked to be brought down from the 10 crore to say 8 crore, 7 crore.
So RBI’s say attempt is or government’s attempt is also that over the period of time we should
also discipline our manufacturing sector that they should stop getting or they should forget
getting the funds in the route of or under the route of CC limit and they should learn the financial
discipline and should try to borrow money from the banks for fulfilling their short term
requirements for fulfilling their working capital requirement through working capital loan system
and under the mode of discounting of the bills system.
But that has not happened because both the sides are not able to implement it. Banks are under
the pressure. They feel that if we implement this policy directive of RBI then what will happen?
They may lose very good accounts because then the firms would not like to borrow from one
bank say X bank. If the X bank says that I will give you 80% loan and 20% CC limit but the
bank buy because now we are in the differential interest rate system.
Banks have the different financial policy, they have the different interest rates on their deposits
and loans. They are framing their own policy they are running their bank or the bank is being run
by its management in its own style. There is no stipulation by the RBI. Totally means complete
decentralization. So one bank may say that I will give you 80% loan, 20% CC limit. Other may
say that okay you come to me. I will give you 20% loan and 80% CC limit.
So until and unless all the banks decide together both public and private and foreign banks, if
they make an understanding that out rules will be like this; nobody will give beyond this as the
CC limit. Nobody will give less than this as a loan. If all the banks are sailing in the same boat
then it is fine. But since they are not doing it so far so what is happening in the fear of losing a
good account, good borrower if they impose this restriction of 80, 20 limit they may lose the
account because the firm may shift to the another bank.
So because of that reason this system of the CC limit even today is also going on and very few
people are resorting to the working capital loan or the discounting of the bills, credit sale bills
facility. But in the time to come this system will change and maybe if the banks themselves are
not doing it RBI may enact some laws or they can issue very strict guidelines that these will be
now the modes of providing working capital limit.
And means the total working capital we were provided under these 2 modes maybe they can
scrap totally the CC limit so nobody may be no bank may be able to issue the say CC limit or to
provide the funds through this mode this may happen. But at the moment it has not happened and
that threshold level of the 10 crores has not been implemented by the banks.
So what is this means what is the say CC limit account, how the banks provide the working
capital finance to the manufacturing sector in India and you see one more thing they do is that
when the CC limit is sanctioned by the banks they clearly specify it that this much out of the 10
lakh rupees this much can be used for inventory, this much can be used for the credit sales,
supporting credit sales. This much can be used for prepaid expenses.
This much can be kept as cash. So they also bifurcate it and they means put a condition that your
entire amount cannot use as cash. Your entire amount cannot use for supporting your credit sales.
Your entire amount cannot use for funding the inventory. So they device the norms and under
those norms or limits the funds can be used.
So this is something about the just in nutshell how the banks provide the working capital finance
to the firms, to the manufacturing firms and what was the meaning of imposing restriction which
we discussed in the previous class so but in detail. All the sources of working capital finance
including bank finance I will discuss with you sometime later before we finish the discussion on
the current assets and the current liabilities.
So we will continue the discussion on the inventory management and next time in the next class I
will discuss with you the concept of incremental analysis in the management of inventory as an
important current asset. Thank you very much.
Dr. Anil K. Sharma
Lecture - 26
Incremental Inventory- I
Welcome students. So in the process of learning management of inventory as a important current

asset, today we will learn a concept which is called as the concept of incremental analysis. How
with the help of incremental analysis the inventory can be managed or the investment in the
inventory can be managed. Under the incremental analysis what we do that we will have to
calculate that for example there is a situation in a company that company want to increase its
investment in the inventory because of any reason, there could be any reason.
Maybe the company is losing sales or maybe the company is, is not able to serve the clients.
There is always or very frequently there is a stock-out situation or anything because of any valid
reason company want to increase the investment in the inventory so the logic as well as the
justification for that increased investment should be that increased investment when we increase
the investment in the inventory, certainly it will it will increase the cost of funds.
Because we will have to increase the investment in the inventory so it means the cost of funds or
the investment cost of the company will go up. Now that increased cost of the inventory has to
be compared with the rate of return available by increasing the level of inventory and by
increasing the level of sales. So it means under the incremental analysis what we do.
That if we want to increase the level of inventory from the existing to the new one maybe the
level of raw material, maybe the level of the finished goods inventory. Especially we do it in
case of the say finished goods inventory that if you want to increase the inventory of the finished
goods then we can use the incremental analysis or even in case of the raw material also we can
use the incremental analysis.
So under the incremental analysis we work out first that how much additional investment is
required to be made to raise the level of inventory or to the raise the stock of the inventory and
against that investment increased investment or incremental investment how much profit is going
to be there, how much incremental profit the company is going to earn, how much incremental
operating profit the company is going to earn. That is a important point of consideration right.
Now in this case, we will have to work out the incremental amount of investment to be made in
inventory if we want to increase the level of inventory. After that the second step is we will have
to work out the incremental amount of the profit available, amount of the operating profit
available because of the incremental investment in the inventory. And then we have to compare
these two.
So we will have to try to find out then the expected rate of return from this increased investment
in the inventory. So we will have to divide that say changed operating profit or increased
operating profit with the increased investment or changed investment in the inventory and then
try to find out that what is the expected rate of return available from this increased investment in
the inventory right.
And then for taking a decision whether we should go for this investment or not we should
compare the expected rate of return with the required rate of return with the required rate of
return and if expected rate of return is at least equal to the required rate of return, we will go for
this investment or in the other case if the expected rate of return is more than the required rate of
return we will go for this investment.
But if the contrary happens that the expected rate of return is less than the required rate of return
then we will drop the idea of making additional investment in the inventories.; so with the help
of incremental analysis that we are making investment in the inventory at present level. Now if
you saving or making investment in the inventory at the given level now if you want to increase
the investment in the inventory from the given level so in that case how much increased
investment we want to make that is the incremental investment we have to work out.
What is the output of that incremental investment in the inventory, incremental sales and in terms
of the profit how much incremental profit and then the comparison of the two; operating profits
comparison with the increased investment or incremental analysis and then the comparison of the
expected rate of return from this investment with the required rate of return and then taking a
decision about whether we should go for this investment or not right.
So incremental analysis is one such technique with the help of which we can take a decision
whether we should increase the investment in the inventory or not and the logic here is that the
incremental investment and the cost of that investment and the output of that investment means
the profits coming out of that the profits must outweigh the cost so that the required rate of return
or the expected rate of return is higher than the required rate of return.
Now I will explain this, this concept with the help of a small case. We will do it here a small case
and then we will make some calculations and then we will calculate the expected rate of return
from some increased investment and then we will try to find out whether that is acceptable to the
company or not or whether the company should increase the investment in the inventory or not.
So there is a company, we call it under any name.
Here we have the name of the company that is the Electrocircuit Inc. and they are manufacturing
100 models of electrical products, 100 models of different kinds of the electrical products and the
total sales of the company for the coming year that is for the ensuing year are the Rs. 176 crores.
These are the expected sales.
So let us note down the data. These are the expected sales and the estimated, estimated gross
profit is about 70 crores, is 70 crores. So we will have to now go for this analysis here. This is
this analysis we will be making here. So this is the sales, expected sales, 176 total sales 176
crores. Estimated gross profit is 70 crores and tax rate is, tax rate is 50%. For the sake of
simplicity we have assumed the tax rate as 50% right.
And now we are given the other information also. If you look at the other information we are
given the level of current assets, existing level of current assets and these current assets are given
in the absolute amount as well as, a percentage of the forecasted sales also because we are
making a working capital analysis. So we have only that part of the balance sheet here which is
only depicting the working capital position that is the level of current assets and current
liabilities and as percentage to the sales also these assets and liabilities are given to us.
So let us see how much these assets and liabilities are. So first we go for the, this is the balance
sheet and we take it as this is in the particulars. We will write here.
This is the amount, Rs, lakh and this is the percentage of forecasted sales, percentage of
forecasted sales. So these are the 3 columns. These are the 3 different types of information is
available to us. So if you talk about the particulars first we have the current assets. First we have
the current assets and these assets are current assets are first is cash. Then we have receivables.
Then we have inventories and inventories are of 3 types right. Inventories are of 3 types.
First we have raw material inventory then we have WIP inventory and then we have the finished
goods inventory. These are the 3 inventories available with us. Then we have the let us see now
put the figures here before we move to the current liabilities. So in case of the first say this part
we have the cash is 175 lakhs and receivables are 3520 lakhs. Receivables are 3520 lakhs, 3520
lakhs. So as a percentage of sales the cash is you can say it is 1%.
Roughly it is 1% and receivables are 20% right. Receivables are 20%. Now we talk about the
inventories. When you talk about the inventories we have inventory of raw material of 704 lakhs.
Then we have WIP of 816 lakhs and then it is 490 lakhs. In percentage terms it is 4%, it is 4.6%
and it is 2.8% of the sales. So total if you work out this works out total works out as how much
that is 5705. This is 5705 and this works out as 4.2.
This amount is given to us 1%, then 20%, 4%, 4.6%, 2.8. So this works out as 32.4%. This
amount is 32.4% this is 2, then it is 6, then 10, 12 ya 32.4%. This is in the percentage of the
forecast of sales and now we are given the current liabilities; less current liabilities, less current
liabilities. So current liabilities given to us are 1305 and they work out as 7.4% of the sales. So
then you can calculate as net working capital.
Net working capital is now it is 4400 lakhs 4400 lakhs and this works out as how much 25%.
This is 25% and these all are in the percentage terms. This is now the picture with regard to the
working capital and the inventory and apart from this information we are given some other
information also. This information is also given to us. But before that I will tell you about the
company.
What is the problem of this company is, what is the situation in this company is that this
company has the total expected sales of 176 crores in the coming year and then the profit is 70
crores in the coming year that is of the forecasted sales and tax rate is 50% as we have seen in
the previous slide. Problem in this company is that this company is suffering from the problem of
continuously lost sales.
Means on the continuously basis they are losing the sales because one problem is that there is a
stock out of the finished goods and company is not able to serve the client’s needs or to fulfill the
client’s requirements and many a times there is a shortage of the finished goods in the warehouse
and when the company receives the order they are not able to fulfill the order because of the
shortage of the goods available in the warehouse or non-availability of the goods in the
warehouse.
When this problem was analyzed by the company they found that recently the company had
introduced or sometime back the company had introduced the policy of very tight inventory
means a tightened inventory policy was introduced by the company that we will not keep much
very high amount of inventory and we will keep the amount of inventory under control or lesser
than the say even the optimum level of inventory.
And to avoid the additional inventory cost or the carrying cost as well as the handling cost it is
better not to keep the high amount of inventory. But as a result of that as a result of the tightened
inventory policy company is losing the sales on the frequently on the frequent basis. When they
are receiving the orders they are not able to serve the client’s needs so there is a problem and this
lost sales or this amount of the lost sales is forcing the company to lose the profits also.
So this entire situation was asked to be studied by the company and companies director of
finance, marketing, and production when they studied the problem existing in the company they
found out that this all is happening the company is losing the sales or is not able to fulfill the
requirements of the customers on the regular basis because there is a shortage of the say finished
goods available in the inventory.
And this has happened because of the tight very tight inventory control or a tightened inventory
control policy which the company has introduced in the past and because of a very tight
inventory level of the finished goods company is not able to make the sales and the profits and at
the same time company is suffering from the indirect cost also, say loss of the reputation and that
is a very huge indirect cost.
So then the company thought of improving this situation and they asked the finance department
to do analysis that if we lose or if we say little means not to say follow the present policy of the
inventory if we lose the control upon the inventory if we loosen the inventory policy and if we
increase the level of inventory by increasing the investment of investment in the inventory in the
finished goods of inventory so what is going to happen.
Means that increased investment in the inventory is going to give what kind of results. Whether
we are going to earn additional operating profit and whether that additional operating profit is
sufficient to justify that investment. So that entire analysis was asked to be done by the
company’s top management by the finance department and when the finance department did the
analysis they found out certain things that yes they move they thought of moving step by step.
That if we loosen the inventory policy from present level to little say furthermore level how
much increased sales we are going to make. How much increased cost we are going to have and
what is going to be the impact upon the operating profit. Then we move to the next step. That
from the first to second we move, how much increased investment is required, how much cost
will increase, and what will be the impact of on operating profit.
Then they move from the second to third to fourth to fifth. So that way they moved rather than
moving straightaway from the one level to a very high level immediately that may be a disaster
or that may prove to be disastrous for the company. So they thought of analyzing the situation in
a way that if we move from the present policy to the next policy by loosening the say inventory
policy to some extent what will happen in terms of investment and in terms of the cost.
Similarly, the next, next, next level they went out to 5, 6 levels and then the entire analysis was
made and then with the help of incremental analysis, incremental level of investment,
incremental level of cost, and incremental level of revenue was worked out and finally the
decision was taken or means is about to be taken by the company that where or to what extent
the inventory policy should be loosened. To what extent or to what mark the control upon the
inventory policy should be loosened that was tried to be worked out.
So how that was worked out and let us see that when the finance department was means passed
on this responsibility what they did and how they studied the present situation and what is the
outcome of that situation.
So they have given us the information in terms of impact of impact of alternative, impact of
alternative inventory policies; impact of alternative inventory policies and here first column is
inventory policy, inventory policy option. Then second information available to us was inventory
level; that was in Rs, lakhs. Then it was lost sales; Rs, lakhs again. And then it was carrying cost,
carrying cost again in Rs, lakhs right. So this is the situation here.
Inventory policy option. They devised it into the 6 parts. First thing was that current policy,
current policy; at the current policy level. The policy which I say or which the company itself
observe that it is a tight inventory policy. So in this case the inventory level which was or the
investment in the inventory level was found to be as 490 lakhs. Sales lost at this level of
inventory was 772 lakhs and the carrying cost was 27 lakhs. It was also in Rs, lakhs.
So this is the 27 lakhs. The carrying cost was also worked out as 27 lakhs. Now in the second
case when they moved or they think of moving from the current policy to policy A then the
investment in the inventory was expected to go up to 610 lakhs. Level of lost sales will come
down because of the increased level of inventory to 550 and the carrying cost will go up that is
up to 34 lakhs.
Then in the third case, policy B that from the current to B if they go from say current to A, A to
B so at this policy level at the B policy level the inventory level will be or the investment in the
inventory will become 770 lakhs and lost sales will be 350, will seriously come down, 350 lakhs.
But the carrying cost will go up to 42 lakhs. And then from the at the fourth level from the B to
C say if they go from B to C in that case say inventory level will go up to 1013 lakhs.
Lost sales will seriously come down to 190 and the carrying cost will be 56 lakhs. Then they go
from the C to D, so here it is 1276 inventory level will become investment in the inventory will
go up to 1276 lakhs and lost sales will seriously come down to 90 lakhs but the carrying cost will
go up to 70 lakhs. And in the last case E here E so it was 1406. Lost sales are 50 and then the
carrying cost will be 77 lakhs.
This was the situation worked out that if this happens then certainly we are going to have the
increased level of sales at this level. The lost sales are maximum that is 772 lakhs if you bring it
down. So over a period of time or maybe immediately if you change the policy from the current
we can change from the current to A to B to C to D to E. Say for example go from the A to
current to E then the investment will go up or the total investment in the inventory will be 1406.
And the lost sales will seriously come down to 50 lakhs and the carrying cost will be 77 lakhs.
Now we will have to see, we will have to decide that whether it is worthwhile to loosen the
inventory policy from the present one or we should not do this. If we do that then certainly we
are going to say avoid the situation of the lost sales but if we do not do that then certainly we are
at the current situation and we are losing sales so it is not only the question of losing sales but the
question of losing revenue also.
So we will have to see and evaluate the whole situation that what should we do in this case. So
let us now this is the situation or this is the information given to us by the company. This is the
working capital position in the company. This is the say inventory policy position which has
been worked out in in the company and in the other case we have the initial say information
about the company that is the expected sales are 176 crores.
Estimated gross profit is 70 crores and tax rates are 50%. Up till this point we are given the
information or we have fetched the information from the company records and now we have to
apply the concept of the incremental analysis and with the help of the incremental analysis we
will have to work out 2 things now. One thing will be that we will have to work out the
incremental investment in the inventory and as a result of that how much incremental sales we
are going to have.
How much incremental profit we are going to have and what is the position with regard to the
expected rate of return and the required rate of return. So in this situation let us go for the
incremental analysis and try to understand that how this all say this situation works out and how
we move forward.
So now we will have to see that say calculation of incremental, calculation of incremental
investment in, calculation of incremental investment you can say, not in inventory but I think in
total. We will have to work out the total investment and that will be indicated with the help of
that is delta investment, you can signify like this; delta investment that will be equal to the delta
investment in inventory plus delta investment in the net working capital right.
So we will have to work out this say changed investment. So investment in the inventory we will
have to calculate. We will have to calculate the total investment in the inventory so this is going
to be what that is the investment and investment in the inventory we will have to calculate. So
here it is we say that this is the investment or you can call as delta investment. In this investment
or how much increased investment we are going to make we will have to think about it and then
this is the investment we are making.
This is investment so what delta signifies here? Delta means change in the investment. How
much change in the investment is going to be there. So that is going to be as a result of that, that
will depend upon the change in the inventory level plus the change in the net working capital of
the company. Because we have seen here that the net working capital position of the company
here is something like this. So what will happen?
Here we have the cash. We will have the receivables. We have the inventories here. So for
example we have inventory of raw material, WIP, and finished goods. We can keep the amount
of cash same. We can keep the amount of receivables same, not change it. Raw material also
same, this also same but stock out is the result of or is the, the cause of the stock out or the say
lost sales is the stockouts an stockouts are because of the low level of the finished goods
inventory.
So if you increase the finished goods inventory it means investment in the finished goods
inventory has to be increased. And if you increase the investment in the finished goods inventory
so what will happen? Level of the current assets will go up. This will not be this much but this
will certainly go up and this will not be 5705 but will increase and as a result of that we will have
if we for example assume that this current liabilities are going to remain the same.
It means this increased investment in the inventory is to be found out or to be arranged from
some other sources and as a result of that as a consequence of the increased investment inventory
is when you increase the investment in the finished goods inventory certainly there is going to be
a change in the investment, automatic, I am not saying that we will make any change. Automatic
change is going to be there in the cash level also, in the receivables level also, in the raw material
level also, and in the WIP level also.
Because it is not possible that simply by increasing the level of finished goods inventory we can
increase the sales. Automatically the, we will have to work at the higher level of the working
capital where we require more cash, where more receivables will come up and certainly more
inventory of all kinds will be there.
So we see that by changing the level of investment in the finished goods inventory by moving
from the policy 1 to the policy next policy what increased investment in the finished goods
inventory is required to be made and as a result of that how much increased investment in the
other say current assets or in the net working capital takes place.
So that way increased investment in the inventory plus increased investment in the net working
capital that is current assets minus current liabilities we will have to work out and as a result of
that total of this, investment in the inventory plus investment in the net working capital will give
us the figure of the investment in the that is the figure of total investment right. So now we are
going to calculate the calculation of incremental investment.
And this will be the result of say delta investment, incremental investment, delta means
incremental, investment will be the function of delta inventory means change in the inventory
level of finished goods plus change in the net working capital. So inventory level of finished
goods we will change ourselves and other net working capital, means other current assets and
current liabilities will automatically change.
If we are increasing the finished goods inventory others will also change. So maybe going up so
it will also go up. Going down it will also go down. So we will see that what happens with the
say entire this process and we will have to work out that how this incremental investment can
make the difference. So here we will have to see that for example change in the inventory policy.
We will have to make the columns. Change in the inventory policy.
First column is change in inventory policy, change in inventory policy. This is one. Then it is the
incremental investment in inventory, incremental investment in inventory we are going to make.
Then is the incremental net working capital; then will be the incremental net working capital,
incremental net working capital other than the investment in the finished goods. Incremental net
working capital how much it will change?
So then we will work out the total investment, total investment and then we work out the
cumulative investment, cumulative investment. So we will have to work out this way right. We
are starting with the change in the inventory policy, incremental investment in the inventory and
then incremental investment in the incremental net working capital total investment this plus this
and then it is going to be the cumulative investment.
So let us move from the policy current to A, current to A, policy current to A. So this is how
much incremental investment in inventory we are going to make; how much incremental
investment in the inventory. Inventory level is this much that is 490 and if you move from the
current to A the investment in the inventory will go up from the 490 to 610. So how much
increase we are going to have here.
That increase we are going to work out here and that increase will be 120 lakhs right. This is
rupees in lakhs you can say this is the, I will write here rupees in lakhs. So for 120, when you
move from the say now we will change the policy here. So current way investment in the
inventory is 120. Net working capital is going to be how much? Net working capital is going to
be how much?
So for example for finding out the, I say the net working capital, change in the net working
capital is going to be 49. Total investment is going to be 169 and cumulative investment is also
going to be 169. Now you must be wondering how this 49 has been found out right. So when we
have to find out the 49 here if you go back in the previous details if you look at these things
given to us here just simply you take out this level of finished goods inventory which is 2.8% as
a percentage.
Look at this column and finished goods inventory just 2.8% of the sales right. If you because we
have already taken this 2.8% so we already have taken the finished goods inventory here 120. So
we will not take it again now. So it means this is 2.8 if it is taken out. So how much is left, the
balance left with us is total amount of this 2.8 and then if you calculate this means the net
working capital again if you work out. So it means this will be total 32.4 - 2.8 right?
And then minus 7.4. So net working capital will be 22.2. Net working capital will be 22.2
because we have taken out 2.8. it means when we have segregated this investment of 2.8 then it
means the remaining level of the current assets will be 32.4 - 2.8 and then funds coming from the
current liability is 7.4%. So it means out of the total net working capital 25%. Now your changed
net working capital will be how much 22.2% and if it is 22.2% this 22.2% is of what.
It is of the sales. So here also we are going to find out that when you are moving from the policy
A current to A how much investment in the inventory we are going to make? That is from 490 to
610. It means incremental investment in the inventory will be 120 lakhs and because of that or as
the increased investment in the inventory how much additional sales we are going to make? If
you talk about the sales we are going to make is that the change in the sales will be will have to if
we work out the change in the sales will be how much 772 - 550.
So it will be 222 lakhs of the sales we are going to increase and as a result of this multiplied by
22 point this increased sales if you find it out then changes in the net working capital. So it
means the 22.2% if you make the changes in this incremental net working capital so incremental
net working capital will be 22.2% and that 22.2% of 222 will be how much? That will work out
as 49 lakhs. So this will be, this we have worked out how this 49 lakh has come from.
This is the 22.2%. This is the 22.2% of the increased sales. Net working capital here we have
calculated as the percentage of the forecasted sales. So if your sales are going to increase by say
net working capital is not going to go down. If you take out the finished goods inventory by
2.8% then the new net working capital is 22.2% and in this case increased sales we are going to
have from here is that is 772 is the lost sales. New lost sales will be 550.
So it means the increase in the sales will be 222 and when there is a increase in the sales by 222
lakhs so as a result of that net working capital will also increase at the rate of 22.2% and the net
change in the net working capital will be 49 lakhs. So the change in the investment that is delta
investment equal to delta inventory plus delta net working capital will be from current to A
investment in the inventory will be increased by 120 lakhs.
Investment in the net working capital will increase by 49 lakhs and total investment will increase
by 169 lakhs and cumulative investment will also be 169 lakhs. So this way we will calculate the
say change in the investment for all the policies from current to A, A to B, B to C, C to D, D to E
and then we will see how much incremental investment is there, how much incremental profit is
there, and how much say is the difference between the expected rate of return as compared to the
required rate of return and whether we should go for any policy change or not.
And if you go then from where, from current to where; A, B, C, D or E that will be the say the
question to be answered after this detailed analysis. So I will stop here and in the next class we
will continue with the same problem and we will move up to the say final decision making of the
say of this analysis; what kind of the change in the inventory policy should be introduced. Thank
you very much.
Dr. Anil K. Sharma
Lecture-27
Incremental Inventory-II
Welcome, students so we are discussing the incremental analysis and in the previous class we
were working out the change in the inventory policy from current to A and as a result of change
in inventory policy by the company how much investment is required to be made in the finished
goods inventory level and in the net working capital.
And we found out that the total investment change Delta investment from current to A will be
169 lakhs right. So, it means additional investment of the 169 lakhs has to be made by the
company if they want to move from the policy current A. But the net effect of that will be that
the company's sales will increase by 222 lakhs. So, the major advantage major benefit and then
we will have to work out the profits out of those sales. We will do that in the next part but
currently lest us workout the requirement of investment and another policy levels.
So, let us move from the policy A to B, A to B, so it means policy A to be here many more from
the policy A to B how much incremental investment in inventory we are going to make a 160
lakhs because in the previous part we have seen the investment in inventory will be how much
that is from 610 to 770 so it means 160 will be the increased investment in the inventory and as a
result of that how much is going to be the change in the working capital in the cost of working
capital that will be increased investment in the working capital will be 44 lakhs and finally the
total investment will be 204 not 169 as in case of the first policy.
So, there will be a change so 104, so total cumulative investment will be 373 rupees this is
cumulative investment and we are moving in the sequential firm from the current to A and then
from A to B not directly from current to A current to B right. So, we have to move in the, that we
have been losing it slowly and steadily so we have move from current to A, A to B. Let see now
situation from the B to C when you move from B to C. So, what will happen the increase
investment in inventory will be how much 243 lakhs and in the working capital you are going to
increase 36 lakhs?
And total investment will be going up by 279 and cumulative investment will be becoming 652
B to C. Then we talk about C to D right when you move from C to D then it will be 263 this is
263 then you will be increasing investment in the net working capital by 22 lakhs total change
and investment will be 285 and finally the change in investment will be 937. And then it is D to
E right, it is D to E, so it means what will happen now increased investment inventory is under
30 lakhs then it is 9 lakhs.
And totally changed in the investment will be 139 and it is 1076 right. So, this is going to be the
picture of that cumulative investment we are going to have here. So, it means when you move
from current to A change in the investment total investment that is a investment in inventory +
investment in the net working capital will be 169. When you move from A to B it will be 373,
from B to C it will be 652, from C to D it will be 937 and from D to E will be 1076. So, this is
the total level of the cumulative investment we are going to make here.
Now the next part but we have to do is we will have to work out the incremental operating profit
will have to work out the incremental operating profit.
So, same way will have to work out the incremental operating profit incremental we will have to
work out as which we called it as Delta OP change in the operating profit as in the previous case
we have seen the Delta investment is the Delta OP in the operating change in the operating profit
and for calculating this again we will have to make the columns first is the change in first we will
have to make the first column which will say that is a change in inventory policy right.
Then as a result of the change in inventory policy, Incremental sales how much incremental of
sales we are going to have right and then we have would have incremental contribution, which I
was talking to you as a gross profit. You can call it as a contribution also incremental
contribution that will be called as Delta sales, change in sales. You can say it is a delta sales it is
called as a delta new change in the delta but it is the change in the contribution.
We will have to see change in the gross profit or change in the contribution, you can say increase
in the contribution or the say incremental contribution we will have to work out and that will be
at the rate of 40% that will have to work out at the rate of 40%. So, 40% is the gross profit or so
we call it as a gross profit on contribution this is 40%. And then we will have to see that next
thing is incremental carrying cost will be how much.
We will have to see the change in the incremental carrying cost, so incremental carrying cost will
be going up change, so you can call it as change in cost, delta cost then will be the incremental
operating profit before tax will have to see incremental operating profit before tax you can see it
is a delta operating profit or OPBT operating profit before tax and then it is the incremental
operating profit before tax sorry operating profit incremental operating profit after tax OPAT
incremental operating profit after tax.
So, that will be the change in OPBT a change in the OPAT right. These are the columns, so
change in the inventory policy change in the incremental sales because of that so it is delta sales,
incremental contribution at the rate of 40% you can say at the rate of 40%. Incremental carrying
cost is, carrying cost will also increase because now the sales are going to increase inventory is
going to increase so carrying cost will also increase and then incremental operating profit before
tax and incremental operating profit after Tax.
So, here we will have no two; make all the calculations this is called as at 40%, so now will
make the all calculation here. So, inventory change in inventory policy from current to A change
in the and inventory policy from current to A, how much is this going to be changed in the sales?
See here is going to a change in the sales, 772 we are losing the sales currently we loosen the
inventory will increase the level of inventory of the finished goods.
Other loss of the sales will come down from the 772 to 550 and then further it will also go down
so it means incremental sales will be how much 772-550; So, in this case how much is going to
the change in sales? Change in the sales will be 222 lakhs I am writing here rupees lakhs, this is
222 then is A to B move from A to B will see here what happens but here incremental
contribution is going to be how much? Incremental contribution is going to be say it is 40 % it
means the 40% off the sales is going to be contributions.
It is going to be how much it is going to be 89% you can calculate it is incremental contribution
at the rate of 40% it will be 89% of the increase sales and services and how much is the
incremental carrying cost carrying cost is given here so it is 27 when we are having the current
inventory policy and we are losing the sales of 200 and 772 lakhs to the carrying cost is lowest
27 lakhs but when you move from the policy current to A your sales will increase investment
inventory will increase net working capital will increase.
So, certainly you are carrying cost will also increase and then increase in the carrying cost will
be by how much amount 7 so it means what will happen finally. So, this is the incremental
contribution 89 sorry this is not the percentage 89 when you say here this is the absolute terms 89
lakhs not percentage comes between the absolute terms. So, it is means it is 89 lakhs so 220 at
the rate of 40%, 220 rupees sales are going to go up at the rate of 40% and contribution 89 lakhs
of the contribution is going to a further added up.
And carrying cost is there is going to increase by 7 so finally you can say that operating profit
before tax is 82 and after taxes because tax rate is how much 50% it means after tax operating
profit will be 41 lakhs it is rupees in lakhs. Now you move from A to B, when you move from A
to B in that case what will happen we will have the incremental sales of 200 lakhs, incremental
contribution will be 80 lakhs and then it will be changed in the carrying cost.
So, if you change that see the carrying cost carrying cost was 34 but not going to be 42 going to
increase by 8, so this is 8 and then it is going to be how much 72 operating profit before tax is 72
and then it is 36 operating profit after tax. After that you go for B to C, from B to C if you go
from B to C so change in the sale is going to be 160 then incremental contributions is going to be
64 then it is going to be 14 and then it is going to be 50 and it is going to be 25 lakhs rupees.
Then you go from C to D, when you go from C to D so change in the sales will be 100 and
incremental contribution will be naturally 40 and then it is going to be 14% incremental carrying
cost is 14% this is 26 and this is 13, operating profit after tax is 13. And then from D to E it is 40
change in the sales is going to be 40. Then it is going to be 16, 40% of the 40 is 16 than carrying
cost is going to go up by 7 and then it is going to be how much?
This will be carrying cost is 7 so it means the next change will be how much D to E will be 9 yes
it is 9 and then it will be 4.5 by half of that or maybe call it as 5 we have taken round out that it
off so it is 5 or 4.5 something like that or say this is going to be changed in operating profit going
to be carrying cost is this. So, your changes say this 40 carrying cost is increasing incremental
contribution is 16 and carrying cost is going to be 7.
So, here incremental profit after tax is 9 sorry incremental operating profit before tax in 9 and
after tax you can see it is 4.5 lakhs. So, this is the situation now has emerged, if this is the
situation then we will have to now go for the next level and that next level is that we have to
work out the say expected rate of return, we have to work out the expected rate of return and
expected rate of return is called as r = change in operating profit divided by the change in
investment.
So, Delta operating profit divide by the Delta investment or the change in the investment, so we
have worked out the say change in operating profit here and we have worked out in the previous
calculations change in the investment cumulative investment. We have found out both
investments are the different policies level are with us from current to A we have the investment
from A to B, B to C, C to D, D to E have all the investments cumulative investment as well.
And the operating profits are also available with us that is at the current to A this much and then
A to B, B to C, C to D, D to E all the profits are available with us. So, you see that when we
move from policy current to A maximum level of increased change in the sales is going to take
place 222 lakhs and as a result of that operating profit after tax is also highest. Then A to B the
change in the sales is now not that much.
But it is still higher 200 and the operating profit after tax is the second highest that B to C, C to C
that know this trend is falling down immediately when be relax the policy from the current to A
level then the sales are picked up after that now the sales are going up but not at the same rate at
the at the declining rate. As same is the case with the operating profit, that operating profit is also
increasing but at the declining rate. Now you have to take a decision what should be do here and
we have to calculate the r, r is called as expected Er you can say expected rate of return.
This is expected rate of return which means simply called as r. So, if you talk about this
compare this expected rate of return r, with the required rate of return then in that case we will
have to now make a decision that how the things are going to be there. so, the basis of the
decision is what that r has to be either then great say equal to or greater than or equal to K, r is
the expected rate of return and K is the required rate of return so it means now we have to see
that expected rate of return should be greater than the required rate of return or at least equal to
the required rate of return.
On the basis of this process let us see now calculate the change in the profit or you can call it as a
rate of return that is the expected rate of it turn. So, we will see that expected rate we will see
that expected rate of return expected rate of return and if you calculate the expected rate of return
here again we will have to change the policy in an inventory policy again we have to go for the
inventory policy. Then it is the before tax expected rate of return and then after tax expected rate
of return before tax expected rate of return after tax rate of return and then the inventory policy.
So it is current to A, current to A so, before tax expected at rate of return was how much 48.5%
or it was 49% so you can say after tax will be how much if you calculate it works out as 24.3%
how we have calculated this 48.4 this 48.5%. We have calculated this 48.5% by taking the
amount of the profit and operating profit given to us in the; so even the calculated is operating
profit here is 41. So, if you calculate this rate so 41 to be divided by 169. So, if you divide this 41
by 169 so the rate is; we have got the rate of return expected rate of return is 48.5%.
So, this is operating profit and the policy current to A and this is the investment in the inventory
that is one total investment 169. So operating profit is divided by the expected investment we are
going to make or invest increased investment in inventory we are going to make and the policy
current to A means it works out as 41/169 so it is 48.5%. So, this is the first expected rate of
return and half of that is made because the tax rate is 50%.
So, half of that is 24.3 % and then from A to B is how much the profit is going to be there 35.3%
this is 35.3% that is before tax and after tax is going to be 17.6% and then is B to C is going to be
17.9 % and it is 9 %, B to C 17.9 % and 9 % and then it is C to D it is 9.1% and in the it is 4.6 %
right and then it is D to E the expected profit before expected rate of return before tax is 6.5 %
and here in this case it is 3.2%. So, these all returns are also available with us.
So, we have worked out all the three things, we have work out the incremental investment in the
inventory, so cumulative investment when we move from the policy A to B to C to D to E. Then
we have calculated the incremental operating profit before tax and after tax over the stage this 5
policies from current to A, current to E current through this operating profit is available with us
and the next calculations we have calculated the say expected rate of return before tax from the
policy current to E and expected rate of return after tax where we move from policy current to E.
So, now all these calculations are with us, now we will have to take a decision here that how we
have to decide about that where we should move which policy we should move from and we
should stop at. Say if you make this analysis of this table you can say that if you move from
Inventory policy of current to A then what will happen your operating profit or even called it as
after tax expected date of return will go up by 24.3% very high.
If you need from A to B then sales will increase but that the operating profit will go up at the
declining rate so it will be 17.6% and when you move from B to C, it will be 9% profit is going
absolute profit will be very high but percentage change in the profit is declining so because you
can sell more in the market you can penetrate in the market to expand the market by selling more
in the market but in that case you have to compromise with the profits.
If you lower than the selling price your number of units your selling in the market of the total
volume of the sales your making the market will certainly go up but your percentage of the profit
percentage of the return will go down. But if you multiply this percentage with the total number
of units of the total sales we are making, if you calculate this 9 % as the given amount of the
sales that would be highest.
So, it is a our choice whether we are satisfied with the same movement from the current to A and
earning 24.3% if you want earn 24.3% obviously your sales will be lesser as compared to the
level that is B to C. But if you want to capture the largest market of the largest size or part of the
market for the largest share in the total market pie in that case you can find out that yes we will
have to reduce over margins.
We have to reduce the selling price that way your existence in the market will expand but the
profit per unit will go down but the total amount of the sales will be very high as a result of this
policy what happens? As a result of this policy while lowering down the selling price and by
lowering down our own margins is also immediately we are seeing that the margin is lowering
down from the 24 % to 9 %. But tomorrow when the many players will go out of the market
because they would not be able to say have the competition with this kind of the giant in the
market.
Who is able to sell at the lowest possible price so many people will vanish from the market many
players will vanish from the market and when the people got off the market at that time you can
jack up the price increase the profitability increase the price at that time you have the double
advantage of increased sales also increase market share also and increased investment also and
increased returns also but currently we see that is a situation to come in the say time to come but
currently be see the situation what is the situation is.
For example our required rate of return that is the required rate of return that is ROR that is say
9% other required rate of return it I would say it is 9%. Now how do you decide by the required
rate of return? Financial experts say that your required rate of return should be, minimum it
should be equal to the cost of a capital. He should be able to recover you should earn that much
rate of return from any business or any say this sales or say any kind of the transactions.
That is minimum equal to the cost of the capital because in the business capital comes from the
different sources either it is owned capital from the internal sources the capital owned by the
firm, their own resources or it is a borrowed capital. If it is a borrowed capital and if it is
borrowed at 9% the cost of the capital we are going to pay the cost of the capital firm is going to
pay is in 9% it means the firm should earn minimum 9% from the incremental investment in
inventory otherwise there is no point making this investment one.
But if the cost of capital is higher if the capital has been taken or he has been borrowed the funds
have been borrowed at 12%, 15% then the required rate of return has to be the same right. And if
it is owned capital if it is from the internal source with this capital is generated from the internal
sources in that case there has to be the opportunity cost of capital. You invested capital in this
business inventory or you invest this capital outside.
So, what is opportunity rate of ; what is opportunity cost of capital that will work here as the
benchmark for considering it is a required rate of return and for example in the situation but they
work that out here is in this situation we find out is that 9% is our required rate of return. So, we
would say that we should accept the policy that is from B to C here before tax will be expected
rate of return will be 17.9% and after tax will be 9%.
So, at this level how much level of sales will be able to make? Our sales will be going up by total
cumulative sales if you make out that is 22 + 200 + 160 will be increasing the sales. So, it will be
somewhere how much 422 and then 522, 582 lakhs of the sales we are going to increase and
increase contribution is going to be 64 lakhs because per unit selling price is going to go down.
And finally if incremental carrying cost is also going to increase by 40 lakhs so finally your
incremental operating profit before tax will be 50 lakhs and then incremental operating profit
will come down to 25 lakhs.
But we are satisfied here because a required rate of return is 9% and we are getting that at the
policy C when we are moving from policy to B to C we are getting that required rate of return so
we are satisfied and if you look at here the level of inventory investment in this case the total
investment in inventory will be making how much 652 lakhs. This much of addition investment
we have to make and this is the total investment will be making.
So, it means 169 at this level to 373 at this level, so it means you are moving from B to C you
will be investing 652 lakhs in the total investment will be making in the inventory as well as the
other net working capital. Increased the total sales will be 582 lakhs right and incremental profit
will be 25 lakhs which is incremental profit after tax and finally as I expected rate of return will
be 9% which is equal to the cost of capital.
But here we can take a precaution for example 9% just the cost of capital but when the capital
invested in the business. Business may take other kind of risks also. The business should not be
compensated only for the cost of capital of the borrowing rate rather they should be compensated
for the risk they are taking. So, we can see here that if it is not 9%.
To be on the safer side to be on the safer side it may be possible that cost of capital me also
increases if possible that they carrying cost also increases or some time investment in the net
working capital of the say assets may also increase in that case of networking case may also
increase. In that case it may be better to be on the safer side and if you wanted to be on the safer
side in that case it can be possible that you reach at this level A to B.
And you earn this rate of return that is expected rate of return will be 17.6% which will be much
higher of this 9% required rate of return the difference is 8.6% and the difference of the 8.6%
covers almost all kind of the risks. All kind of the risk are going to be covered here. Any kind of
the risk of say inventory not being saleable or maybe say investment in the networking capital is
going to increase or maybe any other kind of the risk obsolesce risk is also there.
Lack of sales is also there, change of the market condition and if you look at here the level of
inventory this is also there when we are into business to take different types of the rest if you
want to have a premium for the risk because at 9 % only just cause of capital but we just get
compensation for the other sort of the risks also we should use to be on the safer side we should
select the policy A to B.
So maximum we should stop at the policy B If you stop at the policy B so what will happen in at
that level your sales will be to increasing by 422 lakhs total and incremental operating profit after
tax will be 36 lakhs and in the investment part to talk about your investment will also be not 652
but it will be lesser that is 373 lakhs, so investment will need will also go down your risk will
also go down and required rate of return will also be met from the expected rate of return.
And as a result of all these permutation combination your expected rate of return will also be
sufficiently high which will cover for all kind of risk making it 17.6 % which is 8.6 % higher
than the required rate of return. So, it means it advisable it is better that incremental investment
in the inventory at this stage should be not stable made from current to C but is better to move
from current to B and then see what happens how we are able to capture the lost sales.
How we are able to serve the market? How we are able to say manage the situation in the market
how much risk we are going to take when we are going to increase the investment from the
current level to the new level and how this whole scenario is going to emerge. We should look
for this we should wait for sometime so rather than movie stay away from current to C is
advisable that you move from the current to B policy of inventory.
Invest only this much amount which is total investment that is 373 lakhs and get the sufficient
amount of sales increase, sales increased by 422 and increase your profit that is by 36 lakhs and
in terms of the percentage it will be 17.6. At this moment it advisable that incremental
investment in the inventory should be up to the policy B we should you from the current to B but
not to C because we move from current to C then you are expected rate of return it just equal to
the required rate of return that can be the risky proposition.
So, better it is too strict or currently to stay at policy B from current to B and then earn the 17.6%
return and if the situation warrant sorry if it is feasible of it is more comfortable to expand the
market and increase the sales and increase the level of inventory and to avoid the lost sales then
we can anytime move from B to C. But in the one go moving from the current to C will not be
advisable.
So, this is how we used incremental analysis still working out the investment in the different
current assets. In this case we have seen this use of those incremental investments in inventory
and in the due course will be learning this use of incremental analysis in the other current assets
also maybe the credit sales or the any other current assets. So, at the moment I stop here and the
remaining part of discussion we will do in the next thank you very much.
Dr. Anil K. Sharma
Lecture-28
Management of Accounts Receivables-I
Welcome students so in the previous class we were discussing the inventory management where
we learned the concept of incremental analysis. So, we have to discuss certain more cases about
the inventory management but I thought that first of all we should do all the important concepts
and if the time permits later on that we can discuss some cases also with regard to the
management of different assets. So, for inventory or say managing the inventory or learning how
to manage inventory as a current asset I will stop here.
And first I will complete say the management of all the current assets like receivables cash other
assets and then we will learn about the management of current liabilities, spontaneous finance
and then the sources of working capital finance and after that we are still having the time that we
can discuss some cases also one out maybe some cases on inventory or receivables. I will take up
at the later stage but here at the moment I am stopping.
As for as inventory management is concerned and in nutshell you can see in the nutshell you can
say that the important component which we should learn or the important part in elementary
management which we should learn is that ultimate objective of financial manager maybe the
financial or the operations are the production department people should be to have optimum
investment in the inventory right.
So, in what way we decide the optimum investment in inventory that depends upon the firm but
we have to make out we have to analyse that neither we have to pay extra carrying and handling
cost nor we have to pay the any stock out cost. So, we should be able to serve all the customer's
needs also. We should have the amount of inventory with us also and that we excessive amount
is also not invested in the inventory and no order is going un-honoured or unmet. So, that way
has to decide the optimum level of investment right.
And in any case if he says problem that we are losing sales because we are falling very tight
inventory policies in that case we can think of or we can use incremental analysis the concept of
incremental analysis as we have seen and that we discussed about that if there is a restriction on
the working capital supply by the bank so, how to deal with that particular situation. So, we
learnt something about the management of inventory and I would again say that the important
technique which we should use in environment like India.
Or the manufacturing environment like India is EOQ is valid and very useful technique and we
should depend upon that for working out the optimum level on economic order quantity or
economic quantity of the material which we have to maintain all the times. So I stop here and
then now I will move forward with the next asset or the same learning about the management of
the next important current assets.
In the say balance sheet of any company the next important current asset is the accounts
receivables. We have cash also you have advance payment also we have some other things also.
So, now we are going to talk about the accounts receivables. So, when you talk about the
accounts receivables I would like to throw a light upon that in the balance sheet you might have
seen that there are the different current assets or if you see the balance sheet you will find
different current assets.
We have Inventory of the top which we talked about at length that we have the accounts
receivables then we are sundry debtors then we have advance payments have advanced deposits
so and then we have cash and some short term investments also right. In this case in this situation
you talk about accounts receivables separately given and then you talk about the sundry debtors
you talk about the advanced payments. All these are in the category of accounts receivables.
Account receivables is a bigger term is a broader term and that includes sundry debtors also that
include the advance payments right. So, all these assets we have to learn to manage under the
categories of the receivables management because when you talk about that and accounts
receivables appear in the balance sheet when we sell on credit right.
This is the result of the credit sales so when we sell on the credit we see that accounts receivables
come in the balance sheet but that is not accounts receivable they are called as sundry debtors.
So, sundry debtors are the parts of the accounts receivable. Accounts receivable is a bigger term
account so sorry this is accounts receivable so accounts receivable is a bigger term and it
includes many things and in the many things this is accounts receivable not AC it is AR.
So, credit sales give the rise to accounts receivables but accounts receivables include many other
things also and that current asset which comes in the balance sheet appears in the balance sheet
because of the credit sales is called as the sundry debtors. Sundry debtors also the parts of the
accounts receivable and then say for example you talk about advance payments. Advance
payments for example we are manufacturing such kind of the product where the raw material is
very scares are there is a monopolistic situation in the market as far as the supply of the raw
material is concerned.
Only one company or two companies is available in the market for supplying all kind of the raw
material and all the uses of that material have to depend upon those companies. So, in that case
we want to make sure that supply of the material is always regular on the time and we are not
stopping the production; we are not used to stop the production simply for the want of materials
for that reason we make the advance payments.
So, when you make that advance payment in that case what happens we are again creating the
accounts receivable any kind of advance payment whether we are making supplies material
whether we are making it to the employees of the company for example somebody's say has got
the advance salary from the company because of certain reason. So, in that case that is also
accounts receivable right. So, we had this productive distribution system like this accounts
receivables come appear from this side and advance payments generate the accounts receivable
from this side right.
So, it means when we are making the payment to supplier here we have to recover that payment
from the supplier by receiving the material from the supplier from later date and when you are
supplying the materials the finished goods to the distributors here. So, we have to get this is
goods are given to the distributors on the credit. So, we again have to recover the price of those
goods also so it means in both the case we both the sides accounts receivables are been generated
or they are coming up for their appearance and finally they come to the balance sheet.
Because we call is as accounts receivable we call is as sundry debtors we call is as advance

payments. So, all kind of these assets or these payments or these transactions or the accounts
appearing in the balance sheets cover or are covered under the one category that is called as the
accounts receivable. So, it means out of the total accounts receivables total accounts receivables
in Indian situation say about 50% of the accounts receivables is because of the sundry debtors.
So, for example you all the things are given in the balance sheet
Say for example we have a balance sheet here this is the balance sheet and this is the lower part
we have inventory here and then we have accounts receivables then we have sundry debtors then
we have advance payments right. All the other current assets we have inventory here right it this
is the first assets if we have talked about this asset at length and next thing is the accounts
receivable right and for example accounts receivable amount given here say 100. In this balance
sheet accounts receivable amount given a 100.
And in this case if you talk about then sundry debtors amount is again 100 right and advance
amount is 20 so these figures are given in the balance sheet. So, if you have to cover only under
this one head that is accounts receivables so how much you would show this, you will add 100 +
20 and this will become how much it will be the total amount. We will remove this will not
appear in the balance sheet now. Individually they were not appearing in the balance sheet.
So, this total amount will become 220 right out of 220, 100 is the sundry debtors and 20 is the
advance payments and remaining 100 is the accounts receivable. So, why we show these all
current assets not under one head that is accounts receivable but we show it under the different
head’s say accounts receivable. Because if you show it in the accounts receivable become 220.
But we are showing here we are first what we are doing is that in the accounts receivable sundry
debtors amount is quite large.
Similarly an advance payment is also important current asset and that is also significant amount.
If it is a significant amount so it means it is better to show it individually in the balance sheet
rather than clubbing it under one head of accounts receivable they all are accounts receivable but
you have to segregate them. Because their magnitude is quite high so here that we are showing
here is the sundry debtors 100 and it is a 20 is the advance deposit. Because if you give only
accounts receivable in the balance sheet right.
And then the firm has to go out in search of for generating the working capital finance or maybe
having the short term loans or may be the cash credit limit from the banks. Banks have to analyse
the balance sheet of the company past three years balance sheets of the company. So, if it is not
given clearly that what constitute accounts receivables? what constitute accounts receivables?
In that case bank would not be able to find out the quantum of credit sales, bank would not be
able to find out the quantum of the credit sales and finding out the quantum of credit sales is
very, very important. Finding of the quantum of the credit sales is very, very important. Similarly
bank would not be able to find out how much payments you are making as advance to the
suppliers of raw material because you deal with such kind of the product of such kind of the
industry where the making of the payment advance payment is required.
So, that may be vulnerable situation sometimes that if we did not make that was payment
company will not get, firm will not get the raw material and the production process may get
hampered and if it gets hampered in that case it will be a troublesome situation. So, in this case
showing it individually is very good because sundry debtors is coming out or appearing is a
balance sheet because of credit sales and any funding agency any source of finance whom we are
requesting to provide as finance.
They should be knowing it what is extent of credit sales. Because they would be analysing that
out of the total profits a company showing in the profit and loss account how much profit is on
cash basis and how much profit is no credit. Because when you prepare the profit and loss
account here say we all know that profit and loss account is a nominal account and the profit
which is shown by the profit and loss account is that is not the real profit that is the nominal
profit right.
That is the nominal profit because when you prepare that this is the income statement we call it
as income statement. So, this income statement here we start income statement we take care the
material, labour and other expenses right. We take these expenses here and this time this side we
take by sales and sales when we take we never show the sales as how many sales around cash
and how many sales are on credit. For example we have sold for 100 rupees in the whole of the
year for which they prepare the balance sheet and income statement.
And out of that 60 rupees is the credit sales and the 40 rupees is the cash. It means finally is the
profit net profit before tax which we are showing here that out of that profit the total profit
coming here 60% of the profit is also nominal that is also on credit and when you are showing
this much of the net profit before tax on the credit we have not realised it, in that case it may not
be possible that the firm will be able to realise this 100% credit profit.
Not the profit which is still on credit which still is yet to be received only sales have been made
for the amount has not been received. So, out of this only 40 percent is the cash profit 60% is the
credit profit this 60% of the credit profit whether will be realised or not that will be the question
to answer in future and we all understand that there is the sum something which is known as bad
debts right.
So it means out of the 60 % even 10% are the bad debts and or some time you have to give the
discount or something like that 10% is the bad debt or because of other reasons you are not able
to recover 5 more % took for giving the more discount on making provision for the debtor or
anything. It means ultimate what will happen your profit will come down to 45% so it means the
total profit will be 45% + 40%, 85 %.
So the profit which we are showing here as 100% that will come down to 85%. So, just to know
this situation or this a particular situation to deal with this particular situation what we do is that
be shown in the balance sheet all the accounts receivables there are shown category wise and in
the accounts receivables in the Indian situation in the Indian scenario out of the total accounts
receivables 50% around 50% is because of sundry debtors. Half of the accounts receivable that
because of sundry debtors so we should be knowing that how much sundry debtors are there in a
firm.
And if you know the extent of sundry debtors you will be knowing the extent of credit profits
which we have not received yet. They are not actual profit there the on credit because sales are
still on say credit basis that is why that sundry debtors are there. So, it means any funding agency
or any external stakeholders maybe the internals also but large with external stakeholders they
can get to know that what is the overall financial health of the company.
Company is highly profitable for but 80% of the company sales are on credit means 80% of the
profit is also credit. So, we have to answer this question that is why in the balance sheet under
the accounts receivable we do not show all the things together. We aggregated it, so that we can
find out that if you summed it up in this balance sheet, the total accounts receivable amount will
become 220. But if you are out of this 220 rupees how much is a sundry debtors 100.
How much is the advanced deposits that is 20, so it means these three things make the accounts
receivable and remaining 100 is other account receivable for example some say bills
accommodation bills raised by the firm or maybe sometime we have had other kind of may be
the funds we have given to somebody and we have to receive these funds back so their called as
accounts receivables. So, out of this thought 220, 100 is only sales or sundry debtors 100 is out
of sundry debtors and 20 are advance deposit.
So, other accounts receivables are 100 only so it is always better and we show it in the balance
sheet you might have seen all the balance sheet. So, you will see in the balance sheet that we
have account receivables also we have sundry debtors also and we have advance deposit also or
advance payments also. But in nutshell they all are say categorised under the same category and
their called as accounts receivable right. May be we have to understand that this very important
current assets.
Inventory is the one and after that in the; in terms of liquidity or in terms of lack of liquidity you
can count this accounts receivable earlier as I told you some previous class that accounts
receivables being included while calculating the quick ratio when you are calculating while
calculating the quick ratio when you are calculating the following the liquidity of the firm when
we were calculating the liquidity understanding the liquidity position of the firm.
So, what we were doing we are calculating current ratio, quick ratio and the super quick ratio
right. Current ratio when we calculate with a call current assets divided by current liabilities then
we calculate the quick ratio we take current assets minus inventory and divided by current
liabilities and then you take the quick ratio with take the cash plus marketable securities divided
by current liabilities right.
This ratio is considered as 1.33 : 1 this ratio is considered 1:1 and this ratio is considered as 0.5:1
right. Earlier there was no liquidity and when the sundry debtors are also accounts receivables
were also illiquid like or less liquid like inventory so for calculating the current ratio we were
taking all the current assets into account. For calculating the quick what we were doing current
assets minus inventory minus accounts receivables we subtracted them also and then we are
calling divided by the current liabilities so it means that way it was the current ratio and quick
ratio of the acid test ratio.
We call it as acid test ratios also but now we are doing that from the current; now from the, this
is the current assets and what we are doing now currently when we are calculating the current
quick ratio we are only doing this that is current assets minus inventory divided by the current
liabilities and that is why the rule of thumb has also come down. And this rule of thumb is here
this rule of thumb is now that is 1:1 earlier it was 1.5:1.
Because accounts receivables were part of the quick ratio why we have excluded the sundry
debtors or maybe the accounts receivables for calculating the quick ratio and how we consider
that accounts receivables are now quickly convertible into cash as compared to inventory or they
are far more better or quickly convertible into cash as compared to inventory the reason is that as
we have discussed in the past also that we have the bill discounting facility from the banks.
If we are not we have sold on the credit and you period is for example 2 months we are going to
release the payment after 60 days. But after making the sales of 10 days after making the sales if
the firm required the funds, funds from knows that the funds from the credit buyers will come
over or say debtors will come after 50 days because we have given them a credit of 60 days. So,
what is a way out they would not make the payment before 60 days because it is agreed by both
the sides the credit period 60 days.
In that case firm can go to the bank and firm can get the bills discounted. Those credit sales bills
can be got discounted by the firm and for the time being firm can raise the funds. So, whatever
the bills are there; so, what happens that normally there are the total sundry credited for accounts
receivables I would call it as, they are divided into three categories that is A category, B category
and C category of the accounts receivables right.
A category of the bills firms do not want to get discounted from the bank because getting the bill
discounted for the banks is a costly affair. But it helps the firms to raise the funds as and when
they are required and firm is able to make the payment to its different stakeholders when it has to
be and firm is able to avoid the situation of technical insolvency. So, that is good fine but there is
a very expensive transaction because first bank will give you 80 % of the bills. So, you have to
wait for the 20 % till the credit period ends.
And payment is made by the sundry debtors or the debtor and ones that payment comes the bank
will charge interest for a period of say in the example we are discussing for a period of 50 days if
the funds are given by the bank, the bank will charge interest at a higher rate for that period of 50
days and for the amount which is it amount which is used that is 80% which is given to the firm
immediately and apart from that bank charges on commission and administrative charges also.
So it means it is very, very expensive affair what happens if there is a good category of the bills
firms do not want to get discounted from the banks because by to lose money on those accounts
receivables which are fully secured and on those bills the payment on the due dates is certainly
or it is it is bound to come at a certain that the payment will be received.
C category of the bills are those where which are doubtful accounts receivables or sundry debtors
which are quite doubtful that we have sold to somebody on the credit in the event of maximizing
sales are other than keeping inventory with us we passed on that inventory to the some
distribution channel on credit. But there is doubt that their overall performance is not good in the
past there may be possible that out of the 100% credit sales we may recover only 80% or 90%
are there is a possibility that we may lose 10%.
So, they are the C category of accounts and B category of accounts are which are having the say
moderate credit rating. They do not default normal the normal case they do not default they make
the payment on the due date. Somehow if there is a very serious issues or very serious problem
and there is there is some unforeseen problem faced by the company because of the lack of
liquidity then it will be possible but normally they are good accounts.
But normally they are good accounts not best accounts but good accounts and they are doubtful
accounts you can say little bit doubt is attached to this. What happens as I told you that A
category accounts are very good company does not want to lose any funds on that so that they do
not get these bills discounted from the bank. C category of the bills banks do not want to
discount because banks are really doubtful about the realisation of the funds on the due date.
So it is only the B category of the bills which are discounted by the bank and firms are also
interested to get these bills discounted because they are only in the good category or in the fair
category. So, that amount is at least available means some time with easily could you have
liquidity crunch with the firm and if they are not having any other source to make the payment to
their dues. So, and they do not want to have situation which is called as technical insolvency of
the firms.
In that case what they can do they can get the bills discounted and go to the bank at the B
categories of the bills discounted from the bank and run the show for the time being and on the
due date when the payment is realised that the entire adjustment is done. So, this is there way out
so why we have done is that while calculating the current ratio now accounts receivables are
removed from the numerator. So, only we subtract from the total current assets only inventory
for calculating quick ratio not current.
And inventory is the least liquid you cannot sell the inventory in the market as and when you
wanted. So, in that case is the least liquid current assets but accounts receivables when they least
liquid by bill discounting facility was not there from the banks. It was a part of the quick ratio it
was a part of say subtracting from the current assets for calculating the part of ill liquid assets to
be subtracted from the current assets while calculating the quick ratio.
But now when facility is available from the banks we can get a discount from the banks
sometimes now in India because after 1991 we have got many other sources of working capital
finance also. In some cases when banks are not able to discount some bills that these bills can be
got discount from the other sources an important source which provides a bill discounting facility
is the factor. Factoring service and factory services and factoring services already started in India
that is not picking up.
But the services already started in India and from this factors the bills can be got discounted
about the factors affecting services are that I discuss with you in the sometime later on what
factors is and again alternative if the banks are not providing the liberal working capital that is a
one part. Now in this case we are subtracting it from the current while calculating quick ratio
only inventory is subtracted not the receivables.
Because other receivables have become a little more liquid as compared to the inventory so for
calculating the current ratio we take all current assets for quick ratio current assets minus
inventory but not minus receivables. And for super quick ratio only be take into account the cash
plus very short term securities, marketable securities and then we calculate liquidity ratio. So,
there is one part of the story.
In this case when we are talking about the income statement we talked about the concept of the
credit profit that’s why sundry debtors have to be shown separately in the balance sheet. So, that
anybody outside or any financial institution who wants to analyse balance sheet of the company
they can easily make out of the total accounts receivables but part on account of credit and how
much advance deposits have made remaining how are the accounts receivables which are not
because of the credit because of the advance deposit.
So, in this case we are finding that in Indian scenario 50% of your account receivables are
because of sundry debtors remaining some amount is because of advanced deposits but now we
are in a competitive situation. So even advance deposits are going down over that is and even
you see this credit sales are also going down. When you analyse the balance sheets of the
company pick up the balance sheet of any company and analyse it for the past 2, 3, 4 years.
In the in the recent past if you see that the accounts receivables are going down because
companies are now say minimising the investment in the credit sales. And since in most of the
manufacturing subsectors I would say subsectors of the manufacturing sector in most of the
sectors we have multinational performing. So, because of their discipline because of their
excellence because of their good quality product and because of their say considering the
customer is king their able to sell of their product largely their products on cash.
So, they are creating a situation in the market where all the distribution channels have to by
maximum from the these companies on cash and then for sell it in the market and their they are
again fixing it up of the target also that you buy this much number of units from us, If you are
our distributor and dealer you by if you want to do business with us we have to do it at the
excellent level at the best possible level.
So, if you buy from us will give you the no credit or if you will give you the credit for you for a
minimum period of time and the minimum amount. So, you and we have to sell this much of
units monthly or maybe quarterly or maybe bimonthly in the market and every month for every 2
months after you will be getting this much of the stock and you up to sell the stock in the market
and you have pay us in cash or sometime not in cash at least advance cheques.
So, that when we send you the truck load of material immediately will represent your cheques in
the bank and we collect our payment. Because of this increased competition in the market and
because of the increased financial discipline in the market and because of the presence of the
multinational companies who are very, very efficient and who do not create a situation of the say
buying on credit of selling on the credits. So, in that case the overall accounts receivable
situation is improving.
Or even sundry debtors are coming down advance deposits are also coming down but still they
are there and it will take a time that when it is becoming lowest of the negligible amount but still
in the balance sheets of the firms today accounts receivables exist sundry debtors exist advance
deposit exist and we will have to deal with this current assets. But again I would emphases here
again that we will have to make again say optimum investment in the accounts receivables.
Rather I would say that the minimum investment in accounts receivables. If it is possible try to
sell maximum on cash never to do not encourage distributors, dealer or maybe the company
directly selling in the market, do not encourage the credit sale only in the situation for example if
you are say having a product of selling a product in the market which is less saleable in the
market which does not have the same sufficient market existing of for the product of which
company there is no sufficient market then we are going to sell on credit.
But largely if you want to sell on your product in the market it has to be on cash or it is on the
cash. For example we talk about the electronic sector electronics we have largely 3 companies
operating in India good companies operating in Indian companies Samsung, Sony and LG. On
the other side we have Indian companies like Videocon; we have Onida or some other companies
also. For Samsung there is a market why should we sell on credit and normally they are not
selling on the credit.
For LG there is a market so they are not giving any credit they are not selling on credit. Sony
there is a market the quality is excellence so they are not selling on credit. In case of Videocon
you will find in case of Videocon we find the credit period is very, very high because their
product is not easily acceptable to the people in the market, if somebody has to buy product on
cash why not to buy the excellent product.
If you are going to buy on cash why not buy excellent product. So, in some cases if you see
analyse balance sheet of Videocon and or Onida and finalize balance sheet of Samsung and LG
you find there is a day night difference in the accounts receivables, sundry debtors maybe
sometime advance deposit also advance payments also. Because Videocon has to sell most of
their products in the market on credit otherwise people are not ready to buy that on cash.
If you look at the Samsung is a name in the market and people are after the product. So, they
have made up the Goodwill their brand name in the market. So, why they should sell on credit as
they have the give the credit also very minimum amount of the creditors incentive to the
distributed, dealers just for some period of time but not for the longer duration. So, as the; new
competition is coming in the market new discipline is coming in the market we are aligning
Indian market Indian manufacturers are aligning distributor aligning with the rest of the word.
In that case this market is also moving slowly and steadily towards perfection, excellence and
completion. So, in that case the extent of receivables is going down in the balance sheets of
Indian companies also but still it is sufficient for sufficiently high and we will have to create a
situation where most of the production is going to the market or to the consumers on cash.
So, if you have to make investment in the accounts receivables invest minimum not maximum
and try to sell maximum cash. So, I will stop here and remaining many other interesting concepts
about the management of accounts receivables we will discuss in the next class. Thank you very
much.
Dr. Anil K. Sharma
Lecture-29
Management of Accounts Receivables-II
Welcome students we are in the process of learning about how to manage the accounts
receivables that is a second important current asset in the balance sheets of the firms. And in the
previous class I initiated the discussion on management of accounts receivables where we
discuss the some basics of the requirement of management of receivables and what in receivables
include and than we learn about that what is the importance of sundry debtors? What is
importance of advance payments and how the total accounts receivables account for? Now we
will be moving forward in the same process and let us see here that how the receivables are
behaving over the period of time.
And as I told you that after the liberalisation of Indian economy and the influx of the
multinational companies it has brought many things very positive things in the market. First
thing is that as I told you that it has increased the competition in the market. So, those Indian
companies who were not able to sustain the competition they have gone out of the market. But
the companies for sustaining in the market they also have to align with say the rules and
practices of the multinational companies operating in India.
So, one thing is that competition has gone up and when the competition has gone up as it is
benefit in everybody including customers. So, one reason of discipline in selling on credit is that
since this multinational do not give any kind of credit sorry if they give the credits very, very
lesser amount of credit they give in the market. So, over a period of time seen that the existence
of the accounts receivable and sundry creditors is there in the balance sheet you cannot say that
you can do a business without giving the credit.
But the magnitude of these accounts receivables and sundry debtors has seriously come down
and we are expecting that over a period of time it will be the minimum amount. So, it means it
depends upon the type of the player we are talking about. If the company is very efficient
company's product is very good it is acceptable to the people with the company selling a quality
product and at a very say competitive price.
In that case selling on the credit is not the requirement of the company sometime the distribution
channels are the customers where request the credit which the company can accede to the
request. But not the compulsion of the company because they have sufficient demand for their
product and they have work hard to create the excellence as well as to maintain the price, so, in
that case they can manage accounts receivables in way they wanted. If they want to give the
credit they can give credit if they do not want to give the credit they may not give the credit.
Companies who are in the market competing and trying to sustain in the market it may be very
difficult for them if their product is not excellent and if the price they are not able to control then
it may be possible for them to give the credit in the market to sell the product at a credit in the
market. But slowly and steadily everybody will say sail in the same boat and the credit to be
given by; the leader in the market or may be by the laggard in the market that difference between
the two will not be very high.
So we have seen here if you look at the trends here, important database that database is called as
a PROWESS of the centre for monitoring Indian economy which is reporting say the financial
data or the financial statements of many companies thousands of companies. So, from there we
have seen a trend we have tried to see trend about the accounts receivables and say sundry
debtors.
So, and then we tried to compare with the international trends, so we have found from the data
which is available or maybe you can also verify it by just resorting into the database PROWESS
database where the thousands of companies data is there. So, you can make analysis that in
different companies in any industry what is the percentage of the accounts receivable as a
percentage of the total assets.
And what is the percentage of the sundry debtors as a percentage of the accounts receivable so
we have seen in the trend is declining if you see over a period of time that is trend is declining
that receivables account for about 10% of the total assets in a manufacturing firm. In the
developed economies means it is around 10% of the total assets. So, total receivables we are
talking about and if this is the percentage which shows in the same time some years back.
But this is declining over a period of time and if you talk about the developing economies
including India it accounts for about 12 to 15% of the total assets. So, still the magnitude is very
high but still 12 to15% of the total assets is very high but yes it is coming down over a period of
time. And over the period of time the receivables are coming down in both developed and
developing economy markets.
Because we have discussed the reason that as companies are moving towards excellence and in
the say era of the cut throat competition seller has to reduce the price to the say maximum
possible extent to bring down the price which is the minimum price they can charge from the
customers in the market from the markets. So, in that case if still they have to sell on the credit is
very difficult.
So, they are achieving excellence in the in the quality of the products and they are reducing the
prices to the extent that in this situation seeking the credit or requesting for the credit also this
kind of demands are not coming from the customer the distribution channels also. And in a way
these MNC have created a say situation in the market where they do not encourage the credit
sales.
But still they will give credits because they cannot sell 100% production on cash for their credit
period will be controlled by the seller not by the buyer because if you think about who say needs
a credit. We have the two sides one is the seller and other is a buyer right. Now the objective of
the seller is that the company want give either no credit or the minimum credit.
And objective of the buyer is that he wants have maximum credit and now the objective of the
seller is that not to give the credit at all so that the time value of money is maximum for him.
And the objective of the buyer is that he wants to delay the payment to the maximum possible
time was maximum possible extent. So, that the time value of the money for him which is paying
to the computer by the product is minimum to both are moving in the different directions and to
achieve the different objects.
In this case we have to create a situation that if the if the product is excellent and the prices it is
very, very competitive then the company things about their some time with the situation
demands that there is a negative effect up on the market companies sales or sometime it is very
difficult for the company to adjust manufacturing process or anything else then it may be
possible to give some credit in the market. But largely these MNCs I have personally seen these
MNCs as largely we talk about the electronics sector.
In the electronics sector in India we have three companies who are the say leaders in the market
you can say the different markets in a different proportions we have Samsung, LG and Sony.
Samsung is a leader in the market followed by LG and then Sony. So, it means they have created
a situation in the market that anybody who wants to work with Samsung say for example they
have to work in a way that any distributor or wholesaler or retailer has to sell the product or has
to perform in the market as per the philosophy of the company.
And company wants that you are not expect much credit from us and in many cases companies
asks the distribution channels also to send the advance cheques to the company and production
process is continuous and when any material is ready or any say for example 100 colour TV
ready they have to be now say sold in the market. So, they will be sent to the distributors even
sometime is a distributors not placed any order. Sometime even without order also they will have
to work as per the companies instructions and they will have to perform in the market,
So, and since the company has advanced cheques from the distributors or maybe any other
channel of distribution from the one side truck load of TV to the distributor and they present the
cheque and the distributor to the bank, so companies payment is collected. And company’s
condition is that we cannot perform on such conditions then you need not to be out of the
distributor of the Samsung. So, it means you can see the situation that they are not giving any
kind of the credit.
So, in a competitive scenario when the prices are too low quality is excellent then it is a
prerogative of the seller in the market whether to give any kind of the credit or not to give the
credit and over a period of time because of the increased competition increased excellence
increase performance and existence of MNCs in the market the receivable or credit sales are
coming down. Another thing we are seeing from another point of view in another model is
another indicator.
That is the number of days of sales locked in the accounts receivables say normally when we see
that that the credit is average credit period is say 2 months or on an average that for 2 months
company sells on the credits. So, it means 60 days sales are blocked in the credit sales so they
sell it today and the money comes after 60 days of funds come after 60 days. So, it means for 60
days the company has to arrange for the funds because the production process is continuous and
it has to be supported with the funds.
So it means number of days sales blocked in the credit sales or in the receivables we have seen
that this study is also coming down. Earlier when we talk about the credit period in this country
was sometime 3 months also. It has come down it came down to 2 months and now the current
credit period is somewhere between 30 days to 45 days and in worst case scenario it can be 45 to
60 days. But no company they can be exceptions but largely the companies are added to this
credit Period.
There are the companies were very worst case of companies in the market and want to sustain in
the market so there the credit period can be even given 2 months. But that they are not means
large in number very few companies are even giving the credit period up to 60 days and lastly
the credit period given by the companies in the different manufacturing sectors is somewhere 30
to 45 days which means over a period of time it has come down for 3 months to 2 months to 45
days and 45 days to 30 days 1 month.
So, we can expect that in the time to come it may further go down. The number of days sales
locked to the accounts receivables we have seen the tentatively it is also coming down. This a
good development in the market because people who are in the habit of buying on credit and
then paying it at a delayed periods after delayed period on a delayed then that kind of the say
indiscipline is going away from the market.
And even the distribution channels are becoming discipline and customers are also have got the
message that when the price has got the same remarkable cut and the companies are selling their
product in the market is the minimum possible price then I think as a customer also they cannot
expect any credit. Another important here is easy availability of the short term funds through the
cash credit limit. Even if see where the companies are giving even the credit and they are selling
their production in the market on the credit.
Sometime the credit period is much longer even beyond 45 days that is happening only because
of the one thing that is because of easy availability of the credits from the banks. As we have
seen the different ways that how bank finance can be say used by the companies to finance its
current assets are the working capital requirements. One thing is that one important mode which
is only prevalent in India that is CC Limited cash credit limit.
So since easy funds are available through cash credit limit so companies also do not think much
for selling on the credit. Because they know it that if they are we are selling on the credit maybe
for a period of 2 months then for continue with the operating process for the manufacturing
process they can easily have the funds from the bank and for a given period of time they can
fund their credit sales or maybe the accounts receivables with the help of the funds provided by
the banks and that to on the CC limit basis.
So, that is the one important reason but over a period of time as we have discussed in the past
also that this facility is also bound to come to an end. I told you that RBI has instructed the banks
or issued the guidelines to the banks that any working capital requirement of the company which
is of up to 10 crore and above then the way or the mode of funding that requirement should be in
the ratio of 80-20 with 80% should be in the form of working capital loan + bill discounting
facility and only 20% has to give manager CC limit.
For the time being it is not being implemented by the bank but it is expected that soon banks will
have to do it because of certain reasons because banks overall financial health is also not good.
So, they cannot extend the credit in the form of the CC limit which is highly unproductive
So, now it is the time is coming a situation is arising in the market in the banking industry also
that they are the banks also have to start lending on the basis of the marginal productivity of the
capital marginal productivity of the capital. It means where the productivity of the capital is high
where the banks are expecting that they will generate maximum returns from the loans or from
the lender going to make in the market. So, that is going to the final way out so it means
providing the funds through CC limits even is going to be difficult for the banks.
And is the time or soon the time is going to be there that RBI guidelines are going to added by
the banks because marginal productivity of the capital would force the banks to move say change
the mode of funding for providing the working capital requirements for fulfilling the working
capital requirements by way of the working capital loans rather than the CC limit or the cash
credit limit. So, it means this principle which is already there in the other countries which is
being followed in the other countries.
We also have to fall in line and we also have to follow the; this principle of the marginal
productivity of the capital. As I told you that in US bank finance is the least preferred source of
working capital financing. They resort to other source of financing like factoring, forfaiting, inter
corporate deposits, deposit from the other financial Institutions, commercial paper for these
sources are not becoming important in India because of the easy availability of the bank finance.
So, if it is not popular in USA if it is not popular bank finance is not popular in Europe then how
it can be popular in India earlier you had a situation reverse of the term structure of interest rate
and the rest of the world be had the term structure of interest rate but when we say this economy
was liberalised opened up when we globalise, this economy was globalised then have to follow
the term structure of interest rate which says that the longer the period of the say borrowing
higher will be the interest rate to be charged from the borrower by the banks.
So, now we had to align with the rest of the world, in case of the term structure of interest rates.
In this case also we will have align with the rest of the world where the bank finance is the least
popular source. Where the other countries are in the debt world so why it is so popular in India
and banks are going to pay big price or under a pressure from the industry or maybe the financial
pressure is too much which is now going beyond the capacity of the bank.
So, we can expect that soon the bank may resort to the way of funding for fulfilling the working
requirement working capital requirements of the companies on the principle of marginal
productivity of capital. So if that happens then CC limit kind of the things may completely go out
of market. Banks, companies will get the working support from the banks but by way of working
capital loans and by way of the bill discounting facility and that should be done also because
banks cannot be expected to full fill the companies are the industries requirements unendingly.
So, that is going to happen but currently the reason for the large amount of accounts receivables
in case of Indian companies especially is that easy availability of the bank finance through CC
limit is the one imported reason. Granting credit is basically trading off between the financing
and strategy of the firm. This is important part here see we have the two important divisions or
sub-units in the company's one is the finance department and other is a marketing department
right.
Target of the marketing department is that they shall maximize the sales. Objective of marketing
departments that they should maximize the sale and if they have to maximize the sales every
time they cannot achieve the target by selling on cash, so sometime they have to sell on the
credit. So, company has given it to the market that we have this much of the production. Sales
have to be this much by setting aside some minimum stock which we are keeping.
So, maximum production should go to the market and marketing departments only concerned
with achieving the objective irrespective of the fact whether it is on cash or it is on the credit.
Company selling the product in the market whether the product goes to the market on cash or on
the credit marketing department is not going to answer this question. May be at the end of the
day they would say that our target was this much to sell the 100 units of the product in the
market we have sold 100 units in the market 100, 500, 10 units in the market our target is over
achieved in the market.
But important question is what part of the seles has gone to the market on cash and the credit
component is to be taken seriously. The objective of the marketing department is to sell
maximum in the market whether on cash or on credit that is not important for them. And
objective of finance department is to maximize the return on investment to maximize the return
on investment. So in that case sometimes what happens that say the firm has got surplus funds.
So, those surplus funds can be parked anywhere so finance people sometimes think that rather
than parking it outside may be manufactured and sell beyond our level on the credit. So,
currently when we are selling on the credit by giving a certain credit period and largely on the
cash also our sales are say for example the level given is X but you want to increase the sales
beyond that level. We have surplus funds we can produce more we can manufacturer more and
we can serve the other markets also.
In the existing markets also if we give the credit and start selling on the credit on increase the
credit period the sales can increase. So, how they are going to do that because your surplus fund
then they want to park their funds somewhere. So they can park this first into the credit sales so
in that case of a sometimes to meet the objective of the finance people they have to go for extra
manufacturing or manufacturing and selling in the market and with their objective of maximizing
sales and the profits.
On the say instruction of the finance department to park the surplus funds the credit sales can be
done and surplus funds can be parked was invested in the accounts receivables. But finally we
cannot go pick and how can have to extremes whether the objective was the finance department
subject to a marketing department is there has to be a trade off that how much funds be surplus
funds we have how much credit we can give in the market because we have to keep into
consideration the recovery of the credit sales.
May be unendingly keep on selling in the market on the credit basis that is not going to serve the
purpose. So, we may have to think that there has to be trade of the marketing departments
objective is also met and finance department objective is also met and firms overall value is
maximized. So, that is important objective that this trade off has to be taken seriously and we
should think about that your sales are also going up sales collections are also maximum and the
amount or the percentage of the component of the bad debts is also minimum.
So, that has to be borne in mind and one important reason that to increase or decrease accounts
receivables whether the accounts receivable this should be there or not that also depends upon
the another important point is that is the perfect channel of distribution is important question
here. To decide the extent of the magnitude of the accounts receivables we will have to talk
about think about the channel of distribution. If you think or when the companies want to sell the
product in the market, largely there are two channels.
One channel is the direct sales in the market and another channel indirect sales in the market.
When there is direct sales in the market as I already know it. Some companies have their own
exclusive stores and they manufacture and sell the product in the market not through any indirect
channels by the company owned channels. We had sometime in the past that Bata shoes
available only in the exclusive store of the Bata and they continued with the strategy for the
distribution channel for the longer time.
But now they are resort into the strategy which is both that is their selling through the exclusive
store also and they are selling through the say indirect channels also to maximize the sales in the
market because in today scenario it is not possible to depend upon the one channel on the direct
marketing only. So sometime that is the situation but we have seen many companies are selling
directly in the market and in that case say there are many positive is also there many negative is
also.
The main positive part here is that companies control up on the customers is direct what
customers want what changes in the product customers what changes in the design of the product
customers want and how they are feeling about the price of the product and other attributes of the
product all customer related information is directly coming to the company because companies
directly selling through their own company owned at outlet in the market.
So, they have not to look for the customer information towards the other channels right. The
negative part of it is that having the exclusive stores these days especially in the big cities or
towns is becoming a very, very costly affair because finding the place maintaining the store
paying for the overhead store overhead is very, very expensive affair. So, what happens in that
case the price of the goods go up and in many cases people may not like it.
So, because it is a price sensitive economy we have a limited income we cannot everybody
cannot go to buy the Reebok shoes or may be the Nike shoes or maybe the Puma shoes or maybe
some branded products in the market that is not possible for all. Even if you talk about the Bata
Shoes branded shoe sold through the direct channel and indirect channel also if you compare the
quality of the shoe and price of the shoe there is a big difference because same quality of the
shoes is available in the market.
That may not be Bata that is good quality shoe and is available sometime at the one third of the
price. So, the because of the exclusive stores or maintaining the exclusive stores cost goes off
very high. So, everybody cannot afford to that cost. So, that means sales of the companies are
affected. So, increased cost is the negative part and direct control upon the information and the
requirements of the customers as a director information from the customer comes to the company
just a positive part of the channels of distribution.
But here these days what is happening in India also know the trend has started that people have
very lesser amount of time. Time is the problem, these days when we go out for the shopping
when you go out for the shopping we tried to go to a store where almost all the things of
household are the one for the daily needs are easily available. We do not have the time that for
shoes we can go to exclusive store and for refreshments we can go to another exclusive store for
the grocery we can go to another exclusive store or for the say other requirements pick and go to
the exclusive store.
That is not the time now earlier it was there then the people had a stable life and there is no
shortage of the time there is no paucity of the time now the time is the problem. So, in the
evening when you come from the office we want to buy something for households other
approaches that we want to go to a shop or restore where almost all the things are available at
under one roof or even if you want to buy any particular product or to buy single product people
want to try or want to know about the quality in the prices of different companies and their
products and then they zero in on one product.
Say for example if they want to buy even shoes so they would like to go to store which is having
the product of the multiple companies different companies rather than going to Bata rather going
to Nike rather than going to Puma because if you go there means if you are not decided in your
mind. Until unless if you are not decided in your mind that you are going to buy Nike shoes in
any case you are not going to say compromise lesser than Nike that is good.
But largely people want to buy shoes they can buy Nike also they can buy Puma also they can
buy any other shoes also but if the varieties available people prefer that and if variety is not
available sometime people may drop the sales or maybe we postpone the sales. So, people want
it that yes they should be the different companies product available at the same place so
alternatives are available in terms of the quality in terms of the cost in terms of the price.
And they want to have choices so because of the say requirement of the choices the indirect
channels have much more value rather than the direct channels. So, in the past period seen that
directs channel is also working very well but these days now the trend is changing and their also
we have seen that what happens you might have seen that when we buy the product from the
exclusive stores they are very, very expensive because cost of maintaining the store is very high
overheads are very high.
And all those overheads have to be passed on to the consumers where as it may not be possible
in case of the indirect marketing. If you go to a shop where at a retailer is having the products of
different companies and you have number there you can have a choice that this product you want
to have you can have you do not have a premium product that is also available you want to have
the regular product that is also available.
In that case the retailer’s overheads are distributed to the many companies so cost of maintaining
the store comes down and those over heads or the cost of those overheads can be passed onto the
many manufacturers or different companies. So, that benefit directly goes to the customer
because prices go down. So, this is a very important as a positive point of the indirect selling in
the market. But that the to give the credit or not to give the credit to a large extent it depends
upon the channel we are say finally selecting.
Because building a channel takes a time lot of time it takes and if your building a channel of
distribution network where we have distributors, wholesaler and retailer in the process and we
have built this channel by working hard for many years you cannot stay away convert to direct
marketing or if we have the direct marketing network we have created and we have the number
of exclusive stores in the different cities and different towns.
So, you cannot straight away say that we will dismantle it and move to the indirect marketing
that is also not possible. So, these days at least if that thing is not possible we are falling the
middle path that has Nike shoes will be available at the Nike store also and they will be available
at the other place is also so that both that channels can be used by the companies and maximize
that can maximize the sales and minimise the credits.
For you see when you go for the direct marketing another positive benefit of the direct marketing
is that credit sales are minimum almost negligible when you buy any branded products on the
market on credit we go and pay in cash and come back. So, it means that when then the customer
is paying in the cash the outlet is also as must be buying from the company in cash so it means
there is no credit period at all.
Company can afford to not to sell after their production in the market on the credit or to give the
minimum credit is the store is being managed by some outside agency. But if it is being
organised by the company employees there is no question of credit. But in case of the indirect
distribution yes we have to give the credit and when we give the credit accounts receivables
appear in the balance sheet and this another outcome of the indirect marketing.
But in that case we can increase the sales also we can minimise the price also and if the price is
lower down then certainly we can maximize the sales and in that way seller is also gaining and
the buyer is also gaining. So, that is important part in this important question about you want to
choose. So, in this case we are finding that the trend is like that companies are moving slowly
from the direct marketing to the indirect marketing because of certain things.
And in that case is cost is controllable but the credits are coming up in the market we have to sell
on the credit and what are the important points and other important components and how we
should select a channel of distribution this is the important discussion I think we should have
further more discussion about the channel of distribution because it is a direct or serious impact
upon the accounts receivables so further more discussion on the channel of distribution I will
have in the next class thank you very much.
Dr. Anil K. Sharma
Lecture - 03
Nature of Working Capital Management
Welcome students. So in the previous 2 classes we were trying to understand the balance sheet
and the lower part of the balance sheet and especially the current asset and current liability part
and there I could I think clarify and I could make you understand that why the lower part of the
balance sheet is important and to properly manage the current assets and current liabilities, how
important it is right.
Now, once we have understood the management of current asset’s and current liability’s need, it
means we have understood there is a need for managing the working capital or the short term
funds properly. So it means now we are moving ahead on the ladder and we are trying to
understand what is the nature of working capital management.
As it is clearly written here that what is the nature of working capital management and if you
think about that working capital management number 1 even you forget the nature is a very
dynamic subject. You cannot plan for once and use it for years. You have to plan for everyday.
You have to plan every day in the morning certain things that today I am going to do this and I
have to be ready for that.
Time horizon can be 1 month. It can be 15 days. It can be 1 week for the budgeting. But you
have to very say vigilant, clear, and means clearly understanding everything that what I am
expected to do today and I should be efficiently discharging my duties as finance manager or part
of the finance department or maybe the CFO of the company.
So if you look at this what is the this working capital management if you talk about, nature of the
working capital management, working capital management is a significant part of financial
management due to the fact that it plays a pivotal role in keeping the wheels of business
enterprise running. It is concerned with short term financial decision making. Neglecting the
proper management of working capital has caused many businesses to fail and in many cases has
retarded their growth.
I am again reading that working capital management is a significant part of financial

management due to the fact that it plays a pivotal role in keeping the wheels of business
enterprise running. Business enterprise is running only because of the working capital
management. You have huge plant, building, machinery everything is with us but there is no raw
material. What is the use of that people?
There are no people, no workers to run the plant. What is the use of that plant? What is the use of
those buildings? What is the use of that furniture? You do not have the power. You do not have
the water. You do not have the lubricants. It means if you want to keep the wheels of business
ready going on you need to have sufficient working capital. But if you increase the level of
current assets you are increasing your cost.
So and if you are reducing it below a level you are into the risk of the technical insolvency of the
firm. So you have to keep the optimum level of the current assets and for that you need the
optimum level of working capital. It is concerned with short term financial decision making; how
much raw material we need, how much workers we need, how much power we need, how much
water we need, how much other lubricants inputs we need.
Neglecting the proper management of working capital has caused many businesses to fail and in
many cases has retarded their growth. I can tell you number of companies who if they are very
efficient and if they are not properly managing their working capital, many times they are out of
stock. So they are paying a stock out cost. And there are certain companies who are not very
efficient because of say especially after 1991 with the globalization of Indian economy this total
manufacturing sector sphere has changed.
Those sectors which were closed for the public sector earlier only now they are open for the
private sector. Now for example you take the example of steel sector. Earlier Steel Authority of
India was manufacturing the steel for the entire nation. Today, we have number of companies
manufacturing steel in the different parts of the country. So they have snatched the half of the
market of SAIL.
So SAIL’s manufacturing facility is same but their market has gone down by 50%. It means what
is happening, inventories are mounting because they cannot stop the production process. They
have huge manpower. They have huge plants, buildings, and huge public say assets. If they stop
using those fixed assets, long term assets their losses will otherwise magnify. So they have to
manufacture. Manufacturing process is continuously going on.
But they have lost 50% of the market. So what is happening? Their inventories are mounting.
When their inventory is mounting, inventory of the finished product is mounting, it means there
is the issue of the mismanagement of the working capital. They have huge inventory of the
finished goods. Now you need the funds to support that inventory and you are not able to sell
that inventory in the market as and when you wanted, it is creating a problem.
So it means in this case neglecting the proper management of working capital has caused many
businesses to fail and in many cases has retarded their growth. Lack of efficient and effective
utilization of working capital leads to earn low rate of return. If you are keeping huge amount of
current assets that you want to remain safe, that my raw material is always there, my power is
there, my workers are there, everybody is there.
You are selling too much on the credit to have the maximum market or the larger market share;
you need huge amount of working capital. You have to create the large amount of current assets
and I told you they are least productive. So what will happen? Your losses build. That is the
efficient management of the working capital and that is called as the lack of management of the
working capital.
Lack of efficient and effective utilization of working capital leads to low rate of return on capital
employed even or even on the capital employed or even compels to sustain the losses. When the
cost of maintaining those assets increases and funds are say the financial cost is also very high so
the loses will increase. The need of efficient working capital management has thus become
greater in the recent years right.
Now next thing is the working capital management is concerned with the problems that arise in
attempting to managing the current assets, current liabilities and the interrelationship that exists
between these two that is the current assets and current liabilities and that is why we call it as say
quite dynamic in nature. Management of working capital is quite dynamic in nature because you
sometime you have to plan on daily basis.
How much payments I am going to make. How much sales I am going to make. How much
funds I am going to collect today. How much payment I am going to make today. How much raw
materials is required. How much say raw material it is in transit. When it is going to arrive to us
or reach in the store. Every day we have to be careful. If you are not that much careful you are
not managing your working capital efficiently and you are going to increase the losses of the
firm because the cost to manage the current assets is going to increase.
Now let us understand it from different perspectives. Definitions of working capital. You might
have heard about the working capital in 2 ways. One is the gross working capital and second is
the net working capital.
Gross working capital means total of the current assets. It is from the asset side of the balance
sheet. Total of the current assets is called as gross working capital. All current assets, inventory,
credit sales, debtors, bills payable, prepaid expenses, advance deposits, cash in hand, cash at
bank. If you total it up without not taking into account the liability side of the balance sheet, only
the total of current assets is called as the gross working capital.
But out of those assets if you subtract the current liabilities from the liability side of the balance
sheet then what is the difference that is current assets minus current liabilities that is called as the
net working capital. So gross working capital, net working capital we have the 2 concepts.
Lastly, when you talk about the working capital we will be referring to in the say next part of
discussion about the net working capital that is the current assets minus current liabilities.
So net working capital finally, if you talk about the net working capital you say that current
assets and current liabilities. So it means we have the current assets and we have the current
liabilities. So if you have the if you want to talk about the current assets and current liabilities.
It means current assets minus current liabilities, this becomes the difference whatever the amount
comes here that will be called as the net working capital. But if you have the total of the current
assets means the gross working capital GWC gross working capital is the total current assets.
This is the asset side of the balance sheet. You have this balance sheet with you. You have here
the total current assets and this when you are totaling up the different current assets you are
saying that this is your gross working capital.
But when this, here you have the current liabilities and from this side when you are subtracting,
this minus this then this work out as the net working capital. This is the concept of the current
assets and the current liabilities. So ultimately we are talking about the net working capital. Now,
when you talk about the net working capital, what is this net working capital? Net working
capital is that part of the current assets which are financed from long term sources.
Net working capital, because under the current liabilities you have included both; spontaneous
sources of finance and the short term sources of the finance. Once you have utilized fully the
short term and the long term sorry short term and the spontaneous sources of finance so it means
current assets we require 100 Rs of the current assets right and we have the total that is
spontaneous finance as well as the short term finance we have available with us is 80 Rs.
So it means now the net working capital will be 20 Rs. And this 20 Rs will come from where?
This will come from long term sources of finance because after you have exhausted the
spontaneous finance once you have exhausted the short term finance after that you are left with
only the long term sources of the funds that is the LTF, long term sources of the funds. So it
means first you go for spontaneous finance then you go for the short term finance and then you
go for the long term sources of the finance.
Once these 2 sources, this plus this is fully taken this becomes the current liabilities. So current
assets minus current liability is the net working capital and net working capital is that part of the
current assets which will be financed from the, current assets is that part of the, net working
capital is that part of the current assets which will be financed from the long term sources, not
from the current liabilities.
So it means we are utilizing means step by step we are utilizing all the 3 sources of funds,
spontaneous finance, short term finance, and the long term finance. But I again I caution you,
minimize the use of long term funds. So it means if you want to keep the long term funds as low
as possible. So it means if you have the current ratio of 2:1. So what is happening? Your current
assets are say 100 and your current liabilities are 50 so it means net working capital is going to
be how much?
Net working capital is going to be that is 50. It means half of your current assets are being
funded from the long term sources of funds. How expensive it will be?
So it should be, for example if you keep it say if you want to say that your current asset your
current ratio is 1.33:1 it means only one third of your current assets are being financed from the
long term sources. So where you are talking about the 100% of current assets coming from the
long term sources where only 33.3% of current assets are coming from long term sources. So it
means here if you are maintaining this ratio as 1.33:1 rather than maintaining it as 2:1 so in this
case it is better to have this ratio rather than having this ratio.
Because this in this ratio 2:1, 100% of your current assets are coming from long term sources
which is very expensive affair and it should come from say maximum should come from
spontaneous and short term finance and then remaining part should come from the long term
sources of funds. There are the companies in the market whose current ratio is somewhere you
can call it as 0.8:1 means they are running the show with the negative working capital.
It is not net working capital, it is negative working capital. They are running the show with the
negative working capital. So it means when they are running the show with the negative working
capital so they are keeping lesser current assets as compared to lesser say as compared to their
current liabilities. So you can understand that their current liabilities are more than their current
assets. They are running the show with a negative working capital.
How risky it is for the business. But if you are efficient in managing your business properly and
effectively in that case what will happen? We will be able to minimize the cost of funds. Your
financial cost will be totally under control. There are the companies for example I was giving
you the example of the steel sector.
In the steel sector we have the companies like say Steel Authority of India Limited, then we have
TISCO, Tata Iron and Steel Company. Then we have recently come up Jindal Steel Works which
was earlier JVSL, Jindal Vijayanagar Steel Plant but now it has become the Jindal Steel Works.
Then we have Essar Steel. We have Lloyd Steel. Different steel companies are there. So other
than SAIL if you I will show you in the later part of discussion other than SAIL almost all these
companies are running the show with a negative working capital.
They are keeping lesser amount of current assets as compared to current liabilities. So it means
they are not borrowing any capital from the bank, short term funds from the bank. Nor they
having any investment from the long term sources to fulfill their short term requirements and
ultimately whatever the sources of the funds available from the spontaneous finance and from the
short term finance that is more than enough to fulfill their current assets funding requirement.
But this is not possible for every company. So normally means in the larger chunk of the
companies you will find there is a positive net working capital where the current assets are more
than the current liabilities but if you are in a position to manage the show with a negative
working capital by keeping lesser current assets as compared to current liabilities that would be
the best situation but there are so many other problems because of that.
So I will discuss about these problems with you later on and if you are able to manage or to take
care of those problems then we are efficiently managing our working capital by running the
show with the negative working capital but we will go to that part in the next part of discussion
rather than here but I told you that the net working capital is the one concept that is the say here
that is current assets minus current liability is the net working capital and it is written that NWC
that portion of current assets which is financed with the long term funds.
So you keep this investment as low as possible, minimum, as minimum as possible so that our
cost of funds or the financial cost remains under control. So task of financial manager in
managing working capital efficiently is to ensure sufficient liquidity in the operations of the
enterprise. This is possible to be done either by borrowing funds from spontaneous finance, short
term finance, long term finance.
Choice is of the business or its finance managers how he wants to run the show. If he is
borrowing more from the long term sources increasing the cost otherwise the cost is under
control. Now we talk about certain things. Here we talk about something that is the objectives of
working capital. Why we need the working capital? Management. Why we want to manage the
working capital? What are the different objectives of managing the working capital?
It is written here, the major objective of working capital management is to manage the firm’s
current assets and current liabilities in such a manner or in such a way that satisfactory level of
working capital is maintained. Optimum level of the working capital is maintained which means
optimum investment in the current assets. I am using the word neither less nor more, optimum
investment in the current assets. So how much you require?
You maintain that much level of inventory, that much level of credit sales, that much level of
cash, that much level of marketable securities not more; adequate liquidity. Because we are
raising the funds from different sources like current liabilities, spontaneous finance, short term
finance. Spontaneous finance becomes due to be paid after say when the credit period allowed by
the supplier ends.
So when the supplier’s credit period is coming to an end, you have to make the payment. If you
are not making the payment on the due date you are not considered as the efficient manager. And
that supplier, relationship with the supplier will sour and that supplier may also start feeling that
this firm is not a good pay master. They are not making our payment on the due date. So it will
spoil the reputation of the firm.
And when you can make the payments on the say at the time when they become due, when we
have the adequate liquidity where adequate liquidity means sufficient amount of the cash. But it
should not be excess liquidity. Keeping excess liquidity is expensive. Keeping lesser than the
required amount of liquidity is again expensive negatively. Because then the firm would be
would not be able to make the payment on the due date and that would be considered as
technically insolvent.
Any firm which is not able to honor its obligation on the due date is considered as technically
insolvent firm. So we have to have optimum level of current assets. We have to have adequate
liquidity and at the same time marginal return on investment in current assets should be more
than the cost of funds. Now how to do it? It is only possible, marginal ROI in current assets
should be more than the cost of funds.
So only in case of your spontaneous finance and short term finance you can keep ROI more than
because you can pass on that cost to the buyer or if you are keeping inventory that inventory cost
can be added to the total cost of the product but to a certain extent. If it is the borrowing is from
the long term sources and 20% if you would like to add as the inventory cost or maybe as a cost
of credit sales nobody will be buying the product of the firm maybe on the credit because the
cost is very high and price is because of the cost is very high.
So we would not be able to sell it even on credit. So we have to keep the cost under control and
last objective is maximization of the firm’s value. Ultimately, maximization of the firm’s value
that if you are managing your upper part of the balance sheet properly your long term assets and
liabilities. If you are managing the lower part of the balance sheet efficiently the current assets
and current liabilities then only the firm’s value will be maximized because the profits will be
maximized and overall the return on investment will be maximized and the value of the firm will
be maximized.
Now we have some other concepts relating to the working capital say we talk here about working
capital management or maybe the over capitalization of the working capital, under capitalization
of the working capital, or the zero working capital and fourth one is the negative working capital.
I just talked to you about the negative working capital. When you keep the current assets lesser
than the current liabilities and the current ratio is 0.8:1 it means your current assets are just 80%
of your 100% current liability. That is a negative working capital. Similarly, over capitalization.
When you are keeping the current ratio as say when you talk about the current ratio in the you
are keeping your current ratio that is the very high current ratio.
And if you are keeping the current ratio very high it means if the current ratio is 2:1 in that case
what is happening. Your cost of the funds will be increasing and if the cost of funds increase
then what will happen? Your say 2:1 current ratio is 2:1.
Current ratio is 4:1. Current ratio is 3:1. It means you are keeping 2 times of the current assets as
compared to current liabilities. You are keeping 4 times of the current assets compared to current
liabilities. You are keeping 3 times of current assets as compared to current liabilities but it will
amount to increased financial cost, increased financial cost and that is not in the interest of the
firm because every cost has contribution to the total cost.
Production cost, raw material cost, product manufacturing cost, then your human resource cost,
then your selling and distribution cost. Similarly, you have the financial cost. So you have to
keep the financial cost as low as possible. So if you are keeping your working capital at a very
high level, 2:1 or 4:1 or 3:1 is the current ratio you are maintaining, so you are over capitalized.
Under capitalized for example when you talk about the under capitalization.
Under capitalization means that when we are keeping the level of current assets that is very low.
Say for example you need to have inventory of certain level. We say that you have the need the
inventory, all the times you need the inventory of 100 Rs, you should be selling 20% of your
production on the credit. You should be having say cash with you all the times 100 Rs then you
can need to make the 50 Rs as advance payments.
This is your optimum level of maintaining the current assets right. But for example you are
keeping the inventory of say 70 Rs. Then you are selling on the credit say for 5 Rs. Then you are
say keeping the cash of say again 70 Rs and then similarly you talk about your advance
payments you are only able to make the advance payments to the extent of 30 Rs.
So it means against this much level of desired level of current assets if you are keeping this much
level of current assets you are under performing. Your working capital it is not a negative
working capital I would say. It is the positive working capital but it is under capitalized.
Optimally capitalized is this level and if you are keeping this level it is the over capitalized. But
if you are as I told you if you are keeping the level of current assets is 200.
Similarly if you are selling the for the credit is for 40 Rs. If you are say keeping the cash of 200
Rs and if you are making the advance payments of 100 Rs it means you are keeping this much
level of current assets against this much level of current assets. So this is the optimum level of
current assets. This is the under less than the optimum level of current assets and this is the say
the firm is over capitalized.
Then the current assets are too much as compared to the optimum level. So it means in this
situation this is not good. This is not desirable situation for the firm. So what you have to do is
that you have to maintain the optimum level of current assets all the times. As we have seen in
case of the objectives of the working capital that the important objective of the working capital
management is that we have to keep the optimum level of current assets.
And if you are maintaining the optimum level of current assets in that case we are optimally
working capitalized and if you are keeping the optimum working capital it means everything is
under control and we are say progressing optimally. Now short term versus long term financing
are risk-return trade-off. I have been talking to you in this lecture as well as in the previous
lectures also that we have to keep the cost of funds in mind.
So to manage the cost of funds we borrow from the spontaneous sources then short term sources
and then from the long term sources. But both the sources have pros and cons. If you are
borrowing from the spontaneous finance it is a self-adjusting self-liquidating source of finance
and he is giving you the credit only for a few days or maximum for a few months. Some supplier
may agree, I told you that credit period in India is 45-60 days.
If the firm is very efficient having a good reputation in the market they may be able to have the
credit period for a period of 30 days, 60 days sorry. But if they are not that much credit worthy,
nobody would like to give them even a credit for 30 days. Or if you are in between you can have
the credit for 45 days but maximum after 2 months you have to make the payment to the
supplier. So we have to keep the certain amount of cash ready all the times.
And if you are not able to make the payment to supplier on the due date, it will spoil the
reputation of the firm. So it is said in the financial literature or in the business practices that if
any payment is due to be made to anybody say on 5th of December morning it is better to make
the payment on or in the evening of the 4th of December rather than delaying it to the evening of
the 5th of December. Means the payment was due to be made on the in the morning.
The cheque should have been dispatched or the cheque should have been reaching in the
supplier’s office in the morning of the 5th of December. But you said that we will send the
cheque in the evening. They will not okay what makes the difference? We have to make the
payment on 5th of December. So it means is it does not make the difference whether we make
the payment in the morning, or in the evening, or maybe today or maybe tomorrow, does not
make the difference. But that makes the difference.
If any payment is due to be made and if the supplier is waiting that at 10 o’clock I will be
receiving the cheque from my buyer or to whom I have supplied on credit, he will be sending me
the cheque for say 1 million rupees, 10 lakh rupees and if you delay it just without any reason
that okay there is no difference sending the cheque in the morning or making the payment in the
evening, that makes the difference. You should be very careful.
So it is the to be financially disciplined organization it is better to send the payment in the
evening of the 4th of December rather than delaying it from the morning till the evening of the
5th of December. That much of the delay is also not expected, is not warranted, is not desirable
in the business operations. So means under the spontaneous finance though it is the cheapest
source of finance, lesser costly, least costly source of finance but it is you have to be very careful
while maintaining the liquidity and making the payment to the source.
So it means what is the positive, that the cost of the funds is least under the spontaneous finance
but the negative part is that you have to maintain the proper liquidity and if you default in
making the payment it will spoil the reputation of the firm. Now go to the short term source of
finance. In the short term source of finance we borrow the money from the banks or financial
institutions for a period of say minimum 6 months.
Or short term source of finance means the funds are provided by the source or by the financial
institutions including banks for a period of 1 year. So if you borrow money from the bank for a
period of 1 year or maybe for 6 months, at least for 6 months you are relaxed. You can use those
funds for 6 months and after 6 months you have to return the short term loan so it means that
much of hurry is not there as it is there in case of the spontaneous finance.
And in case of the long term source we have borrowed the money for 5-10 years so it means
regularly we have to pay the interest and we have to send the installment of the long term finance
maybe 6 monthly or maybe say quarterly. So that only installment is going. You are not to pay
the 100% loan back to the source so that luxury is there. But the negative part is cost of the long
term funds is very very high.
So it means both the sides are there. Both the sides of the coin are there that pros and cons go
with the sources of the funds. So if sometime cost is lesser then we have to be careful we have to
maintain the proper liquidity and make the payment on time. If the cost is high so some means
we can be relaxed for some period of time that okay that is not going to be paid now, it is not
becoming due now, we have to make the payment after some period of time.
So we will make it and we will make the arrangement of the funds. So it means ultimately both
the sides both the extremes are not good. Both the extremes are not good. So what we have to do
is we have to have a trade-off. You have to take the some positives of the one source and you
have to say deal with some negatives of that source. It has to be a trade-off. You cannot afford to
have total working capital finance from long term sources.
You cannot have or you could not afford to have total working capital finance from the short
term sources or from the spontaneous sources. So it means you have to have the mix of the
sources. Partly it is coming from spontaneous, partly it is coming from short term, partly it is
coming from the long term. So ultimately, we will have to have a trade-off because if you are
minimizing the cost you are maximizing the risk and if you are minimizing say maximizing the
cost you are minimizing the risk and both the extremes are not good.
So why not to have the path in between, that which is good for the firm also, we can maintain it
also, we can manage it also and we can keep the cost under control. We can keep the liquidity all
the times available with us so that technical solvency is also maintained, financial cost is also
under control and ultimately the desired amount of the profit is also earned and that is also
expected to be earned.
So when you talk about the trade-off between the profitability and risk so it means here we have
to deal it from the 2 angles. Say for example if you are funding large say chunk of your current
assets from the long term sources I told you just that the net working capital means that is the
difference between the current asset to current liabilities. That difference between the current
asset and current liabilities will be something like that.
If you say if you are borrowing money and if you are maintaining the current ratio of 2:1 and
other side you are maintaining the current ratio of 0.8:1. Choice is yours what you want to do. If
you have this so what will be your net working capital? That will be 1; 2-1 is the 1. Here it is
your negative capital is - 0.2. In this case, risk is very high. In this case, the risk is very low
because you have double of your current assets to pay the current liabilities.
So if you first you will utilize the cash. Then you utilize the marketable securities. Then you will
go for collecting your credit sale bills and if all these things are fully exhausted then the turn of
the inventory will come which is I think the farthest most. That need does not arise. You are
most comfortable because you have kept two times of the current asset as compared to the
current liabilities.
But in this second case you have kept as only your current assets are just 80% of your current
liability. So how careful you have to be. And if you are managing the financial cost in one, you
are maximizing the risk and in the second case if you are minimizing the financial cost you are
maximizing the financial cost, your risk is low. So in this case so what is happening that the 2
parts of the working capital story is higher the net working capital lesser the risk but the
profitability is low.
And second case is low net working capital higher the risk but the profitability is higher. So in
these 2 approaches we have the 2 extremes.
And once you have the 2 extremes so it means extremes are always bad especially in the
business extremes are always unmanageable. They are bad. So why not to have a trade-off. You
pick up some good parts of the one, something good and you took the take the say some good
part of some other something else and then you mix up the good parts and finally you will be
having a middle path. That is called as a trade-off.
It means not to resort to the extremes but to have the middle path and then to picking up the best
of the two things then we will try to create a theory or use the theory or approach a working
capital so that we can keep the risk also under control. We can keep the profit also at the
acceptable level and finally the overall profitability of the firm is not affected negatively, rather it
is affected positively. So what is the trade-off, how to have it, and what is the benefit of this
trade-off I will discuss with you in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture-30
Management of Accounts Receivables-III
Welcome students so in the process of receivables management we are talking about the
distribution channel and in the distribution channel to understand whether we should go for the
direct marketing or we should go for the indirect marketing. But channel of distribution we
should select and we should say work with that let us understand with the help of an example
that if you go for the direct marketing how it is going to benefit us and if you go for the indirect
marketing how it is going to benefit company.
Because ultimate objective of the company is to maximize the ROI Return on Investment and
where ROI is maximized that should be the preferred mode of distribution channel of distribution
of company’s products in the market. So, we will have to evaluate the two different channels and
let us see that if company goes for the direct marketing what will happen when company goes for
the indirect marketing what will happen. So, we have situation like we have information here
that there is company which is manufacturing about say how much units?
Number of unit’s they are manufacturing in the market in a given period of time or maybe in a
year is 360 right. And investment which the company has made that is in the manufacturing
assets investment in manufacturing assets the company has made is that is, may be assume the
smaller figure 20000 rupees and company manufacturing 360 units in a year.
And in this case the cost of production when you talk about the cost of production per unit
is, cost of production is rupees 100 per unit. And the selling price which the company can fetch
from the market or company can sell the product in the market is that is rupees 150 right. Now
there are two channels possible company can go for the indirect marketing also or company can
go for the direct marketing. Now the company goes for the indirect marketing it means if the
company prefers to sell the product in the market through indirect channels or through indirect
marketing channels.
So, there is a possibility that company can sell the product in the market at 10% trade discount.
Company can give the 10% trade discount on selling price to a distributor or to a retailer and the
product can go to the market this is at the 10% trade discount the company can sell the product
and the credit period which the company has to give in this case is, credit period will be 2
months company has to give the credit period of 2 months.
So, at the 10% trade discount product can be sold in the market and credit period has to be given
is 2 months. This is the information available if we go for the indirect marketing was selling the
product in the market entire production can go to the market at 10% trade discount to be given to
the channel and then he would be requesting for a credit period of the 2 months. There is another
method also that direct marketing. If companies prefer to go for direct marketing they can have
their own exclusive marketing stores in that case what they have to do is they have to make
further investment.
One investment which they have made is the investment in the manufacturing assets 20000
rupees and their make the; to make the further investment under the investment in manufacturing
assets; marketing assets may be they have to make investment in the store or may be creating the
network it has a cost and that investment is to be rupees 4000 which is additional investment this
and this investment will be that you can see it is the capital investment.
And additional marketing overheads which is on the recurring basis marketing overheads will be
how much rupees 3000 they have to incur additional cost of say marketing of overheads will be
3000. But credit period will come down to 1 month credit period will come down to 1 month. So,
here we are selling the product selling price is 150 which is decided by the market. Our cost is
100 and when we are selling into indirect marketing they are giving the product and 135 rupees
to the channel.
And channel is selling for that the product in the market and the credit period which the channel
is asking for his 2 months. If you go for the direct marketing the product will go to the market
and 150 rupees and we have to make some additional investment in the marketing assets also and
some marketing overheads we have to incur which is 4000 and 3000. But the major advantage of
that is that credit period will be half that will come down to 1 month.
Here, one important information which I am not sharing with you is, I will add up later on that is
the cost of say getting the market information or the credit information or the customers
information that cost is we have to consider it later on. But let us see evaluate this situation the
first of all we go for the say indirect marketing.
When we go for indirect marketing this channel if we are selecting so what will happen? What is
the market price market? Market price per unit is, rupees 150 and how much are a trade discount
less trade discount we are giving at the rate of 10%. So, that will be how much that will be
somewhere 15 rupees so it means finally net sales price would be how much net selling price
will be how much that is 135 rupees. And what is the cost of the product less cost per unit cost of
the product of the cost of production per unit is 100 rupees.
So, it means you have how much the operating profit per unit is operating profit per unit is
rupees 35 operating profit per unit is rupees 35 right. This is the operating profit available and
how much is operating profit on a 360 units, operating profit on total production or total output
this is how much this is a 360 units multiplied by rupees 35 this works out how much this is say
rupees 12600 right. This much of the operating profit on the total annual sales is available to the
company.
Now we go to the other part of the other side of the story that how much investment is required
to meet in this case or this channel of distribution if you want to go for the investment accounting
for the investment so it means here investment in the manufacturing assets investment in the
manufacturing assets is how much rupees 20000 we to make the investment of 20000 which we
have shown here.
This investment of 20000 we have to make in the manufacturing assets that is going to remain
the same in both the channels direct or indirect one. And then what is going to be the additional
investment here. Additional investment we are making here is that on account of the investment
in investment in accounts receivables or sundry debtors that is going to be how much that is
going to be something like 360 into 135 into the say how many months 2 months 2 by 12.
If you think this is going to be the investment here. So, this will work out as how much 8100. So,
total investment will be how much? If you take the figure of the total investment total investment
is going to be in this case is 28100 right. Now let us calculate the return on investment so it
means if you calculate the ROI let us see the ROI that is return on investment that will be how
much after profit is 12600 and other investment is 28100 so the return on investment for the
company is how much if you calculate this, this works out as 44.884 % multiplied by 100.
This is 44.84 % if we are going to sell the product in the market through the indirect channel
where we are going to manufacture say the marketing market price or maybe the selling price per
unit may be something like 50 you can write it as the selling price also. So, selling price per unit
is going to be something and then we have to; this is the selling price per unit is 150 trade
discount is 15 given to the channel.
So, net price for the company's 135, cost of production of the company what we were assumed is
100. So, operating profit per unit is 35 operating profit on the total output is 360 into 35 is
12,600. Now let us talk about the investment when we walked out the investment two
investments are required to be made investment in the manufacturing asset investment in the
accounts receivables.
So, when you compare the operating profit with the investment we arrived at conclusion that the
total investment you are going to make here is that is of 28100 and operating profit or ROI
available is 44.84% this is the one part of the analysis of the calculation. Then we see the
valuation of second channel that is the direct marketing.
If company goes direct marketing channel right directing marketing channel if the company goes
for again selling price per unit that is rupees how much 150 right and less cost selling price is
150. And here now we will be called less cost, now the cost will becomes cost of say cost per
unit here the cost per unit is it means we are not talking about now the cost of production. We are
talking about that earlier the 15 rupees difference which was going to the; which was going to
the distribution network now it is being retained by the company.
So, we are assuming that remaining amount that 135 is a cost per unit and that is 135 so it means
return per unit is extra 10 per unit is how much return for unit rupees 15 and how much is a gross
return? Gross return is going to be 360 units into 15 so that is going to be something like 5400
rupees. Here what we see that when we go for the direct marketing we have to make an
investment in the revenue or in the recurring expenses also. So, at or would say here gross return
is 5400 here.
But now here we have to make our cost will increase, so in this case what we will do here we are
going to incur some additional expenses on the marketing overheads so you have to subtract that
less marketing overheads and if you subtract the marketing overheads of how much 3000 rupees.
So, your returns capital in operating profit becomes how much? Operating profit is operating
profit is 2400 we are left with 2400 rupees.
Now we talk about the investment part how much investment we are going to make. So, let us
talk about that part investment part and if you see the investment in case of the direct channel,
how much investment we are making investment? We are not talking the manufacturing
investment that is already made that is common in both the channels 20000 rupees we are not
talking about.
When we are going to sell directly in the market what additional investment we are going to
make here and that will be say capital investment first thing is the capital investment in the
marketing assets. How much that investment? We are assuming that we are going to spend extra
4000 rupees to create the marketing assets of the exclusive stores. And second investment where
is going to be how much that is investment in the receivables.
Accounts receivables are going to be how much they are going to come down to one month from
the two months. So, it means that will be how much that is 150 rupees selling price 150 mind it
now. And this is 360 number of units divided by 12 so this will come down as this will be come
as how much 4500 rupees. So, it means how much is a total investment both in the marketing
assets and in the accounts receivables.
Total investment is going to be totally investment is 8500 this is investment here. So, now let us
calculate the ROI, if you calculate the ROI, in this case we have found the ROI here is 2400 and
divided by 8500 into 100, so this is how much is 28.24% this is the new rate of return. So, now if
you compare from this information only, if you compare the two channels we find the direct
marketing is less productive unless profitable as compared to the indirect marketing where we
have the ROI which is much higher that is 44.84 %.
So, I think we should go for the indirect marketing but the decision does not come here we will
have to go for the further analysis also.
Say for example the important benefit which I have discussed with you is that the major benefit
of the direct marketing is that is the cost of the credit information or you can we talk so it about
that is the cost of the say the market information. When you talk about the cost of the credit
information or the market information in that case when we have directly selling in the market
the information about company's product about the customers requirement about any kind of the
changes in the product, design, quality price or any kind of the customer’s choice is there directly
available to us right.
We did not to spend anything extra on that but when we sell indirectly in the market that what
happens we are manufacturing somebody else is selling in the market and customer is at the third
level. So, when the customer wants to communicate anything to the company, company has to
depend upon somebody either the distribution network. Since the distribution network is selling
the products of many companies same product of many companies.
So, it means sometime the correct information reaches to some company sometime the correct
information does not reach to the companies. In that case they have to spend some extra money
companies were selling their products in the market they have through indirect channels they
have to shell out extra money to get the customer information. Regularly companies keep on
conducting that customer service or the market survey and their specialised companies specialise
firms are there who are into the marketing research.
And companies depend upon them and they had to spend lot of money in say getting that desired
information for making their project product as the best acceptable product in the market. So, in
our analysis we make some changes and we see that for example when they are going for the
when we are talking about the cost of market information cost of market information when you
talk about the cost of market information which includes the credit information also.
In case of the indirect marketing the cost is rupees 1800 right and in case of the direct
marketing the cost that cost comes down to 300 rupees that cost is still there, but not very high ,
so there is a clear cut difference of how much rupees 1500 in both modes. When we are going for
the direct marketing we are saving how much money that is 1500 rupees we are going to save up
on. So, that will be adding up on the return on investment of the company.
So, here how much we have here this of operating profit is 2400, so in this 2400 rupees in case of
direct marketing if you are going to add this 2400 rupees into this 1500 also so this is becoming
how much 3900 and this is 3900, now if you compare this that is 3900 is the operating profit
against 8500. So, finally I think what is going to be return that the return is going to cross the
limit now and this will be now 45% or 45.88% or almost 46%.
Now this is becoming 45.88% and in case of the indirect marketing it was 44.84% so it means
we are saying that it is better for us to go for the direct marketing and not to depend upon the
indirect marketing. But in this case when we are talking with indirect marketing this return is not
44.84% because you missed out one point here that see, when they are selling through two
channels will be direct or indirect marketing what is happening here that say amount of accounts
receivables.
We have accounts receivables equal to 1 month sales in case of direct marketing. We have
accounts receivable equal to 2 month sales in case of direct and indirect marketing the only
difference. So, it means how much investment we are making in the accounts receivable when it
is the direct marketing, the investment in the accounts receivable when we are making in the
direct marketing that is 4500. So, this 4500 is constant this is a minimum investment we are
making.
When we are moving from the direct marketing to indirect marketing so what investment we are
making here that is 8100. So, what additional investment we are making here additional
investment we are making here is that is something like say 8100 this is under indirect marketing
and under the direct marketing how much we were spending this is the cost of the accounts
receivables is investment in the account receivable is 4500 right.
So, the difference comes out here is of work this additional investment which we are making
here is that is of 45 4500 we are already investing under the direct marketing here this is the
investment into the accounts receivable at this investment is there. Under this case the
investment here is 8100 so it means out of this if this is the minimum we are going to make here
how much additional investment in the accounts receivables we are making this much is the
additional investment in the accounts receivables we are making and this is say 00 and then 5, 11
-5 is 6 and then it is 7 - 4 is 3600.
So, it means information, investment we are making in the accounts receivables here additional
investment that we are making the accounts receivable here is that is only 3600. So, what we will
do here is we will have to subtract that if we subtract that from 28100 and then this in our
investment is how much investment in the accounts receivables is only we should talk about the
additional investment that is 3600, so this is 3600 so it means the difference we are making here
is 4500.
So, a total investment which we are made here is that is 28000-3600 if we calculate this amount
this will work out as how much this will work out as 00 then it is 5, so then it is 4 then it will
work out as 24500 it is not 20000 but it is 24500 so it means how much additional investment we
are making here we have not counted for that. So, final investment will be we have said here that
investment we are making in the manufacturing asset is 20000 and investment in the accounts
receivables is 8100 right.
But it is not 8100 additional investment is because of 4500 is already made an in the first
analysis additional investment we are making here is that it would call it has not this much but
only 3600 this in addition investment we are making so this amount becomes how much this
amount becomes 23600 this amount is 23600 if you compare now what is your operating profit
this is same 12600 and your investment has come down to 23600. So, it means what is now the
changed profit that is 53.39%.
And if you compare this return with the return from the direct marketing that return from the
direct marketing was this much that is returned from the direct marketing we have calculated is
45.88 % and here the return if you calculate is this is 53.39% it means we can say indirect
marketing is much better as compared to the direct marketing because of number of reasons that
you are not to make any investment into the marketing assets will be able to save this 4000
rupees.
We are not going to make an investment we will have not to make any expenses on the
marketing overheads we can save this 3000 rupees right. When we are talking about the accounts
receivables level even under the direct marketing also accounts receivables level is 4500 rupees
and in this case in the indirect marketing when you talk about we are making the no additional
investment for passing of the product to the channel and how much investment we are making
the accounts receivable that additional investment in the accounts as well we are making is 3600
rupees only.
And if you talk about this the so in manufacturing asset is 20000 and additional investment in
this is 3600 so it means total investment we are making is 23600 and from this if you compare
the return that return works out as 53.39%. So, it means we have seen here that as it was
expected there are much better results from the indirect marketing as compared to the direct
marketing. So, we should depend more upon the indirect marketing rather than of on that direct
marketing because of many other advantages of the indirect marketing.
Because here is it important to; major is we are running into is let us say building as a marketing
assets. Though we have assume it as 4000 it can be 4 crore or say 400 crore anything. When we
built up own marketing network our marketing distribution channels. Tomorrow if the market
changes are you the company loosing sales in the market. Company goes out of the market
recently was seen is Reebok is not the brand which is no more in existence. So, you can think
about those stores which were created by Reebok of the partners of the Reebok.
Now what is there fate so that may create a problem? We have made investment in the marketing
assets. But in those marketing assets are marketing assets are becoming useless. In that case it
will be a big problem for the company under indirect marketing there is no such a risk only of to
manufacture and sell in the market through the channels. So, there is a problem of the
information but that information can be collected from any other sources also. And there is
another point that when we are selling through indirect channels our receivables or investment in
the accounts receivables increases.
But that can be taken care of by many other means because in the direct marketing also some
investment we have to make in the receivables. So, we can find out that is much better to sell in
directly in the market order them directly in the market. Some people say that which is sometime
considered as a negative part in case of the indirect marketing that when we go for selling of
distributing our product in the market indirectly.
The company's destiny is locked in the hands of distribution channels companies destiny is
locked in the hands of distribution channels in distribution channels want to support the company
they can support the company if they do not want to support the company then there is a problem
sometimes. Many times we might have seen that when the companies give the incentive to the
channels distribution channels.
And when the customers come to the retailers maybe the first channel which is directly related to
the customers, we might have seen or we might have experience many times that form our place
when you go to the market or to the store or to the retailer we are made up our mind that people
by this particular product of this company. But when we reach at the store retailer of the
shopkeeper the store owner or their salesman they totally changed your mind.
And say account so much of the properties of the other products in which they are interested to
sell or pass on to the customer against the product which you have already decide in your mind
to buy. So, because of those reasons because of those factors customers buying preferences
changed and if that happens in that case ultimate it is in the hands of the retailer or the store
owner or his sales force that which companies project product they can promote and which
company's product they do not want to promote they cannot or they may not promote.
So, that kind of the situations are going to be there so companies handle these situations also by
giving extra incentives to the distribution channels to the distributors to the wholesalers to the
retailers so that they motivate the customers or their channels remain motivated so that they can
maximize the sales of the companies that normally happens.
And when you talk about the direct marketing and indirect marketing there are number of other
things also to be to be considered in mind. One thing is that say for example if the companies are
selling directly in the market we have a situation where we assume a situation here.
For example there are the 4 manufacturers right and there are the 4 customers in the market.
These manufacturers have to sell their products to the 4 customers in the market in this case what
will happen number of contacts will be how much number of contacts for contract sequence a
will be how much that is 4 into 4 that is 16 contacts will be maintained they have to be the 16
contacts not contract but it is your contacts we have to maintain 16 contacts will come up will be
appearing because will be appearing.
Because individual manufacturer all the four manufacturers had to go to the individual for
customers, 4 companies have to go to the 4 customer it means 16 contacts will arise. But for
example this 4 manufacturers sell through one distributor or the retailer in the market so what
will happen? All the 4 companies they sell their product to one distributor and all the 4
customers they can also go to the one distributor.
So, in this case number of the contacts will be 4 + 4 that is 8. So, that is again the simplification
of the selling process reaching up to the customer and selling their product in the market that is
also very positive point. It is major important or the major benefit of the indirect marketing is
the serious receiving upon the cost. If you saved up on the course seriously means if you are
going to sell indirectly in the market and rather than maintaining a full-fledged store.
If you are able to sell in directly with the help of the existing distribution channels cost of the
production distribution and marketing comes down seriously and when the cost of any product
comes on seriously price also comes down and the benefit of that lowered price or lesser price
can be passed on to the consumers and when you lowered on the price of the product same kind
of the product the lesser price.
Then their loyalty towards the company to other companies products increases. Many times you
will see that if you want to buy the Nike shoes and if you go to the retail outlet of the company
all outlet specialised company owned outlet exclusive store you find the product is expensive,
shoes are expensive. But when you want to buy the same to same Nike shoes from a store which
keeps the product of multiple companies are different companies.
There you will find the product is at the same as much lesser rate and certainly there will be the
difference in the price because in that case the marketing or the distributions overheads of that
channel are getting say distributed to the different companies and their products. If there is
exclusive store then entire has to be recovered by the store from the customer only so that is the
major difference.
And then you start selling in the market indirectly what happens your receivables will go down
sorry receivables go up investment in the receivables will increase. But there will be so many
other benefits which will certainly out smart or outweigh the investment in accounts receivables
and if a company's product is excellent and it very reasonable price in that case even under
indirect marketing also the accounts receivables level can be brought down.
So, ultimately we conclude here that accounts receivables are largely affected by the selection of
the channel of distribution and the company should decide it very carefully which channel of the
distribution they should adopt or they should use and they should sell the product in the market
by falling or by sail through which channel of distribution. So, I stopped here and then further
discussion on the receivables we will carry on in the classes to come. Thank you very much.
Dr. Anil K. Sharma
Lecture-31
Motives of Credit Sale-I
Welcome students so we are in the process of learning about the management of accounts
receivables and in the previous class we learnt about that how to select the channels of
distribution and we have seen it with the help of a small example that both direct and indirect
channels can be used by the firms for distribution of their products. But in the modern
competitive scenario it is better to use the indirect marketing channels because that has
multifarious advantages as against the direct marketing and one important thing is the reduction
in the cost which can be passed on to the consumers right.
So, now in the next the current discussion we will be now knowing something about that why
receivables are to be extended by the companies or why they should sell on the credit right. What
are the motives why company sell on the credit? See we have two side one side is a seller
another is a buyer. And both have the different motives I told you sometime in the previous
classes that the motive of seller is that he wanted to maximize the sales and when it is not
possible to it maximize the sales on cash then he can think of selling it on the credit this is a
direct one objective.
But there are different motives of the sellers so I will come to you on those say motives of the
sellers. But first we will see that what is a motive of the buyer and what is the motive of the
seller. Whether it is buyer or whether it is a channel of distribution maybe the retailer or the
wholesaler or the distributor wants the goods from the manufacturer on credit and that was that a
sales are made and the amount is collected from the buyer's. Then it can be paid back to the
company. So, let us talk first about the buyers motive that or the customer’s motive.
May be it can be anything but largely if you are talking about the customers, customers motive is
buyers motive is that he wanted to minimise the say present value of the money. When he
wanted to make the payment when he wanted to make the payment longer the credit period and
when he makes the payment after the end of the credit period at the end of the credit period so
time value of money goes down and he is whatever he is a paying to the seller or may be the
retailer or may be directly to the company he is paying much less of the price.
So, his motive is the maximization of the say you can call it from his side minimization of the
time value of money or maybe paying lesser rather than say maximizing the time value of money
he wanted to minimise the time value of money he wanted to pay less he wanted to delay the
payment and delaying the payment is directly helping him. This is the one motive that he wants
to buy the product in between if she talked about the channels of distribution by they want to buy
on credit from the manufacturer.
Because they are not sure that directly if you are buying say 100 colour TV is today from the
manufacturer and immediately they will be sold in the market they have to be stored they have to
be kept for some period of time. So, he has two options strategy can invest his own money and
then you can say keep the stock and then sell in the market and at the later date when it is
converted into sales that he can pay the make the payment.
But in many cases if not be possible so for him because of the lack of availability of the funds he
would like to buy on credit from the firm and once it is sold in the market you like to make the
payment back to the manufacturer to the company because here we have to understand one
important point, when we talk about the easy availability of the working capital finance from the
banks even in India that is possible in case of the manufacturers.
Manufacturers has a easy access to the working capital finance whether it in the form of CC
limits or in the form of the working capital loans or in the forms of say you are discounting of the
credit sales bills that is only available to the manufacturer not to the middleman and say the
channels of the middleman they have to invest their own funds. So, the formal market the
organised sector financial sector or the organised lenders they are not available to the channels or
channels of distribution or to the state distribution network.
They are only available to the manufacturer, manufacturer can have CC limit also manufacturer
can have the loans or the manufacturer can have the bill discounting facility also. But the
middleman the distribution network has two dependent be dependent upon the unorganised
sector. And when they are dependent upon the unorganised sector then the financial market tariff
is very high for them. What is a financial market tariff?
I will discuss that also but here in this case we will talk about that financial market tariff
reproduce very high for him that why would he like to buy on cash. His objective would be that
to buy on credit from the manufacturer keep it till the time it is sold in the market and once the
material goes to the customer and he pays in cash he can remit in the company's part to the
company manufactures part to manufacturer and his own margins can retain.
So, this is objective buyer want to pay minimum so, he wanted to delay the payment so that the
net present value of the money is make in the present value of the money he is the payment is
making that is minimum he wanted to minimise the present value of the payment which he is
making and that is possible after delaying the payment. As per the distribution channel is
concerned their objective is that rather than investing their own funds they should buy the
materials are the goods on credit from the manufacturer.
And after selling it in the market to the customer and recovering the cash he can pass on the
payment to the manufacture. Because for the distribution network organised funding is not
available he has either depend upon the unorganised market or even if from the banks the funds
are available they are at a very high interest rate. So, his financial cost increases that is financial
cost increases because of the increased financial market tariff then he is in trouble.
So he does not want to say be in the trouble and he does not want to say put himself in that kind
of the situation. So, his objective is to buy on credit from the manufacturer. And sell it to the
customer on cash in between recover the funds and paid back to the company and retain his
margins. These are the three important stakeholders and if say a buyers will be the distribution
network or maybe the customer.
Their objective is that they want to minimise the present value of the money which they are
making the payment may be the buyer making a payment to the distributor or distributors
making the payment to the manufacturer. Now come to the next side that is the objectives of the
manufacturer's. Why are motives of the manufacturer's, why they want to say give the credits are
they want to sell on the credit why they are extending the credit or by their creating the accounts
receivables in the balance sheet?
They have already seen that this asset is also we call it as asset but to create the receivables in the
balance sheet and generate the funds to fund the account receivable it is a cumbersome task. And
ultimate is the sales are the credit sales not cash sales. So, in that case maybe it is possible that
they are going to recover the sales fully which are made on the credit or part of the sales maybe
the bad debts also.
So, but still they sell on the credit because we have already concluded agreed upon the
discussion and finally we have concluded that selling everything on the cash is not possible in
any business world. So, we have to extend the credits a part of the sales go on cash and part of
the sales go on credit. So, why they sell it on the credit maximize the sales or maybe entering
into the new market or maybe any other objective.
So, here for our discussion I have divided the manufacturers motive into three broad
components.
First component is the operating motive second component is a marketing motive and third
component is the financial motive. One is from the operations point of view he want to extend
the credit and other is for the marketing point of you he want to extend the credit and third one is
the from the financial angle he wants to extend the credit because by say selling on credit
sometime he can maximize his return on investment that is why maximizing the sales when he is
selling on cash + credit that total sales go up.
So, his revenue increases his profits increases doing this process it takes a lot of risk. So, let us
talk about these motives in detail. First we will learn about the first motive that is operations of
the operating motive and here the reason for extending credit in the market for the manufacturer's
that there can be different situations in the market.
One is adjust manufacturing process second is because of the varying prices of the products third
is formation of the customer queues or product queues and fourth one is allow receivables. Now
he has a four options right he has four options available and which one is more suitable to him ,
which one is more useful to him, as a manufacturing he would go for that right. He will prioritise
all these options and which one is more useful and suitable to him to go for that.
So, first one is a adjust manufacturing process see when we if it is a seasonal industry then
certainly there is going to a problem and if it is a normal a product still that is subject to the
cyclical trends of the market sometime sales pick up and sometimes it go down sometime there is
a week period sometime lien period. So, in all the period he has to maintain the sales and say
when we talk about the festival season in India the sale of electronics go up.
The sale of your automobiles also go up, people like to buy during festivals. But when festival
season is not there still they have to maintain the sales. So, maybe people are postponing their
sales or they are not interested to buy but in that case means manufacturing has to go on.
Because otherwise but will happen his option is that if you want to sell on cash only he will
produce he will manufacture maximum and when the sales go down then he has to minimise.
So, he has to stop the production or he as to lower down his production. He has to minimise the
production in this entire process what he is doing he has to adjust is manufacturing process very,
very frequently. And adjusting the manufacturing process very, very frequently is not possible. If
it is not possible in that case if some production is going on at the same phase. But sales decline
in the market because of any reason then what will happen the inventory will mount and when
inventory will mount in that case is cost of maintaining and managing that inventory will also go
high. It may be possible tomorrow that whether he is able to recover that cost from the customer
of sometime it is not.
So, his option is either to adjust the manufacturing process if it is not possible to adjust the
manufacturing process then what is option either to raise the inventory or sell on credit in the
market. If he is raising the inventory to avoid the say the non recovery of the credit sales in that
case he is increasing cost. And cost is normally cost increases because of the carrying cost
handling cost all these cost. But sometime the cost is because of obsolesces also.
Some of the material is sold in the market today and sold at a later date then there is a say we can
call it as a reduction in the quality of the product, so that is the problem, so he has option either
to adjust the manufacturing process at the time of peak sales produce maximum at the time of
lean sales for the lean sales produce less produce accordingly. So, what is the option if it is easy
for him to adjust the manufacturing process he would be the first person to do that and to sell on
credit?
But if it is not possible then what is there, either to mount the inventory or to sell on credit in the
market because people are not ready to buy on cash that network distribution network is not
ready to buy on cash and in that case either to give the credit. If he is giving the credit, if he is
selling on credit so what he is doing converting his one current asset that is inventory into
another current asset in to accounts receivables.
Because of the credit sales though cash is not there, he is not receiving cash. He is converting
that into another asset. But when his converting that rather than from inventory to accounts
receivables if you prefer secretion of accounts receivables then in that case he is passing on
almost all kinds of the risk to the distribution network or to the customer. That if he is not
mounting inventory it is going to the distribution network, distributor, wholesaler or retailer then
it is his job now to maintain and to keep the stock with him.
And for example he is passing on the product even to the customer on credit to his customer not
got the cash. But he has passed on his delivered the product to the customer and customer is
bound to make the payment to him at the end of the credit period. So, the choice is always with
the manufacturer, so this is the first option that either to adjust the manufacturing process or to
sell on the credit. There is nothing useful to by building the inventary because that way he is
creating the problem for himself.
And sometimes it happens that even selling on the credit is also not possible selling on the cash
is also not possible selling on the credit is also not possible for some companies for some product
for some period of time. For the time being the problem comes in that case the option is that if
adjustment of the operating or manufacturing process is not possible then manufacture and store
then inventory will start mounting.
I am sure that you are sometime in the past also have discussed with you the story of SAIL Steel
Authority of India Limited in the late 90s when the company had to say company face the stiff
competition from the private sector companies from the Jindals, Lloyds then Essar Steel. So,
because before 1991 steel sector was used only open for the public sector players not for the
private sector manufacturers.
But after 1991 after liberalisation of Indian economy when this was opened up for the private
competition of the private players the steel sector was opened up for the private manufacturers or
private companies. Then SAIL had to face a big competition from them and as a result of that the
immediately lost market. Further market was nest by the Jindals even they were in the north also
in central India also best market went to the ESSAR and Lloyd. So, it means almost you can say
that 40 to 45 % market they immediately lost.
Now you see SAIL is a big company India manufacturing steel and having 6 plants and lakhs of
employees and a big network and big setup. So, for SAIL it is not possible to not to produce and
adjust the manufacturing process that with the sale can do but what will happen that there are
thousands of employees who were working on the regular basis. Their salaries have to be paid
they will come to office; they will come to the plant, if there is no production for this reduction
in the production.
So, what that additional work force will do, there on the permanent or the regular rules so what
the company had to do you have to continuously go for the production. But when the production
was continued but sales got declined because of her they lost the sales in the market for what is a
way out. Even if for sale people were not ready to buy the company's product even on credit. It
was not possible even for the company sell the product on credit either to the distribution
network or to the customers.
So, only option that left at that company at time to the company was that to store the product
finished goods. Finished products and ultimately that caused the mounting level of inventory and
when you see that when the production is continuous for sales have got stuck or they have half
from the 100% market earlier if it is reducing by 40-45%. Then what is happening It means is a
big problem for the company which is a very large public sector company and immediate
suddenly they lost their sales.
So, only problem to the company which the company even faced and facing even today is that
the company's financial health will get this deteriorated. And slowly and steadily the company
will become sick organisation and if that problem is not resolved as early as possible then
ultimately it may be required that company has to be closed down. So, sale is since then SAIL is
trying hard to become a profit making organisation or to see come out of the situation of the; you
called as state of sickness.
But that is not possible because Steel sector is open now for the private participation private
competition they have better product lesser price is better distribution Network and sale being a
public sector company lacks all these kinds of capabilities. So, there was a problem that despite
the fact that company wanted to extend the credits it was not possible that nobody was ready to
buy company's product on even credits only option was that production means no adjustment in
the manufacturing process possible so produce and store.
So, it means inventory started mounting that caused the sickness of the company which event
today still it is going on and even today the Steel Authority of India SAIL is a loss making
company. So, that is the problem we face so it means first option is even you are just for
manufacturing process or do something else. Second varying prices of the products see when the
company sell on credit. When some companies their first objective is to maximize the market
and retain their market position or expand the market position.
After sufficiently selling for cash when they decide to sell on the credit this is the precondition
and it has to be mutually agreed by both the side’s buyer and seller also that the product being
sold on credit will not be sold on the price as it is being sold on cash. It means the credit period
which is being given or being allowed by the manufacturer to the customer or to the distribution
network that will be loaded with their price will be loaded with the interest component which the
manufacturer is supposed to pay to the lender from where they got the funds through from the
credit sales.
And if it is their own resources it is coming from their own resources that it also has the
opportunity cost. Two prices cannot be same cash price has to be different and the credit price
has to be different. Now sometimes company gives the offer that ok if you want to buy from us
on cash will pay you delivery at this price. But you want to buy on credit will give you on this
much. So, varying prices are offered at that in that case the seller is also not at loss.
The manufacturer is also not at loss one thing is that his maximizing he sales, he is maximizing
is market or the market where he is in companies in that is retaining its market share. So, cash
sales or cash is immediately coming as the delivery of the goods takes place. But in case of the
credit sales they are loading the price basic price with the interest component which is either a
opportunity costs or the cost of the capital they have to pay which is used to fund the credit sales.
So, varying prices are there, so they vary the prices and whichever the price is acceptable to the
customer on maybe the distribution Network at that they sell the product. But in both the cases
first the company's option in sell maximum of the cash after that now when the cash buying on
the cash capacity is over of the buyer and the distribution network then after that the story of the
credit sale begins and then that is sold at the varying prices.
So it means and here also varying price means depends upon the credit period. Somebody wants
a Credit period of 10 days price will be different; somebody wants the credit period of say 1
months price will be different and the company has a standard policy of giving the credit sales
for a period and maximum period which the company has decided his 2 months then the price
will be different for 2 months.
But in every case company is able to maximize it sales retains its market share and company is
able to recover its price also that the basic price inclusive all the cost plus interest cost also so
there is no problem to the company. So, if you want no credit you pay different price you want
some credit you pay different price you want a moderate credit you pay a different price and if
you want the longest credit of 2 months you pay different price.
So, depending upon the market requirements companies opts to give the credit and that is
causing the selling the product of the varying prices. But in any case company does not want to
keep the product in the warehouse they do not want to mount the inventories. This is always
advisable to sell on the credit so that is one option available with the company this is the second
option. Third option is formation of the customer’s queues or the products queues.
Now for example if the company is adjusting the manufacturing process somehow. So, and the
production goes down because there is insufficient closing stock of the closing inventory and
immediately for example the demand picks up what will happen company has adjusted the
manufacturing process they have minimise the production and whatever the material is there in
the warehouse in the in the inventory.
If for example immediately that also goes to the market so then there will be the problem of the
customer queues. People want to buy the product as and when they wanted but the product is not
there with the company so customer’s queues will be there which is also not good for the seller.
Because it will create the out of stock on the stock out cost so that is also a not good for the for
the for the manufacturer's which means they want to go for the regular manufacturing process
sell on cash as well as on credit or some time there is a product queue.
If they do not adjust a manufacturing process what will be there, there your product queue and
product queue what will do it will mount the inventories. In both the cases company has to see
that there is no loss of reputation there is no loss of revenue there is no loss of profitability and
their ROI is maximized. Out of these first three options last option is Allow receivables. So, it
means adjusting manufacturing process is also not good. If they do it then either they will
customer queues or product queues and varying prices if it is possible.
Again then the outcome is selling on the credit that if when buying on cash capacity is over may
be for the distribution network for the customer then they would like to buy on credit and
companies have no other option but to sell on credit. So, because of this just these ultimate that
the bottom line is companies want to run their operations smoothly. Low fluctuation in the
operating process is desirable, no ups and down in the manufacturing process is desirable.
So, if this was a situation of this kind of the situation is there then they have to resort to selling
on the credit so that production is continuous sale is continuous inventory is minimum and there
is no either the customer queues or the product queues. So, operations allow credits. Second
motive can be quite interesting motive can be marketing motive. Now marketing motive is also
there because ultimate purpose of every company is to manufacture and sell maximum in the
market, expand the market.
So, if we are in one market if we want to go to the other market because they are different market
geographically also and other wise also different segment of the market demographically also
different segment of the market. So if you are in one market we will move to the other market
say we are an Indian company we are operating in currently mapping for three states.
Now we have thought that we have reached that is saturation point in 3 states. Now let us move
to the fourth state, 5th, 6th, you want to enter three more states initially the product may not be
possible to be sold on the cash and to beat the target of the company what they do they give the
credits. They develop the habit to the distributors also and among us the buyers also.
And when the people start buying this company's product that people start buying this any
companies product in the new market maybe for the first time then and if they like the product
then there is a demand for the product and after that company may reduce the component of
credit sales and company may increase the component of cash received so for example we will
discuss.
A small story of you might have heard about a product which is detergent which is washing
powder and the brand name of Nirma. Nirma then it was for the first time developed the product
was manufactured in developed by Mr. Kersanbhai in Gujarat. Initially he thought of developing
this product and he developed it also he was not sure about whether should be acceptable to the
people in the market or not. So, because he had to face a big competition from the multinational
company named HLL at that time it was HLL today it is called as HUL Hindustan Unilever it at
that time it was Hindustan Lever Limited.
So, he was expecting that at that time the largest market share of the washing powders and cakes
hospital was with the HLL or HUL. And if this kind of the product comes in the market because
at that time to the premium segment HLL was providing Surf and for the lower segment they
were providing one product which is named which was named as sunlight, sunlight. Even the
sunlight was beyond the reach of the common man.
So, that Kersanbhai thought of develop a washing powder which is a comparable to sunlight not
at least Surf and if I price it means at the lowest possible will that would be acceptable to
the people. So, he developed a product and he started distributing is free of cost. First he
distributed to his neighbour then in his own street where he was living. Then when the response
was very good he started giving it to his say relatives and some other near and dears.
And everybody responded very well response was very good who got wonderful then he started
formally selling the product in the market. So it means initially it is free sale and then when the
product was accepted and it was successful in the market now you see today then NIRMA is
where the NIRMA is a popular brand name of India. But they have started with a story by selling
the product free of cost in the market.
So, here we are talking free of cost sometime very big companies also do they start selling the
product for passing on the product to the customers free of cost or sometime then move to the
next level that selling on credit and once the product is established in the market there is a
sufficient and significant market for the product after that then they change the proportions of
cash and the credit sales. One thing is as a marketing motive to break into the new market or the
competitive market we have to sell some time more on credit less on cash and the position can be
replaced later on.
Second is monitoring and carrying cost will go up that when we are going under the marketing
motive and selling more on the credit? There has to be a specialised department of special
department to be created in the company which is known as the credit sales department. Because
when you are selling on credit you have to recover that credit sales also. So, to receive the orders
pass on the orders means meeting their requirement of the people that maintaining the total
records and then preserving the invoices.
And then say sending the notices when the payment is due if it is not paid by the buyer and then
making sure that yes on the payment is received on the due date. And all these things have to be
done the companies have to create a specialised department which is known as the credit sales
department of the debt collection department right so the cost goes up that has to be; there that
cost will go up certainly that cost will go up.
But anyway when you are prepared to sell on the credit the companies are prepared to have that
department also because selling is one part for the collecting the credit sales is another part and
people who are doing this job only for that we have to pay with the specialised department. So,
what will happen the cost of the credit sales will go up? That is why I am telling you prices are
different for the cash sales the price is different and the credit sales the price is different.
But to deal with this cost component part companies normally treat it as the promotional cost
because otherwise also the company has to spend on advertising of their product. So, partly they
can advertise it in the market and partly the cost of maintaining a sales collection department or
debt collection department plus some other costs associated with means the financial cost is used
as the loading factor to recover the cost of capital.
This total cost can be treated by the company as the promotional cost of the promotional expense
or advertising expense or maybe that every company has the advertising budget. So, that the part
which is being say required by the company to beat it say maintaining the sales collection
department or for say recovering the cost of capital that can we met and if any amount is left that
that can be used for further advertising the product in the market.
So these are the two motives operative motive and the marketing motive for selling on the credit
in the market for extending credit in the market and creating accounts receivable. We will
continue the discussion for the most important motive is the financial motive that I will discuss
with you in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-32
Motives of Credit Sale-II
Welcome students so we are in the process of learning about why manufacturers extend credit
and what are the motives. So, we learnt in the previous class about the operations related motive
that is operating motive and the marketing motive. Let us talk about the very interesting motive
very useful motive for which they maximize their sales all they sell on the credit that is a
financial motive. In this financial motive because ultimate purpose of any business is
maximization see value of the firm that maximization of the wealth and that happens to the
maximization of the value of the firm.
So, when we are selling in the market may be in cash or on credit ultimate purpose is a
maximization of return on investment and that is possible when you sale maximum in the
market.
So, financial motive is first important motive is that investment of surplus cash. Sometimes when
the companies have surplus cash in some when the companies of surplus cash they have to invest
that cash somewhere. Because keeping cash, cash is another current asset and we have already
learnt about that have keeping cash as cash is not useful it as a cost. So, it means that cash should
be moving within the organisation or out of the organisation within the firm or outside the firm if
it is in the movement it is productive if it is stagnant if it is stopped if it is not doing anything
then it only has a cost it has no returns.
So, sometime when you have surplus cash and you weighed different options where to invest that
cash then this may be very one very useful option that why not to manufacture more sell on
credit, load the credit sales with the interest factor and if they are able to load the credit sales
with the interest factor which is little more than the other options available or other avenues of
investment available then it is always useful to sell on credit.
Invest the surplus cash in the credit sales and maximize the sales, maximize the profit and
maximum the returns. First motive because we well we have surplus cash within the company
we will have to look for that way to invest its cash. If it is not desirable when to sell on credit say
for example if the buyer or may be the distribution network they are not ready to pay the interest
cost or they are paid that the interest cost which is returning back to the company.
It is much less as compared to the other avenues of investment of the cash then it is no point in
investing into the say credit sales and then increases the sales because I return on that investment
is not comparable with the other revenues or at least not more than other revenues. That it is
always advisable not to sell on credit and not to invest surplus cash. But if it is advisable or if it
is useful then this is the first motive surplus cash has to be reasonably or rational invested
somewhere and one important option is invested cash in the credit sales that has the multiplier
effect.
Your market increases your sales increase your existence in the market goes up and ultimately
your cost is recovered your say price is recovered and recovered with the profit, so companies
profit loss increase and ultimately this is a purpose of business that we use the cash as the capital
and if that is available then there is no problem and we can maximize the sales by selling on the
credit because we have surplus cash to invest.
Second reason is again very, very important and interesting reason is the financial market tariff
important reason is a financial market. Now what is financial market tariff I will discuss with
you with the help of a small example say there is a two parties one is the seller and that is
manufacturer we call that is A
And here is the buyer that is B right, A and B he is a manufacturer and he is the seller. B wants
to buy goods worth rupees 10000 from this, this 10000 from this, this is a requirement and A
says to B that I am ready to sell you but pay me on cash, I am ready to sell you for 10000 rupees
but you have to pay me on cash. He is not agreeing for the credit sales. B want to buy the product
at any cost but he does not have that 10000 rupees in cash in hand.
So, what will happen we will borrow this money borrow these funds from bank, bank is one
important player in the financial market. And bank charges 20% rate of interest and the credit
period is 3 months in this case now how much interest B will pay to A sorry B will pay to the
bank. Like borrowing 10000 rupees from the bank at the rate of 20% per annum just 20% per
annum and the credit period which he wants the credit and he want to buy the goods on credit is
3 months.
In this case if you calculate this will come out as how much 10000 into 20% into 3 by 12 right.
So, how much this works out this will work out as say rupees 500 for a period of 3 months by
borrowing 10000 rupees from the bank at the rate of 20% per annum he ends up paying 500
rupees to the bank as the interest charge. Now these 10000 rupees he will pay and he will pay to
the A. A will get the cash.
When you see A will invest that money in the bank for example he has no other option he
invested money in the market and you know it that there is a difference in the interest rates
between the lending between lending and borrowing money banks get the deposits the pay lesser
the rate of interest on deposits. And when the lend as a loan which are high rate of interest. Here
for example this 10000 rupees again go to the bank and this again goes to the bank and it is
10000 rupees A is investing in the bank and bank for example pays him 18% rate of interest on
how much period is that is 3 months and this is the situation.
So, in this case if you calculate this how much is amount works out is rupees 450. This 500
rupees which B has paid to the bank and then he paid 10000 rupees to A by boring the money
from the bank, A has invested that money in the bank and has got interest on deposits at the rate
of 18%, I am telling 18% the difference is 2 but it can be more in the practical situation. So, here
means there is a loss of 50 rupees sorry loss of 50 rupees.
This is a loss of 50 rupees to whom to both the sides rupees 50 both the sides. He paid 50 rupees
more he got 50 rupees less who got this 50 rupees financial market. This money has gone to the
financial market so to avoid the financial market tariff what they could have done is so that
nobody is losing this 50 rupees what they could have done is A rather than because A knew it
that I have to deposit this money in the bank and I will get 18%.
So, why not I should extend the credit to B and these 10000 rupees sales I will make on the
credit period of 3 months at the rate of 20% interest. So, at the end of 3 months he would have
ended up getting 500 rupees more. But he did not agree for that then you got 10000 deposited in
the bank got the return 450 rupees ultimately both lost 50 rupees in this process and that 50
rupees is going to the financial market.
Option would be better option could be that you could have extended the credit 20% by loading
20% so it means at the end of 3 month important got 10500 rupees. Now how much is getting his
getting 10450 rupees, how much is paying? He is paying 10500 rupees back to the bank better
option would have been formally remains.
That again AB, A is loading with that 20% and again B is loading with the 20 % he is getting 5%
and he is pay 5; he is getting 500 he is paying 500 or maximum if they want to help each other A
could have reduce the rate of interest to 19% he will also be 19%. In this case what would have
been the situation A is getting 475 rupees he is paying 475 rupees so to say little loss to him. As
compared to this figure there is a loss of 20 rupees but it is a gain of 25 rupees but it is a gain of
25 rupees as compared to the this situation.
He would have ended up getting 475 rupees but he has not agreed for that and got 450 rupees
and in this case he also lost 500 rupees so it means 50 rupees in this case both would have easily
agreed loading the 19% he also getting something, he is also getting something, he is getting 475
he is paying 475 of 25% of 25 rupees both the sides that could have been the better option. So, to
meet these objectives and to avoid the funds to be lost in the financial market tariff as in this case
we have seen that rupees 50 are lost in the financial market receivables or credit period they have
extended by the companies by the manufacturer's to the customers.
This is the financial market magic of financial market or this is the concept of financial market
that how we have to avoid the financial market tariff and to avoid the financial market tariff A
extend credit to B and either at the credit period which the B A wants or sometime mutually
agreed credit cost, cost of capital and for the period and so in that case is either A gets benefited
or B have to pay in anyway the 500 rupees for both of them are getting benefited by 25 rupees.
So, A is getting 25 rupees more as compared to the returns from the bank B paying 25 rupees
less as compared to the interest is paid to the bank they both could have enjoyed but nobody has
enjoyed in this case because that 50 rupees have gone to the financial market as tariff. Then is
the price discrimination people say that best way to increase the sales as well as the returns on
the sales is, you can sell it both ways cash on credit.
What is the best base you sell both ways cash also and credit also? As we discussed in the
previous class also that first objective is selling on cash and if people who are the buyers are the
parts of the distribution network, if they are ready to pay the increased price so what is the harm?
Yes firm has to calculate the risk possibility of converting those credits is into the bad debt that
has to be taken into account. We will have to evaluate the worth of that buyer.
Financial reputation of the buyer should be known to the seller and if the financial reputation is
acceptable or the credibility of the buyer is at the acceptable level is no harm because he is ready
to pay the increased price so you can easily discriminated the price and you have the justification
as a seller. I am selling on the credit I have the right to load my credit sales with interest factor
there is no point people were ready to buy on cash sell them at the cash prize.
People were ready to buy on credit price and sell them at credit price and everybody is happy in
that case that is another motive for pushing their products. Naturally we have to push the product
in the market of course is the product in the market. So, here people say that if you want to
maximize the sales or you want to avoid the situation of mounting inventories it is better to sell
on the credit always provided your buyers on the credit should be enjoying a good financial
reputation.
So, you have to rate your buyers A, B and C, A means excellent buyers and I mean excellent
reputation. B means moderate or acceptable level of financial credibility and C means poor. So,
we can have a credit policy like there is no restriction of credit to the A then here also we will
have to be say some judicious means we have to take care of all the factors. In case of the C we
have to be selective careful and we feel that we can expect some bad debts.
But even after adjustment for some bad debts, so if you if you can make the sales it is not bad.
To here you can say when you are selling to A you can charge the different price when you are
selling to B you can charge different price and since here your taking the maximum risk by
selling to C who has a doubtful credibility in the market you can increase the price. So, we are
serving the needs of both all the three customers are you sell maximum to him, you sell moderate
to him, you sell minimum.
So, that way you can manage the risk but not selling in the market on the credit. If it is possible
that our capacity is production capacity is fully exhausted and we are able to sell maximum cash
and part of the credit sales to A and to the B only. Then there is no point to sell to C that is okay
accepted. But if there is no problem in the production process and we can produce as much as
possible then certainly we should weigh this option that if the risk is wroth taking or the quantum
of the risk we are going to take.
If it is calculated risk you must take this is this risk that way as I told you that selling on the
credit and maximizing the market as the multiplier impact. Your increase prices will increase
markets increase the sales may be when we are selling to the C categories if example 5% of the
credits has become the bad debts. Then what makes the difference that be loaded with such a
high interest cost that even 5% of the bad debts are not the bad debts in the real sense.
So, you should think of; so for pushing the product in the market we can do this kind of the say
calculations. And if we are ready to seller to take the calculated risk we must take this risk that
will give us the multiplier effect and we would have many advantages by expanding the market.
Then we have the last motive that is a motivating distribution channel is a very critical point. See
in the market distribution channel distributors, wholesaler and retailer especially retailers the last
channel and directly connected to the customer.
They act as retailers agents of buyers not as agents of sellers because he is more concerned about
customer. He is more concerned about the well being of the buyer. So he would like to serve his
customer in the best possible way or in the way in which the customer feels happy and always he
remains is permanent customer, he does not become is formal customer. So, whatever he is going
to sell to him or he is going to advise to buy from him that he would always keep in mind the
buyer's interest not the seller interest.
Because sellers are multiple buyers also multiple but he can afford to lose the seller but he
cannot or he can afford to lose the manufacturer but he cannot afford to lose customer. Normally
the distribution channels especially the retailers who are directly connected to the customers they
are the agents of buyers not the agents of sellers organised sectors. In that case now if you want
to change as a manufacturer the retailers loyalty towards manufacturers if you want to shifted
from the buyers to the customer to the manufacturer then what we have to do.
We have to give him the credit we have to sell him on the credit we have to give him the option
that ok you keep the product and sell it in the market and we will give you this much incentive or
you enjoy the credit period for 2 months and after 2 months you can remit the price of this, this,
this is much of the stock back to us. From this case what can happen the company which is
giving him the maximum credit period and maximum other incentives, maximum credit period
and the maximum incentives he would like to sell that company's product in the market.
There are the companies who are not otherwise finding the market so nobody customers are not
intended to buy their products. But when we go to the market with the mind fully prepared if you
want to buy this product of this company this variant. But there at the shop of the store the seller
changes your mind set or the retailer changes your mind set you buy this once more useful as
compared to this and many times we change the decision, so, why he is doing all that.
For example if he is selling 5 companies product, if he is selling the 5 products of 5 different
companies such A, B, C, D and E there for him whether the customer wants A, B, C, D or E or
is highly affected because A is also giving him some margins B he is also giving some margins
C is also giving some margins D is also giving me some margins E also giving some margins.
But where he is having the maximum benefit you would like to puss that product to the customer
and he would like to help the company that you buy this company's product.
Why because of number of incentives and one important incentive is that his gaining maximum
by buying on credit keeping the stock, selling in the market remitting the payment after 2
months? So, it means experts say marketing experts say that is not only that you can buy the
retailers loyalty by giving the financial incentives you can buy the retailers loyalty by give him
the maximum credit, credit period also.
That is also possible you can do that and the companies who are giving him maximum credit
period or companies who are selling to the retailers or to the distribution networks on the credit
they are successful to sell more in the market rather than the companies who are not giving any
credit who are giving minimum credit for the minimum period of time then the retailer has no
incentive.
So, you would say it is your choice you go for A B C D or E he is not bother about that . He want
to sell the product make sure that customer goes with the product. He buy this this this this
product is not bother about that. So, this is one important say conclusion that by giving the
extended credit period and at the acceptable rate of interest of with the loading factor the
companies are manufacturers sometime they can shift the loyalty of the retailers from the buyers
to the manufacture.
Then he will have the reason to act as a agent of the manufacturers rather than acting as agent of
the customer. He can convince the customer so he is gaining from both the sides he is selling the
product also and he selling the product of the company which is giving maximum credit period
apart from many other incentives giving credit can also be reasons that how to maximize the
sales or how to help the retailer to change loyalty from the buyers to the sellers.
So, these are the different motives we call it as investment of surplus cash, we go sell in the
credit, financial market tariff understood, price discrimination is the one important reason
pushing the product and maximizing the sales in another reason and motivating distribution
channels for channel members is the another important reasons. These are the three important
motives buyer, sellers or manufacturers extend the credit and why they are selling on the credit
in the market.
So, first go for cash and after that credit and credit and cash both makes a total sales when is the
profit and loss account of the companies they only show the total sales did not bifurcated in cash
or credit so in that case it total sales maximization of the sales maximum presence in the largest
market and gaining or retaining the largest market share right.
Let us move to the next part and here we talk something about limitations of credit period time.
First limitation is the marginal loss consideration this limitation is such limitation which restricts
the buyer now to buy on the credit beyond the credit period because marginal cost of marginal
consideration there are now two customers two parties A and B, A is the manufacturer and B is
the buyer when you are amazing A is selling to B on the credit.
A says if you want the credit period of 2 months say introspective will be 8% and talk about the
annual. Then if you want to have the credit period of 3 months I will be charging 10% interest if
you want to have a credit period of say 4 months that I will charge the interest 12% and if you
want to have a credit period of 6 months then I will charge the interest at the rate of 18% because
he as to charge interest, so we are talking on the marginal cost consideration right.
Now here if you talk about the buyers B as a buyer and his cost of capital. So, in this case for
example we have to see that how much interest he is asking for and how much it is cost of capital
he will make a comparison. And in that case he will see that for B he is charging 8% interest. So,
how much interest I am paying to the bank for example he buys on cash then no interest, and
then there is no interest.
And if he buys on credit there is 8% interest and the credit period is 8% of the credit period is 2
months now he will compare that he is paying 8% interest to the manufacturer to the company or
to the buyer buying on the credit. Then at what rate he is getting the funds from the bank that is
6%. In this case what he will do, he would buy or borrow funds. He will borrow the funds from
the bank and then he will make the payment to the A to the manufacturer.
And then in this case she would see that what rate he is borrowing. Here it is not 6% but here the
rate of interest is like 10% rate of interest here is 10% from the bank. If you want to buy on cash
he will have to borrow money from the bank or his cost of capital for this is opportunity cost is
again 10%. So, if he is earning 10% or he is paying 10% to the bank and he is making the
payment to him on cash. So, it means how much interest is going to the back 10%.
But if it is possible to have a credit for 2 months he is sufficient if he is happy with the credit of 2
months for the credit period of 2 months and manufacturers is ready to sell him at 8%. So, what
will happen he would like to buy for a credit period of 2 months or for example here it is safe up
to 10%, bank is charging 10% and for 3 months credit period the manufacturing also charging
10%. So, where maximum we can go is maximum go up to 3 months.
But in this case when you talk about the next month it is a 4th month if you borrow the money
from the bank will charge 10% per annum where as the manufacturer is charging 12% per
annum. So, what will happen he would restrict the buyer even the buyer despite being the buyer
when we say the buyers intention is always to minimise the present value of the money he is
paying back to the seller.
He himself would say that my credit period should not be 4 months I would like to buy it for 3
months because here his cost of borrowing funds from the bank on his opportunity cost is equal
to the cost is paying to the manufacturer maximum beyond that there is a imbalance. He is
paying less to the bank and his paying more to the manufacturer, so, he himself would say any
how and if in any case for example in any situation if he has to buy the product 4 months credit
period.
In that would he do borrow the money from the bank and pay to the manufacturer. So, he would
not be asking for the say credit period of the credit for the 4th month and he would say that yes I
will be paying cash because so if he is only paying 10% to the bank rather than 12% to the
manufacturer. So, he would buy or rather like to buy on cash if it is a 4 months requirement.
Normally what he will do that his limit is credit to his buyer up to 3 months.
And that there is a limitation on the credit period marginal cost consideration because in that case
marginal cost for the buyer will increase because the loading factor in the fourth month is very
high from the manufacturer as compared to the opportunity cost or borrowing from the bank so
he would to go for the credit period of 3 months rather than credit period of 4 month. So, this is
the one important reason which is limiting the credit period to be expected or to be enjoyed by
the buyer.
And companies also have to have the reasons to load the credit sales because they have to
recover the cost of capital.
The Other important limitation is the tax conservation which is again very, very interesting and
serious consideration that consideration for that limitation of not allowing the credit period to be
extended to any limit or any extent of any number of months that the reasons for that I discuss
with you in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-33
Limitations of Credit Time Period
Welcome students so we are in the process of learning about the extension of the credit period
but there are certain limitations. And we have discussed in the previous class the first limitation
that is of the marginal cost consideration. And this limitation is from the perspective of buyer not
from the perspective of seller. Because buyer would not like to buy at interest rate when his say a
borrowing cost from the bank is lesser than the borrowing cost which is used by the seller to load
the credit sales is more.
So, in that case he would like to borrow from the bank and then pay directly to the seller. So, it
means he would like to borrow for a period where the marginal cost of getting more credit longer
credit is equal to the opportunity cost. If the opportunity cost for his borrowing cost from the
bank is lesser than the borrowing cost from the seller in that case it is better for him to buy for
that much credit period we are both the costs are equal opportunity cost or the loading factor or
the selling cost or maybe the interest which is being charged by the seller from the buyer is equal
to the borrowing cost from the banks.
In that case it is indifferent if the buyer is indifferent at that point and because whether he borrow
money from the bank and paid in cash to the seller or whether he borrows from the seller on a
credit period and allowing him to allow load the credit sales with the interest both the interest
rates are equal the costs are equal. But you would be more comfortable with the seller borrowing
from the seller or buyer on credit for that much period from the seller because he has to not to go
for any further documents when is borrowing from the bank.
So, that is the only period is the maximum period for which the borrower or the buyer would like
to buy on the credits from the seller after that if the credit period is extended in that case what
will happen the borrowing cost for the buyer from the seller will be much higher as compared to
the borrowing cost from the bank. And in that case for him it is advisable to borrow money from
the bank and then to pay to the seller after that credit period.
So, it means the credit period limitation is there and this is the first limitation from the
perspective of the buyer not from the perspective of the seller. Seller is ready to sell for any
period because buyer is of a good credit worthy is enjoys a good credit worthy position and he is
having a good reputation in the market is well off, he is financial well off buyer is there is no
problem to him. But there is a problem to the; he is a very good credit worthy buyers there is no
problem to the seller.
But the problem is to the buyer, that the buyer will not be able to save up from the cost of the
borrowing cost and buying on credit from the seller beyond a particular period of time with the
opportunity cost is less than the cost of paying the interest or buying on credit from the seller is
higher so, this is the first limitation. Second limitation we will learn about is that is because of
the tax part or the say tax consideration.
What is that let us see that part with the help of an example say for example we have these this
information is available with us and we considered the 4 credit period 3 months credit period, 6
months credit period, 9 months credit period and the 12 months credit period means is there any
limitation because of the tax factor to decide the length of the credit period. Yes there is a
problem because of that tax factor and how that promise comes up in the way.
And how the tax factor creates a problem in extending the credit from the seller side and how it
is again a problem to the buyer also means the seller is not able to sell beyond period in that case
there will be a problem to both the sides.
So, see when we talk about these limitations you were talking about the two limitations marginal
cost consideration this is a limitation to the buyer because he cannot buy beyond the given period
of time or a particular period of time is a tax consideration is a limitation to the seller because
seller also cannot sell beyond the certain period of time. So, how it is a limitation we have seen
already that is marginal cost consideration.
We have already seen that how it is a problem to the buyer and in this case we will say how is
the problem to the seller. And this is coming up because of the tax factor and selling on credit for
the period or other time period and then how the tax factor creates a problem that we will be
considering here now which is a limitation serious limitation for the seller that he cannot extend
the credit beyond the period because of this important factor which is called as tax. Let us see
when you talk about the selling on credit.
Here we will have to see that being in that case seller is selling today and he is going to receive
the funds after a certain period of time and that is it in period of time is the credit period allowed
by the seller to the buyer the funds are going to be back with him the end of the credit period .
But in India we follow the advance tax payment system it means it is assumed and it normally
happens also in the market that when any sales are made by the seller in the market whether it is
on the cash or it is on the credit seller is supposed to pay the advance tax on those sales to the
government.
So it means the Indian corporate tax system is the advance tax payment system and that is paid
quarterly after every 3 months. So, for the ensuing quarter the taxes to be paid in the beginning
that for the next quarter the taxes to be paid in the beginning of the quarter this way for all the 4
quarter the tax is paid in advance by the sellers in India and at the end of the year then the total
calculation is made that how much actual sales the seller has made? How much tax has in
advance when paid by the seller?
And how much tax was due to be paid if yes paid less tax will pay the balance tax to the
government. If he has paid more tax then the; say he is supposed to pay that he will get the
refund of the tax. So, because of this advance tax payment system there comes a problem in
extending the credit to the buyers. Because here the problem is that you see that when the seller
is selling he has to pay at the point of sales to the government one component that is called as a
tax.
So, if somebody is selling today he is selling to the buyer but he is not getting anything in return
to that because those sales are for a credit period of stay 3 months 90 days it means sale proceeds
will be realised to the seller back after 90 days around the 90th day earliest is the 90th day not
before that. So, on the point of sale but he is but he is making the payments to first payment he is
making is that is the cost of production.
He has already made the payment to suppliers of raw material, he has already made the payment
to the workers has already made the payment to all these utilities, power, water and other
overhead. So, that is the cost of production has already paid right. Second thing is because of the
advance tax payment system he supposed to pay the advance tax on those sales. At the point of
sale however the sales will be realise by him 3 months down the line.
In that case he is paying the tax on those sales also which he has not yet collected. Those sales
will be collected at the end of the quarter means after 3 months but he is supposed to pay the tax
today. If it is the system like in India if the seller is allowed by the government that after the
collection of the sales of 3 months he should be asked to pay the tax on those sales collected then
there is no problem any period can be extended by the seller to the buyer.
It is up to the buyer whether you also enjoy any unlimited period or not but because of the
advance tax payment system he is paying that tax on the point of sales on those sales also which
he has not collected in cash it means when we are selling on credit it is assumed that the sales are
made when the sale are made sales are always made on profit, profit is also earned and the part
of that profit has to be paid to the government as a tax.
So, on the point of sales, sales are made, profit is an tax is paid where as in the in the real sense
nothing has happened means only sales have taken place but neither the revenue has come not
the profit has been earned in cash only say nominal profit nothing not it has been out in cash and
if sales are made no cash received, no profit is received in cash but if the seller is supposed to
pay the tax on that in cash he has to deposit the advance tax to the government.
Then that is because of the present value of money there comes a problem in the way and how
the problem comes in the way that we are going to learn here. So, because of their problem of
that advance tax payment system seller cannot extend the credit beyond a particular period or be
on a particular date.
So, in this case we are taking the 4 time period first 3 month 2nd is 6 months third is 9 months
fourth is 12 months right. You see this that these are the particulars we have taken here and the
particulars the first particular is base price of the product, base price of the product means that
this is total cost plus profit everything is that is the base price of the product that is 10000 rupees
that is the selling price we call it as base price means the selling price of the product is 10000
rupees worth of the sales 10000 rupees worth of the sales if are to be made by a seller to the
buyer and the credit period has to be any of the 4 this options.
Then what will happen base price is 10000 or 4 period 10000 loading factor is we are taking 2%
per month 24 % per annum this is realistic factor. In the market when we make the credit sales
seller load their credit sales with this much of the credit of the loading factor within trust factor
that is 2% per month or 24% per annum. So, here we are loading those sales because we are
going to make the sales on credit 10000 Rupees are being made on the credit.
So, the loading factor is two percent per month when you are loading the sales that the selling
price of the sales we are going to make in the market that is 10000 rupees worth of the sales
which include everything that is a cost as well as profit apart from that the third thing we are
going to add up here is because sales are on credit our own credit that is the interest factor. If he
is loading with 2% per month so the loading factor comes up as a causes the increase in the
selling price from 10000 to 10600 because 600 is the interest which the buyer has to double up
on a Credit period of 3 months.
In the second case if the credit period is extended by the seller to the buyer the loading factor
becomes double because the credit period is also becoming double from 3 to 6 months. If it is
becoming still further more by 3 months then the load factor become again 3 times that total
loading amount of the total interest the seller will charge from the buyer will be 1800 and if it is
to increase up to 12 months the loading factor will go up 4 times again 2% but 12 months it
means for the whole of the year he is charging then interest at the rate of 24%.
So, it means final selling price in the column number 3 or the point number 3 final selling price
is becoming has 10600 if the credit period is 3 months 11200 if the credit period its 6 months and
11800 if the credit period is 9 months and 12400 if the credit period is 12 months or the one year
right. So, he is; this is the final price going to be decided but you see this final price is going to
be received by him.
In the first case after 3 months in the second case after 6 months in the third case after 9 months
and in the fourth case after 12 months or one year this amount is not going too received today.
This is going to receive after the period of time which we are considering and these are 4
time periods. Now subtract from this cost of sales we assume that the cost of sales is 80% say in
this case is 8000. So, that is same in all the 4 cases because cost will remain the same.
Cost of production we are talking about not the interest part and interest is different. So, cost of
production of the cost of sales is 8000, 8000, 8000 and 8000 what is the net profit selling price is
10600 cost of sales is 8000 so net profit is 2600 first case, 3200 in the second case, 3800 in the
third case and 4400 in the fourth case. Now I was talking to you the problem now it has come up
here income tax we assuming here is for example the seller has to pay seller subject to pay a
corporate tax or the income tax or the tax on his income is say 45% at the rate of 45%.
It is a assumed rate it can be anything it actually it is 30% but it is say for example let us assume
there is 45%. So, see at the point of sales where is not getting anything in cash he has already
paid 8000 rupees which is the cost of sales in terms of material in terms of labour in terms of
power in terms of water and other things. And other think he is going to pay to the government
bank in India the advance tax payment system that is 1170 that is 45% of his profit is going to be
paid by him deposited by him in the Government treasury as the advance tax.
So, how much is the profit after tax left in the first case it is 1430, second case 1760, third case
2090 and fourth case 2420 that is the profit after tax right. Now amount payable at the point of
sale how much is playing at the point of sales which is going out of his pocket. He is paying this
first 8000 rupees which has ordered spent his already paid right. Second thing is that he is paying
this 1170 in the first case 3 months credit period and this is going as advance tax to the
government.
So the total amount which is going out of his pocket is 9170 he has already paid 9170 but not
received any cash right. Now after 3 months after 3 months or 6 months or 9 months or 12
months he will receive the credit sales amount total amount right that is a cost + profit + loading
factor. So, he will receive in the first phase 10600 which is the final price, in the second
case 11200 which is the final price, third case 11800 which is the final price and fourth case
12400 price inclusive of all the inputs including profit. Now we calculate the present value of
these sales proceeds which is going to receive after the credit period and let us discount because
we have to calculate the NPV net present value. How much actually is getting that has to be
calculated because say 11 10600 received after 3 months is not 10600.
Similarly 11000 after 6 months 11200 after 6 months is not 11200 certainly 11800 after 9 months
is not the same amount and 12400 after 12 month was not the same amount. So, let us discount it
we are discounting it at the load factor again it is the interest factor cost of capital and loading
factor here is 2% we have loaded the credit sales when you are discounting it the sale proceeds
we are receiving at the end of the credit period.
We are using the discount factor that is at rate of 2% per month which is again the opportunity
cost of the seller. We are getting these factors and multiplying the sales proceeds we are
receiving at the end of the credit period with the discount factor we are getting the present value
of those sales we are receiving right. So, we receiving actually how much, we are receiving
10600.
But the value the real value present value of that is at discount factor of 2% is 9988, in the
second case against the 11200 rupees received we have actually received 9946 in the third case
against 11800 receive 9874 and in fourth case against 12000 we have received 9777. This is the
present value of the amount we have received it means in this case how much amount was paid
at the point of sale he has paid it is at 8000 is a cost and 1170 as the tax and how much is
receiving now as the present value 9988.
So, 9988 - 9170 is the net present value of the total, that is how much is a cash outflow, how
much is the cash inflow if you calculate the present value of both cash out flow and cash inflow
we calculate the net present value that way. If you calculate the net present value that way for 3
months credit period and NPV is positive, six months credit period NPV again positive but
coming down it was 818 for 3 months, 6 months it is 506 and 9 months it is 1647 further come
down NPV and at 12 months credit period it has become negative -203.
Net present value requires that any project any investment proposal is acceptable to the investor
if the NPV of that proposal is zero minimum if it is positive very good. But it should not at all be
negative. So, in this case seller is investor here because he is going to invest his money in the
credit sales. So, seller reinvesting here, he is investing 10000 + tax part on that so it means NPV
is positive he is having no problem 818 is the NPV and his happy to sell, 6 months also no
problem if is selling for 6 months credit period NPV is coming down but no problem still it is
positive.
Even after 9 months is not at all having a problem NPV is coming out as 164 positive but when
he extends the credit period from 9 to 12 months then NPV becomes negative. It means he
cannot sell for a period of 12 months on credit because at this period NPV becomes negative. It
means maximum length of the credit period in this case can be somewhere between 9 to12 is
neither 12 months and if he want to extend it then it can increase beyond 9 months because we
have a positive NPV at 9 months also.
But it can be say 10 months or 10.5 months or 11 months let see after the calculations but not at
least 12 months, in 12 months NPV is becoming negative. Then in that case any project any
investment proposal which is giving us a negative NPV with that we do not consider that
proposal worthwhile for investment so, we will not make any investment here. Now why this
problem has come as credit period is going out.
The NPV is coming down why this problem has come up here just a million dollar question now
we have to see and this is creating the problem this is the limitation here. Why it is happening
like say because you see that if you talk about that credit period here we are extending from 3 to
12 months at the important components which we have here are some of the profit and the other
sales consideration is we have to recover first the selling price that is 10000.
Second thing is the loading factor that is the interest cost for which the credit is going to be
extended up total this recovery has to be there but in this case why it is happening so because of
the tax factor because he is asked or he is supposed to pay the tax on that amount which is say
the profit is no problem. He can pay the tax but on the loading factor also he supposed to pay the
tax loading factor is his interest cost.
He should not be supposed to pay the tax on that but he is supposed to pay the tax on loading
factor also so that is a bone of contention. One problem is that and the first problem is there is a
second problem; first problem is that is because of the advance tax payment system. He is being
asked to pay the tax in advance. So, it means here at the point of sale we are saying how much is
paying he is paying at the point of sale is 9170.
He is not paying at the point of sale only 8000 if the if the system allows him if the tax system
allows him that ok you sell on credit and on the date of collection or after the collection of the
credit sales that means that is at the end of the credit period from the sale proceeds what are the
profit you are earning you have to pay the tax and you pay the tax after your sales are realized
then there is no problem at all.
That I can say that even after 12 months period also the NPV will be positive even after 12
months period also which is a very, very lengthy credit period 12 months credit period the NPV
we will be positive but because of this issue that he is going to pay the advance tax to the
government. So, he is going to shell out too important components he is going to shell out 8000
rupees which is his cost of sales.
Second thing is, he is going to pay the tax in advance on that profit which he is self as not
received in cash on that day because of the net value net present value problems if you calculate
NPV out of that the total transactions in that case will say that because of the advance tax
payment system NPV is becoming negative at the 12 months credit period, if he is allowed to
pay the tax. On the collection of the credit scenes maybe after 3 month maybe after 6 months
maybe after 9 months or maybe after 12 month in that case even after 12 months NPV will be
positive.
How let see that that is how the NPV will be like we will assume here for example what is the
gross realisation after 12 months is going to be how much is going to realise how much that is
12400 this is the amount which is going to realize 12400 going to realise that is 12400 at the
point of not at the point of sale but gross validation after 12 months he will be getting 12400 so
right.
In this case the when we talk about this total amount then less tax how much tax is going to pay
less income tax. Income tax we have already calculated here what is income tax year that income
tax in 1980. So, in this 1980 let subtract that let him pay his 1400 from the buyer then he will
make the payment of the tax which he has to pay on the on the profit income taxes 1980 he will
be paying this. So, it means net realization is how much net realisation is how much is getting
that is 10420 he paid the tax after the realisation of the sales proceeds after 12 months which was
12400.
And on that he is paying that tax that is 1980 supposed to pay on the profit which he is earning
anyway all the calculated this tax part and then net realisation to him is 10420. Now you discount
this and discounted value if discount this so this will be somewhere 10420 into discount factor is
what is the discount factor here discount factor is here that is 0.785 if you discount with this
factor, this amount will come out as say something like this 8216 net realization we can call it as
a discounted value of the realisation we have got is which is 10420.
And what is the cost of sales here is this is 8000. So, what is NPV now net present value this is
216 positive. So it means because of the advance tax payment system in India the credit period
cannot be extended beyond a particular length because of advance tax payment system after
certain period of time that net present value earned by the seller on that investment on credit
sales becomes negative because of this particular effect of the advance tax payment.
Now you see that problem is structure more aggravated because of an important thing why that
that important thing is the problem is furthermore aggravated when he has to pay the tax on this
loading factor also this 2400 here. In this case that is the time in case of your say this loading
factor 2400 is his interest cost that is not his profit. But he has to pay the tax on this loading
factor also and that too in advance.
So, because of this reason he is ending up paying more tax even on the loading factor also he is
ending up paying more tax as compared to what is earning from this interest income after loading
the credit sales. Let us see how it is happening and how it will do something like we did not here
that say for example we are talking about the opportunity cost for 12 months.
And how much is the load factor he has used at the rate of 2% per month he has total amount
which the credit sales you have added with this rupees 24 100’s that is 2400 right and on this is
being the tax at the rate of 45% how much is paying? He his paying 2400 the 45% 45 of that is
how much that works out as 1080 this is rupees 1080 he is paying. What is the total tax he is
paying out of 2400 which is his interest cost 45 % taxes paid and that 1080 out of this loading
factor has gone to the government as tax and that too in advance right.
After paying this check how much is realising? He is realising 2400-1080 so how much is come
it is coming to him, amount coming to him is that is 1320 this amount is coming to him. And if
you calculate this amount is coming to him when he is paying this 1080 at the point of sales. So
it means there is no loss of present value to the government 1080 means 1080. But this amount is
coming to him after to 2400 is coming to him after 12 months out of this has already paid 12
months back 1080 is a tax to the government.
So, in fact he is receiving from this which already is gone this amount is gone it mean is he in
fact is receiving 1320 and now you calculate the present value of this 1320 into this 0.78 what is
a factor here 7885. So, if you calculate this then this works out as 1040 what is the net present
value of this opportunity cost NPV of net present value of opportunity cost is that is 1040. How
much has gone to the government 1080 so, NPV of the opportunity cost is, if you see here the
NPV of the opportunity cost is that is rupees -40.
So, this is because of this particular problem the net present value becomes negative and the
problem is further more then he has to pay the tax on is opportunity cost then this NPV is
negative after 9 months may be not after 9 months but at the exactly at the 12 months credit
period. And we have seen already in the previous this calculation that if he is allowed to pay the
tax after the realisation of the sales after 12 months.
Then even after 12 month maybe 3 months 6 months 9 months for 12 months even after say the
period of 12 months NPV will be positive which we are seen here is 216 here and hear the reason
for this problem which we are seeing here is the NPV which is negative that is of the opportunity
cost that is a loading factor, loading factor is cost not his income and on that also he has to pay
the tax, advance tax and because of that NPV becomes negative had the 12 months credit period.
So, how much should be the real credit period? How to work it out and furthermore discussions
will be talking in the next class, thank you very much.
Dr. Anil K. Sharma
Lecture-34
Written Credit Policy-I
Welcome students, so we are discussing the problem of the length of the credit period and we
have seen in the previous class that since seller has to pay the advance tax on the sales he is
making and the profit is earning on that he has to make the advance payment of the tax because
of that the credit period cannot be extended unlimited leave. It has to have some limits because
we have seen with certain calculations here that because of the time value of money and because
of the say a tax the seller is paying on the loading factor also the net present value becomes a
negative after 9 months sorry after 12 months.
And it proves that the credit period cannot be extended up to 12 months it has to be somewhere
between 9 months and the 12 months and we have seen here that the problem for the aggravates
when the seller has to pay the tax on his loading factor also which is not his profit the prop tax is
paid normally on the profit not on the loading factor. But he is supposed to pay because that
loading factor is also added into the profit and on that also has to pay the tax at certain rate.
We assumed here the 45% tax rate so NPV becomes the NPV of the opportunity cost is negative.
So, because of that reason is a limitation serious limitation for extending the credit from the
seller side. Earlier we have seen the limitation of the buyer side. You know the question arises
that in this case what should be the maximum length of the credit period.
From this say set of calculation the set of calculations we have seen that it is point it is you see
that we have the credit period with NPV is 164 it is positive 9 months and 12 months it is
negative. So, it is somewhere here that the between this and this it is somewhere here that it is
this and up can go up to this somewhere it has to be more than 9 months but less than 12 months.
So, is there any mechanism to find out the exact length of the credit period at which the NPV
becomes 0.
Yes there is a mechanism that with the help of which we can find out that NPV is 0 that length of
the credit period will be the most suitable on the maximum credit period which the seller can
allot to the buyer beyond that it is not possible he should not do it. If is a informed seller and his
wise seller if they say making all the sales on credit and all the factors and making all the
calculations he should not extend the credit beyond that particular period of time because after
that he is not earning on those credits is rather is paying up and NPV is becoming negative.
In this case let us learn that what should be the maximum length of the credit period at which the
NPV is 0 or he can extend the credit. In this we have not been able to get the answer that we say
that it is somewhere between 9 and 12 months what part is exactly that period. So, let us see
what is that period? And let us try to learn that what is the way out? Is there any model available
which can help us to calculate that period? Yes that is all model available with us.
So, how to find out the maximum, maximum length maximum length of credit period maximum
length of credit period so, how to find it out we will have to see here, for finding out that
maximum length of the credit period, we will see here that maximum length of credit period. We
have model here this model is M, M=m + N/ N-W (n-m), this is a model with the help of which
we can determine the maximum length of credit period M=m + N/ N-W (n-m)
So this is a model what is M here, M is the maximum length of credit period CP this is thing we
want to find out. What is the small m? Small m is the credit period before the NPV becomes
negative NPV becomes negative right. In this case what is credit period? Credit period before the
NPV becomes negative NPV becomes negative at what period and NPV becomes negative at 12,
so credit period is 9 months in this case it is 9 months.
Credit period before NPV becomes negative so that time period is 9 months in this case and then
we have to find out the answer for the N. And N is the NPV at credit period m small m at 9
months means in this case it is 9 months and that is at the 9 months what is NPV? NPV at the 9
months is 164 rupees 164 that is the NPV and which will be the numerator here. And then we
have the and small n that small n is the credit period after m at which at which NPV becomes
negative.
This is CP credit period after m this is a credit period after m at which NPV becomes negative
and in this case the what is that that is 12 months. And now We have left with one thing only that
is W. W is the NPV at credit period and small n NPV that is the at this NPV at the credit period
NPV at the credit period n small n that was how much that is-203. So, with the help of this model
you can easily find out the length of the credit period that what should be the maximum length of
the credit period.
If you apply this model in our case in this situation we have seen here in this case we apply if
you would find out we have got an answer here that the credit period is somewhere between 9
and 12 months. But how much exactly is with the help of this model will be able to find out that
What is the value of M maximum length of the credit period.
So, let see and calculate that here M is the maximum length of the credit period we want to find
out so what is that 9 + 164 this was the NPV at 9 and then is the 164 is minus and here it is at the
NPV at credit period N this was how much -203 right this is -203 and into 12 - 9 so if you solve
this you will get here 9 + 164 divided by say how much because it will become positive plus so it
is 364 but I think it is going to be how much 347 is going to be 7.
So, in this case 367 right and we are multiplying it by 3 so how much it is going to be you will
get this something like 10.34 months, 10.34 months this is the maximum length of the credit
period in this case. The value of M is that is a maximum length of credit period that is 10.34
months at up to maximum credit can be extended is that is up to 10.34 months not more than
that. If you extend the credit needed him up to 10.5 months or 50 months in that case also then
NPV is going to be negative.
You can check it also that weather at 10.34 months NPV is becoming 0 or not at this point NPV
will be zero after this if we extend the credit period for more than 10.34 months even for 10.50
month in that case sources NPV will be negative. So, at this length of the credit period which is
the maximum length of credit period NPV should be zero rights. Let us apply a check here try to
find out whether NPV becomes 0 at this length of the credit period or not right.
In this case go for this first thing is what was the base price? Base price was 10000 right rupees
10000 we wanted to sell for 10000 rupees without credit period we have to sell on cash this was
the amount that will be selling for 10000 sales of 10000 for 10000 right. Now second thing is
loading factor loading at the rate of 2% per month we will call it was loading at the rate of 2%
per month that is the opportunity cost per month opportunity cost and for a period of how much
for 10.34 months loading is at rate of 2% per month opportunity cost for 10.34 months.
So, how much will that come out to be if you calculate this will come out as 2068 right. So, what
will be this? This will become the final price, this is the final price. So, how much it will be it is
12068, this will be 12068 rupees 12068 this is a final price right. Now what is the cost of sales,
cost of sales is finally it is 8000. So, how much is the profit net profit is NP net profit here is
4068 rupees 4068 and what is the profit after tax.
If we apply the tax rate income tax at rate of 45% how much is going to be that? That will be
somewhere 1830. So, so profit after tax is it is 8 then it is say 3 and then it is 22, 2238 this is our
PAT right. And amount receivable now amount receivable after credit period will be how much
12068 this is one amount receivable after the credit period or we can say that here how much
amount is payable amount receivable after so this is a profit after tax as 22, 38 we have
calculated amount receivable after the credit period is 12068.
And amount payable at the point of sale at the point of sale is so much that is going to be a
something like first you are going to pay 8000 + you are going to pay how much that tax we are
going to pay that is how much that is 1830. So, this amount is 9830 we are going to pay how
much 9830. Amount receivable after this the credit period amount receivable after CP is, that is
we have already written here that is 12068 right and discount factor now discount factor for how
much at the rate of 2% per month.
Opportunity cost 2% per month and for a period of discount factor for 10.34 month that factor is
0.8147. So, if you try to find out here the present value of amount receivable present value of
amount receivable after CP after credit period is how much that is going to be for multiply 12068
with the factor, this will work out as 9831. So, how much is the amount which we are going to
pay at the point of sales 9830 and what is the present value of this amount receivable after the
say at the end of the credit period that is 10.34 months that is 98.
So what is NPV? Is here it is 1 or it is almost 0 so verified. This is a verified amount that is here
we have to calculate here that if this is the time period maximum that is 10.34 months if we are
going to extend the credit in this case in this situation only for a period of more than 9 months
less than 12 months and maximum that is for a period of how much 10.34 months. Before this
period you are going to extend the credit NPV is going to be 0 after that even 10.50 or 11 months
11.50 and NPV certainly how much and NPV will be negative.
So, we have to find out that where NPV is 0 that is the maximum length of the credit period
which can be used or the credit period can be extended up to that limit the credit period can be
extended by the seller to the buyer otherwise it will go against the seller. He should not make
those days where the credit period is our expected by the buyer is more than the nine months or I
am sorry in this case 10.34 months
Here I would like to clarify one thing for those people who have less idea of the discount factor.
How we have calculated the discount factor here we have used the discount factor that is the say
0.817 sorry 0.8147 so we have calculated this, this discount factor is discount factor we are you
there is 0.8 147 so we have used the discount factor formula. So, it is we can use this that is Df =
1 by that is 1 by 1 + I / 12 and here we have to take the power n.
With the help of this formula we have done this discount factor see this will become like 1 by 1 +
interest in this case is 24% per annum and divided by how much 12 months and raise to power
here is 10.34 months N is 10.34 months if you solve this works out as 0.8147 so this is the
discount factor we have used here that is 0.8147, so, with the help of this discount factor because
opportunity cost is 24% per year 2% per month.
So, when we are discounting it for a period of 10.34 months here we are finding out is that the
NPV of this deal is 0 for this maximum length. So, here the cause of limitation or maybe the
cause of concern here is the advance tax payment system. If we have to not to make the payment
in advance tax payment in advance then as I told you that even after 12 months or even on the 12
months credit period the NPV will be positive.
As we have seen in the previous slides in the NPV are found that works out to 6. So, that is the
main problems that we will have to look for and we will have to restrict the credit period. So,
both the sides have the problems buyer also has a problem not to get the extended credit period
and seller also as a problem not to give the extended credit period. And here you can say that
when you talk about say 10.34 months.
Then important point 10.34 months is initially to have an idea is not exactly has to be 10.34
month. For example in this case we got an idea that the NPV is going to be negative after 10.34
months so it does not mean that exact it has to be in the terms of sale agreement of sale like that.
It can be like say 10 month and 10 days so maximum length of credit period he can say to the
buyer that if you want to buy from me on credit I can extend you the maximum credit if the
discount factor is 2% or loading factor is 2%.
And I think more than 24% per annum nobody will be able to make the payment to the seller
because at that more than that more than 24% is better for the buyer to borrow from the bank and
to make the payment to the seller and only expect the credit for a period up to the 12 months
after which the loading factor is 2% per month or 24% per year more than that is a limitation to
the buyer and in case of the period because of the advance tax payment system it is a problem to
the sellers.
Both of them are caught in certain conditions because of certain factors. So, unlimited extending
credit unlimitedly is not possible because if you are doing that if the seller is doing that is not
making any profit out of that rather is ending up making losses in the form of the net present
value. The absolute value there might be a profit what is the apps in the NPV in which we should
normally look at he is making the loss or he is not making it right.
It is not a right proposition we should not go for that kind of the business. So, these two
limitations we have seen for the buyer as well as the seller also. And we were talking about the
set and other things so we have seen here that limitations of credit period we have seen that from
the buyer's perspective also from the sellers prospective also. We have learnt that how to
determine the maximum length of the credit period we have seen in the model for that also.
And next important thing now will be learning about and talking about is that is up elements of
the trade credit policy.
There are the two important elements of the trade Credit Policy one is the written credit policy
and other is the say a credit policy of the credit limit. Written credit policy and the credit limits.
Here credit policy when we talk about that the credit extending the credit we have the different
stakeholders in the business. Management of the Company fixes the sales target to the sales or to
the marketing department.
That you have to sell this much then we prepare the overall budget for the firm or for the
organisation we say that in the coming one year or next 6 months or the next one quarter this
much of the sales you want to make in the market. Now that is a sales target which is fixed. Then
it remains maybe sometime explicitly mentioned or sometime it remains silent.
How much has to be on the cash on how much sales have to be on the credit. Now once it is only
written that the sales target is this much lacks of the rupees crore of Rupees millions of the
rupees in that case it is silent in this case that whether the sales are to be in cash or credit that
means sales are sales whether weigh on cash on credit. So, since it is not explicitly mentioned so
marketing department when will you communicate with the target by the say with the board of
the directors or maybe the companies top management.
They would be communicated that this quarter you have to sell say 1 crore rupees worth of the
sales or but 1 crore rupees worth of the goods to sell in the market. Objective of the marketing
team remains that yes we will have to achieve the target. They are little concerned whether the
sales are on cash or the sales are on credit. If sales are on cash fine they would like to sell on the
cash and that is there first choice.
But to meet the credit or some time to meet the objective for the target at some time to cross the
target or to say reach up to the target. If credit is required to be given or sales are to be made on
the credit then they would not even like to think about that. Yes they would say that somebody's
ready to buy on cash ok first you buy on cash after that we are ready to sell on the credit also and
how much credit to be given to the different buyers that is a million dollar question.
See that it depends upon the bargaining capacity of the buyer also. If some say marketing
manager goes to a distributor and he request that you this much of our product in the time to
come and he would say that his intention would be that maximum sales would like to say that
with the material is going to receive from the company that would be on the credit after that he
sells the product in the market after the sales proceeds are recovered he will make the payment to
the company.
So, marketing guy will be requested by the distributor will be impressed upon by the distributor
that you sell me on credit and after the credit will make the payment to the company. Now the
marketing department is written credit policy from the company inside if say for example if there
is no return policy from the company side in that case marketing guys objective would be that I
should achieve the target maybe on cash on the credit.
So, he may agree on any kind of the absurd credit conditions imposed by the distributor or by the
retailer or maybe sometime by the customer. It is up to him that any kind of the conditions you
can accept any kind of the credit period he can give any kind of the say loading factor he can
apply on that and you can say that ok this much of the sales you this much of the material you
buy from us on cash and the remaining you buy from us on credit and then sell that in the
market.
I will give you this much of the credit period I will be loading your sales at this much of the
loading factor because nothing is in the black and white there is no return credit policy. So, this
kind of the problems come sometime the marketing people in the in the lust of achieving the
target and quickly achieving the target what they do they extend unlimited credit we say
unrealistic credit to some of the distributors and when the material is passed on to the distributor
and further sales in the market part of those become the bad debt.
Because distributor’s intention was not to pay 100% sale proceeds back to the company. So, just
avoid this kind of situation sometime the loading factor is lesser. So, just to avoid this kind of the
problems what the company should do? Company should have a clear cut written Credit Policy
so that every sales guy every marketing guy has to follow those terms and conditions and he has
no liberty to say extend any kind of the credit on any kind of the terms and conditions.
He has to communicate the credit policy of a company to the distributor or to the customer and
the customer of the distributor has to agree of that. Because if there is no liberty there is no laxity
provided to the marketing guy or the sales guy. In that case he has to work within that given
Framework which is in the black and white which is in writing. So, this the first and the foremost
requirement for the company that they want to sell on the credit.
They can sell on the credit no problem because nobody can sell under percent of the sales on
cash back credit has to be on at some acceptable terms and conditions. It should be useful for the
buyer also but it should be a beneficial proposition for the seller also. And for that we should
have a written credit policy and the marketing staff, sales people should not have the liberty to
say agree upon any kind of the terms and conditions with the buyers and then the risk the sales
collections of the company.
So, for that there is a need for the written credit policy this is a very important requirements. So,
how to design that written credit policy there is a Framework quantitative Framework for that so
I will discuss that Framework with you maybe in the next class. It is a very interesting
framework and we can work out a score with the help of that framework that every distributor
customer or any other channel of distribution maybe retailer.
Looking at the probability of say the sales can be made to him payment will be made back by
him the profitability the company will earn after making those sales or if there is a problem in
collection of those sales from that customer from that channel of distribution channel how much
loss the particular company is going to make what is the probability of that loss and what tax
expenses the company has to make in collecting those the credit sales.
By taking into consideration all these factors there is one policy written policy can be can we can
be created and the score can be worked out while dealing with each and every individual channel
member or the customer and if that channel member of the customer touches the score or cross is
at score then only the credit will be granted otherwise if it is less than that then no credit will be
granted to the customer or that number of the channel of distribution.
So, how to work out that score and how to move towards having a written credit policy all that
has many other things also I will discuss with you in the next class, thank you very much.

Dr. Anil K. Sharma
Lecture-35
Written Credit Policy-II
Welcome students so in the previous class we were talking about the written Credit Policy that
there should not be any liberty given to the marketing staff or to the sales people to extend any
amount of the credit period as well as the say every any other kind of the decision making that
should not be left to the marketing people or to the sales people because the objective is only to
maximize the sales or to achieve the target and not to bother about that whether the sales are on
cash from the credit.
And even on the credit then what will be the position of collection of the credit sales they can be
the possibility that they are selling more on the credit so we will have to face a problem of the
more bad debts. So, as I was discussing with you in the previous class that people are experts in
the area many say academicians also research is also have emphasised up on that firms should
every firm should have the written credit policy. So, that no marketing of the staff people are
given any laxity to decide the credit period or that trade discount or anything else.
So, if it is written a component then that becomes very clear to all and becomes objective also
and the say content of the subjectivity goes down and that is much more in the interest of the
firm because maximizing the sales is important objective. But selling more on the cash or maybe
on acceptable credit terms is more important for any firm to think about that their credit sales are
collected on time collected in full and the magnitude of the bed debts for the better losses is this
is very, very less.
So, I was talking to you in the previous class as well that the firm should do something like
working out a score that we can have the credit rating of the different buyers or we can score
them or we can asses them their borrowing capacity as well as buying on the credit. And if they
attain a certain score then its fine we can extend the credit. But if the any buyer or any channel of
distribution is not attaining that scored then I think they should be denied the credit.
So, how to work out that score and how to have a objective and the written credit policy that is a
million dollar question and we will learn about that that how to develop some framework some
system that that every marketing and the sales guy has to follow that and take the decisions in the
broader perspective as well as in the largest interest of the firm. So, let us see a mechanism or the
Framework which is worked out.
And which is suggested to us by academician and researcher called Smith, Professor Smith has
worked out a mechanism very simple not very complex very simple and on the basis of that we
can work out the score on of the different say buyers. Maybe channel is a distributor wholesaler
and retailer or maybe the final buyer he as to attain certain score and if it is not possible then the
scoring can be taken a sacrosanct and that the person or borrowing entity may be denied the
credit.
You might have been seeing the these days also the banks in India they also work out some score
that when we go to seek the credit maybe for say constructing a house buying a car or maybe any
other kind of the loan we want to take from the bank. They calculate the score that is a credit
score for a every potential borrower and if that potential borrower attaining that much score
calculated by the banks on the some given or pre-specified methodology then its fine.
Otherwise it is not say possible to extend the credit to all kind of the borrowers because credit
scoring is important mechanism and we should I say rely upon that and everyone who is
involved in granting the credit sanctioning the credit must follow the instructions as well as must
follow the tradition of working out the working out the score for every borrower so that the
investment made by the firm in the credit sales is safe.
So, let us see that how in the same business terms or in case is selling the goods in the market on
the credit and extending credit to the different buyers on credit how the score can be worked out.
Let us learn about the mechanism about that, so it is very simple as I told you Professor Smith
has worked it out and suggested to calculate score. So, let us assume some particulars here some
parameters here.
And first we talk about it at some but some person want to sell something in the market on credit
and that sales amount is safe which take it has very simple amount say rupees 100 they want to
sell 100 rupees in the market on credit and return on sales ROS is expected is to be 10% right.
That is 10% that ROS return on sales is expected to be 10% and additional collection cost in the
event of default or maybe in case of the delayed payment.
Sometime what happens at the collection terms as well as the time period given credit period
given may be pre-specified. But sometime somewhere or maybe some customers on the due date
do not make the payment. So, firm has to make some extra efforts and it involve some cost issues
the notices or maybe some sending the letters calling them so people have to work on that so
there is a cost.
So, additional collection cost say let assume here in this case is rupees 1 right. Now with these
three things in mind sales of 100 rupees return on sales is 10% additional collection cost is
rupees 1, if these three things the particulars are there with us then how to calculate the credit
score of the different buyers on the credit. So, we will have to develop a framework and this can
be developed like this say we will write here something like that alternative outcomes of our
credit decision.
That if you want to alternative outcomes of a credit decision that if you want to give the credit
then how that should be decided. So, we will have to say for example we have here the
particulars with put here as the particulars. And here we have three outcomes we can say that
there can be possible three outcomes first outcome with customer pays promptly on the due date
customer pays when the it comes due date customer pays promptly.
There can be another possibility say customer delays payment and third can be customer never
pays customer never pays this can be 3 things 3 outcomes customer pays promptly, customer
delayed payment and customer never pays right these can be three things. Now under these
circumstances or 3 situations let us work out whether to grant the credit or not to grant the credit.
First we say start with let us assume firm takes decision to grant the credit grant credit. So, it is
grant credit it means what will happen, first will write here the amount. This is the amount and
amount here is customer pays promptly so what will happen. If you are going to take the decision
of granting the credit what will happen sales and profitability increased this is one. Second can
be increased collection expense because when he will delay the payment certainly we will have
to write to him making phone calls or maybe sometime if you the issue notices.
So, we have to go for the increase collection expensive collection cost will increased and that if
he never pays then what will happen we will first try what will happen increased collection
expense plus bad debts so in that situation this will happen in the first case with the customer
please promptly we sell him grant him credit on the due date he makes the payment so sales and
profitability both increased.
In the second case customer delayed payment in case the custom delays the payments what will
happen that firm has to make some extra efforts to receive the payment. So, that will be causing
the increase collection expense and in the third case customer never pays so what will happen
increase collection expense plus bad debt losses, so, bad debt losses will increase. So, in this case
first we start with something like say we will see here that first thing is that the amount.
So, we will start with the amount and amount here is that is how much amount we are selling 100
rupees to him, sales and profitability increased or return on the sales is 10%. So, it means what
will happen if we customer pays promptly so sales and sales increased 100 rupees he sold to him
on credit and profitability will increase by how much amount 10 rupees right. But if we delays
the payment so what is the additional collection cost that is 1 rupee.
So, what will happen here that customer delays the payments increased collection expense so
what happened because of the increase collection expense that 10 will be reduced minus1 = 9 we
will not receive 10 rupees as the profit or the profit will be reduced by 1 rupee because we have
to send a notices, say make phone calls we have to spend time energy everything. So, that 1
rupee will be lost the increase collection expense. So, the firm will find you receive out of 10
only 9 rupees.
And for example in customer never pays he defaults he says that I will not pay and maybe
because of any reason firm is not able to collect that credits sales. So what will happen that will
be totally a bad debt for the firm. So, but the firm will not lose that bad debt just without even
trying from loose only after trying sufficiently they will send him notice they will convince them
they will make him phone calls, they were write to him everything.
But even after doing everything if it is not possible to recover the sales from him in that case
what the firm has lost from first thing is forgone the profit means no profit is come to the firm
that 10 rupees are gone and out of that 100 rupees sale 90 rupees is the cost that cost is also not
recovered right. So, first formula direct loss is the cost and that cost you say for example 90, 90
rupees loss is there and in this case say for example the total loss is how much first is that is 1
rupee which they spent as a collection cost plus 90 Rupees the cost which is adding to
manufactured that part that is also lost.
So, finally the total loss is how much minus 91 that is 90 rupees is the cost of production and 1
rupee is the collection cost so that 90 rupees is lost in the market. What is the probability of these
three situations this, this and this situation? Let us find the probability now probability is
probability of happening this is only assume the probability on the basis of the experience of the
firm and for example the probability here is 60%.
Here the probability of happening this situation is just 35% and here the probability of happening
this is just 5 only 5% so this is the 100% this makes sound and probability what is weighted
value. If you calculate the weighted value, weighted value in this case with me how much you
can calculate the weighted value the here it will be 6, here it will be how much that is 3.15 and in
this case they weighted value will be how much more minus 4.55 this is the outcome of the first
case that if the firm takes decision to grant the credit.
There can be three possibilities customer promptly pays, customer delays the payment but pays
later on and customer never pays. So, if the customer makes the prompt payment firm is earning
10 rupees profit probability of that is 60% so weighted value is 6. If he delays the payment but
makes a payment after the delay but the firm has to spend shell out 1 rupee as a collection cost so
it means firm will get only 9 rupees as a profit not for profit is lost in the expense.
So, the weighted value of that will be 3.15 and in the third case if he does not pay entire amount
cost plus increase collection expensive will become the bad debt and that will be the increase
collection expense plus bad debt losses that will become that is the weighted value of that that is
91 and weighted value of that becomes assigning the probability which is only 5% but 5% there
that is minus 4.55.
Seconds situation can be reject credit the firm can say that no will not give the credit to this
person on this firm. So, in that case what will happen they will take a decision that is of reject
credit? So, if they reject the credit what will happen now again they will have to take the three
things and the first thing here is that is the amount, second here is the probability and third here
is the weighted value right.
So, in this case the outcome will be what rejects decision will be that lost sales and profitability
and profitability. In the second case lost sales and profitability lost sales and profitability minus
collection expense at least we save the collection expense and third case can be that is that
collection expense and bad debt losses avoided. We saved everything people are rejecting the
credit what will happen we lost 10 rupees.
We did not make in the sales we lost 10 rupees in the second case we rejected the credit, the
second option can be second outcome can be lost says we lost 10 rupees but we did not lose 10
rupees we lost 10 minus1 rupee otherwise that was not going to come to us as we have seen in
the first case that is 9. And the third case that if we are not granting him the credit and the
probability was that he will not make the payments in that case we have saved the total that is 91
rupees we have saved here.
So, what is amount we are talking about here is that is minus 10 amount is 10. Second is here
that is a minus 10 -1 that is say finally it is = minus 9 and in the third case it is 1 plus 90 = 91 that
the amount which we have saved is that is 1. So, you see the sign here is minus 91 and it is 91,
we lost 91 here that is what is minus 91, we saved the 91 here, so that is a plus 91 again there is
same probability here. So, the probability here is her gain 60 % probability here is that is 35%
and probability here is that is just 0.05 only 5 %.
So what is the weighted value, if you calculate the weighted value here this will work out as how
much that is minus 6 this will work out as minus 3.15 and here it will work out as 4.5 right. So,
these are scores finally with us again as it was earlier, these score again available with us and
here the score the same only the signs are changing. In this case it is plus 6 here it is minus 6
because we had earned profit here we have lost profit here.
When we are not rejecting the; when we are not granting the credit, in this case here the
weighted values that is plus 3.15 that is weighted value because we are earned only 9 Rupees not
10 rupees but here we have the weighted value is minus 3.5 that we did not lose 10 rupees in this
case we would have lost 9 rupees and in this situation be saved 91 rupees so the weighted value
of this is to here the sign is positive, it is negative, it is positive. It is negative.
We see the sign here it is negative which we had lost miss you would have lost in case of
granting the credit but if it turns out as a bad debt. But in the another case we have saved the total
91 rupees that is the cost of 90 plus collection cost of 1 everything is saved maybe the probability
is 5%. So, if you look at this, this is 4.55 and in this case the finally the values 4.55 earlier it was
minus 4.55. Now I would ask you to calculate the final summit it up of all the 3 this plus this
plus this how much is the value.
You again summed it up this plus this plus this how much is the value. If you will submit our
final score will work out as final score of final respective of sign the final score will work out as
that is 4.6 this is the final score the score is 4.6. So it means after say evaluating the whole thing
here we are found out here is that we have used a mechanism with the help of which we can find
out score and the score which we are worked out here on the basis of the framework provided to
us by Professor Smith.
That has been worked out as 4.6 and this way the score for every borrower or the potential
borrower can be worked out. We can think about that what could be if he is a say grant in the
credit be not grant him the credit what is going to the final score and that score will remain the
same depending upon the probabilities. Here in this framework the million dollar question is that
assigning of the probabilities.
We know that what is the amount of sales their going to make clear we know what is our return
on sales that is 10% in this case and otherwise in the practical how we know that how much is
the return on sales and we also know that what is our collection cost. Only thing is which we do
not know and which we have to be very careful looking at the past behaviour or maybe if the if
the buyer is totally new is the firm has no relationship with the with the buyer all the potential
buyer in the past then we can enquire data about his performance on his overall financial position
or his behaviour with other supplier or the other firms in the market.
On the basis of that we have to assign the probabilities. Assigning the probability is a million
dollar question here most complex task here it may be possible that the customer was good but
be assigned him very high probability of not making the payment it may be possible that
customer was bad but we are assigned him lesser probability of probability of not making the
payment of defaulting making the payment to anything may go any outcome maybe there. So,
we will have to be careful that what probability has to be assigned.
Another important question here is we have assigned only three probabilities because we have
taken the three cases. So, there can be more cases also say for example we are saying here
customer pays promptly, customer delays payment customer never pays right. These can be 3
situation with having a broadly thought off. But there can be in between situations also which
have to be practically seen.
And if not in between situations only 3 are there then the probability is a very important thing
that how much probability we have to assign in this case we are staying in the first case is 60%
which is larger than second probability which customer delays the payment and we have to
spend on extra collection cost that is only 35%. In the third case we have assigned the probability
only 5% that can be changed also.
We can make it 70 maybe 25 or maybe 5 or maybe we can have any other a set of the
probabilities. So, working out of the probability will be a very, very tedious job very serious kind
of the job which should be done at the firm level or at the senior level in the firm. So, that the or
maybe there should be very clear cut mechanism that for example look at his financial position.
So, we can assign some score on the basis of that we can think of assigning the probability.
Second thing is his behaviour with the existing suppliers in the market you can on the basis of
that assign the probability. Third thing is his existing level of the sales is making in the market
and say the customers base he has that he is serving in the market all these factors can be taken
into a count and finally we have to work out a score. Maybe we can use these three out comes,
under these three outcomes in this case for example we have worked out score which is 4.6 right.
In both the case you are totally top it works out as 4.6 in the lower part 4.6 in the upper part so it
means what the score means. Firm may finally have a written very clear cut policy that for every
potential buyer on credit. We will work out a score and that score is not permanent that is has to
be revived at every point of time because credit worthiness of the people buyers in the market
keeps on changing right. It may possible that depending upon the order size.
If he selling for a smaller amount he do not to spoil is name in the marker so he is not defaulting
so he regular so he prompt and he is very careful in making the payment but if he increase the
order size looking at his past behaviour if he can increase the order size and if he increase the
order size and firms sell him for the increased amount also and once he buys at a larger scale and
then he refuses to make the payment and if he starts defaulting.
Then there a possibility so firm has to have a clear cut policy but for every customer may be
adjusting then on the project interval and if it is a new then we have to work out a score and
credit score and on the basis of the score we will have to take decision. So, for example in this
case we have found today score is 4.6; firm may have in nutshell a policy that any customer who
has to be granted the credit must have a score of not 4.6 but at least 4.5.
If the score of any customer process or who attains the score of the 4.50 or crosses this score will
be granted the credit automatically if this score is less in case of in respect of any buyer we will
reject him the credit. Because in that case it may be possible that he will default in making the
payment we have to spend a lot in say in prompting him to make the payment or if they will be
there maybe possibility that he never pays firm cannot do anything beyond level it cannot be
done.
So, it has to be considered as a bad debt and finally we have to bear with that losses or that bad
debts. So, firm can have a written policy to the marketing force to the sales people that remains
communicated let you go to the market you talk to the different channels of distribution or the
customers you calculate the score of every customer every buyer on the credit and think that is
the score is 4.5 or above than you grant him the credit.
But if the score is less than that do not grant him the credit so that will create a create a create a
bottleneck or may be a benchmark also I would call it is a benchmark for the sales people also
for the marketing people also that they cannot take a decision blind fully and without considering
the credit worthiness as well as the past behaviour and the financial position of the customer and
the risk the firms the sales or maybe the collection of the sales that should not be done.
In that case finally they have to arrive at because if the score is working out is 4.5 then or 4.5 or
above then there is no problem I think they are quite objective and taking the decisions and he
can defend himself even despite that there can be the possibility of the bad debts are the losses
but at least sales and marketing people can defend themselves that we have calculated the score
this was the probability of making the payment this was the basis of assigning the probability to
these three different outcomes.
And finally we could make out that the score is certainly that the above 4.5 so even after that his
defaulting then it is a different issue that can be taken care of. But to the score is less than 4.5
then it should not be allowed. In the bank also they are doing like this that when we go to the
banks and like to borrow the money from the bank they always in calculator score age is the age
of the borrower is a very important criteria his income total income is also very important
criterion number of dependents on him is very important criteria.
On the basis of all these different criteria their sight some points and then the total it up. At the
borrow at age that minimum score decided by the bank on the basis of the risk profile of the
borrower all the potential borrow then only the credit is granted otherwise bank ask the borrower
that you improve your scores. If improve the score then bank find he is a good customer if it does
not improve the score then he is not a good customers.
So, here every company while selling their production in the market on credit because it is a very
hard effort of the companies to manufacture and then to sell the product in the market, selling on
the credit is not bad but it has to be secured credit. Since we are selling in the market without any
collateral you are not taking any security. If you are taking advance tax from the buyer then there
is no problem or maybe there is any other collateral we are taking then there is no problem.
But without any collateral without any security without any advance tax received from the
buyers are the channels of distribution if this thing happens then this will create a problem. Many
times what happens the companies who do not have the good rating of their products in the
market who's products are not know be like by the customers pushing those kind of the products
in the market companies take the risk.
For example you want to buy a colour TV normal if you want to buy a colour TV you will go to
the market and think of brand that is available Samsung, Sony or LG this kind of the products.
But in the market if you go in any electronics store you find Videocon is also there and Onida is
also there which enjoys lesser as a preference from the customers of the lesser rating in the
market these days of course they were the leaders in the market.
Because of that changed economic scenario their preferences has gone down so people do not
want to sometimes do not want to buy this products. So, even these products are there in the
market. So, what happens these companies to push up there sales they give the unlimited credit
unlimited period of time as a credit period to the distributors or to the owners of the stores that
you keep this product on the shelf and in the store we are supplying it to you on credit.
If you are able to sell it off in the market then you say return our part to us and then you retain
your part. Otherwise you are either we will collect the product back from you or wait for the
sales in the market. So, in that case if that kind of situation happens companies taking a
unprecedented or uncalculated or the unlimited risk because otherwise also company knows that
this product if it is not passed on to the mark on credit this has to be kept in to the warehouse.
So, this will create the in mounting in situation of the mounting inventory and inventory itself as
a cost. So, because of that reason they passed on to pass on their inventory to the channel of
distribution in the anticipation of the sales in the market. So, if that is a situation then it is a
different ball game then the firms take any kind of the risk and then the scoring does not matter.
But in the normal cases is the product is good it is acceptable it available in the market in that
case we will have to be careful in deciding to whom to give the credit.
How much credit what should be the order size and what should be the credit period all these
credit terms have to be carefully decided so that credit sales made in the market 100% of the
credit sales amount is collected it comes back to us and nothing is caught in the market. So, this
is the way how to calculate the score and how to take the objective decision and the firms can
have a written Credit Policy.
Now we will talk about certain other things also that is say credit limit. How to decide the credit
limit for deciding the credit limit we have the two different ways that is information credit limit
and the risk credit limit. So, what are these credit limits and how these credit limit can be
decided that these are the two other important things also as far as the collection of the
receivables is concerned. We will discuss these things also we learn about deciding the credit
limit also but that too in the next class, thank you very much.

Dr. Anil K. Sharma
Lecture-36
Goals and Functions of Accounts Receivables Management
Welcome students so we are in the process of learning about the receivables management and in
the previous class I was talking to you about deciding the credit limit. So, one thing is that we
learned about is that working out the credit score and after that if the if the borrower or maybe
the customer or maybe any member of the channel of distribution if the cross the desired score
4.5 be discussed in the previous class.
In that case now the question arises what should be the credit limit to him, how the credit limit
should be decided. For deciding the credit limit there is a problem that credit limit has to be in
terms of the number of days the credit period and second thing is the order size what should be
the order size up to what order size we should full fill his demand then let him sell the product in
the market return the sale proceeds of the order back to the firm.
And then we can think of sending in the second order so these are the two important things. So,
while sorting out this issue. Two important issues were raised by the people by the experts and
finally we have zeroed in on that the credit limit should be decided in two ways. There should be
to credit limits one is the information credit limit and the second one is the risk credit limit and
they are not mutually exclusive.
They are interdependent they are interrelated they are interdependent information credit limit
means when we decide about the repaying capacity of the borrower or maybe the by number of
factors are taken into consideration one we saw that we can calculate the score and one
somebody crosses the score that we have to see his financial position maybe under the score we
have already seen the financial position, financial position is good.
But another important factor to be taken into account is the liquidity position of the buyer or the
other borrow his a very good in financial terms is very good his asset liability position is very
good his overall financial performance is very good his selling too much in the market he is
making a lot of sales in the market is having huge profits is overall performance is excellent in
the market but sometime even the best performing buyers are the players in the market are
caught into a situation of the technical insolvency and simply because of the lack of liquidity.
Because he has to make the payment on the due date and it is a rule in the business world that
say if X has to make the payment to Y after period of 30 days X is the manufacturer Y and Y is
the manufacturer's by extending in the credit for period of 30 days and X has to make the
payment to buyer after 30 days because the credit period is 30 days. So, always quotes he
demands discipline demands that he should make the payment is better for him for the X make
the payment to by that he can make the payment on the evening of 29th or may be 29 day.
It is better to make the payment one day before that is on the 29th day evening or rather than
postponing it to the 31st day. For the buyer or maybe for X In this case it may be a question of
one day that he is only delaying the payment by one day how does it matter. I can make the
payment today I can make the payment tomorrow it does not matter it does not make a
difference. But it makes a difference in the business world because Y is depending upon that I
received this payment for X and I will make the payment to my supplier.
So, that supply of the raw material and other inputs remains continuous and there is no
interruption in the manufacturing process. So, because of the problem created by the tax buyer in
this case funds could not reach up to buy that is a manufacturer and finally the funds could not
reach to the supplier by his supplier right. So, this disturb the total symbiosis disturb the total
synchronisation. One is depending upon the other and other is depending upon the other is
depending upon the channel.
If there is one channel in the chain does not work well then the other all other channel get
disturbed. So, there is a disciplined financial discipline which is demanded in the manufacturing
world or in the business world that always stick to the date and make the payment on the due
date. So, when we have worked out score that only financial position was taken into account we
have not thought about that whether he is having a sufficient liquidity or not. For that purpose
even that is ok with the banks also.
When the banks decide the CC limit they also demand certain liquidity ratios and liquidity ratios
we have already seen that three important ratios there is many liquidity ratios but at least three
liquidity ratios are also worked out by the bank and in that case current ratio is the most
important ratio for the banks and banks also want some cushion because they are lending the
funds without any kind of security without any kind of collateral.
The banks want to make sure that as and when the payment will be due to be made by the
borrower to the bank the borrower has a sufficiently liquidity and for that they demand the
current ratio should be more than one It was too is 2:1 but now it is 1.33:1. So, when the firm’s
manufacturers look at the deciding of all the work out the credit limit they depend upon certain
information and that information is about the liquidity performance of the liquidity position of
the buyer.
He is very good financially but what is his liquidity on that particular day he may not have the
funds to pay to the manufacturer so he disturbs the total symbiosis. So, in that case the credit
limit is decided in terms of information credit limit. And information credit limit says that look at
the liquid to work out the liquidity ratios of the borrower and think about what is current ratio
what is his quick ratio what is his cash ratio.
So, it is within the given rules of thumb say for example the manufacturer also demands the
current ratio has to be more than one thing that case he was sure about that the total current
assets are not being finance from the current liabilities. He is financing from the long term
sources also so it means at any point of time if any current assets is not convertible into cash. He
will have the funds from the long term sources, so he can make our payment.
On the basis of that possibly or similarly you talk about the quick ratio and the cash ratio. So,
similarly we take the decision on the basis of this information limit that if say If some firm is
some borrower, some channel member distribution channel member is having a good liquidity
and having a good overall financial position is also good liquidity position is also good and he is
not solely depending upon the supplies from the manufacturers but he is investing his own funds
also in the process then there is no problem.
Then you can decide the credit limit on the basis of that information financial information
liquidity information little on the higher side. But if that is financial position is good but the
liquidity position is not good then we will have to think about while deciding the limit this is the
information limited.
Second limit is the risk credit limit credit limit is in terms of the order size. Normally when we
work out the information limit information credit limit we saw that he has a good liquidity he has
sufficient funds with him and he can make the payment on due date to the firm so there is no
problem. But that information limit was decided for a particular level of a or the given level of
the order. Say for example every month will be supplying 10 colour TV’s to a retailer or may be
50 colour TV’s to a retailer that his normal order size.
If he 50 colour TV’s from the firm Samsung on credit for a period of 30 days or 45 days so it
means he has the capacity of selling those 50 colour TV’s in the market during that period of 45
days in the market and immediately on the 45th day or 46 day morning he can remit the payment
to Samsung. So, that information is fine that is decided that limit is decided on the basis of the
liquidity and the financial performance and the information which the company has gathered.
But if the order size increased is a company says he is doing very well his excellent distributor is
excellent in the market increase credit limit from 50 colour TV’s to 100 colour TV’s, so what
will happen now that is called as a risk credit limit. Now the company the manufacturer itself is
taking a huge risk. They have increased the order size is means the borrower also place the order
and company has agreed to that of size.
This batch size they have increased the company of started supplying him not 50 colours TV’s a
month but 100 colours TV’s a month and there comes a problem. He has a capacity to sell 50
colour TV’s efficiently in the market. For selling hundred colour TV’s in the period of again 45
days maybe a problem. So, in that case he does not want the distributor of the retailer all the
customer does not want to default he wants to make the payment on due date.
But if he could not sell all the 100 TV sets in the market and if he does not have the own
recourses also like to make the payment back to Samsung in that case what will happen there is
the situation of default. Despite the fact that the channel number does not want to default, despite
the fact that companies also clear about his financial and liquidity position but because of the
increased order size that much of the liquidity was not maintained by the retailer and he
defaulted in making the payment back to the company.
So, company got the payment for 50 TV’s on the due date for the remaining 50 the payment is
blocked. So, we have to decide the limit taking into account first thing is you work out all kind of
financial and liquidity information about the customer or the potential buyer. Decide the limit
and that limit will be for a given order size so the risk level is calculated. But as the order size
from the buyer increases and company accepts to the request at that level company is taking the
extra risk for that level we have to work out the again a new limit.
Therefore 50 C TV’s yes we are ok but for the 100 colour TV’s you have to improve your
liquidity position. Then your current ratio will not work as 1.3 you will have to keep the current
ratio as 1.5 or we have to have multiple resources or your cash position must be very good. You
keep more amount as cash to improve your cash and marketable securities short term marketable
securities position and you keep more assets into the cash or the near cash forms.
We have to ask him to improve before rising is risk credit limit on raising the order size or
accepting that increase request for the order size we will have to ask him to improve is liquidity
position. So, that that risks the companies going to take is not the risk and he is able to make the
payment on the due date. So, this way we decide the limits that is a information credit limit and
the risk credit limit and before that score we have to work out which is going to facilitate had a
written Credit Policy.
Now we proceed for the next part and that part is some goals and functions of accounts
receivables management. Functions of accounts receivables management when you managed
accounts receivable we have to take into account certain other important things number one is
the credit terms, number 2 is opportunity cost and third one is receivables at the cost of that the
sales price right. Credit terms now it is important question when you talk about the credit terms
what are the credit terms normally we have two credit terms.
Credit terms include here we have two credit terms one is credit period and second is the; one is
the credit period and second is the cash discount these are the two credit terms, credit period. We
have to decide very carefully the credit period to be given to the different buyers. Normally in
the business language we write the credit terms like this 2 by 10 net 30 this is a credit term what
does mean 2 by 10 net 30 what does it mean.
That I will discuss with you but two important terms are one is a credit period and second is the
cash discount. Normal credit period for example in India the normal credit period in the
electronics are in the manufacturing sector and that too in electronics sector is say 45 to 60 days.
But that is normal credit period for the buyer who has the normal standing or the manufacturer
normal standing in the market. For the firms who are excellent performance in the market for
example these multinational companies Samsung, Sony and LG you talk about.
They are excellent performers in the market they will not agree to the credit period. They will
say they will give you the minimum credit period and the; our credit period is say 30 days. You
have to; if you want to do the business with us you will have to sell the material in the market
within a period of 30 days only that maximum is 30 days nothing else. After 30 days they are as
a security these companies as a security from the retailers or from the any bulk buyers they ask
them to say provide advanced tax to the company and the credit period is 30.
Company has supplied for example 100 colour TV’s one retailer and for a period of 30 days on
the 30th day whether he has sold those colour TV’s in the market or he has not sold in the market
company will present his cheque in the bank and they will collect the payment from his account
standard. Second option that normal credit period we are giving you 30 days but if you want to
say earn more while doing business with us we can give you some cash discount.
But in that case you will have to remit us the payment on the 10th day so it means in that case we
will reduce your credit period but we will give you discount of 2% and see in the business
language discount earned is the cash earned. So, many retailers and many a times they take it
very seriously that if I am able to sell the product push product in the market at the reduced
credit period.
I will be able to increase my return on sales or my return on investment and I am getting the
credit for example for a period of 10 days not 30 days but I am getting the cash discount of 2 %
so it means if I have to pay 10 rupees to the company I am ending up paying only 8 rupees and 2
Rupees are directly come into my pocket. So, nobody would like to forgo allow that discount to
be foregone and to be not to be enjoyed.
So, this is a very important term, so credit terms credit period normal credit period and cash
discount if both are to be given if only one has to be given then you can say normal credit period
is 30 days. But if you want to enjoy the cash discount then the credit period will be 10 days. So,
for example I have written here 2 by 10 net 30. 2 by 10 means normal net 30, 30 means normal
credit period is 30 days. But if you make the payment within 10 days you will be given 2%
discount, 2 by 10 payment within 10 days 2% discount.
But if you are not able to enjoy that discount, if you do not have the discount then you have to
make the payment was on 30th day. So, these are the two important credit terms which
everybody has to be careful about. Then we talk about some other things opportunity cost,
opportunity cost is an important part while deciding the credit sales or the limit of the credit sales
or the credit to be given.
Opportunity cost is the one which the seller has to take into account and the buyer also has to
take into account. Buyer has take into account the opportunity cost we have discussed in the
previous class that 2 classes back in the past that as we have seen the marginal cost
consideration. Because marginal coast consideration means is that what is his opportunity cost is
opportunity cost is say that he is borrowing from the bank his paying a particular rate of interest
to the bank.
But when he is borrowing from the supplier or maybe manufacturing he is paying the higher rate
of interest to the suppliers. So it is better for him to borrow from the bank and make the payment
and to enjoy the only credit period where the interest charged by the manufacturer by the
supplier is lesser than the bank rate. This is from the buyer's point of view but for the
manufacturer also is a million dollar question they have to be very carefully looked at the
opportunity cost.
What is opportunity cost for the seller see we talked about the investing the surplus funds in the
credit sales when firms seek or the manufacturer's seek cash credit limit from the banks, banks
also decide the cash credit limit at in total first and then they divided into the different current
assets this much of the CC limit you can invest in the inventory. This much of the CC limit you
can invest in the credit sales, this much you can use as cash, this much you can use this for
making the advance payments all these.
So, here opportunity cost that whatever the surplus funds maybe from the bank or form is owned
resources the manufacturer has first he would sell on cash after that he would think that
remaining to expand my market the remaining production can go to the market on credit. And I
know that if I am going to sell on credit I am going to load my credit sales with the interest
factor. Now how much that interest factor he can load the sales with normal there is a standard
percentage in the market various standard rate in the market.
For example the normal loading factor is we have been discussing in the previous class is there
2% per month or 24% per year now here if he is investing his surplus funds in the credit sales by
extending the credit to the different channels of distribution or to the customer he is earning 2%
per month or maybe if it is the credit period of say 2 months that he will be earning 4% that is
opportunity cost for a period of 2 months.
Annually that is 24% what say his otherwise opportunity cost is high because if we invest that
surplus funds in any other investment avenue for example in the stock market for example he
may be on say any other assets or any other investment he earns 30%. So, I think he would be
very serious that only limit the credit that I will give you this much of the credit, this much of the
sales on the credit and loading factor since it is 24%. So, I will be loading with 24 % but if you
want to have more sales on the credit for me you have to pay to the interest at the rate of 30% per
annum and in that case that will increase to 2.5% per month.
So, if now the buyer is ready to pay 30% per annum rate of interest or 2.5% per month then he
would extend the credit beyond that level also otherwise he will restrict the credit he should
restrict the credit because he is earning by investing the surplus funds in the other revenues is
30% investing in the credit sales is 24% but he has to invest in the credit sales also because
market has to be served both in cash as well as in credit.
So, that is fine but opportunity cost is important component and we have to see here that if we
are having the better opportunities to invest the funds elsewhere that we should go for that after
selling for a minimum amount of the credit sales or selling on credit. But if it is not there then
yes then we will have to think about that our credit terms can be little lenient or say we can have
the loose Credit Policy or we can say some relaxed Credit Policy that can be possible.
But if the opportunity cost of selling on the creditors high then the Credit Policy has to be
tightened. Third important function of the receivables management is important question that is
million dollar question that is valuing the receivables at the cost of the selling price at what
should be valuing account receivables while talking about the investment in receivables which
we are talking about the opportunity cost.
What cost of what opportunity cost of production or the sales value now there are two schools of
thought one school of thought says that in the receivable we are investing only the cost of
production and not the profit there are two components. One components is that when you are
talking with the receivables total sales value when you are talking anything in the sales value it
has the two components cost of production COP Plus the margin or the profit which the firms is
keeping.
Now I meant it not investing as a manufacturer the margin I am investing only the cost of
production. Cost of production comes in terms of material, in terms of labour in terms of other
overheads. So, these are this maybe they are the direct and indirect overheads this is the
investment I have made. For example one product colour TV which Samsung is selling in the
market for a 20000 the cost of production of their TV is a 15000.
So it means while selling that colour TV in the market he is investing or selling that in the
market on credit he is investing only 15000 he has not invested 20000. Should he value his
receivables credit sales is making in his own records for the analysis purpose 20000 or else
15000. Because the cost is 15000 and selling price is 20000, 20000 selling prices includes the
profit of 5000.
Now this profit is not been invested by him, should he think about it also while calculating the
cost of the funds invested in the credit sales. Now let us discuss it in some detail the logic here is
that when we manufacture a product and product goes on the market we sell it on cash. It is
converted product is converted into cash and operating cycle is complete your operating cycle is
complete here. But when we manufacture the product it is not possible to be taken to the market
on cash.
It has to go to the market if it has to go to the market it has to go on credit. Otherwise it will have
to be kept in the warehouse. So, you are having options like either you will have it as an
inventory or you will have it as another current asset that is the credit sales. So, either it will not
be converted into cash right. So, if it is not possible to be converted into cash what will be either
it is inventory in the warehouse or accounts receivable.
And in both the cases you are not getting the cash here also here also you are not getting the cash
only is a conversion of one current asset into another current assets which is certainly not cash.
So, here first we talk about the inventory when if you keep it is inventory we are keeping it is
inventory with us and inventory is inventory. But we are converting passing on that inventory to
the channel of distribution in the market to the distributor, wholesaler, or the retailer.
Again he is not paying us back in cash so he will also keep the product until unless it is sold in
the market. So we shift that inventory to the channels place and again that is inventory but it is
gone out of the books and place of the manufacturer to the books and place of the channel of
distribution. But it is still not converted into cash now question people who say that the
receivable should be valued at cost they say that since inventory is being valued at the cost of the
selling price which aboriginal over.
We have standard rule because of the convention of conservatism in the accounting we value
always this is standard rule that inventory should be valued at the cost of the selling price
whichever is lower. So, why not account receivables? Again the accounts receivables is also the
converted form of the inventory had you not passed it on to the channel warehouse then you
could have retained it in your own warehouse as a manufacturer.
So, that it would have been called as inventory so if it is converted from the accounts inventory
to the accounts receivable still it is inventory it should be valued like inventory should be valued
at only cost and the logic for that is there is a manufacturer is investing only the cost part not the
profit part. But this is another school of thought who says that profit also has the opportunity
cost. If for example he had been sold the product on cash you would have realize the entire
amount and that 20000 would have come to the manufacture to Samsung.
And then they could have reinvested that reinvested that for manufacturing the say other number
of the colour TV’s. So, it should be valued at the selling price and sometime back RBI also had
the stipulation and it was the guideline to the banks that while you are providing the working
capital finance for supporting credit sales or say for creation of the accounts receivables by
manufacturers. The inventory sorry accounts receivable should be valued at the selling price not
at the cost price to help the manufacturer to see more credits on the banks.
He should be asked to calculate or bank should accept his calculations on the selling price of the
accounts receivable and the accounts receivables it should be valued at the selling price not at the
cost price. So, that was the one direction or the guidelines from RBI but recently the RBI has be
drawn this direction to the bank now to the left to the banks that what is to be done whether they
want to consider it on the cost price of the selling price that is between the borrower and the
lender that is between the firm the manufacturer and the bank.
But both the schools of thought are valid and they can be accepted so some firms can valued
some firms can evaluate the selling price both way it has to be accepted by the banks and the
firm also has to apply a logic here. See when you are talking about the logic to be applied here
we will have to think about that say what is opportunity cost of that profit which we are investing
elsewhere. For example if he sell the product on cash we get the cash back immediately that is a
cost plus profit and that that total sales proceeds are investable.
We will be there in to the next lot of the production and again the new accounts receivables or
somewhere outside the firm and that is going to give us the sufficient or the handsome amount of
the return. So, they have to think about that, that but is my total cost of say making these credit
sales including the financial cost and the handling cost and if I value it at the cost price then how
much you return on that extended credit of those increase credit sales is there means how much
is a return on the credit sales.
What is my cost while considering the investment at the only cost price and what is my cost
while considering the investment and total cost plus the profit both then he has to compare those
cost, cost at the cost of production cost of funds as a cost of production as cost of investment as
at the cost of production level at the cost of investment at the total selling price level and then he
has to compare with the return on sales of those credit sales available.
If in both the cases the return on sales is higher than the total investment cost then there is no
problem to decide whether you valued at the costs are valued the selling price always it is a
profitable proposition because selling price is very high. But if the decision is different that if
you are valuing at the investment cost at the cost price then it is a profitable proposition but if
value at the selling price investment will increase cost will increase return on the sales remains
the same.
So, it will become a negative proposition that depends upon that practically in the market what
happens what is the cost what is investment different firms have to take the different decisions
and arrive at whether to extend the credit sales weather to loosen the Credit Policy relax the
Credit Policy or not that will depend upon the situation in the market. Now how to take that kind
of decision and how to compare the investment cost with the return on sales and some other
important related issues I will discuss with you with a small example or small situation we will
have the information about in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-37
Valuation of Receivables at Cost or Sales Value
Welcome students, so we are in the process of learning about the valuation of receivables. So,
the previous class we raised this question that whether the receivables should be valued at the
cost price or the sales value and I discuss the certain things with you that even RBI has also
raised this issue and issued the guidelines sometime back to the banks that the receivables should
be valued at the selling price not at the cost price.
And bank should provide the liberal finance on the basis of the sales value rather than the cost .
But these days as I have already told you that these days weather to value it at the cost of the
selling price that depends upon certain factors that how much additional sales we are making and
how much extra revenue the firm is going to earn and as compared to the revenue what is going
to be the cost. So, we can value the receivables in either way and then try to find out that if value
and get at the cost is a profitable profitable proposition.
Then we will go for valuing it at cost and then we will see at the selling price also and then we
compare with the selling price the additional profit available by say investing surplus funds in
the receivables are creating additional receivables and then the decision will be taken. So, it
depends upon the firm to firm situation to situation there is no standard rule about it and decision
will be depending upon the marginal profitability available from the additional investment
weighed in the receivables.
Additional cost which is going to be there because of the say additional investment of the funds
as well as the say bad debt losses as well as a collection cost and we will have to look at the
situation and evaluate the this case and then accordingly as per the situation and parameters we
will have to take the decision. So, let us try to understand that what should be the valuing criteria
whether the receivable this should be valued at the cost of the selling price.
At what price they should be taken into account and finally what decision the firm should arrive
at so I have a small example here we will try to make certain calculations small calculations not
very lengthy one and then it will try to learn that how the receivables should be valued. As in
case of inventory we have a standard rule that it should be valued at the cost of the selling price
whichever is lower whether same holds good for the receivables also.
As such there is no rule that at which cost should be valued it depends upon the situation and
circumstance is available. So, let us see we have the situation here we will evaluate the situation
and then we will try to learn that how to take the decision in the different situations.
So, it is a small situation here small illustration we have here that the existing sales of Alfa
Limited are 800 crore rupees 800 crore with an average collection period of 30 days and bad debt
losses of 1% variable cost of goods sold is 80% of the selling price with the present policy is
relaxed. The firm is expected to increase it says by 200 crores it means the firm is selling worth
rupees 800 crore with an average period of average collection period of 30 days and bad debt
losses of 1% and the variable cost is 80% of the selling price.
So, when you are talking about the 800 crore this is partly and the cash and partly on the profit
partly in cash and partly credit and there is certain credit policy which is being followed by the
company. So, it may be appropriate credit policy as per the companies rules or say credit policy
devised by the company but currently the company is facing a situation that they have the slow
moving inventory for example they are slow moving inventory. So, in a situation sometimes
what happens that when the firm has the slow moving inventory?
So, they relax the credit policies and they would like to invest further funds in the sales or in the
accounts or in the accounts receivables through sales. So, in this situation as it is given that is the
present credit policy is relaxed means if the present current credit policies followed total sales
are 800 crore but if the company relaxes the present credit policy the firm is expected to increase
sales by 200 crore will go up by 200 crore from the 800 to 1000 crore.
For the average collection period of the sales the negative part here is the average collection
period of the sales and the bad debt losses will increase to 90 days and the 2% respectively. So,
currently the credit period given is 30 days when the sales are 800 crore and bad debt losses are
only 1% of the credit sales. But if company will relaxes the credit policy there will be 3 effect
first effect will be that sales will increase by 200 crore’s it will become 1000 crore and go up
from 800 crore to 1000 crore increased by 200 crores.
This the first effect, second effect here is that collection period will be increasing from 30 days to
90 days that will be going to by 3 times and 2% and the bad debt losses will be 2%. So, it will
also become double that is 1% it will become 2% the cost of capital of the business is 20%. So it
means the company value is making additional sales of worth 200 crore it means they will have
to make additional investment in the receivables.
And for that they will have to call the additional investment cost to advice the firm to relax his
credit policy or not. Means that they should go for additional 200 crores of the credit sales or not
and that is only possible in the credit policy is relaxed this entire 200 crores of the sales are on
credit right this is on the credit. So, do you have to evaluate this by taking into account the cost
as well as the selling price value of the receivables?
And then we will have to arrive at a decision that at what receivable should be valued at whether
the receivables should we valued that the cost of the selling price and how these things should be
taken into account. So, what we have to do here is that is we have to use the incremental say
analysis here also or the marginal profitability analysis here also. There is a technique which is
called as a marginal profitability analysis. Say we are selling are current level at 800 crores we
have marginal increase by 200 crores. So, total sales will be become 1000 crores. So, we will
have to calculate the marginal profitability cost, marginal profitability and cost for the alternative
valuation of the accounts receivable.
Marginal profitability and cost calculations for the alternative valuation of accounts receivables.
And let us see that is how we can take the decision and finally arrived at conclusion that how it
should be valued at. So, we will have to follow the marginal analysis marginal profitability and
cost analysis.
So, we will be doing something like this marginal profitability and cost calculation for
alternative valuation of accounts receivables for alternative valuation of the accounts receivables
right. So, first one is will have to write a particulars then is the receivables valued at cost right
and receivables valued at selling price receivables valued at selling price. These are the three
situations number one first of all number one it is first of all we have to calculate the marginal
profitability of sales profitability. Marginal profitability of sales is how much that is how much
increase sales you are going to have 200 crores.
And what is the profitability if the variable cost is 80% so the marginal profitability his 1minus
0.80 so this is going to be how much that is 40 crores and here is 40 crores weather is valued at
cost of the value that the selling price the marginal profitability on the marginal sales of 200
crores is going to be 40 crore then both the cases. Now you go to the second level now that
additional investment in receivables valued at valued at cost additional investment in accounts
receivables valued at cost.
So, how much is going to additional investment now what is going to a new level of sales that is
going to be 1000 crores and what is the valued at cost we are valuing the cost what is the cost
that is 80% only and then it is going to be the investment will be what is the credit period? Credit
period will be going up to 90 days and divided by 365 right. So, this is the one part next is going
to be what was the earlier situation we have the sales of 800 crores then multiplied by 80% and
then it is how much days credit period 30 days credit period divided by 365.
So, how much investment worked out is additional investment in additional investment in
accounts receivables valued at cost is going to be something like 144.66 and it is nil here because
it is valued at cost so additional investment in accounts receivable valued at cost is this much.
So, because first effect of the additional sales is going to be that accounts receivables here selling
it credit period of 1 month earlier.
Now we will be selling getting credit period of 3 months so when you are increasing the credit
period for 1 month to 3 month certainly your investment in the accounts receivables is going to
increase. So, this part first we have to work out that how much additional investment we are
going to make if we are value cost here we are value of the receivable at cost because we are
multiplied this 1800 of the sales with the cost only so it is first converted the selling price in to
cost price.
And then multiplied by the number of days sales are going to a blocked in the accounts
receivables so this is the additional investment in accounts receivables valued at cost. Number 3
now additional investments in accounts receivables valued at valued at selling price valued at
selling price additional investment in accounts receivables valued at selling price. So, simple it is
now what you will be doing you will not multiply these things with the cost. So, it is going to be
more simple now in this case this is it is rupees 1000/90 by 365 by we are not multiplying it with
the cost now.
So it will be something like this minus 800 into 30 by 365 right this way we are going to take it
30 by 365 so much is going to be the investment when the receivables are valued at selling price.
We are going to invest here that is 180.82 crores this is a investment we are worked out while we
are valuing the receivables as the selling price this is 180.82 crores right. Now we go for the next
level that is number 4 marginal cost at 2 marginal cost at 2 above. How much is the marginal
cost now we will have to calculate the marginal cost here.
And when you are calculating the marginal cost so that cost is going to be marginal cost that to is
going to be how much that is first cost is the cost of investment and what is the cost of
investment and what is cost of capital that is 20% so, 20% is a cost of capital into 144 point what
is the cost of this is 144. 66 so we are going to invest this much cost of capital is 20% so that is
we are taking 20% this is one part then plus 1000 into 0.02 minus 800 into 0.01 multiplied by
0.80 because the cost is 80%.
So, we have taken the marginal cost first so cost of the investment is the cost of capital and we
are investing this one 44.66 crores so your first investment is the cost of the first cost is the cost
of investment that is 20% of the 144.66 and the second element of the investment is that your say
the bad debts are going to increase. So, there is a bad debt cost also at the bad debt cost is going
to be that now the bad debt losses are going to be or maybe what we have given here is that is
2% that bad debt losses collection.
But the average collection period of the sales and the dab debt will increase from this to this. So,
now again that and the investment which will have to make it that is bad debt losses and that will
be 20% investment cost and 2% now it will be bad debt losses of the 1000 of the increase the
sales against 1% of her left. So, it means the total cost is going to be how much that will be if
you solve this the total cost will come out at 38.53 crores 38.53 crores.
And similarly if you calculate the cost here in this case so the cost is marginal cost here is going
to be how much 0.20 into how much is investment we weighed that the selling price 180.82
crores plus additional is equal to 1000 into 0.02 2% bad debt losses we are not going to get these
funds back by the bad debt losses are going to be there and then minus 800 this is going to be
how much that is 20 % in 280.2 plus 1000 into .02 minus 800 into 0.01, so we will not multiplied
it by this 80%.
Because we are taking it at the selling price so the cost working out here is how much is the cost
hear that is of 48.16 so now the all the calculations are in front of us we have the marginal
profitability of sales which is 40 crore which we are selling say extra for 200 crores our the ratio
of the cost to sales is 80%. So, cost to sales is 80 % so it means remaining is the profit the profit
is 20% marginal profitability we are going to add is 40 crore. Now how much to earn this 40
crore how much additional investment you have to be additional investment we have to make is
number one in the accounts receivables.
And that our accounts receivables will increase from the 30 days to 90 days that you for 1 month
to 3 months so that will become 144.66 at the cost at the selling price this investment will be
more because we are including profit here 180.82. So, then the receivables additional investment
accounts receivable valued at cost and selling price and then marginal cost at 2, the marginal cost
at 2 is how much that marginal cost 2 is here that is 2 and here you have to write one thing would
be calculated here is marginal cost we will write it again here that it is marginal cost at 3.
This is the this is called as marginal cost this is the marginal cost at 3 marginal cost at 3 marginal
cost at 3 above is how much marginal cost here is that is 20% is the cost of capital multiplied by
how much 182 is going to be the how much is a cost 182.2 right plus we are going to have
something over and above and over and above this we are going to have 1000 then into 0.02 is
bad debt losses in the current minus existing is 800 into 0.01 this is like this.
So it means this is an investment cost of because of the cost of capital and this is the bad debt
losses. So, finally we are going to have how much that amount is going to be something like
48.16 crore now the figures are available calculations are available with us on the basis of that
we can take a decision right. If you see now look at that whether to value receivable at the cost of
the selling price here we are going to answer this question and in this case first of all we saw that
normal sale is 800 crores.
But what if company wants to relax its credit policy then they can for the sell for 200 crores in
the market but additional investment is required. So, whether the company should stay relaxed
credit policy or not now we have to evaluate that situation of those propositions and for
evaluating that situation what we did we calculated first the margin of profitability and that was
same at both the levels then be calculated the additional investment we are going to make for
valuing the receivable.
And the cost which worked out is 144.66 and then the receivables are valued at selling price this
is 180.82 than at these two investment levels be calculated the cost of investment that is the
marginal cost of investment plus bad debt losses, so that worked out as 38.53 crores at the cost
when the receivables are valued at cost and in this case it worked out at work out as 48.164 crore
and the receivables are being valued at the selling price.
Now you have to make a comparison of this and this here also this and this right. So, see if we
are valuing the receivables at cost so decision of relaxing the credit policy and increasing the
saved by 200 further crore or additional course is positive because here the marginal profitability
is more than the marginal cost and marginal cost by spending extra 38.53 crores our marginal
profitability is going to increase by 40 crores certainly there is the profitability outweigh the
marginal cost so decision is in favour.
But when you if you take this receivables valued at the selling price again the profitability is
remaining the same but your cost is going to increase marginal cost is going to increase. For
earning the profitability of 40 crores we have to sell out 48.16 crore. So, that is not acceptable
proposition and here in this situation we are we are showing that it is a loss making proposition
so we should not a relax credit policy.
And we should not go for the additional sales because in that case marginal cost of investment
plus bad debt losses are more as compared to the additional profitability as against the
profitability when the valued receivables are valued at cost. So, I told you that like inventory
there is no fundamental or golden rule that the receivables should be valued at cost or at the
selling price. I told you earlier also it is a situation analysis it depends upon the situation that
how much additional investment we are making in the receivables.
And how we should evaluate the receivables value at the cost is also ok valuing at the selling
price is also ok this no problem at all it can be done either way but only thing is that we will have
to have some logic that why we are valued at cost and why we are valuing at selling price here
we have a logic that if you valuing at the cost you are ending up in the profits. If valuing at the
selling price you are ending of making the losses so making decision of the function to take.
If the firm has no other opportunity cost sorry if the firm has the opportunity cost and there is no
other better avenue to make this investment of 200 crores at any other avenue then it is better to
make this investment here justifying that we are only investing the cost we are not investing the
profits right here not investing the profit we are only investing the cost and which is 80% of the
selling price by investing that much of amount and calculating the marginal cost we have found
here that we are adding up making the additional profits of 1.47 crores right 1.47 crore.
But if we have some other opportunity available then we have the reasons also to reject this
proposition or maybe the proposal to relax the sales because in that case what we are going to do
in that case we are going to end up a loses because your additional profitability is 40 and your
additional cost marginal cost is 48 so I think we have also the justification to reject the credit
policy relaxing decision we should not relax it right.
So, it is no standard fundamental rule whether the receivables should be valued at cost or valued
at selling price it depends upon the situation and largely about the opportunity cost of the
investment if we have the better Investment avenues other outside the firm we should go for that
otherwise if surplus investment is possible to be made and we can think of investing that the
accounts receivables then either way we can value the receivable weather at the cost of those are
at the selling price like inventory here for valuing of the receivables there is no fundamental rule.
So, we say stop the discussion hear about this particular topic know the next thing which I will
discuss with you is that is the changes in the credit policy changes in the credit policy. Many at
times as I told you that firms as standard credit policy discuss remain the written credit policy
and that remains communicated objectivity to all. But in certain cases that Credit Policy which
the firm is following sometimes that needs to be relaxed and relaxing of the Credit Policy
relaxing of the Credit Policy depends upon the market the market situation.
Sometimes what happens that firm’s production is not going to the market in the normal course
and inventory is of the firm mounting right. We have same situation like that we are
manufacturing 1000 units of a product per month and he was telling that easily maybe some 800,
900 units easily selling in the market both credit and cash and only 150 units were in the godown
in the warehouse. So, that was the normal stock situation.
But maybe because of certain factors may be the availability of substitutes in the market or
maybe sometime availability of the similar products as the lesser price from the other
competitors in the market or maybe because of any other reasons the sales may declined. Earlier
for example they were manufacture 1000 units selling 900 units. It may possible that because of
any external factors sales have declined to say 600 units.
So it means that now in the warehouse there will be on an average 400, 350, 400 units all the
times every month they are added to the inventory and that was slowly and steadily the inventory
of the firm is mounting. So, that in that situation the firm may think of that not for always not
for the long-term normally the credit policy of the; for firm will remain as it is at it has been in
the past. But since currently because the market is no not favourable situation is not favourable
and have our sales have been negative effect by some external factors which are temporarily
done at which are temporary these factors are temporary nature.
This not going to stay forever permanently in the market there only short firm that temporary and
nature but they are there if they are there and sales have been badly hurt or negative hit so for the
time being firms may think of relaxing its credit policy. If the firm has to relax as credit policy
then the firm can evaluate that if he is relax the credit policy we will make some additional sales
the market currently we are selling for 600 units we can think of selling say again 900 or 950 or
1000 units in the market.
So it means that what will be the outcome number 1 our inventory will be under control so we
will have not to sell out extra funds are extra expenses to manage that inventory that is one part.
Second thing is that say market situation will improve for the firm and they will be able to sell as
much as their producing. So it means they are not big gap between the production and sales and
inventory will also be under control.
So, it means just to handle the temporary change in the market on in the market situation
sometimes the firms announces the changes in the credit policy which can be both long term also
and short term also and so we will have to evaluate those changes and we will have to see that it
firms changes its credit policy in the short time what will happen and if all changes with credit
policy in the long time what will happen.
So, whether the firm should change its credit policy or not changes its credit policy that will be a
very important point to be discussed and if it has to be changed then what points to be born e in
mind and if it has not to be changed why you should not have to be changed and what are the
important consideration while changing it for the short time. And what are the important
considerations by changing it for the long time.
So, that they will have to discuss and learn about any changes in the credit policy of the firm
maybe it is a short time maybe it is a long time all those changes will have to measure and try to
see the effect of those changes of the credit policies right. So, not in this class but in the next
class with the help of a small illustration we would like to learn that if the firm has to evaluate
the credit policy what is the process available what is the model available.
And how we can do that and what are the important factors to be taken into account for say
changing the credit policy first we will learn about changing the credit policy for the short time
and then we will move to the next part learning the change in the credit policy of the firm for the
long time. So, today I will stop here and whatever the remaining discussion regarding the change
in the credit policy by the firm that we will take up in the next class, thank you very much.

Dr. Anil K. Sharma
Lecture-38
Credit Policy Changes-I
Welcome students so in the previous class we discussed something about the credit policy
changes and in today's class we will learn about the credit policy changes by the firms and the
impact of these changes on the overall accounts receivable and their management and then say
how to manage the funds blocked in the accounts receivables because of the credit policy
changes. Because credit policy which was once decided by the firm which is fixed by the firm
that remains fixed for some period of time.
And looking at the changes in the market looking at the developments in the market we will have
to change the or review the market policy for say credit policy over a period of time so that sales
amount either can be kept safe sustained kept intact or can be increased. So, credit policy is a
very important document. And we have discussed in the previous classes that as I told you and
emphasized up on that this should be no flexibility upon the marketing force or up on the sales
force to say I play with the credit policy.
So, the outcome other solution for that is that it should be returned credit policy and for every
borrow or the buyer on credit we should work out the score so that if somebody is attaining that
score of maybe crossing the score then its fine otherwise we should not extend the credit.
Because it is not the question of selling on credit rather say the question of collection of the
credit sales also. So, our credit sales also so sales maximization is objective of the firm but at the
same time collection of the receivables is also important part.
So, we have to make sure that if receivables are safe and their collectible at the time as and when
they become due then its fine otherwise there is no point selling on credit blocking the funds and
losing the sales as well as the profit so that is not to be done that will requirement extra efforts of
the collection department and extra expenses on the part of collection department. If their efforts
are required to collect the receivables if we have sold the receivables to those people who are not
say wroth of getting the credit.
Now when you are going to talk about the credit policy changes we will discuss and learn it in
two parts first one is the short-term changes and second one is the long-term changes. Sometime
what happens firms face is that short term problems they do not change the policy as such for the
long term. But for the short term they have to make some changes which otherwise the policy
remains the same cannot go to make any changes affect any changes but to deal with some short
term problem some momentary problems.
We will have to change the credit policy and the problems could be like same the firm is this is
facing the problem of increasing inventory, mounting inventory is not because of sales it is not a
regular feature but just because of that and changes in the market or sometime when the firm
passes through the cyclical trends so they may be the reason that the sales get affected and they
will get corrected in the long-term but in the short-term sales have negative believe in it and we
are not able to sell more in the market on the given credit period and the credit terms maybe as
well as on the cash.
So, we will have to relax it for some period of time some short term changes and then we will
have to see that whether it is possible to pass on the inventory on the credit sales because if you
keep the inventory with you, you will have to increase the cost. So, sometime we review it and
we see that will be relax the credit policy for some period of time is it worthwhile to pass on or
convert that inventory into the credit seeds are we going to collect those credit sales which
additional we are going to make because of relaxation of the policy.
So, if it is possible then we can relax it for the time being and then we can say pass on or convert
that inventory into the credit sales. Sometime firm want to enter into new market. So, when we
have to enter into a new market you have to not to sell the product on the same terms as we are
selling it in the say market where we are a stabilised player. So, the new market we will have to
give some relaxation to the new buyers or just to induce the people that yes they should come
forward and they should buy the product of the firm the alternative which is provided by the
firm.
So, we do not follow the same credit policy which we are following in the stable market and that
is without affecting the interest of the existing buyer and we when we move into the new market
existing buyer also understand that yes firm has to introduce some policy changes and there is no
harm in that and as a new buyers to induce the new buyers to attract the new buyer some
additional credit period for some say liberty in terms of the sometime cash discount or sometime
if they want to buy on the credit and they cannot buy and sustain the product and the sales for the
same given level of the credit which we are giving in the stable market.
So, we will have to give the extended credit period that okay you keep the product and you try to
sell it in the market try to say familiarise the people with the product and when you are able to
pass on the product to the consumers and collect the price for that you pass on our part to us.
Sometime these are the changes so to deal with the cyclical trends to convert the inventory
mounting inventory because of the cyclical friends into the accounts receivables.
And some time to enter into the new market we will have to relax the credit policies and we have
to affect the changes in the credit policies. But these are not permanent they are not long term,
first we are talking about the short-term part they are not long term there only some you can see
situational changes and we are falling the normal trend. So, our old customers to new buyer
existing buyer or to say permanent customer they are selling it on the standard credit period and
at the same discount and the same other terms and conditions.
But sometimes even to the existing buyer then be relax it we communicated to them very clearly
that this is as a special case we are giving the extended credit for say 60 days to 75 or 90 days.
But do not take it as a regular feature and we would normally for the next consignment you ask
your order for you will have to have the same terms and conditions. So, short term changes are
there and we can say take the help of these changes and we can pass on that inventory to the
market or to the channels of distribution or to the customers on their relaxed terms but on a
temporary basis and its communicated to the buyers also to the standard customers also that this
change is a short time change not a permanent change.
So, you have to be very careful about that and next time we will not be giving you the same
credit terms. So, we have to resort to the old credit terms so if there is a short term policy change
then how the firm has to evaluated it. See when we are going to relax the policy it means
objective in the mind is that we are going to increase the sales. So, we have to again take the help
of the incremental analysis.
There is how much additional investment we are going to make in the accounts receivables or
when we are going to change relax the credit policy how much additional investment we are
going to make here and how much additional profit will be available. And if there is additional
profit then you must be clear that there is additional cost also. So, we have to make an
incremental analysis that how much incremental profit we are going to have how much
incremental cost we are going to have because of the increase the sales.
And whether the profit is acceptable or not acceptable or says we are going to end up the
situation where the profit is certainly going to be there and even part of the profit is converted
into the bad debts also or part of the sales is not recoverable and part of the profit because profit
is a credit profit is not a cash profit for part of the profitable is not recoverable still not have the
profit be earning on the incremental sales because of relaxing the credit policy then that profit is
acceptable to us.
So, incremental change will have to incur incremental profit analysis we have incremental sales
we have to find out in incremental profit we have to find out and incremental cost we have to
find out then we have to make the analysis whether it is worthwhile effecting these short term
changes or we should continue with the existing policy. So, let us make a analysis and try to
learn that how to evaluate the short-term changes and how to take a decision that if some short
and changes are required to be done by the firm.
Then how to go about it so is there any model available is there any method available is there
any say formula available to find out that how to evaluate those incremental sales because of
relax policy and how much is going to incremental cost and profit. Yes there is a model there is a
formula we can use that model and we can try to evaluate whether we are going to end up at a
profitable state by relaxing the credit policy and selling phone in the market or we are going to
have same profit or sometime the loss.
So, if you are going to have very negligible profit even then and if you are going to have lost
even then we are not going to relax the policy what is the profit is expected to be there after all
these calculations then yes we have to think about it seriously because otherwise also keeping the
inventory as inventory will create the problems right. So, we can think about that profit should be
there and profit should be substantial.
Is not a nominal profit when is not in a good qualities minimum profit this should be profit figure
should be the profit and there should be the substantial profit then only we are going to take the
decision in favour of the in favour of the short-term credit policy changes. So, let us learn that
how to evaluate the short-term changes in the credit policy.
We have a small problem have we have worked out here and we will try to find it out that how to
find the solution about it. Say for example we have a problem here that Beta Limited is facing
problem of the slow moving inventory gathers information’s from its market intelligence that it
can make additional sales of rupees 375 crores if it relaxes the credit policy up to 90 days from
the present no credit sales level.
This is peculiar case company is presently selling on cash entirely on cash but they sales are
lesser and here they are facing the problem of slow moving inventory when the inventory is
moving at a slower pace in the market they have conducted a survey and they found out as a
report outcome of the report is that they sell further in the market for 375 crores if the relax the
policy or maybe they start selling on the credit relaxing here means that 0 credit to some credit.
So, their policy is not at all no credit they are selling for the no credit sales level to some level.
So, fraction of new sales entry to be bad debt is 2% out all this 375 crores 2% will be better that
is known to us that is also as per the say calculations of the survey we have done. Cost of goods
sold only variable cost because here we talk about cost of goods sold variable including
collection expenses is 80% of selling price. In this kind of situation only be considered the
variable cost changes are only very short term.
In the short term fixed cost do not change only variable cost changes so we will have to consider
that cost and opportunity cost of the capital is 20%. So, whether you invest in the accounts
receivables or you invest anywhere else the opportunity cost is 20%. So, if you have surplus
funds it is increased to 375 if you invest in account receivables then what is the return available
and invest these funds elsewhere then 20% funds is available.
Here also a minimum 20% fund is available so that opportunity cost becomes 0. Advise the
companies relax its credit policy or not. Now you see if you are very peculiar case that from 0
credit to means it is clearly written here that from if company relaxes the credit policy up to 90
days from the present credit sales level. It is a peculiar case companies selling not at all on credit
entire sales are on the cash and now they are thinking of that every inventory are not moving to
the market quickly so we will have to think of no selling it on credit right.
Now let us evaluate this situation and try to find out that how we can evaluate the situation is any
model available for that yes there is a model available for evaluating the short term credit policy
changes and that model is very simple because he is taking into account only the factorial part
what are the important factors involved important factors are say how much incremental profit
we are going to have and we are relaxing the credit policy and selling more for 375 crores.
How much additional sales we are going to make how much additional cost we are going to have
how much additional bad debts we are going to have and had how much additional collection
cause we are going to have all these factors have to be taken into account factored into a model
and finally we will have to find out that What is the value of additional or incremental profits
that is the important consideration here.
So, we will see here that how to deal with this kind of situation, so in the credit policy changes so
credit policy changes this is I am calling it a shot term right, not the long time changes so how to
evaluate that. For evaluating the credit policy changes in the short time changes in the credit
policy these are the credit policy changes short term we very have a clear cut model available
with us is small p = s (1-v) –[ sv + ivc s/ 365] we are taking the number of days in year 365 we
can some time take 360 also.
So, this is a model available here that is p = s (1-v) –[ sv + ivc s/ 365] this is the s is this is a
smallest s not the capital S and we can take it as like that the small s this is small s. So, this is a
model with the help of this model we can evaluate the credit policy changes and the incremental
sales they are going to have because of relaxing the credit policy. Here if you talk about this p is
the incremental profit because of the relaxing the credit policy.
In our problem which we are seen here is we are going to have incremental profit if we selling
more for 375 crore this is p is the incremental profit small s is what, small s is the additional
sales expected due to credit policy changes due do credit policy changes this is small s what is v
this is the variable cost this is the variable cost of sales variable cost of sales in percentage terms
not absolute only percentage terms this v then what is b, b for Bombay b is expected bad debt
losses.
Expected bad debt losses as expected bad debt losses as percentage of as percentage of
additional sales right it is b for Bombay and what is i now here we have i is the opportunity cost
of capital opportunity cost opportunity cost of capital opportunity cost of capital in percentage
terms in percentage terms this i and what is c and here we have some term called small c it is the
credit period this is the credit period right. So, these are the terms so, this is a model means I
think we have factored everything in the model which is going to be as a consequence of the
increase the sales.
So, we factored everything here you can say that we have the how much incremental profit we
are going to have this is p. So, because this the major concern here that if you have the
incremental profit. Then we go for the additional sales a relaxing the credit policy if there is no
incremental profit then we will not relax the sales or we may not possible relax policy and why
should we go for the additional sales.
Yes if there is any incremental profit fine so how to evaluate that that take it as s into 1minus v, s
is he additional sales expected you to credit policy changes, v is the variable cost of sales in
percentage terms as I told you earlier that we consider only the variable cost because changes are
only short term not long terms. So, if the long-term changes there I think we may consider the
fixed cost also but if the short-term changes we are going to make then only the variable cost has
to be considered A and B is the expected bad debt losses.
Because when we are going to sell on credit certainly the bad debt are bound to be there even
sometime what happens when you relax the credit policy even the existing buyers who are
buying say for example in this case if we are selling 100% on cash it means if the product is like
that then the buyers of the channel distribution channels of distribution are ready to buy from
them on cash and sell it in the market.
But if the company relax is a credit policy and apart from the cash sales if company start selling
on the credit also that even those customers who were buying on cash and who are very, very
disciplined and careful while dealing with the company they will also become relaxed because
now the company's policy is there company has started giving the credit. So, we will also
become little relaxed and as a result of that relaxation both the sides one side will be gaining
another side will be paying the price company will be paying the price.
And the customer will be gaining so as a result of that situation you will have the bad debts also.
And everywhere we have found it in the business history that when you sell on the credit all the
sales are not collected that part of the sales are remain uncollectible. In case of the banks also we
see that went the loans are given 100% to the loans are not recovered back part of the loan
become the bad and bank said to be at the burnt to bear the losses.
So, here we are going to have the additional expected bad debt losses as percent of the additional
sales then i is the opportunity cost whether to invest the funds in the accounts receivables or to
invest the forces elsewhere that is our choice. and opportunity cost is is 20 investing in the
account receivables opportunity cost is 20% we have to recover that cost also means minimum
return available should be 20% or more because otherwise that returns is also available
elsewhere.
So, I to make investment here and take the additional risk and c is credit period how much credit
period now we are going to give. If you are already selling on the credit maybe for 60 days and
now we have to make that credit period 90 days then also we will have to take that take that as
additional credit period. As a result of relaxation and in this case the problem we saw that it is
from 0 credits to now we have to start giving the credit.
So, how many credit days or the credit period how many days of the credit we are going to give
you will have to factor that also. So, we have factor profit also sales also cost also bad debt also
opportunity cost also and the credit period also. So, in our situation let us see that how this model
works out and how the situation works out for us and what is the case. So, we are studying here
that how many sales 350 crores it relaxes a credit policy then the credit period is up to 90 days.
So, we have to take the 90 days and bad debt news new say this but that is 2% and cost of goods
sold variable cost is just 80% of the selling price and opportunity cost 20% all the I think
information is available with us. So, we can easily evaluate this situation with the help of a
model and here we have to see.
So, we will have to find out the p right small p of for calculating that how much is the first thing
was s is 375 is the additional sales, we are going to make into 1minus v, v is the variable cost and
that is how much 80% this cost is 80% so this is v and then minus here we have next item s again
375 and what is a b, b is the bad debt loss. So, bad that lost his here we are expecting is 2% plus
additional items what that is opportunity cost and the variable cost.
So, what is opportunity cost? Opportunity cost is 0.20 into the variable cost is how much 80%
into then is the credit c is a credit period is going to be 90 days and again to be multiplied by 375
and divided by 365 right. We have put all the values in this model, so if you solve this situation
is this model that is again let us check it again no item should be left 375 into 1 minus 0.80 that
is a variable cost minus we getting everything from the 375 sales so and then that is 375 into 0.02
that is a bad debt loss plus 20 % is the opportunity cost of 80 % and then because investment is
only 80 % not 100%.
And then is the 90 is the credit period we are taking here the 90 is a credit period divided by 375
and 90 is a credit period multiplied by 375 / 365. If you solve this so what will happen here your
p will be = 75 - if you solve this it will work out a 75 into say 75 - 7.5 + 14.80 if you solve this I
am going to the next step directly so this is p = 75 - 7.5 + 14.80 and that will be something like
rupees final if you calculate This will work out as 52.70 crore this is the p that is the incremental
profit this is the incremental profit this is p incremental profit.
So, we are going to have the incremental profit of 52.70 crores if we relax the credit policy by 90
days from 0 and making the additional sales of 375 crores. Now here one factor have forgotten to
factorise just see when we are converting the inventory into the credit sales why we have taken
this decision of short term policy change because the company was following the for facing the
problem of the slow moving inventory.
So, they thought of has that rather than keeping the inventory with us and bearing the cost of all
kind of cost that is a investment cost carrying cost handling cost of obsolesce cost all kind of the
cost is better to convert that inventory into the credit sales. So, here when they are converting
that inventory into the credit sales so one important factor is that their inventory carrying cost
will be saved their carrying cost will be saved investment cost will be there because that amount
invested in the inventory is not invested in the accounts receivable.
So, that investment cost is same but the carrying cost will be saved because their warehouse will
be vacated so they are not required the warehouse space did not record the people to take care of
that they are going to save the obsolesce cost anything which is related to the handling cost for
carrying cost that will be saved. And if that cost is considered here then that cost will be now you
can say that will for the increase the profit.
I would say not decrease the profit is good for the increase the profit. So, how you have to
factors that cost there you have to factor that cost here that is we have the model actually he p = s
1- v into sv + ivc + 365 + this is the savings into the carrying cost and g away adding up that on
the right side gsv g is the physical carrying cost this g is the physical carrying cost of inventory.
So as a proportion of the variable cost you will have to take it as that is a percentage of the cost
of goods sold. So, it means g will be saved and that g will be further added into the profit here so
because we have calculated the profit here so that is 52.70 crores let us assume now that in this g
equal to say 0.5% right this is g this is 0.5% we have assumed g so what will happen now g we
will become that is rupees 52.70 crores + 0.005 this has to be into 375 because it is gsb 375 into
0.80.
If you solve this, this profit will become something like rupees 54.20 crore this profit is rupees
54.20 crores this is not the 52.70 crore this will become 54.20 crores so p will be 54 small p will
be 54.20 crores. So, this is the actual effect of this is the actual effect of changes in the credit
policy and that to the short time changes. So, we have seen here that additional profit by selling it
in the market for 375 crores additional profit we are going to have here is that is 54.20 crores
which is a substantial amount and we can see here that if you calculate because when we are
talking about 375, 375 is not the say investment part.
Investment we are making his 80% because variable cost is going to increase so we have to take
the 80% of the 375 and not say entire amount of 375 so we are investing 80% of 375 and we are
getting has a return 54.20 % I guess this is a very good return and we should seriously think of
the company should seriously think of relaxing the credit policy and extending the credit in the
market because here we can assume that even the part of the sales although factored up to two
2% as a bad debt.
But if more than that is also bad debts they are going to have for example it is not 2% it is 3%
even then I think this profit will be able to sustain those losses and finally we are going to end up
a situation where buy relaxing the credit policy for the short term we can increase the profit
substantially and the opportunity cost of 20% can be easily earned here. So, it is better to go for
relaxing the credit policy because multifarious effects will give it to us.
The aftermath effects our many because when you are moving to the market and selling on the
credit is it say helping us to expand the market right it is helping us to expand the market that is
one important consideration when you are expanding the market and many side effects or you
can say the by products of the additional sales is also there your market presence increases and is
your market performance increases market share increases. Initially we are affecting the short
term policy changes we are increasing the sales by 375 crore.
If I think of spending it on the long-term relaxing the long term basis may be it may convey
message in the market that this company is ready to sell on the credit and people who wish to do
the business with the company but could not do the business because the company never gives a
credit or they give the credit period of the say lesser amount of time. If they are not ready to give
the credit and they are giving the credit as per the customer's requirements.
So, I think in that case is going to be very useful proposition and many people may join hands
with the company and they can permanently expand the market they can permanently increase
their presence in the market and overall increase market share will give them the many say you
can call it as by products and increase overall performance of the company in the market will
increase.
By evaluating the situation and be taking the help of this model we have tried to learn that if
short time changes are to be done by the company in the credit policy whether they can be done
or not and if they are done then how much incremental profit is there and whether that profit is
acceptable or not. Here when I talking about is the profit as I told you that this figured should be
the positive means profit.
And the profit should be sufficient of substantial so we have seen in this in this case it is a
substantial profit sufficient profit is there but if there is a little less amount also profit is there
except that after evaluating the short term policy we will have to go for the long term policy
changes and when you talk the long term policy changes some more factor have to be taken into
account.
Because in the long term policy changes manufacturers there change number one is the changes
in the accounts receivables so that level will also increase a investment in the accounts
receivables will increase and as a result of increased credit sales and accounts receivables your
other current assets will also increase, so, how to evaluate the long-term changes in the credit
policy of the firm that I will discuss with you in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-39
Credit Policy Changes-II
Welcome students so we were discussing the credit policy changes in the previous class and we
have seen the short term changes and as a result of that we have seen that there is incremental
profit and that profit was substantial. So, we will have to see only in case of the short term that if
we increase the sales and increase the variable cost only so what will be the incremental profit
and how should be take the decision.
Now we talk about the long term policy change that is not the short term changes long term
change permanent change that will be remain fixed for next one or two years then will review the
market situation and then we will see that for the changes required or not when we go for the
permanent or the long term in the credit policy see the factors to be considered are different.
Again we have use the incremental analysis also but that has to be used in a different way in
different style.
And we have not only take into account variable cost but we have take into account the variable
cost but we have to take into account the total cost and as a result of change in the credits is not
only going to increase the investment in the credit sales what is going to increase investment in
the other current assets also your inventory level will increase because you have to have to buy
more because we are going to produce more and more and more in the market on the permanent
basis.
So, you have to produce more you have to say keep in the inventory more you have to sell more.
So, because of that you are inventory requirements will go up your advance payment so
sometime requirements will go up. Your cash requirements will go up this not only going to
increase investment in the receivables is going to investment in the other current assets also. So,
in that case we have to evaluate the total changes or total increase in the investment in all the
current assets including the accounts receivables.
And then we will see that as a result of that increased sorry relax credit policy on the long term
basis what is going to be the net result. Apart from that was a investment cost is there say our
collection cost is there, our bad debt cost also increased. So, many, many factors will be
changing and all those factors should be considered while evaluating the policy change on the
long term basis and it will be totally different as compared to what we did in the previous class
and learnt about say measuring the short term policy change.
A relaxing the credit policy only for the short while or the short period so say changing the credit
policy for the long term and long term basis is totally different and is going to create a different
situation. So, how to evaluate the long-term changes again let us take the help of another case
and that case is quite interesting and that is going to take into account too many factors.
And finally we are going to learn about that if some long term credit policy changes are expected
to be done by the firm then what important factors should be considered and how the decision
should be taken right. So, we have another case here and that case is quite comprehensive and it
takes into consideration almost many factors.
So, what the cases let us understand the case for the situation present market size of the industry
in which Ghama Limited name of the company operates is 5000 crore rupees 5000 crores which
is growing at the rate of 10% per annum industry is growing overall that market is going for the
product of that industry at the rate of 10%. So, 5000 crore is today and is growing at the rate of
10% per annum, Ghama limited has 20% growing at the rate of 10% and Ghama limited has 20%
market share which works out to be 1000 crores out of 5000 crores 1000 crore is held by Ghama
limited.
Its desire is to increase market share by 5% right from 20 to 25% they want to make the market
share as a part of various strategy formulation the company is also considering an alternative
receivables policy because they cannot increase the market share without not extending the
further credit by without not relaxing the credit policy so, they will have to consider the changes
in the credit policy also. Marketing department is of the view that it can achieve 25% target if its
credit policy is relaxed not on the present credit terms.
But they have to relax credit policy terms but as a consequence of it the average collection period
is likely to increase from 60 days at present selling at present for 60 days credit period they are
giving currently 2 months credit and then they want to increase it now from 60 days to 90 days
means from the 2 months to 3 months. For that company believe that relaxation of the credit
policy would not have any major impact on the existing customer’s right.
Existing customers would continue to co-operate with the company and they would not have any
negative impact upon the existing customers. Both in respect of collection efforts and the bad
debt losses if you are selling for the 60 days even then they are ready to do business with the
company and if you are increasing the credit period for them as well as to others even then they
are going to have same terms as well as the same situation cost of collection department is 5
crores.
Currently the collection department which the company's maintaining is 5 crores which is likely
to be increased by 20% due to increase in sales right. So, it means that increased is 1 lakhs
rupees increasing 1crore rupees increased expected. So, 20% increase is expected to be there
relaxation of credit policy may cause increase in the bad debt losses to rise for the new
customers. New customer because they are going to be tried for the first time they are not for the
existing customers.
When we tried for the first time so it means that is going to have the problem the company is
going to face that is of the increased by the bad debt losses. Overall impact is expected to be
1.3% as against 1% of the bad debt losses. So, bad debt losses will may go off from 1% to 1.3%
cost of sales will come down to 78% due to the economies of increasing scales from present
level of 80% of sales that is a cost of sales the total cost of sales will come down to 78% due
economies of increasing scale from present level of the 80% of the sales.
So, the cost of sales is 80% currently but when you are increasing the production and increasing
their market share and selling more in the market your cost of production will go down or cost of
sales will go down from 80% to 78%. Investment in current assets account receivables is
expected to grow yes that is a very important question I was talking to you that not investment in
the accounts receivable is going to increase.
Investment in other current assets also inventories, advance deposit then say your cash that is
going to increase along with the investment in the current assets or maybe in the in the current
assets along with the investment in the receivables. Investment in current assets other than
receivables is expected to go up to 318.99 crore from the present level of 231.5 crore right, funds
available in the current liabilities not going to going to increase the investment in the current
assets.
Funds available from the current liabilities from the spontaneous finance that is supplier's credit
and the expense credit that is also going to supplements that are also going to increase and funds
available from the current liabilities will also increase up to rupees 87.31 crores from the present
level of the 63.24 crores. So, it means there is also going to be increased of something like say
about how much that is 20 about 24 crores of the funds will be available from the current
liabilities from the spontaneous finance others we have to arrange.
Physical carrying cost of inventory is 0.5% per annum and opportunity cost of capital is 20% per
annum. Advice the company about the changes in the credit policy proposed to be made. Advice
changes in the credit policy about to be advice the company about the changes in the credit
policy proposed to be made. So, whether company should relax is credit policy from 60 days to
90 days.
As a result of that additional investment will be there, additional cost will be there, additional
losses will be there and despite that the company is going to have additional profit or not
incremental profit or not. Companies going to achieve the target of having 25% market share or
not that is the million dollar question. So, because your market share is 20% so, you want to
increased by 5% which is a very, very large amount substantial amount 5% in the market of 5000
crores which is growing at the rate of 10% growing is means increasing the market share say by
5% that is a very big task.
So, whether the company will be able to achieve the target of not they are going to increase this
sales by selling both on cash as well as credit relaxing the credit terms on the long term basis so
that they become the sustained player in the market. So, whether the company will succeed in
achieving that target or not they are evaluating all these is a possibility and propositions and what
will be the net result that has to be seen after the detailed analysis.
So, now let us make the analysis here the method of making analysis is little different method of
making analysis is little different. Here we have to work out is first we have to work out is the
additional investment in the total current assets. First the beginning will be how much additional
investment we are going to have in the because you have the say increase the credit period
information is a with us that from 60 to 90 days bad debt losses information is with us right.
And that same collection cost department’s cost information is with us but the opportunity cost is
20% and how much would be that cost that will only be possible for us to work out if we have
the total investment information with us. Such we have concluded here that when we are going
to increase the investment in the accounts receivables is not only accounts receivable then when
it is going to increase all the current asset level is going to be at the next level.
So, we will have to first the start analysis to start this analysis by working out of the investment
that total current assets increased investment in the total current assets. So, if you look at this
information you have given the information about the current assets other than accounts
receivables where additional investment will be required and how much that investment will be
required. So, investment in the current assets other than receivables is expected to be 318.99
crore from the present level of 231.05 crores.
Other than accounts receivables investment need or increased investment requirements are
already given to us that is in the current assets other than that can be the entry that can be cashed
that can be advance deposit. But accounts receivables investment we have to work out as the
increase the credit period and the because of some other factors. So let us do this analysis and
learn how to evaluate the long term policy changes.
So, Credit Policy changes Credit Policy changes we take the and this is long term this is long
term right. So, first of all will have to begin this analysis by working out the additional
investment in the accounts receivables so, we will have to do this calculation of investment or
you can call it as additional Investment calculation of investment or not additional total
investment we are going to do calculation of investment in accounts receivables right.
his will have to do other is available to other than account receivable investment is available to
us. So, we will have to do it at two levels first thing is particulars right then is the say as
investment at the selling price and at we have to evaluate the price at cost price selling price and
at the cost price and amount is in rupees crores this also available with us. So, we will have to
see here what is the existing investment existing investment here is at the selling price is how
much existing market share that is 1000 crore.
And how much is the credit period we are giving that is 60 by this is 60 by 365 this is the one
because this is only investment we are making in the accounts receivables because we are giving
the credit period of 60 days and at this level at the cost price if you calculate you have to take it
as a rupees 1000 and we have to take the cost and the cost of sales is 80% right. And again the
credit period is 60 days so this is at the cost price divided by the 365. So, how much investment
works out here this is something like 164 if you solve this 164.38.
And here this investment is how much this investment is 131.85 crores so it means this
investment sorry this is not 85 but this is something different this investment is 50, 131.50 crore
this is growth of the investment right. There are two investment which are existing that is at the
selling price we had invested or we are expected to invest 164.38 crores and the cost price we are
investing the 131.50 crore.
Now projected how much is additional required now projected investment right so how much we
are expecting or market share to be that is 375 crores what was the market share if you look at
his the 1375 crores if you can work out the market share which is the we are growing at this level
and we want to increase the market to 25% and the market is also growing at the rate of 20%. So,
our total market share will become if you should take it to 25%. So, what will be is this will
become not 1000 now it will become 1375 crores and credit period is going to be how much 90
days right.
Divided by 365 this is 90 days 365 and here it is how much at cost we will have to see 1375 into
what is the cost is that will not come down from the 80% to 78%, 0.78 into 90 by 365 right. So,
this is going to be the new investment level that our market share will increase from the 1000 to
say 1375 crores and the credit period will increase from 60 to 90 days. But the selling price we
are taking 1375 as 1375 and at the cost price we are taking the 78% of 1375 because the cost is
expected to decrease from the say 80% to 78%.
But the credit period is against that is 90 days so how much investment we are expecting on the
accounts receivables that is rupees 339.04 crores and here it is this investment is going to be how
much this is going to be at cost price if you consider 264.45 crores this is this much of the crores
of the investment is there, this investment is there. We are going to have this much of the
investment right. So, this thing is very clear in the problem given to us that if we are investment
in the current assets other than accounts receivables sorry I will say other than accounts
receivable is going to be 318.99 crore at both the levels.
Because we are not valuing the other receivables or the selling price or the cost price so the
investment in the current assets other than the receivables is expected to be 138. 318.99 crore
from 231.05 crore and the investment in the accounts receivables we have worked out at the cost
this is going to be the at the selling price this is going to be the investment at the cost is going to
be the investments this is the existing level of investment that is 164.38 crores.
We have invested if you are valuing at selling price and 131.50 crores we have already invested
into the credit sales accounts receivables if you are valuing them only at the cost and we are
ignoring the profit. New investment expected to be at the selling price it is expected to be 339.04
crores from the existing level of 164.38 crores and that the selling price and the cost price this is
expected to be 264.45 crores from the existing level of 131.50 crore. So, now this investment we
have worked out in the receivables.
Projected investment in the other current assets other than the receivables is already given to us
know on the basis of this total investment requirements let us workout do incremental analysis
start doing the incremental analysis and try to find out that how much say the final outcome is
the whether we end up at making the profits or we end up at making the losses that will be seen
with the time. But let us make the calculations and let us go ahead with this further analysis and
this further analysis again called as the incremental analysis or we have to calculate or we have
to prepare the marginal profitability statement.
So, for this let us make this analysis, so let us go for this preparing a statement which is called as
profitability statement of alternative credit policy of alternative credit policy profitability
statement of alternative credit policy right. So, what we have to do we have to again make a table
and do the detailed incremental analysis. So, first one it is the serial number then is the
particulars then we have to take the say receivables valued at cost or receivables valued at cost
and receivables valued at selling price right.
Receivables valued at cost receivables valued at selling price so this way will have to do this
further analysis. So, in doing this analysis we will have to now consider all the factors which are
important for this analysis. So, first of all number 1 what we are going to calculate here is
marginal profitability of sales or incremental profitability of sales marginal profitability of sales
because we are going to have additional sales when we are going to relax the credit policy on the
long term basis.
We are going to have the additional sales so this is the marginal profitability of the sales and how
much is going to the marginal profitability of the sales of the incremental profitability of the
sales this can be calculated how much we are going to sell extra now the total sales will be worth
rupees 1375 crores and what is the say we are talking about the for the profit part. So, how much
is the current 1375 so what will be the cost here, cost will come down to 0.78 right and 1375 into
1minus 0.78 and in this case as we close the bracket.
And what was the existing level existing level was 1000 into 11 minus 0.80 right this is the
profitability we are going to have. If we are considering the 80 and 78 as the cost of sales total
cost of sales including all the cost not only variable cost in this in that case what will happen
your new sales level will be by increasing the market share of market which is growing at the
rate of 10%. Our new share will be 25% and that will be 1375 crores and the cost of sales will
come down to 78% as against the market share which we had when we had the credit policy like
say not relax what only 60 days credit period.
Our total sales were 1000 crores and the cost of sales was 80% so in that case if you look at the
profit here profit is same right that is rupees 102.50 and here also 102.50 right. This is same
profit we are going to have at both the levels despite knowing the profit is going to be remain the
same at both the levels102.50 whether the investment in the receivable is considered at the cost
or is considered at the selling price.
That will affect only the investment cost but not will affect the profits. Profits we are going to be
102.50 at both levels whether we considered account receivable at the cost price and selling
price. Now calculate the investment, how much investment is required to be made. So, additional
investment in the net current assets including receivable additional investment in current assets
additional investment in net current assets valued at accounts receivables valued at cost accounts
receivables valued at cost.
How much investment is going to be their now when the receivables at valued at cost you see
that when we are talking with receivables are valued at cost here it is the important component
for us. So, what is going to be the new investment here we are going to have that investment
which is 264.45 will be in the accounts receivables and 231.68 which is given to us here is that
was 231.68 that is the investment which is given to us.
So, a total investment will become how much that investment will be this investment is given to
us here is that is the one, so it is going to be how much this is 231.05 old and new will be 318.9
crores 318.99 crores. So, this investment we are working here and that is the additional
investment in the net current assets. So, when the receivables are valued at cost so what will be
that additional investment is the net current assets that will be 231 this will be the additional
investment that is 231 this is going to 231 rupees 231.68 plus 264.45.
This is the investment in the receiver total investment in the total current assets and was a new
investment and what was the existing investment? Existing investment is 168.81 plus 131.50
crore so this is going to be the new investment this is 167.81 plus 131.50 and it is 231.68 and
264.45 so from where it is coming here that how much is the old investment in the other current
assets 231.05 and when we taking old investment of current assets is 231 point say this much
crore and here if you take this is how much is the new investment in that assets here.
This investment here we are taking here it is 264.45. So, look at this how much you have work
now here is 264.45 crores is the investment here. So, this is the new investment minus old
investment and old investment if you look at the 167 is we have calculated in this is the 131.5
crore that was in the accounts receivables investment earlier this investment was there and if you
look at the investment which we had now existing investment which we had a calculated was
164.38.
And in this case if you look at this investment this investment is now at the cost price is 131.5
and at the selling price is was 164.38. So, if you calculate this total investment that is 231.68 plus
264.45 this is the additional investment know the total investment new investment and what was
the existing investment this is the sum total is this investment. So, if you talk about the additional
investment we are making here is this minus this, this works out as 196.82 crores this is 196.82
crore that is at the when the receivables are valued at cost.
Next thing is that when the receivables are valued at the selling price additional investment
additional investment in net current assets when accounts receivable are valued at when the
accounts receivables are valued at the selling price. How much investment we are going to make
here now that investment is little think we will have to work out which is already investment in
the net current assets receivables valued at selling price so it is going to be again 231.68 and plus
it is going to be 339 339.04 minus167.81 plus 164.38 so we are taking this 164.38 this is the
164.38 this is the investment here.
And if you look at this investment how this investment works out as receivables valued at cost
was 196.82 and this minus this, this minus this, this will work out as rupees 238.53 crores 238.53
crores so this is the two investments and incremental profit share this is incremental profit at both
the levels receivables are valued at cost and receivable are valued selling price and this is the
investment we are making because investment in the current total current assets only the
investment will be differing in the accounts receivables If they are valued at cost.
And they are valued at selling price where is Investment visa the current assets will remain the
same total investment which we are making or you can call it is marginal investment we are
making here is that is 196.82 crores which we have worked out here and will be valued the
receivables and selling price. So, for the other assets investment is remaining the same only for
the receivables the investment level is changing.
So, when we have taken that into account then we worked it out. So, we have seen that because
of the relax credit policy increase the sales and increase credit period we are going to have the
additional investment in this is that investment in the receivables we are going to have at the
selling when the receivables are valued at selling price that investment is going to be 238.53
crores. So, we have worked out for both investments profit is also worked out in both the levels.
Investment which we worked out is different 196.82 the cost price when the receivables are
valued at and 238.53 when receivables are valued selling price. And the next step would be to
calculate the cost marginal cost after profit marginal profit and marginal investment. Now we
will have to calculate the marginal cost at both the levels when the receivables are valued at cost
price and receivable are valued at selling price.
What is going to be the total cost of this investment in all senses taking into account the
investment cost, bad debts losses, collection cost, opportunity cost all these coast by taking these
into account how much is the cost when the receivables are valued at cost how much is the cost
when the receivables are valued at selling price and then that cost both these cost will be
compared with the profit which we are going to have the marginal profit that is 102.5 crores.
And then we will have to see if the cost is less than the profits then we will go for say taking the
credit policy decision otherwise you will not take this credit policy decision and we will not relax
the credit policy. So, how to calculate the cost now and that total cost at 2 levels when
receivables are valued at cost and valued at selling price, how to calculate the cost and how to
compare it and how to take the final decision that I will discuss with you in the next class thank
you very much.
Dr. Anil K. Sharma
Lecture - 04
Approaches of Working Capital Management - 1
Welcome students. So we were talking about the trade-off in the last part of discussion, trade-off
between the profitability and risk right. So as I told you just I will recoup it back that if you
borrow more funds from the long term sources what will happen? Your cost will increase,
borrowing cost will increase and your borrowing cost will go up and your returns will be less.
So in this case, when you are talking about the trade-off between the profitability and risk, so
what will happen? If you are borrowing the fund from the long term sources in that case your
cost will go up but your risk will go down because we have sufficient funds available and we
have borrowed those funds for a longer period of time for the longer duration. So in that case, we
not need to pay it means more quickly.
So you are means at ease to make the payment, to return the funds back to the source. So in that
case anytime any funds becoming due to be paid to the suppliers, to the electricity company to
water supply company or to any other source, we have the funds available. But what is
happening? The cost is increasing. As I told you that in India we have the term structure of
interest rates. Now what is the term structure of interest rates?
That the term structure of interest rate is that longer the duration or the longer the maturity
period, higher will be the cost of the fund. So when you talk about the term structure of interest
rate you can show it something like this that you can have say the term structure you can show it
something like this that.
Say for example this is your structure. So we are talking here we have the maturity of the funds.
Here we have the interest rate and it is the yield curve right. We call it as the yield curve. So it
means longer the duration means as the maturity is increasing here from this to this side when
the maturity is increasing your interest rates is increasing. So initially it was going up and up but
after some period of time it becomes stable.
So it means if you are borrowing the funds for this much period of time your interest rate is this
much. If you are borrowing the funds for this much period of time your interest rate is this much.
If you are borrowing the funds for this much period of time your interest rate is this much. So it
means because of this term structure of interest rate it is still say till July 1991 we had the reverse
of the term structure of interest rate.
But after July 1991 after the liberalization of the Indian economy we have now the term structure
of interest rates. Earlier it was the reverse of the term structure of interest rates but now it is a
term structure of interest rate. Why it was reverse of the term structure of interest rates means
lesser longer the maturity period lesser is the interest cost. Or the yield curve was say moving
differently, it was not going up but rather it was going down.
So in that case if you talk about the yield curve it was going down like this. So it means if you
are borrowing the funds for the longer duration you have to pay the lesser rate of interest. Why
that was happening in this economy that is a long story. It is a different reason, different story.
But now we have the term structure of interest rate because in the entire world all the businesses,
financial institutions they follow the term structure of interest rates.
So India also has to align, Indian companies, Indian businesses, Indian financial institutions also
have to align with the term structure of interest rate so we have now the same structure and if
you are borrowing the funds for the longer duration you are paying the higher amount of interest
and because of that reason if you are investing long term funds for the short term purposes for
the financing of the current assets, in that case what is happening?
That you have to pay the higher interest rate your financial cost will increase but the risk will go
down. But if it is reverse, if you are borrowing funds from the spontaneous sources short term
sources in that case what will happen that your risk will be more but the financial cost will be
under control or that can be easily managed or that will be manageable. So now I will discuss
with you.
Before we move to the trade-off as I told you in the last class that we will have to have the trade-
off that 2 extremes are not good that having the funds from the short term sources and increasing
the profitability by increasing is also not good. Similarly, borrowing the funds from the long
term sources and reducing the profitability as well as the risk is also not good. So I told you that
we should go for the trade-off.
So what is the trade-off and how we go for the trade-off before that I will take you to some other
concept. We will discuss something before say talking about the trade-off and in that case I will
talk to you about the approaches of working capital.
Approaches of working capital, management you can say. Approaches of the working capital
management. If you talk about the approaches of working capital management, we have 3
approaches. One is the hedging approach and second one is the conservative approach. Second
one is the conservative approach and third one is the aggressive approach. Next one is the
aggressive approach. So we have the 3 approaches.
One is the means hedging approach, conservative approach, and aggressive approach.
Conservative approach says that most of the short term financial requirements of the firm or the
financial requirement for funding of the current assets will be fulfilled from long term sources.
We are more conservative toward the risk. We can compromise with the profitability but we
cannot take more risk.
We are more conservative and we are borrowing funds from the long term sources and we are
investing those funds for managing the current assets or the short term funds so if that is the
approach the firm is following or the business is following then that business will be called as the
conservative in nature or following a conservative approach of the working capital management.
Third approach is that is the aggressive approach.
Aggressive approach says that more and more funds will be arranged for financing the short term
or current assets from short term sources, spontaneous and short term sources. So it means if you
are following a aggressive approach so what will happen? That your say more funds are coming
from the spontaneous finance and the short term finance and we are not borrowing from the long
term sources at all. We are not utilizing the long term sources at all.
So that we call it as the following the aggressive approach of the working capital. So it means by
borrowing funds from short term sources you are financing total current assets and even
sometimes the part of the long term assets also. That is why we call it as aggressive approach.
The result of this aggressive approach is that your cost of funds will be lowest and risk will be
highest but the profitability will be highest.
In case of the conservative approach there will be the other extreme that the cost of funds will be
very high. Profitability will be low but the risk at the same time will also be lowest. So what you
want to choose? As I told you that conservative and aggressive approach, both these approaches
as per the experts and financial experts as per as the business experts, both these approaches have
some limitations because both these approaches talk about the extremes.
So we have to have something in between and if you want to have something in between then
that approach is called as the trade-off approach or the third approach or the other name of this
approach is the hedging approach. That is the trade-off. You can have hedging approach or
maybe exactly not trade-off but hedging approach is that you are managing the risk to some
extent. You are managing the financial cost to some extent and you are trying to have the
optimum profitability which is expected to be there from the business.
So now in this case how these approaches will be or how they can be depicted or how these
approaches will be looking like we will be talking about the different 3 approaches. So in this
case what we will be doing is that we will have to say show with the help if a structure that how
the different 3 approaches will be something like right.
So this is your you can call it as say this is the time. This is the or oblique output and here we
talk about the investment. This is the investment. Time, oblique output, and on the this axis y
axis we have the investment. So in this case, we have say this is the level of assets which you call
it as fixed assets. This is the level of assets which is some other assets and then the we have the
next level of the assets.
So in this case we have the first level of assets is the this is the fixed assets; fixed assets or long
term assets. This level of the assets is called as the PCA or the permanent current assets and after
this we have the level of assets which keeps on increasing that is called as the fluctuating current
assets or this is you call it as the FCA fluctuating current assets. So we have the fixed assets in
the firm. We have the permanent current assets in the firm and here we have the fluctuating
current assets in the firm.
Now you come to this side. If you have this much level of your time and output in this case what
will happen? If you are following a conservative approach in the working capital management, if
you are managing the working capital by following a conservative approach so what I will be
doing? In that case I told you most of the financial requirements will be fulfilled form the long
term sources of the funds.
So it means this is the fluctuating current assets. In between we are dividing it with the with a
dotted line and you call it as this is the half of the fluctuating current assets. You can call them as
the real current assets also. These assets are the real current assets also. Fixed assets plant,
building, machinery, land everything is called as the fixed asset. You understand it? Permanent
current assets.
Permanent current assets are the current assets like inventory, like your credit sales, like your
cash, like your prepaid expenses or advance deposits, bills receivables. But we call them
permanent current assets why because that is the minimum level of these assets the firm always
maintains. The level of inventory, the level of credit sales, the level of advance payments, the
level of your say cash never goes below this level of the current assets.
So they are called as permanent current assets or in the other way around they are as good as the
fixed assets. So we treat them differently as compared to the current assets which are called as
fluctuating current assets. Then you have the minimum level of inventory maintained. After that
if you take up the level of inventory then that will be called as the real current asset or fluctuating
current assets. You are selling say, 10% of your sales are permanently on credit.
But more than that if you increase the credit sales that will be the fluctuating current asset. So we
have 3 categories of the assets; fixed assets, permanent current assets, and the fluctuating current
assets. Now if you are following the conservative approach, how these 3 categories of the assets
will be financed means what will be the source of funds for financing these 3 categories of the
assets.
Under this means the conservative approach, I told you conservative means more funds coming
from the long term sources and from the short term sources minimum investment is being made.
So it means what will we be doing? We will be up to this level. We will be financing from the
long term sources, long term sources of the funds. Your entire fixed assets, entire permanent
current assets, and half of the fluctuating current assets will be funded from the long term
sources.
No problem, you can fund your fixed assets from the long term sources, even your permanent
current assets from the long term sources. But you are funding your half of the current assets,
fluctuating current assets or real current assets from the long term sources, it means here is a
mismatch right and only this part, particularly this part smaller part, only this part will be
financed from the short term sources of the funds.
Half of the fluctuating current assets will be financed from the short term sources of the funds
above this dotted line and up to this dotted line right from the first base line up to the dot half
means up to this dotted line all the funds will come from the long term sources. We are highly
conservative. So what is going to be the result that the cost of the funds is going to be maximum
and the risk is going to be minimum and the profitability is going to be minimum.
This is one extreme. Now if you are not following this approach and if you change your
approach in this case what will happen? We will now changing our approach and if you are
changing the approach it means we are moving towards the aggressive approach. I am not taking
to the hedging approach right now. We are moving towards the aggressive approach means
aggressive approach is just reverse of your is just reverse of your conservative approach.
In this case aggressive approach as the name indicates what you were doing under the
conservative approach? We were up to this level from the long term sources. Now you are doing
reverse. Most of the financial requirements of the firm will be fulfilled from the short term
sources. To minimize the financial cost, maximize the profitability and to earn the maximum
return on the investment.
In that case what are you doing? In this case total of your current assets and of your permanent
current asset and even sometimes part of your fixed assets are being funded from short term
sources. Up to this much extent the investment is coming from the short term sources. Part of
your even say I would say that even the plant, building, and machinery are being funded from the
bank loans which are short term in nature.
Or even that much level of the aggression is not there. At least you can be easily up to this level.
Your total current assets and your total means fluctuating current assets and total permanent
current assets many firms are funding their total not up to this level but at least up to this part
they are funding from the in this case means if you talk about then what is happening up to this
case you are easily up to this level you are funding your requirements, investment requirements
from the short term sources.
So it means short term funds which you have to pay after some period of time, maximum within
a period of 1 year if you are investing those funds in to fund the permanent current assets which
level is always maintained by the firm in that case is little risky proposition because these this
part this particular region of the permanent current assets that will never become liquid. You will
not be selling the inventory below this line right? You will not sell credit sales less than this line.
It means when this much of the credit sales are always there it means this much of the funds are
always blocked in the credit sales they will not come back to us. But we have to return these
funds maximum after a period of 12 months. So it means it is little aggressive because you are
investing short term funds which are available for a few months for fulfilling the requirement
investment requirement of those assets which are almost maybe considered as fixed asset or
which are as good as the fixed assets. So this is called as aggression.
So but what will happen that your cost will be financial cost will be lowest, your risk will be
highest but the finally the result will be that your profitability will be the maximum. You will
have the maximum profits. Your profitability will be the maximum. So these 2 approaches we
consider them they are the 2 extremes.
And the third approach when you talk about here is now if you talk about the third approach
which we call it as the hedging approach or we call it as to some extent not exactly trade-off but
it is called as the hedging approach or the matching approach means the 2 names which are
given. Hedging approach we normally use in the trade-off but it is called as hedging approach it
is called as matching approach and under hedging or matching approach what we do?
That under this approach we have clear cut demarcation. Up to this level we call this level of
assets as the long term investments or the long term or the fixed assets. Fixed assets are fixed
assets. Permanent current assets are also considered as fixed assets and both these assets, means
fixed assets and permanent current assets are as good as fixed assets. So both these assets will be
being long term in nature will be funded from long term sources, LTS.
They will be funded from the long term sources, no risk of liquidity, no risk of say making the
fast payments or means defaulting in terms of the payment, no risk of the financial or the
technical insolvency nothing. Our requirement is long term. Our source is long term and both the
maturity period of the loan as well as the utilization of the loan period are matching with each
other. But here this level is called as the real current assets or the fluctuating current assets.
So since they are short term real current assets it means they will be funded from the short term
sources. This is hedging. You have created a hedge. This line is creating a hedge here. This is
called as the hedge. Hedge between the short term requirements, hedge between the short term
and the long term requirements.
If the requirement is long term, requirement is permanent, more funds will come from the or
larger chunk of the fund or the total funds will come from the long term sources and if the
requirement is short in nature then the total investment will come from the short term sources.
This is called as the hedging approach or you call it as the matching approach and this approach
we use in trading off between the profitability and the risk.
So in this case if you talk about this case or these approaches, so we have talked about the these
3 approaches of that how to use the funds and how to utilize the different sources of the funds for
fulfilling the financial requirements of the firm. Now, we will see the level of current assets
under the 3 approaches. If you talk about the level of current assets under the 3 approaches let us
see what is the level of current asset under 3 approaches.
This is the level of going to be the level of current assets under the 3 approaches. This is the
output or time. And this is called as level of current assets right? This is the level of fixed assets.
This is the level of fixed assets and this is the level of current assets under one approach, level of
current assets under second approach, level of current assets under the third approach. You can
easily understand what approaches we are talking about here.
This is the fixed assets. This is the level of current assets under the aggressive approach. This is
the level of current assets under the hedging oblique matching approach and this is the level of
current assets under the conservative approach. This is the fixed assets. This is always fixed,
plant, building, machinery, land. Aggressive approach, you are keeping the minimum level of
current assets and your current ratio is that is the 0.8 : 1.
You are maintaining the lowest current ratio, minimum level of current assets. Minimum level of
cash, minimum level of inventory, minimum level of credit sales, minimum level of marketable
securities and you are following a negative working capital approach. Your current assets are
less than the current liabilities because we are following the aggressive approach. Under this
hedging or matching approach, your current ratio is 1:1.
Current assets are equal to the current liabilities. There is a zero net working capital. Nothing is
coming from the long term funds to fulfill the requirement of the short term assets of the current
assets. And under this your current ratio is 2:1 I would say 2:1. Your current assets are two times
of your current liabilities. How much is due to be paid? Two times of that we had kept with us as
a cushion you call it as, as a safety measure you call it as, or as a measure of maintaining the
sufficient liquidity.
We do not want to take any risk in terms of making the payment. We do not want to see the firm
becoming technically insolvent. Maybe it is affecting the profitability of the firm. We can
tolerate that. We can earn the lesser profits but we should not be earning bad name or bad
reputation in the market.
So the level of current assets, under the current conservative approach current ratio is 2:1, under
the matching approach current ratio is 1:1, zero net working capital. Maximum net working
capital under based under 2:1. So net working capital is 1. Here net working capital is - 0.2. And
here the net working capital is zero. Means no requirement from the long term sources to fund
the current assets. No requirement from the long term sources to fund the current assets.
Current assets are just equal to current liabilities and 100% of your current assets are being
financed from the long term sources of the funds. So this is the level of your current assets under
the 3 approaches. Now choices of the business, finance people and the different department of
the firm what type of the approach they want to have whether they want to maximize the
profitability or they want to take some risk or they want to have a approach in between.
So at least when you talk about this your conservative and the aggressive approach, either of the
two is not good. Means if you use them solely then in that case that is not going to serve the
purpose. So we have to have something in between or we have to follow the middle path. So it
means I say that if you are following the conservative approach, level of current asset is 2:1 that
is too high we are on the safer side but the profitability is being unnecessarily compromised.
If we are keeping very low level of current assets under aggressive approach our profitability is
maximized but we are taking huge risk. So in this case how to solve the problem of having the
level of current assets which is called as optimum, neither too high nor too low. Let us see it. We
will find it with the help of another structure. You can find the level of optimum level of the
current assets we would call it as and in this case the optimum level of current assets here we
will call it as the level of current assets.
This is the level of current assets this is the level of current assets. On the x axis you take the
level of current assets so in this case level of current assets and here we take the we take the cost,
level of current assets and the cost. Now if you see if you are moving like this, this is called as
the cost of liquidity which will go like this. And this will be called as the called as the cost of
illiquidity. This will be called as the cost of illiquidity.
So it means either of the cost is not good for us. So this is the cost of illiquidity right. If you are
increasing the level of current assets what is happening? Your cost of liquidity is going up like
this. If you are keeping the level of this is the level of your current assets. So what is there? This
is the cost of your liquidity. You are increasing the level of current assets because you want to
have the maximum liquidity. So this is the cost of your liquidity.
And if you want to minimize it that my level of current assets because they are least productivity
I will keep the minimum level of current assets your cost of illiquidity this is the maximum. This
is the cost of liquidity. This is the cost of liquidity and this is the cost of illiquidity. This is the
cost of illiquidity. So it means if I am going from this side to this side my cost of liquidity is
going up. If I am going from this side to this side my cost of illiquidity is going up.
Cost of illiquidity going up means the risk is going up. I may technically be insolvent. I may not
be my firm may not be able to make the payment of my short term obligations on the due date or
on the say the time when they become due. So it means and if I am keeping the larger amount of
current assets I am following the conservative approach. So what is happening? I am managing
the risk of technical insolvency. But at the same time my profitability is also being compromised.
So what is the solution? I say that we will have to have neither too high level of current assets
nor too low level of current assets. Neither we have to pay the cost of liquidity nor we have to
pay the cost of illiquidity. We have to have something which is called as the optimum level of
current assets and you see the optimum level of current assets is here where these 2 costs
intersect with each other where these costs intersect with each other.
These costs are called as the cost of these costs are called as this is the cost of illiquidity. So it
means they are intersecting with each other here. So when they are intersecting with each other
here it means this is the optimum level of current asset. Here the total cost is minimum. You call
it as this is the minimum cost. You will say that is the minimum cost. This is the minimum cost
right and this is the level of optimum level of the current assets, optimum level of current assets.
And here my cost of liquidity is up to this level. My cost of illiquidity is up to this level. So if I
am coming down, I am stopping here and if I am going up I am stopping here and this is the level
of optimum level of current assets. This is how you can decide where both the costs are equal
where the cost of illiquidity and the cost of sorry cost of liquidity and cost of illiquidity are
intersecting with each other. That level that point is the level of optimum level of current assets.
If you are able to decide that, if you have clearly know sometime what happens, their cost of
deciding or finding out the cost of illiquidity becomes a problem. If we are able to find out the
cost of liquidity which we are easily able to find out and if we are able to quantify the level cost
of illiquidity also, in that case it will be much better that rather than following 2 extremes under
the conservative or aggressive approach it is better always to have a middle path and follow the
middle path.
And we should maintain the level of current assets where both the costs are equal or they
intersect with each other. Point where they these costs intersect with each other that cost is called
or that level is called as the level of optimum current assets and you keep this level of current
assets always with you in the firm. If you go from this point to this point what will happen? Your
cost of your liquidity will increase, cost will also increase.
But if you go from this point to this point, your liquidity will your cost will go down but liquidity
will also go down and the cost of illiquidity will increase so if it means if the firm is paying the
higher cost of illiquidity in that case what will happen? The possibility of technical insolvency
will be maximum. So we will have to avoid that situation and we will have not to create a
situation where we are either paying the higher cost earning lesser profits and taking very low
level of the risk.
Similarly, we are also not to create a situation where we are paying a very low cost, we are
taking very high level of risk for the sake of increasing the profitability because these are the 2
extremes. So neither conservative approach is good nor the aggressive approach is good. Always
have the in between approach that is the hedging approach because that facilitates the trade-off
between the profitability and risk that keeps us at the middle level.
Helps us to follow the middle path and that helps us to maintain a level of current assets which
are equal to the means which is at the optimum level and there you can have both the costs equal
to each other, cost of liquidity and cost of illiquidity they are equal to each other, they are
intersecting with each other. If you maintain the level of that much level of the current assets
then we will be able to have the optimum level of current assets and if the level of current assets
is optimum everything will be optimum.
Your profits will be optimum, your risk will be optimum and your liquidity will be optimum.
There will be a least risk of technical insolvency and we should look forward for that kind of
situation where we are optimally able to manage everything. Practically how to do it and how we
can facilitate that optimum situation in the business or in the business organizations.
And one more thing here I would like to say that if you are saving upon the financial cost while
managing the while managing the working capital that directly adds up to the profitability of the
firm because time period is very short. You are you are managing the current asset sometime on
the daily, weekly, or monthly basis. So you are saving upon the cost directly. There is no leakage
of that cost and that is directly adding to the profitability of the firm.
But if you are not saving so that is affecting the profitability of the firm if you are following the
conservative approach. So how the profitability of the firm is impacted by saving the investment
to be made into the current assets or optimum investment to be made to the current assets and if
you are not following the principle of optimization in that case we are wasting our say scarce
resources by investing them into current assets.
And that will add up to the say reducing the profitability of the firm or sometimes making the
firm a loss making proposition. So how that does how that takes place and how say following the
optimum approach contributes into the profitability of the firm that I will discuss with you in the
next class. Thank you very much.
Dr. Anil K. Sharma
Lecture-40
Credit Policy Changes-III
Welcome students in the previous class you were discussing the long term credit policy valuation
and if company relaxes the long term credit policy then what kind of the analysis is required. So,
we saw that we will have to use the incremental analysis of the marginal analysis and under the
marginal analysis on under the incremental analysis we have to see that how much incremental
profit is available by say relaxing the credit policy.
And we have seen that when credit policy is relaxed by 30 more days from 60 days to 90 days
the sales level is expected to go up from 1000 crore to 1375 crore.
So, the profit assumed here is that is 102.5 and both the levels that is true value the receivables at
cost of value the receivables at selling price profitable remain the same that is 102.5. And now
we have to talk about the investment part that how much investment is required to be made to
earn this profit of this incremental profit and to increase the sales. So, additional investment
required in the net current assets that is both in the receivables as well as in the other current
assets.
So, we have found out that the new level of investment will be this much that is the 231.38 plus
264.45 minus 167 that is existing level here this level is existing level of investment. So, this is
the level of investment we were making in the existing level of investment was that is in the
167.81 is in the; your current assets.
Which was there in the; we have seen in this problem that what was the level of current assets
that we have calculated this investment is by say which is given to us in the in the problems
sheet. So, that investment was that is the current assets here that is 318 we were expecting that
investment in the current assets other than receivables was expected to go up by to 318.99 crore
and the present level of 231.05 crore right.
And in this case is funds available from the current liabilities will also be; will also increase up to
rupees 87.31 crore from the present level of 63.24 crores right. So, now we have to calculate
the how much is the new level 318.99 and how much will be available from the current liabilities
that is it 87.31 so what we are doing his new level of investment you are working out is 318.99
minus 87.31 so that amount works out as we have calculated 231.68 crores this is the one that is
318 the level of investment which will be like say 318.99.
And this much is required 87.31 will be available from the current liabilities, so how much is
required to be invested from the pocket that amount is required to invest from the pocket to the
companies 231.68 that is in the current assets other than receivables.
And in case of receivables we have worked out the investment in the receivables new investment
in the receivables that is the cost price that is the 264.45.
So, we have seen here that total investment new investment required would be 231.68 plus
264.45 that is the new investment in all the current asset net current assets and existing level of
investment was that is 167.81. Now how we have calculated this 167.81 that has been calculated
from this one that is the total amount here we have is that the level of current asset was
previously before relaxing the policy was 231.05 crores out of that 63.24 will come from the
crores coming from the current liabilities that is from the spontaneous finance.
So it means the investment requirement though so 231.05 minus 63.24 was say so the net
investment requirement was that is the here is 167.81 that is in the current assets other than
receivables and receivables investment that we have already calculated that is 131.50 crore. So,
both the investments made total investment is that is 167.81 plus 131.5 so it means totally
investment which is a new investment required in case of the relaxation of the policy is that is
231.68 plus 264.45, 231.68 is the investment in the current assets other than receivables.
And 264.45 is the investment required in the receivables so total investment in the current new
investment will be this plus this and then the existing investment in the net current assets was
167.81plus 131.5 so additional investment required is when the receivables are valued at cost is
were 196.82 crores. Similarly additional investment required in net current assets when the
receivables are valued at the selling price. So, see here the investment in the other current assets
other than the account receivables will remain the same.
Earlier cost also was 231.68 here is also 231.68 so there is no change in the investment in the net
current assets other than receivables. However there is a change in the investment in the accounts
receivables say at that the selling price. So, we have seen we have calculated the investment in
receivables at the selling price we have seen that the new investment requirement will be 339.04
crores and existing was 164.38 crores.
So, we have taken here that is 213.68 same in the other current asset at both the levels whether
you value the receivables at the cost of the selling price only the investment in receivables
changing because we are changing the measurement parameters that is one is in cost terms and
another in the selling price terms. For total investment when the receivables are valued at selling
price total investment is becoming new investment that is becoming 231.68 plus 339.04 and
existing investment is that is one is common in the other current assets it is common that is
167.81 is common that was existing.
And the new one will be as per the selling price investment is that is one is common in the other
current assets it is common that is 167.81 is common that was existing and the new one will be
as per the selling price then new one we have worked out is that is the 160 how much we have
worked out here is 164.38. So, that is when the receivables are valued at the selling price that is
the existing investment 164.38 this is in the receivables and this investment is in the other current
assets.
So, this total is this and these total is this so this minus this will become 238.53 crores this is
238.53 crores is the investment so we have worked out now the profits at both the levels
marginal profit has both the levels and the values receivables are valued at cost and receivables
are valued at selling price and then the additional investment at both the levels and when the
receivables at cost which is the additional investment here and then the receivables are valued at
selling price this is the additional investment of 238.53 crores.
Now we will have to calculate the cost of that these two levels cost at this level and the cost of
receivables means total cost of investment bad debt losses and the collection cost at 2 and 3
when the investment is this 196.82 then what is the total cost and when the investment is 238.53
crores what is the total cost now we will have to calculate that cost right. So, for calculating that
cost we take it as number 4.
So, marginal cost marginal cost at 2 this is 2 so we are going to calculate the marginal cost at 2
now 2 above we can say marginal cost at 2 above point number 2 above so what is the marginal
cost if you calculate the marginal cost how much investment we are going to make here that
investment is safe 196.82 crores and what is the your opportunity cost is how much that is 20%.
So it means this is the cost of capital that is 0.20 is the cost of capital this is the one plus then
collection cost was something like here we have given here the collection cost somewhere here it
is given as the collection cost where that is 5 crore cost of collection department is 5 crore which
is likely to be increased by 20% due to increase in the sales. So, it means now we will have to
calculate add the collection cost.
First is investment cost it is 20% of the investment and then we will have to add the cost that is
the collection cost and collection cost is how much 5 into how much is going to increase by 20%
that is multiply 1.2 this is 1 and then it is minus 5 that was existing so this is the collection cost,
cost of the collection department and then plus we will have to add something here and that
something here we are going to add is that is the bad debts cost.
By that cost is what is this 0.013 that is 3 % 1.3% will be 1.3% of which amount 1375 and at cost
we are taking so we will have to multiply by the new cost that is 78% minus here 0.01 existing
was 0.01 of what that is of 1000 old level of sales and the cost was 80% right. The cost was 80%
so this is going to be the total cost first we have taken the first component that is the cost of
investment that is at the rate of 20% because why we have taken 20% here because that is clearly
given that physical carrying cost of the inventory 0.5% per annum and the opportunity cost of
capital is 20 % so we have taken the 20% here so how much investment we are going to make
money value in the receivable that caused by 196.82.
So, 20% of that is the first component of the cost second component of the cost is that is the
collection cost so collection cost will increase from the 5 crore to by 20% so we have taken that
5 into 1.2 minus 5, so that cost will be automatically added plus the cost of bad debts that level
was 1% what was the level of bad debts here level is 1% overall impact is expected to be
relaxation of the credit policy may cause increased in the bad debt to rise for the new customers.
Overall impact is expected to be 1.3% as a against present level of 1% so it means the bad debts
are also going to increase from the 1% to 1.3% and 1.3% is of what 1375 crores but at the cost
we are taking so it means we have to multiply by cost and then the existing level was 1% of the
old level of sales that is 1000. But we have taken the cost and cost was 80% at that time. So, we
are multiplied by the 80%.
So if you calculate the cost in this case here this works out as how much rupees 46 point This is
46.30 this is 46 point if you take this will come out as 46 point this is rupees cost is rupees 46.30
this is a cost here. Similarly we have to work out the cost at Number 3 at this also when the value
receivables are valued at selling price right. Here so marginal cost at 3 above right. Marginal cost
3 above will be how much we will have to again calculate like this.
So, how much investment we are making now when the receivables are valued at selling price
we are going to invest 238.53 and what is the cost of capital that is again 20% so again multiply
by 20% and another is going to be something like the bad debt cost of collection, so cost of
connection is how much 5 into 1.2 again and minus 5 which was existing so it will become
increased by 20% right so minus 5 and then you are going to add here the bad debt losses.
So, bad debt losses will be how much 0.013 that is1.3% of what about 1375 and minus existing
level is how much 1% of what that is of 1000. So, this is going to be the bad debt losses which
we also have two factors out. When we are calculating the cost here marginal cost means so we
have to factor 3 things here first thing here factoring is that is the investment cost of investment
that we are making in the increase level of the total current assets and receivables are valued at
cost as well as selling price.
Second factor is for the collection cost because it cost of the collection department is going to
rise by 20% so we have two factor for that increase cost is rising because we are going to have
the additional sales on credit as well. So, we have to have extra expenses for monitoring the
credit sales. And then we have another component of the cost and that and the main component
of the cost is that your bad debt losses.
So, we have two factor for that also so it means that will be 1.3% of new sales level as compared
to the 1% of the old sales level that was 1000 crores. So, if you calculate this cost this cost
comes out at then the value of receivables are valued at selling price this is something like rupees
56.58 crore so these are the two cost. So, all the three information’s are available with us.
How much is a marginal profit 102.5 agreed how much is the additional investment when the
receivables are valued at cost 196.82 how much is additional investment by the receivable was
valued selling price 238.53 right and how much is the additional cost of maintaining the
additional current assets including accounts receivables so marginal cost increasing the cost will
be when the receivables are valued at cost that is 46.3 this is 46.3 and in the second case this
costume 56.58.
Now the time of making analysis whether we should relax the credit policy or not for example if
you go by the information given here in this case that company want to increase resources level
from 20% to 25% existing market size in which of the industry in which regions company
operates Ghama Limited operates is 5000 crore and market is growing at the rate of 10%. So,
companies Ghama’s market share is 20% and they want to make it 25%. So, it means currently
they are selling for 1000 crore worth of goods in the market.
And if they want to have 25% market share of the rising market then it will become 1375 crores
so it means to have the sales of 1375 crore they have to relax our credit policy and if they relax
the credit policy so two three things are important they have to do that one thing is that is the
credit period they have to increase from 90 days 60 days to 90 days and his they do so then the
collection cost the collection department sales collection department credit sales collection
department will rise from the 5 crore existing to by 20% right.
And then another component of the cost will be the bad debt losses which are currently 1% of the
existing level of sales of 1000 that will become 1.3% of the new level of 1375. So, that will be
another change and then you are relaxing the policy and increasing the investment in accounts
receivable at the same time the investment in the other current assets and also increase that is in
the inventory all kind of inventory that in the advance deposits and then in the cash.
So, all the current assets investment will also increase and we have seen here that existing level
of the current assets is other than the receivables is 231.05 crores which will become 318.99
crore out of 318.99 crores 87.31 crore will be available from the spontaneous finance. So, it
means only we have to find out the investment for the difference that is 1318.99 minus 87.31 and
in the existing level also we were having the investment only 231.05 minus 63.24 crore so that
much investment was made by the company.
And out of the new level of investment which will be required from the company's resources
would be 318.99 - 87.31 crore remaining amount will come from the spontaneous finance. So, if
you; and the cost of capital is 20% so if you considered the all the situation of the situation and
all these changes which are expected to take place because of the credit policy changes long term
credit policy changes then we have to make this detailed analysis.
And when we analyse the whole situation we found out that how much investment is required to
be made in the accounts receivables at the cost and selling price that additional investment that
was required to be made and then saw that total investment will be also going up with that is a
investment in accounts receivables as well as investment in the other current assets. So, we can
apply the concept of incremental analysis will be calculated three things one thing goes
calculated marginal profitability at two levels.
And receivables are valued at cost and selling price which was found out to be 102.50 crores and
then be found out the additional investment that is at the cost when the receivables are valued at
cost it was 196.82 our valued at selling price it was 238.53 and the marginal cost when we
calculated which was sum of 3 things investment cost then the bad debt losses and the cost of
collection. So, when the receivable was valued at cost the total cost workout has 46.30 crores.
And then the receivable were valued at selling price total cost containing these three components
that is an investment cost, collection cost and say bad debt losses that worked as 56.58 crores. So
now all the things are available with us now we have to make the final decision. And final
decision if you have to make, how the final decision compare the marginal profitability with the
marginal cost marginal profitability at both the level is 102.50 crores.
Whereas marginal cost and when the receivables are valued at cost marginal cost is 46.30 crores
so the marginal profitability sufficiently higher than the marginal cost so it means the decision is
yes we can relax the credit policy because difference in the past and the profitability is very, very
significant. Second case if you look at this is the marginal profitability and the marginal cost
when the receivables are valued at selling price.
Again here in this case also there is a sufficient difference between the marginal profitability and
the marginal cost which is 56.58 margin profitability is almost you can say double of the
marginal cost which is 102.50 crore. So, I think in this case also the answer is yes so in both the
cases whether we value the receivables at cost or we value the receivables and selling price for
the sake of working out the investment in the accounts receivables additional investment in the
accounts receivables plus additional investment in all the other current asset then the receivables.
So, in both the cases we have seen that ultimately the purpose is says that we should be able to
recover the opportunity cost of capital and second thing is the profitability should be so much
which covers the all the cost associated to the increased sales that is a investment cost then is the
collection cost and third one is bad debt losses and sum total of these 3 cost in both the cases is
much less as compared to the marginal profitability available from the increase the sales.
Because for as a result of the relax credit policy so the decision is yes the firm must relaxes
credit policy that even by paying the increase collection cost and even by say increasing
expecting then increase in the bad debt losses final net profit marginal profitability is much,
much higher as compared to the marginal cost. So, there is no loss in say relaxing the credit
policy apart from the marginal profitability which is much more than the marginal cost from this
going to have multifarious advantages.
Firm is going to increase its market share increase presence in the market. So, it means that
competitive position will strengthen in the market existence distance of the market and as they
increased at strengthed position in the market of Ghama Limited their competitors may feel
threatened. So, they may think of shifting to other markets so it will create their own existence
that edumoney in the market.
Their presence in the market and as a result of that increased market increased sales increased
profitability overall net result in the win-win situation for the Ghama limited so the firm must
relax its credit policy not on the short term basis not for once or twice but on the long term basis.
They can review the policy after say one here or maybe one or two years down the line. But
currently this policy needs to be relaxed and increased sales must be achieved by the company
and the company must say improvement in the market.
So, this is how we evaluate the credit policy relaxation may short term or relaxation long term
relaxation and in the previous class we have seen the relaxation for the short-term purpose and
now we have seen that the result of the long-term relaxation of the credit policy, credit policy
change that is on the long term basis and how that analysis has to be done.
For evaluating the short-term change we have the clear cut model so that model is also factor all
these cost there also in that model we have also affected all these three cost which are affected
here so there we have calculated the marginal profitability from this model.
Say for example we have to calculate marginal profitability and then we have marginal
profitability and then we have seen the increased cost but they only have calculated the have
taken into account the variable cost only. We have not take into account the total cost so we have
factored the variable cost and we have factored the collection cost then we have factored the
credit period and the bad debt losses.
So, everything we have factored there also in the same manner be effected here also in the same
manner and finally we have learnt that how to evaluate the credit policy changes by the firms
maybe they are the short-term changes or maybe they are the long-term changes firm must
evaluate these and time to time they must keep on review in their credit policies and taking the
decision because without selling on credit in the market is not possible to sell everything on cash.
So, if you want to have your increased and large presence in the market the firms must think of
selling on the credit in the market and only thing is that the ultimate purpose is the marginal
profitability should we higher as compared to the marginal cost so how to evaluate that in the
short term relaxation and how to evaluate that in the long-term relaxation. We have learnt that
with the help of the model standard model we can evaluate the short term changes and with the
help of incremental for marginal analysis we can evaluate the long-term changes.
And finally we can decide that whether to relax the credit policy or not every time we have to
compare the marginal profitability be the marginal cost. So, here I will stop discussion on the say
credit policy of the changes both short term and the long-term and from this now will move to
the next part that next part is the deciding the optimum credit policy by the firm deciding the
optimum credit policy by the firm.
So, ultimately as we see that credit policy should be relaxed firms must sell on the credit no
doubt about that. The discussion so far we had about the accounts receivables we have seen that
in every companies balance sheet receivables will be there they are important current asset
without this current asset no firm can exist no firm can sustain. If you think of manufacturing and
selling everything on is not possible so we will have to have both type of the sales cash is also
and the credit sales also right.
But the question is that the investment accounts receivables again here should be optimum
investment which is manageable investment which is controlable investment if you make
investment in the accounts receivables beyond the limit unaccountable which is unmanageable
which is unforeseen then what will happen most of the sales will become the bad debts and
ultimately the marginal profit from those increased sales will be much less as compared to the
marginal loss because of the bad debts as well as the cost marginal cost that is because of the
collection cost.
So, there is no point selling that way in the market but you cannot say that we will not sell on
credit we have to sell on credit in the market we have to give the credit of the market because it
is a two way traffic one thing is manufacturing firm is expecting credit from the suppliers along
the productive distributive pipe line system. On the one side we have the accounts payable see it
means when the accounts payable appearing in the balance sheet when we are buying the raw
material we are receiving the credit from the suppliers.
When the suppliers are giving the credit to the manufacturer why not the final user or channels of
distribution of finished products can expect the credit from the manufacturer. So, only thing is
that some excellent manufacturers are the manufacturers of the excellent highly competitive
products makeup the lesser credit where credit policy maybe tight or their credit policy maybe
stringent. But no credit is very difficult to imagine in today's competitive scenario.
So, question arises if you have to sell on the credit how much credit we have to give ultimate
again I would say emphasize up on that the level of all the current assets or investment must be
optimum either too low nor too high because if it is very low profitability will be compromised
and if it is too high in the profitability will be risk because in case of the inventor of obsolesce
should be very high wear and tear risk will be very high.
And in case of the receivables cost risk collection cost risk and bad debt losses risk is also very
high. We have to be very, very careful sell on the credit but at the optimum level. So, now the
question arises which is a million dollar question how to decide that say optimum level of
investment in the account receivables and what should be our optimum credit policy that
optimum credit policy how to have it, we have, we will have the entire discussion total
discussion on having the optimum credit policy in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-41
Optimum credit policy
Welcome students, so we were talking about the optimum credit policy in the previous class we
just started talking about the optimum credit policy and I have decided upon that every firm must
have the credit system selling their product of the credit in the market but that investment must
be optimum neither too less or neither too high. So, that it remains manageable, it controllable
and it remains profitable for the firm, so, now here a million dollar question is how to decide the
optimum credit policy right.
So, for deciding the optimum credit policy first of all what is the optimum credit policy?
Optimum credit policy is the one which maximize the firms value or which contributes in the
maximization of value of firms value is the optimum credit policy we have seen in the credit
policy changes analysis that when we were say thinking of relaxing the credit policy changing
the credit policy.
Every time we saw whether it is short time or a long time change that the marginal profitability
must outweigh the marginal cost. So, if that happens then certainly receivables credit sales will
be profitable one and they will be contributing in the maximisation of the firm’s value. Now we
can use here again the analysis which we have been talking for the quite some time that is the
incremental analysis. The incremental analysis can also be used say while deciding the optimum
credit policy analysis.
And under the incremental credit analysis we have to calculate the incremental rate of return on
investment that is equal to or greater than the incremental cost of funds used to finance the
investment that ultimate incremental rate of return of an investment should be equal to or greater
than the cost of funds use to finance the investment at least there is no profit this should not be
loss. So, we should be able to recover the cost of the investment means that is a total cost
including the investment cost the bad debt losses as well as the collection cost.
Even if you are able to recover the cost and the profit is equal to that cost still we can think of
selling on the credit because that way immediate profitability is not there aftermath effects are
there and as same by products of the selling on credit though the profitability is not there but the
by-products are so high so many that increase presence in the market increase market share
automatically deliver the value and everything will be contributing in the value maximization of
the firm.
So, here what we have to do is we have to use the concept of incremental analysis that if we are
selling on the credit already and he want to expand the credit then how much additional want to
make how much is the increment the rate of return available how much is it cost of selling more
on the credit as compared to the current level and then finally we will arrive at a decisions, it
maybe situation that we are not at all selling on the credit right now.
We are selling everything on cash but we are thinking of selling on the credit. So, if you want to
start the credit sales we have to take the help of the incremental analysis and there we have to
calculate the IROR incremental rate of return. Incremental rate of return we must calculate that
will be calculated with the help of two things one thing is incremental operating profit which is
here and second thing is the incremental investment in the receivables.
How much incremental investment is required and after considering the total cost of the
increased credit sales how much is the incremental operating profit is there so we will have to
calculate IROR that is an incremental rate of return right. Once that is calculated means we have
to do 4 thing is first thing is that incremental estimation of the incremental profit. How much
incremental profit is there?
Second thing is estimation of the incremental investment in the receivables how much additional
investment is required how much additional profit is there and then we have to compare that
these two and calculate the incremental rate of return that is that is IROR increment rate of return
on investment and then compare the increment return with the required rate of return right.
There are the two rates of return what is the rate of return which is available from the say
increased sales that is available because of the market situation how much is available that if we
are selling on the cash this is the price. If you are selling on the credit we will have to obviously
sell on the increased price. So, how was the price we are charging will be determined by the
market credit will be determined by the market? Even the bad debt losses will also depend upon
the behaviour of the external factors that is a buyer's and channels of distribution.
So, it means the ultimately the available profit available cost or increased cost and that will be
say helping us to calculate the incremental rate of return which is available from all this as a
process of the increased sales and then what is our required rate of return right. So, here the
important thing is that the required rate of return when you calculate the required rate of return
that is the required rate of return.
What is this required rate of return? Some people say that it is should be cost of capital that at
least as we have seen in the previous example in case of the long term credit policy change the
opportunity cost of capital was how much that is 20% but I say here or maybe some other expert
also see that the required rate of return should not be mere the cost of capital. But it should be
something more and something more means that is the premium for premium for risk that when
we are selling on the credit we are taking there is risk also.
So, if I am only recovering my opportunity cost of capital I am not getting any premium for the
risk then why should I take the risk of selling my production on credit then remain under the
constant fear whether the sales will be collected or part of the sales will be converted into the bad
debts or I will be losing the sales in the market because of the happening of the bad debts so it
means if am selling on the credit I am taking the risk also. So, it should not be nearly the cost of
capital it should be cost of capital.
Say for example the cost of capital is 20% then some premium should be there for example
premium for the risk is 2% so my required rate of return will become 22%. So, in this case when
we are comparing comparison of the incremental rate of return with the required rate of return so
that incremental rate of return which is available from the business by selling on the credit
should be compared with something called as the required rate of return and the required rate of
return should not be only opportunity cost of capital plus some premium for the risk we are
going to take.
So, if opportunity cost is 20% premium should be at least 2% that is the reward for risk say for
example if we are totally risk averse totally averse we want do not want to take any risk we are
zero risk taker so what we do in the above the surplus funds we simply go to bank and deposit
those funds in the bank and we take zero risk because we know that in the bank on the safe and
we can expect some minimum return on those funds.
And if it is a fixed deposit in today's scenario 6% we are getting minimum and if it is a savings
deposit minimum 3% is assured to us and without out any risk right. But if we want to earn more
returns then we will have not to invest the funds in bank and have to invest the finance for
example people who to stock market people go to the real estate and some other risk taking
investment avenues.
So, if people are taking additional risk by going to stock market or by investing the funds in the
real estate. So, in that case why they are going out they are looking for the higher rate of return
then the bank rate is not taking the increased risk they should be compensated for that by the
premium for the increased risk. So, I should not be 6% of the fixed deposit like as a bank rate it
should be somewhere 6 plus 6 that is 6% for the opportunity savings or they may be the cost of
capital which is available from other alternative investments.
And 6 % should be minimum risk the premium for the risk which I am taking by same coming to
the stock market, investing in the real estate. Same is the case here when the firm is investing is
surplus funds in the credit sales certainly they should not be compensated for the opportunity
cost of capital. Opportunity cost of capital is a safe investment right but in the credit sales they
are taking different kind of the risk.
Their say bad debt losses are expected to increase the reflection cost is expected to increase why
not the premium for that. So, that premium will have to add to the opportunity cost and then that
total will become the cost of capital plus the premium risk will become the required rate of return
and that required of rate of return should be compared with the incremental rate of return with
that additional investment incremental investment in the receivables.
And the profit available out of it that becomes incremental rate of return IROR should be
compared with the RROR so that if IROR equal to RROR the decision making parameter should
be that if IROR is equal to the required rate of return then we can say yes. But if incremental rate
of return is less than the required rate of return we should not invest into that kind of the credit
sales because that is not an advisable investment right.
Reverse find that increment rate of return is more than the required rate of return and there is a
win-win situation for the firm and firm should without thinking twice they should invest into the
credit sales and they should create a current asset in the balance sheet which is called as accounts
receivables sundry debtors accounts receivables and important current asset after the inventories.
So, it means ultimately optimum credit policy demands that firm should be carefully judiciously
investing in the credit sales.
So, that ultimately investment is productive that is not a loss making proposition the investment
is productive useful and that is increasing the overall firms value and that will happen only if the
incremental rate of return which is available from this investment is either equal to the required
rate of return or is greater than the I greater than ROR. So, it means deciding the optimum credit
policy we should take into consideration two important things incremental profit and the
incremental investment.
How to calculate the incremental profit and incremental investment already discussed in the
previous class in the say example then be measured the say the credit policy changes will be the
short-term same model was used and in case of the long-term also be calculated the marginal
profit or the incremental profit and the marginal investment or the incremental investment both
cost and the selling price valuation of the receivables.
And then we calculated the cost and then we compare the cost with the say the rate of return the
profitability finally we have decided that yes cost is much less than the profitability available. In
a way you can say that the increment the rate of return is much higher than the requirement of
returns. So, it means we can go for say relaxing the credit policy. Here also in case of deciding
the optimum level of current assets same parameters will be used and will be our decision will be
based upon that you calculate the incremental profits.
You calculate the incremental investment consequently the incremental cost compare these two
then compare the incremental rate of return with the required rate of return and then see that we
should I go for investing in the in the say credit sales or and the decision criteria is only one that
your IROR should be either equal to or greater than RROR. So, then only the investment can be
made and up to that level of the receivables can be created after that level of the credit sales can
be created in the firms balance sheet by the firm where the same criteria is matter of to which
level the same criteria matter that increment the rate of return is equal to or greater than the
required rate of return.
When the movement and the movement comes that when the incremental rate of return decline
as compared to the required rate of return there we should stop selling on the credit there is no
point selling on the credit is so it is totally useless and is not a advisable proposition right. So,
this is how we can decide the optimum credit policy. Now we will take account into the
important concept that important concept is Credit Risk Analysis Credit Risk Analysis it is very,
very important as a student of working capital.
If you are professional manager or maybe if you want to become the professional manager
tomorrow and maybe it is possible that you are handling the management of short term funds in
the firm in which you are working then certainly you have to do the credit risk analysis it may be
a situation that either you are working in a company who is a borrower in the market or who is a
borrower in front of the bank or in front of the supplier or if you may be working with the
company tomorrow or you are currently working in a company who is the lender in the market.
And who are other supplier or the lender in the market so in both ways this credit risk analysis
important right. Now so credit risk analysis of every manufacturing companies should be done
whether that company is borrower then that the lender has to do that analysis and if they are say
again borrower then they themselves be doing the analysis for themselves because they know it
that when they will go to borrow the funds from the market then certainly lender would ask some
questions and those questions will be pertaining to the credit risk analysis.
Because every lender who is going to lend either money or any material as a supplier or as a
lender of funds. Both are interested into the safety of their funds so their funds are safe their sales
amounts are safe and finally they are going to get their funds back everybody is interested in that.
So, in the capacity of a borrower also in the capacity of a lender also both ways for the finance
manager this analysis is important this analysis is useful.
So, what are the important parameters from the say point of view of analysis of this credit risk
analysis for the managers who deal in the management of the short term funds or the working
capital management right for the analysis is based upon the four important things right.
The important aspects of the analysis are operating structure of the firm, financial structure of the
firm, managerial the structure of the firm and industrial scenario these are the four important
things should be there clearly in the mind of any person whether he is a borrower in the market
or he is a lender in the market he should be very clear about these three important for these four
important points of the say credit risk analysis.
Now what is the Operating Structure Analysis, under the operating Structure Analysis we can
take the help of say for example to analyse the operating structure of the firm the help of the
some you can call it as important ratios. Before we go for the analysis I would talk to you about
that how to go for the operating structure analysis or maybe the operating management how to
analyse the operating management of the firm or operating structure how to analyse operating
structure of the firm for that I would have little discussion before we move the different ratios
which are important, different ratios to study the operating structure of the firm right.
When we talk about the operating structure of the firm right the operating structure of the firm is
understandable or can be studied from their operating structure of the firms we talk about the
operations right we talked about the operation of the firm and when we are talking with the
operations of the firm it means we are talking about the manufacturing firm, a firm which deals
with the manufacturing. When we started discussion on this subject in the beginning if you recall
I give you certain assumptions that when you talk about the Working Capital Management.
You are talking about a manufacturing company because in the manufacturing company only
there is a need for working capital in the services sector organisations there is no need for the
working capital as such right. So, if you are talking about the working capital management of the
working capital analysis it means we are talking about a manufacturing company. And when you
are talking about the manufacturing company then yes we are talking about the operations of that
company as far as the operating structure of the firm is concerned right.
So, it means there is a special fundamental golden rule that look if the operating structure of the
firm is good is strengthened and strong but the financial structure of the firm is poor there is no
need to worry about. Because a strong operating structure because a strong operating structure
will improve the weak financial structure but if reverse happens that a firm has a weak operating
structure but strong financial structure then that firm or the investment in that firm is highly
risky.
Because of weak operating structure will eat away the strong financial structure and slowly and
steadily firm will becomes sick organisation and the strong financial structure will become the
weak financial structure their operations are already weak and if the finance is also become weak
ultimately there is no point for the firm to survive to remain into existence firm will closed down
soon. So, it means always bear in mind that under the operating structure analysis and the
financial structure analysis we are talking about the two analysis operating structure of the firm
and the financial structure of the firm.
Under the operating structure analysis we have to see now that operations of this firm must be
very, very strong so how you can say measure the operations of the firm operations. Operations
of the firm means the operating structure of the firm and the financial structure of the firm can be
studied from the profit and loss account or another name of the statement is income statement
right.
When you prepare the income statement say for example here it is the income statement we have
is this statement like this we prepare this statement like this so we call it as trading and profit and
loss account trading and profit and loss account right. Trading account is upper part and after that
the profit and loss account starts output of the trading account is gross profit GP and output of
the profit and loss account is NP that is the net profit right. So, when you prepare the trading
account what you take in the debit side?
We take direct materials we take direct labour and we take the other overheads or direct
overheads right. We write like this to direct material, to direct labour, to direct overheads and
this side what we take by sales, less sales returns and then is the by closing stock. So, total of this
we do here we put this total here and we could be total balance both the sides and difference of
this minus is this site this man is this side is 2 gross profit or it can be by gross loss GL.
So, it is your sales then it is a closing stock or and then it can be gross loss and it is here direct
material, direct labour, overheads and it is a gross profit. So, either of the two will be there is a
gross profit will be there or gross loss will be there right. So, if you want to see the strength of
the firms operating structure you simply look at the trading account you simply look at the
trading account because trading account is the account of the operations of the firm. In this
account you see what we are taking we are taking only maximum 5 things one is we are taking
sales on the credit side and how much we have not been able to sell in the market that is it fixed
level that is the closing stock.
So, total output is on the credit side right and total input is on the debit side. So, how much input
the firm is made in terms of the material, labour and overheads that is clearly given here. How
much output the firm has been able to have that is the sales and the closing stock right. So, then
if the sales plus closing stock is a bigger this total of these two is bigger than the total input it
means a difference is the gross profit right and when you move further you take this gross profit
that is by GP here then by indirect incomes all indirect incomes.
And here this side you take to indirect expenses right and then the difference for example again
here also we have decide which is bigger it becomes the total here we have to again total it up
and then it becomes to net profit before and NPBT that is Net Profit Before Tax. So, this
statement is enough largely to understand the operating structure of the firm and the financial
structure of the firm.
Trading account is exhibiting the operating structure of steps of the firm and profit and loss
account lower part 2nd part of the income statement is exhibiting the financial structure of the
firm. If operating structure of the firmer strong I am saying and the financial structures weak for
example you have a gross profit here but here while you come down you do not have the net
profit before tax but you have say by net loss right.
You have not loss here nothing to worry about firms operating structure as shown by the trading
account to strong your financial structure is poor so the say profit and loss account is exhibiting a
lost not to worry about you can extend the credit to this firm and your credit is safe or if you
want to go to seek the credit from any agency you can explain your case like this that look my
operating structure is very, very strong my financial structural currently weak but I am sure that
the strong operating structure will help me to improve my weak financial structure.
How the operating structure means how much I am investing as an input my output is so much
more than my Input and I am into the gross profit. Because we are a manufacturing concern the
firm we are talking about is that firm is the manufacturing concern it means in a manufacturing
concern major source of the profit should be their operations if their earning profit from the
operations but because of some very heavy financial structure here the interest cost is very high.
For example we say here that interest cost is very high so, your indirect expenses will go up and
in that case if your indirect expenses are increasing financial structure being very heavy financial
structure so here finally we have reported the net loss but we have reported the net loss. But I am
sure that this GP will improve over a period of time and I will be able to restructure my finances
and I have borrowed the funds in the past from the source which are very, very expensive.
So, because of that my financial structures become very, very heavy but my operating structure
is very strong I am earning gross profit from my operations. So, this strengthened operations will
help me to restructure by financial structure I will replace my expensive sources of funds with
the cheaper sources of funds slowly and steadily. I will manage my financial cost will manage
my indirect expenses other indirect expenses also and probably my indirect incomes also
improve so my financial structure will also improve.
So, the lender also be looked at and would take a decision that he has their major source of
revenue should be the operations and this firms operations are strong because trading account is
exhibiting a very, very strong picture because they have the gross profit. Coming to the lower for
it has become a net loss of example it is not net loss let us assume hear that it is not the net loss.
But say it is the net profit to net profit before tax but it is a very insignificant about this amount is
not very significant insignificant amount.
So you should not get scared that our net profit before tax is very, very low our financial
structure is poor so I think people will not lend no that is not the case people should look at the
manufacturing concerns trading account and the operating structure because major source of
their revenue and profitability is the operations. So, because in that case say we are not a finance
company, so, our major source of the profits should be from the operations since gross profit is
high so I am sure that my low net profit or the net loss.
I will be able to convert from net profit significant high net profit so there is nothing to worry
about it and if the reverse is the case for example here you have the not the gross profit but you
have the gross loss for example you have a no gross profit here you have the gross loss right. But
somehow while coming down here we have not hear the net loss but the net profit before tax. We
have now say net profit before tax so it means you look at in this case.
Despite having the gross loss from operations the firm is reporting net profit before tax. It means
from where the net profit has come this net profit will come from source that is indirect income.
And indirect incomes come from where say if you have surplus funds have invested those in the
market so interest on the investment this is a one. Second for example the firm during their good
days they have constructed the buildings and those buildings are rented out today.
So, it means that rent is coming as a income but you see interest income rent income this firm is
the manufacturing concern this firm is not finance company so the so that the interest income
should be considered as a income from operation. So, this company is a manufacturing concern
so interest income is today tomorrow it will not be because this gross loss will slowly and
steadily believe this investment also and this investment will also go down in the drain.
We are not a real estate come that we have construction the building rent them out and major
source of our income is the rent from the buildings. We are a manufacturing company and major
source of the profit and the revenue and the profit should be the manufacturing operations. So, if
this is the case that in the upper part in the trading account the firm is reporting lost in the lower
part the firm is reporting the profit in that case it is very, very dangerous situation.
But the reverse is there that in the upper part is a gross profit in the lower part there is a lesser
profit or net loss nothing to worry about is very good situation because operating structure of the
firm is strong and strong operating structure will improve the weak financial structure also and
the firm has a bright future. Second thing is another important thing is that this gross profit we
have to check how much gross profit has to be there. Gross profit has to be there for example you
talk about that if you compare these two sides. These two sides are say we have sales on the one
side and we have the expenses inputs on the other side.
And both the sides whether you talk about the output you talk about the input both are variable in
nature. So, if your expenses increase your cost of material labour and overheads increase you
should be able to recover that from the market by increasing your selling price right and then
partly through the closing stock also which will go to the market tomorrow. So, in that case all
the 5 items being variable either the GP should be depicting a rising trend like this or not raising
or at least it should be having a sustainable like this.
GP should not have a trend like this Gross Profit should be there and gross profit is either rising
or remaining stable. You should not be depicting declining trend and if it is stable or depicting a
rising trend it means with the passage of time firm is improving, is improving its operations,
operations are very strong so strong operating structure will improve the weak financial structure
for example here gross profit is there for the gross profit over the years.
If you make the analysis of surpass 3, 4, 5 or 10 years and we see that the gross profit is
declining over the years then again it is very serious case to be taken care of that here there their
operating structures getting weak and how it will affect the financial structure have already
discussed with you. So, sure about the operating structure of the firm and the financial structure
of the firm we have discussed something till now and will have to continue this discussion for
the remote to arrive at through some logical conclusion.
And that further discussion which we will continue and we will have we will have in the next
class at the moment I stop here and I will in the next class again I will pick up about the
operating and a structure analysis financial structure analysis important ratios which can be used
to study the operating structure and financial structure as well as the managerial structure and the
industrial scenario of the firm. All this we will discuss in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-42
Credit Risk Analysis-I
Welcome students showing the previous class you were talking about the say credit analysis of
the firms that how to find out that any borrower is worth giving the credit or not and I discuss
with you that we should we are looking at the operating structure of the firm and the financial
structure of the firm and we had this detailed discussion also here that while preparing this
format of the income statement trading and profit and loss account.
And then I emphasize the upon that we must look at the first your trading part trading account
part and trading account is the reflection of the operating performance of the firm. Because they
say you have 5 items are largely that is sales and then the closing stock and then this side we
have the three inputs that is a direct material, direct labour and direct overheads. So, we have to
compare these 5 with each other and they may be with the two sides debit in the credit side.
So, we have to see that your net results that is the sales minus gross direct expenses is the gross
profit and that gross profit must be intact that gross profit must be kept safe for that must be
intact because reason for that is that all the 5 items in the trading account are variable right. So, it
means if the cost of input is going out than the selling price also must go up for must be capable
to fetch the essay increased cost from the customers and that should be passed on efficiently to
the customer.
So, selling price increased selling price must reflect the increased input cost so it means if both
the sides are variable even if the cost is going up and sales are also going up or the selling price
is also going up.
So, we have seen here that you again I would say that your GP line will be something like this
maximum it should be like this that should remain stable period should have the rising trend or if
it is not then at least it should be stable in and none of the cases depicting the declining trend. If
the GP of the firm is declining it means you must be careful that the operating performance of
the firm is questionable it is coming down and that will have the impact upon the financial
performance also.
And then we talked about the financial structure which is indicated to us by the lower part of the
income statement that is why the profit and loss account. Here we saw that the net profit if there
is a net profit in the business then that net profit must be coming from the trading account say
first we should have the GP and then we should have other expenses and indirect expenses and
incomes and the net result can be NP that is before tax.
But the reverse is the case that in the trading account there is a gross loss and in the net profit
there is profit so it means something fishy about it that this firm despite being a manufacturing
organisation major source of the revenue and profit is not the operations but the indirect incomes.
So, if this the income for example I give you the interest if it is from the interest income it means
the surplus funds which the firm as earned either in the market then the firm is earning interest
income out of that.
And because of the increase interest income the gross loss has been converted into the net profit
or there might be surplus investment that is invested in the building and buildings are rented out
now rent is coming from the buildings or huge fixed assets are there which are not being used in
the firm outside the firm and rented out and huge rent is earned by the firm. So, that rent income
is converting the gross loss into profit.
So, we would all agree that there is interest income which is the source of the profitability it
means this firm is not a finance company. This firm is the manufacturing organisation so major
source of the profit must be the operations and your rent incomes your interest incomes they can
supplement the profits but we should start the say looking at the profitability from the trading
account and from the gross profit.
If the trading account is good is strengthened and strong and this is reporting the gross profit then
you can say that the operating structure of the firm is good and if the operating structure of the
firm is good then certainly even the weak financial structure currently might see that their
financial structure is very heavy. They are borrowed money from the sources as a loans which is
very, very expensive.
So, if you have a good operating structure and your earning a good gross profit then slowly and
steadily those heavy and expensive sources of funds can be replaced with the cheaper sources of
the funds at our own priority and the choice that is possible. But if the reverse is the case that the
trading account is reporting a loss and net profit and loss account is reporting a profit then you
can see that the days of the firm are numbered.
That a strong financial structure will be killed will be eaten away by the weak operating structure
so we will have to make a detailed analysis of the operating structure of the firm and the
financial structure of the firm and the analysis be a manufacturing sector firm that should be
analysed in the way as we discussed now starting from the trading account moving down to the
profit and loss account and finding out what is the source of profitability.
Now apart from your this basic analysis of the income statement there are certain ratios also that
which we can use and we can quickly try to find out something about the operating management
of the operating structure of the firm. And there are three ratios we will not put you in trouble by
giving you more number of the ratios only 3 ratios are enough to evaluate the operating structure
of the firm 3 ratios are enough there good enough.
If you probably calculate the ratios you will be able to find out the signals about the operating
structure of the firm and these resources are first ratio is fixed assets turnover ratio, second ratios
is ROI that is return on investment and third one is the gross profit ratio.
First one is fixed asset turnover ratio we all understand how we calculate this issue this ratio is
calculated as net sales divided by the operating fixed assets net sales divided by the operating
fixed assets which are the operating fixed asset not non-operating fixed assets right. Say if you
talk about the; if it is a goodwill for example that is not your operating fixed asset, operative
fixed assets are the plant, building, machinery which is in use.
So, it means how many times the sales are of the operating fixed assets and that is a net fixed
assets just not gross fixed asset we have to take care that is the gross assets minus depreciation.
So, we will have to find out the ratio and how to analyse this ratio higher the ratio better it is
means this ratios is used two times in one firm, this ratio is 3 times in another firm; this ratio is 4
times in another firm.
So, it means that means the firm which is repeating the ratio 4 times I think that is considered as
a better firm because their use of the fixed asset is maximum. This ratio indicates the use of the
fixed assets and any firm which is able to maximize sales in the market by utilising its fixed
assets to the maximum possible extent that firm is considered as efficient. And if you are
utilising a fixed assets efficiently manufacturing more selling more in the market I am sure that
your trading account will be depicting a very strong picture right.
So, this is the one thing that we have to look at the operating system is the operations of the firm
can be valued or can be evaluated with the help of the relationship between the net sales and the
operating fixed assets and net sales should be this ratio should be as high as possible. Then we
talk about the ROI return on investment operating profit divided by the total operating assets,
operating profit divided by the total of operating profit is that we are talking about the profit
from the operations first right.
You only have to take the profit from the operations that is not from the interest income not as a
rent income only the profit from the operations that is both taking into consideration the direct
and indirect expenses. So, if you take only direct expenses pictures only considered in the trading
account then we will be coming to the third ratio that is GP ratio. But we are talking about the
operating profit ratio should have to calculate the profit from operations.
Profit from operations is only that from the manufacturing operations in which the firm normally
deals and in that profit in that revenue in that Income we will not have to include the indirect
incomes. So, we will have to take the direct expenses direct income and indirect expenses also
both. Both expenses 3 expenses in the trading account and other indirect expenses in the P and L
account profit and loss account and then we will have to subtract those from the sales revenue
only largely.
And no other revenue that is indirect income that should be totally excluded. So, operating profit
we have to calculate as a ratio of the total operating assets that is both fixed and the current
assets total operating, fixed and current asset have to take care in the upper ratio we are taking
only fixed asset but in the lower ratio we are taking both of total operating assets that is the both
current assets and the fixed assets and we have to see how many times or what is the percentage
normally we calculate the ROI in terms of the percentage and fixed asset turnover can be in
times.
But this return on investment should be calculated in the percentage so what is the percentage of
the operating profit as compared to the total operating assets and total operating assets means
that fixed assets as well as the current assets we have to take the total operating assets means
fixed assets minus depreciation plus current assets. Then we have the GP ratio is the gross profit
ratio we have discussed at length what is a GP ratio here we have to calculate the ratio from the
trading account only.
Because GP is in the trading account so from the if analyze the trading account find you will find
out what is the gross profit ratio in the trading account and taking the GP from the trading
account and the net sales from the again from the trading account we have to calculate ratio. So it
means we are calculating ratio at number 3 but the other two ratios are also largely depending
upon the third ratio right.
Because I told you that operating profit should also be coming from the trading account and net
sales should be maximum so is then the sales are going up only then the cost should increase
right in the trading account when you talk about we are seeing here that if the sales are going up,
these are the sales, if the sales are going up only then these 3 cost have to increase. If this cost is
going up and this is raising trend but the sales are is a depicting rolling down trend.
So, it means there is something wrong about that firm is not that efficient that people are not
ready to buy the firms finished product at the increase price despite the fact that the cost has
increased and firm is simply passing out the increased cost to the buyer they are not ready to pay
the increase price to the firm. So, that is an important question issue, so we should be able to
increase the sales maximize the sales and as a result of the maximization of the use of the
operating fixed assets we should maximize the sales.
And then if the sales are maximum certainly your operating profit will also be highest and
operating profit will be highest because sales are maximum and profit cost is taken care and the
gross profit is higher. So, these three ratios are normally can be calculated by the trading account
and balance sheet and from the profit and loss account we will have to recalculate the operating
from him because profit and loss account depicts only the net profit before tax and net profit
includes are indirect income or the indirect revenue also.
we should be careful about that we have to subtract the indirect revenue that is a revenue from
the rent income from the interest income as a commission on some business transactions or
maybe a interest income or maybe there any other source of say or maybe the dividend on the
say investments made in the equity of the other companies we will have to subtract everything
and then only the sales income that is a direct revenue and both direct and indirect cost which are
related to the business only both have to be subtracted so the operating profit will be worked out.
So operative management first you look at the trading account part and how much is a GP and
whether GP is depicting a stable picture or depicting a rising trend that is the case. if it is lowered
and declining trend not good should be depicting either the rising trend or the stable trend this is
a first thing from the trading account and then calculate 3 important ratios that is the fixed asset
turnover ratio looking at how to clear how efficiently we are using the fixed assets.
Return on investment that how much return we are generating from this investment we are
generating the return on and GP that is what is the ratio of the gross profit to the sales because
you are the sales are going out gross profit should also be going up if the sales are going out
gross profit should also be going up maximum it can be as I told you that it can be stable because
if the sales are going out and expenses are also going up.
So, what will happen GP will remain stable that if it is possible picture or slightly rising picture
that if the GP is declining so it means there is something wrong about that you have to be careful
about it. So, make analysis of the trading account and then the three important ratios. Now we
talk about the some important ratios for the for studying the financial structure of the firm. There
a number of ratios which can be used to study the financial structures of the firm but here for our
purpose the purpose of our discussion we will only talk about the 3, 4 ratios maximum not more
than that right.
So, financial management or the financial structure of the firm these 3, 4 ratios are important
here and if we apart from studying the profit and loss account in the net profit position we should
calculate and work out some ratios also so that to understand the financial management part of
the company who is the prospective buyer or the borrower from the seller. So first ratio is the DE
ratio that is the total debt to equity ratio total debt to equity ratio; so it means for calculating this
ratio we take into account that ratio into total outside liabilities to the net worth, now what do
you means by this ratio here.
We have a balance sheet here preparing it in the T form this is the balance sheet and we are
analyzing this ratio from the liabilities and capital side of the balance sheet. This is our balance
sheet and this is liabilities capital and the assets and this is the amount this is the amount,
liabilities and capital so what is the ratio is;
That is the total debt equity ratio means we are only talking about the liabilities and capital of the
balance sheet right we are talking about the what the ratio is say the ratio total outside liabilities
to net worth total outside liabilities total outside liabilities to net worth first of all we must be
clear about what is the net worth what is the net worth, net worth is there the two definitions of
the net worth. First definition is total assets minus total outside liabilities means to finance the
total asses this side total assets here right.
The total amount here to create this level of the assets we have invested the funds in the business
and the funds in the business come from the two sources internal sources and external sources.
And total funds become the equal to the total funds invested in the business should be equal to
the total assets right. Now when you are calculating the net worth simple ways total assets total
of the balance sheets assets side total assets minus total outside liabilities outside sources of the
funds.
So, you have the long term loans you have debentures have bonds you have short term loans you
have anything else or maybe creditors or anything subtract everything from the total assets. Then
what is left with you is that is called as net worth or NW other way around. Second way of
defining this that you take the equity capital equity capital or you can say not equity capital I
will call it as this is share capital because it includes the preference capital also share capital
sorry share capital plus the reserve and surplus that is free reserves and surplus so it is also the
net worth.
Naturally because in the balance sheet share capital here then you the reserves and surplus R&S
that is a free reserve and surplus which is not having any claim current claim on the contingent
claim against that that part. So, this is the first part then we have the outside liabilities outside
liabilities means your long term loan then you have the debentures you have bonds and then you
have the short term liabilities so many things.
You subtract total outside funds from the total assets what is left over is that is called as net
worth. So, either you use the formula total assets minus total outside funds find out the net worth
or you simply look at the liabilities and capital side of the balance sheet and you see share capital
plus free reserves is the net worth. So, first of all you calculate the net worth and then you see
that the ratio in this case the ratio is that is a total outside liabilities divided by the net worth it
means indirectly can say this is the ratio between the insiders' funds and outsiders funds invested
in the company.
Inside are owners, shareholders on promoters and shareholders and outsiders are the lenders. So,
promoters create a company when it runs for the sufficient time and converted into a public
limited company shareholders will also gives fund and subscribe shares of the company they also
give funds to the company they also become owners. Promoter plus all the share holders they
will become the owners of the company they are called as insiders.
So, the total funds provided by the insiders will be considered and how much funds are invested
by the insiders and against that how much funds are borrowed from the outside sources as loans
or as debentures are as by issuing the bonds or maybe the supplier credit or other things
everything will have to take into account which will give you an idea that what is the intention of
the owners of the business.
If the standard ratio we all know that this is the total debt equity ratio the standard ratio is 2:1 if
you invest 1 money in the business you can borrow 2 rupees from the market this is the standard
ratio which standard rule of thumb. In the is a practice there can be different also for example
this ratio can be fine instrumental 5:1 or even 6:1 that if the company is doing very well
exceedingly well and financial Institutions are satisfied with the performance of the company
and they are ready to lend them any amount how much they want.
Then there is hardly any problem there is hardly any problem that issue can be 5 times 6 times
are any times for standard is that if you invest 1 rupee from your own pocket as your owner of
the company both promoter and shareholders. Then you have the right of you have the say
expectations you can have from the market that is you can expect to borrow 2 rupees from the
market right you can expect to borrow 2 rupees on the market.
The standard ratio is 2 : 1 so it means we will have to see that how much funds are invested by
the owners of the company in the company and how much is borrowed from the outside and then
you have to see that what is the ratio between the insider and outsider of funds. Because it just
got to tell the intentions of the owners. Whether the owners want to continue with the business or
he wanted to just play with the interest of the outsiders grab the money declare insolvent
business and run away.
So, financial management or the financial structure can be studied what is the proportion if for
example large investment is coming from the internal sources and only part of the investment is
coming from the external sources then there is no issue at all companies financial structure is
good because every say shareholder or the promoter would like that outsider claim on the
company should be minimum.
And most of the funds requirement should be made from the internal funds. But if that is not
happening in that case we have to be careful that something is fishy about it more investment the
companies seeking in the firm of the borrowed funds their own investment is very limited. So, it
means they do not want to carry on the business for the longer duration so we should be carefully
thinking about it right.
Similarly you talk about the short term debt equity ratio short term debt equity ratio in the upper
ratio we will be taking the total outside liabilities including short term and in the second ratio we
are taking into account only current liabilities to net worth that how much spontaneous finance is
available to the firm from its sources current liabilities that is expense credit and then that is the
say bank finance then it can be the suppliers credit all the current liabilities to net worth.
Higher the amount of current liabilities better is the indication because current liabilities are
spontaneous finance and who gets the spontaneous finance in the market who enjoys a very good
financial reputation in the market. If the financial reputation of the firm is not good, no supplier
will supply to the firm on credit no bank give the funds to firms to the firm and no say worker of
the company would wait for their wages to be paid after even 30 days they would like that they
should you paid every week or every 15 days.
So, if this ratio is high then we should consider it good but we should carefully analyse it that
after how many times companies pay what is borrowed this buyer is paying suppliers claims.
How efficient they are in making the payment of the bank loans or the bank funds and how
efficiently means what is the level of happiness of their employees and how they are utilising this
shot maybe spontaneous sources of the finance. We can collect information from the suppliers
also about the borrower; we can collect the information from the bank also.
We can collect information from the employees also and if we get the good information that the
current liabilities are high is a good indication positive indication because spontaneous finance
extent is high. So it means you should consider this ratio and that is the second ratio to study the
financial structure of the firm. So, first case more investment from the internal sources and or
maybe it is a comparable investment from the internal and external sources standard ratio is 2:1
but the ratio is higher that we should be carefully analysing it.
Second issue is the short term debt to equity ratio that is a current liabilities to net worth we have
to see higher the ratio better it is but again carefully the caution here is that we should carefully
analyser ratio. Finished goods inventory turnover ratio just another important ratio cost of goods
sold divided by the finished goods inventory. Finished goods inventory turnover ratio cost of
goods sold divided by the finished goods inventory.
So, how many times the cost of goods sold is as compared to the finished goods inventory
however issue is better it is because if the denominator is smaller numerator is bigger what bit
but indication day gives it gives indication that the finished goods inventory with the firm is
very, very small it means most of the production of this borrower is going to the market quickly
and they are not keeping are they are not bound to keep much of the part as inventory.
So, it should be the ratio as higher as possible then we have the other issues days of stock
holding that for how many days the stock is say is being capital stock finished goods are kept as
stock. It gives an idea that finished goods are going from the plant to the market or its going from
the plant to the warehouse ratio is finished goods inventory divided by the COGS. So, now what
is we are doing here we are converting that ratio to the previous ratio that this ratio we have
reversed it.
So, for example you calculate this cost of goods sold divided by the finished goods inventory so
we get this ratio that cost of goods sold his say;
You can see here that cost of goods sold is something like 300 and the inventory is for example
here is say for 30 rupees 300 rupees received 30 rupees inventory. So, what is the ratio this is 10
times right after calculating this ratio that is a inventory turnover ratio we have to calculate the
next ratio now then that ratio is reverse that is the again now we are COGS is divided by the
finished goods inventory so it means me this ratio we have already calculated.
So, what have to do is that you have to divide this 365 by 10 and 6 days of stock holding 36.5 on
an average for 36.5 days the inventory is staying in the warehouse finished goods inventory is
staying in the warehouse and maybe whatever inventory there keeping that everything is not
going from the plant to the market part of the inventory is going from the plan to the warehouse
and in the warehouse after the production the inventory is staying finished goods inventory is
staying in the warehouse only for 36.5 days or 37 days.
So, we have to now see that we can say how whether it is good or bad that will depend upon the
industry average you can take the industry average industry average easily available that in that
particular industry what is the average stock holding a day’s number of days is blocked in the in
the in the stock. So, we can take the industry average or we can take the say becoming the
comparison with the other similar firm in the market not if industry than 2, 3, 4 more firms you
can take the average of those firms in the market.
And if this companies for example is on an average performing on an average basis then I think
we should consider that it is a good company but for example the company which we are
evaluating their days off the stock holding are higher as compared to the others in the markets
gives a feeling that this company is not a good manufacturers and their production not like in the
market. So, it means if their stock is not converting into that sales quickly you can expect that
they will have the liquidity problem and the suppliers funds can also be get stuck to be should be
very careful about that.
So, compare it with the other firms compared with the industry average and then draw a
conclusion that their days of stock holding weather 30 days 35, 36, 25, 10 days is acceptable or
not. Then is the receivables turnover ratio with the help of this ratio is always ratios are the ratios
of the working capital where they are not ratios of the fixed may be they have their ratio for
example they have ratio like say first ratio was the long-term analysis of the funds that the debt
and equity.
But lower is the short term debt and equity ratio and all these ratios are the working capital
because these resources the working capital ratio whether it is a inventory turnover ratio
receivables turnover ratio for debtors collection period. All these are the working capital ratios
and then are the creditor’s turnover ratio, creditor’s payment period and current ratio all these are
the working capital ratios.
So, the financial Management we have complete idea about the overall financial performance of
the firm the liquidity positions of the firm of and to know whether investment in these companies
is safe or not. Here next ratio receivables turnover ratio receivables turnover ratio is that gross
sales divided by the trade receivables. How much of their total sales are on credit the company is
going to be the borrower from the company is making the analysis.
This ratio is also important that is gross is divided by the trade receivables are you can take you
the net sales also there is no harm in it gross - sales returns you can take the net sales also and
then you can find out the trade receivables divided by the trade receivables means the accounts
receivables. So, again the higher the ratio better it is because the proportion of the total sales
must be very high and the proportion of the credit sales out of the total sales must be very, very
low.
So, gross sales or net sales are very high and credit sales are very low they certainly in this ratio
will be very high right. And next ratio which is related to this receivables turnover ratios that is
the that is the debtors collection period as in case of the inventory turnover ratio we have seen
that is true that we calculated the first we calculate the inventory turnover ratio and then be
calculated the calculate the days of the stock holding.
Similar is the case now that we calculate the receivables turnover ratio and then we say calculate
the debtors collection period then we calculate the debtors collection period so it means gross
sales and trade receivables again we calculate here that is the again we take the gross sales are
300 and then is the average receivables are 30 this ratio is again 10 times and then you have to
reverse the ratio and then divide the 365 that is the number of days in a year by 10 is again it is
the 36.5 days.
So, it means that is debtors collection period is trade receivables divided by the gross ratio is a
reverse of that upper ratio and this period comes out as again 36.5 days or if you take 360 days a
year than 36 days it means the company who is going to the prospective buyer from the company
is making analysis there sales credit sales are being collected in 35 days so it means 35 days is
appropriate credit period in the market.
So, there say total sales and proportion of the total shares as a credit sales is acceptable level so
this ratio is indicating the acceptable level and that can be as I can take taken for considered as a
good indicator. So, apart from these ratios these are few ratios about the financial analysis we are
many other issues also which are given 3,4 more ratios not many 3,4 more ratios we will have to
discuss.
And then we will have to arrive at the conclusion so looking at the total financial performance
related ratios with long term and short term ratios. Largely these are the short-term ratios are you
call them as are working capital ratio and we have discussed till now say 4, 5 ratios and the
remaining ratios in the series or to know about the financial performance of the company we will
discuss in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-43
Credit Risk Analysis-II
Welcome students so we are in the process of understanding the financial management process
of the companies and we are learning it with the help of certain ratios in the previous discussions
we have learnt some important ratios to understand the financial management process of the
company under consideration there we saw different ratios like a debt to equity ratio and then the
short term debt to equity ratio and then we talked about the resources like they finished goods
inventory ratio.
And then the days of the stock holding so are in the series we will go for that and I like to discuss
with you more ratios which are important from the perspective of a potential buyer that whether
we should extend him the credit or the firm the credit or not and apart from these ratios which we
have already talked about which maybe relating to the your operating the structure of the
operating management or the financial management. So, in the financial management we had
talked about 2, 3 ratios earlier.
And now will be talking about some more important ratios so in way we are trying to find out the
level of their current assets there holding currently and then the promptness with which they can
pay the liabilities short term liabilities as and when they become due . So, you can say that we
are studying the liquidity position of the firm also and when we talk about the inventory levels so
we see that what level of inventory is there a holding if the component of inventory is very high
it means we consider that inventory is a current asset.
But it is least liquid so are we will try to understand that how much inventory they are having
and what is the; what are the days of their stock holding we talked in the previous class and now
I have will be looking forward to another ratio is also the one ratio is like receivables turnover
ratio receivables turnover ratio. So, in this ratio what we are to see is that is since any firm is
borrowing from the company which is making the analysis of the borrowing company.
So, it means that companies the borrowing company is also selling the product for the in the
market may be to the final consumer. So, maybe you are making the analysis of your wholesalers
or maybe the retailers or maybe one company is involved into buying from other company and
then selling it in the market to the customers. So, certainly they must be selling at the credit
along with the cash. So, by calculating this ratio that is the receivables turnover ratio we are
trying to study the Working Capital Management by the potential borrowing company.
And we are trying to find out that if they are selling on the credit in the market so how quickly
they are able to collect the credit sales. So, first part in this ratio will be to find out that what is
the extent of their credit sales as compared to the total sales are as portion or part of the total
sales what is the proportion of the credit sales, number 1 if you are not selling at all in credit it
means we can expect that there are highly liquid company and to sell them on the credit then not
be any problem for them to pay back to the selling company.
So, but if they are also selling for that in the credit on the credit in the market first we have to see
that what proportion of the total says they are selling on the credit one and if this proposal is very
large then it raises the question mark that if they are selling further in the market on credit and
the large part of the sales are going to the market on credit. So, if their sales are not collectible
quickly the how will they be able to pay back to the firm from whom they are buying?
So, the firm who is making analysis about the borrowing firm of potential or say prospective
borrowing firm, the borrowing firms receivables management has to be reviewed and has to be
analysed. So, there are two parts like inventory turnover ratio here also in the receivables
turnover ratio also we have two parts first we try to assess the level of the credit sales receivables
level of receivables accounts receivables.
And then is the collection period average collection period is how much for how many number
one they are selling on credit yes they are selling on credit what magnitude of the credit sales is
there out of the gross sales this much for example X amount and then or that credit sales are
collectively in how much period of time so that will be the say finding out debtors collecting
period. In this case receivable turnover ratio as we have seen in case of the inventory turnover
ratio finished goods inventory turnover ratio.
We taken the numerator the COGS divided by the finished goods inventory in this case we are
taking the gross sales we are not taking the only cash all the credit says we are taking the gross
sales or the total sales right. Here we can say take into account the total amount not minus excise
duty because that has also to be collected from the credit sales out of the total sales of the gross
sales if you divide these gross sales by trade receivables are by accounts receivables.
By accounts receivables so it means in this part out of this total amount when you calculate gross
is where I think is the gross sales.
We are writing here the gross sales that is the receivables turnover ratio accounts receivables
turnover ratio so what we are doing it that is the gross sales divided by what we are saying here
that is a gross sales you by the weather trade receivables or the accounts receivables trade
receivables or the accounts receivables. So, that is for example there their sales are 3000 rupees
they are selling in the market for 3000 rupees and there you say that the trade receivables are in
this case if you talk about is a 100 for 100 rupees out of the total 3000 sales 100 rupees sales are
on the credit.
If you try to find so it means these sales are 30 times it means that ratio is very, very high. Their
total sales are 30 times of the sales their making on credit their total sales are 30 times of the
sales their making on credit so it means here if you talk about this ratio which is in terms of the
times. So, are you can say that the total sales the amount of the magnitude of the total sale is very
large and as a part as a fraction of their selling on credit.
So, this not a very big amount and the company is very efficient mostly their production is going
to the final consumers or maybe what they are procuring from the other company that is going to
the market to the customers on say cash largely on cash not on the credit. So, and if there is a
credit then it is very small amount of sales which is on the credits. So, it means it is a good sign,
similarly after calculating this accounts receivables turnover ratio which is 30 times in this case.
If you see the next part next part is the debtors collection period that is debtors collection period
if you look at this that was c debtors ollection period here if you look at the debtors collection
period here this that was collection period is how we have to calculate is that is 365 divided by
the; if you divide this 365 here we have to divide 365 by 30 times if we have to divide the 360
time 30 time it means it is 30 times so if you can if you divide it so how much it works out that
that is almost 12 days.
So, it means their average collection period is 12 days that debtor collection period if you
calculate the debtor’s collection period here that works out as 12 days. So, it means total sales
out of the total says very small amount is on the credit and that credit is also been given by the
company for a how many days that is for the say 12 days, 12 days credit period is also not very
large if you talk about the Indian average for the average in the Indian manufacturing sector out
of the total sales how many are the credit sales you will find that proportion is quite significant.
And second thing you will find out is that they say sales collection period debtors collection
period is ranges between 30 to 45 days in certain cases it is up to 2 months also that is 60 days
and in certain sick companies for example you talk about that the electronic sector Onida,
Videocon there's debtor collection period is sometime you can say up to about say about 3 to 4
months also sometimes it is a 6 month also.
So, that indicates the efficiency of the firm, the firm who is efficient in the production whose
product is easily acceptable in the market and who is able to pass on the product on their terms to
the customers their credit period will be very, very short and the total sales or the credit sales out
of the total sales will also be a very small amounts. So, if you see if this kind of the situation if
you find in some company which you are analysing tomorrow in the life.
Then we have to see that out of the total sales how much sales are on credit and what is the
debtors collection period so that the first ratio should be which is the receivables collection
period or the receivables turnover ratio. This should be very, very high as high as possible you
can say and as far as the debtor collection period is concerned it should be the lowest possible
period. So, we have to see and there is another way out one of example we will be talked about
here that is 12 days weather 12 days good or bad.
There should be some benchmark to compare these 12 days and the benchmark is the industry
average and you calculate the industry average in overall in the Indian manufacturing sector. As I
just told you 30 to 45 days credit is normally been given by the seller to the buyer or by the one
company to the channel of distribution industry average that differs from industry to industry
also. May be in the electronics this one month period in the say automobiles there is 15 days
period or maybe in the other sectors.
So, that different from sector to sector also so then we have to find out the industry average we
have to take the average of that respective industry in which that firm or to which that firm
belongs and then find we will have to take a decision say for example you find the industry
average is 30 days industry average is 30 days. So, it means if this company is your finding it 12
days this is a sign of efficiency and if it is in this case for completing 5 days in some companies
and if it is 12 days so it means this is sign of inefficiencies so we will have to be careful while
analysing this ratio right.
Now the next ratio is creditor turnover ratio this is also very, very important ratio creditors
turnover ratio is that how quickly the firm is making the payment to his suppliers and this firm
who is making the analysis they are going to be their suppliers tomorrow if the company is the
selected for granting the credit. So, creditors turnover ratio means first of all it has also to be
studied in two parts first part is the creditors turnover ratio which is purchases divided by the
accounts payable or other name is the trade creditors we call it as the accounts payable order
trade creditors right.
And the second part will have to find out is that is the creditor’s payment period. So, first of all
you have to see that out of the total purchases what is the out of the total purchase what is the
amount of the purchase on credit and second thing is that to look at workout is the creditors
payment period so purchases divided by the trade credits for purchases divided by the trade
credits you calculate here
So, that is a creditors turnover ratio payment being made to the creditors so here we have to take
the total purchases they are making total purchases divided by the what was the ratio here total
purchase is divided by the trade creditors or you can say that is accounts payable or trade
creditors trade creditors or accounts payable. We have to take sometimes people say that we
should take the average figure of the accounts payable of the previous year’s closing and the
current year closing.
But here you can take the closing of one year only that is the year in which you are making the
analysis also making the analysis of the past 3 years or past 5 or 6 year then you take the closing
figure that at the end of the year how much say accounts payable on the trade creditors were
there in the balance sheet of the company and you compare that with the total purchases they
have made in the year. So, we will have to find out that say for example the ratio we are finding
out here is that is the say again 300 rupees purchase they are made.
And they are creditors if you find here that is say 30 that is a trade creditors for accounts payable
is 30, so it means it works out as 10 times. So it means this figure is showing that of the credit
purchase as compared to credit purchases their total purchase are only 10 times this is not a very
high figure. It means whatever the total accounts payable they have and what about the total
purchase a have made they have made total purchase of 300 rupees in a year and out of that say
you can call it as a 30 rupees purchases are on the credit.
So it means this is the total purchase are only 10 times for example this figure is 20 times, 30
times, 40 times so we can say that out of the total purchase whatever the total of purchases they
have made that is say for example here we take that the figure 3000 and this is 30 so it means
how much is this is 300 times. So, it means you can draw a conclusion that out of the total
purchase is only 30 rupees out of 3000 rupees total purchase this is us we are taking it and not
300 times but this is a 100 times we have to make this correction here so the sales are 100 times
not 300 times so we will have to make it 100 times.
So, they have made it 300 to 3000 now so it is not 10 times it is 100 times and 100 times there
total purchases is only 30 out of 3000 is on the credit it means that credit purchases are not very
high. So, it means there is a sufficient scope for this company to buy on the credit from the other
suppliers and if the company who is making analysis of the prospective buyer on credit. If they
decide to give them the credit I think the sign is that says their credit purchases out of total
purchase are not very high so they will be able to pay off their dues on the time.
As and when how much credit period is given by the selling company to the buying company on
the due date when the credit becomes mature on the due date buying company will be able to
make the payment to the selling company. So, let us see second part of this that is the creditor’s
payment period. And if you talk about the creditors payment period here you have to again to the
that is the creditors payment period is; we have to calculate again have to divide the 365 or you
can say that not 365 so you can say it is 360.
If you even take the 360 so or even 365 years total number of days in a year and for example the
total purchase a 10 times it means that your payment is there period is that is 36.5 days normally
within a month almost little more than a month time they are making the payment to their
suppliers. So, then again we have to see that this creditor’s payment period is about 37 days. So,
whether it is acceptable not acceptable good or bad again you have to take the decision with the
help of industry average.
Or you can see the other players in the in the market who are into the same industry how much
credit period they are enjoying and how much day after period they are making the payment. So,
they will have to compare that or industrial average is easily available these days. So, we can
find out the industry average for example you can refer to the database of the database name is
PROWESS and this the database is owned by a company called as CMIE Centre for monitoring
Indian economy, Mumbai.
So, if you refer to this PROWESS database you will easily find out the industry average of the
credit period payment period by the different companies in industry or in the different industries.
So, we can compare this figure of 36.5 days with industry average and then we can conclude
weather this average coincides with industry average this credit period coincide with industry
average it is more than that is less than that or any way we have to decide it we can decide it.
For example we say that other way around if the total sales are not only 10 times but they are 100
time so you have to divide here by 100 with this only because works out as how much 3.65 days
or almost 4 days in that case this company must be very good efficient pay master and as and
when the sales are miss first thing is only a very small fraction of the total purchases is on the
credit and the credit period which they are availing is only 4 days, after 4 days they are making
the payment to their suppliers.
So, it means it almost it is a negligible period and you can say that almost a total purchase these
are on cash very small fraction of the total purchase is on the credits still there is a scope that
they are not fully exhausted their borrowing capacity there is a sufficient borrowing capacity for
this company to expect the credit from the supplier. So, we can easily decide what is the picture
is like this that they have not 100 times 10 times and their average payment period works out as
on their own payment period works out as 37 days 36.5 days.
In that case we will have to compare this figure with industry average and try to find out whether
this period is acceptable or we have to reduce the period or we have to scope for giving
furthermore period. So, in that way the analysis can be done in a way we are making the liquidity
analysis of the borrowing firm or the prospective borrowing firm if they maintain the sufficient
liquidity with them then there be no problem for them to make the payment.
But if it is facing a problem that the firm is doing a good turn over there make a good sales in the
market and they are having sufficient profits but what extent of what extended what part of their
properties on cash that has to be measured here and finally we have to end up by looking at the
liquidity position of the firm. And liquidity position is to be studied by these different short term
ratios.
Then we have the other ratio is the current ratio and learn one more ratio is the get us Debt
Service Coverage Ratio. So, let us see these ratios I think you must have read these ratio
somewhere these are not very new special ratios everybody understands if you have some
background knowledge of some say liquidity analysis of the firms how to do the liquidity
analysis of the firms
So, current ratio is also one important component in the liquidity part and while we studying the
current ratio as you know we compare the current assets with the current liabilities current assets
with the current liabilities and if you talk about the standard rule of thumb in this ratio we have
the standard rule of thumb and acceptable current ratio should be somewhere nearer to or maybe
around 1.33 times right 1.33 times so that is the current asset to current liabilities.
Your current assets have to be certainly more than the current liabilities the current assets have to
be certainly more than the current liabilities have to be greater than the current liabilities so that
is the greater part is how much more that is at least one third level of the current liability should
be more. Why these ratios do I have discussed with you sometime in the past also that this ratios
is by the suppliers of the credit it is desired by the suppliers of material or other interest group
largely banks who are providing the short term finance to the company.
They are more interested to know about this ratio because they want to make sure that there
should be sufficient liquidity with the firm if there is liquidity firm is less likely to default. But if
dearth of liquidity with the firm liquid cash available with the firm then there are likely even then
they would not intentialy they would not default. But they are bound to default because they
have not money to no funds to pay.
So it means they should be something so what we are doing here current assets for example the
series of the current assets is like inventory here and then we have the say accounts receivables
then we have the prepaid expenses then we have your say cash then we have the advances we
have made already we have the marketable securities out the short term investments. All these
other current assets and then the current liabilities, so they want this ratio to be more than one
and that can go up to 1.33 normal sufficient ratio.
Why because if the current asset this ratio is allowed as current assets to current liabilities ratio is
allowed as equal to one in this case but will be there the current liabilities are all the current
assets just equal to the current liabilities and if any payment becomes due to be made first the
firm will do they will utilise the cash right. Once the cash is fully utilise still they have to have to
make payments then they will go for the marketable securities that they will sell of the short term
investments in the market and convert them into cash.
Advance deposits are not convertible into cash prepaid expenses are not convertible into cash
then you talk about the accounts receivable account receivables are easily converted to cash but
somehow that they can get a discount from the bank and then they can easily raise the funds and
they less likely to commit a default but in case of inventory this is least most liquid assets. So, it
means the banks wanted that as and when our funds will be due to be paid back by the firm for
borrowing the short term finance from the bank.
So, for them up the cash is not sufficient marketable securities are not sufficient and say prepaid
expenses and advanced deposits are not convertible into cash. So, they should have sufficient
current assets which can be used to sufficiently pay off or efficiently pay of the liabilities current
liabilities. So, they want that if and in this case for example if they have no their cash is fully
exhausted marketable securities are fully exhausted.
Now they have two assets inventory and accounts receivables, accounts receivables time is given
already to the buyer's credit period so they cannot be are supposed to force to payback before the
end of the credit period. So, the firm who is help us to make the payment to the other firm they
first like to sell the inventory is in the market but anyhow if the inventory is not saleable in the
market.
Then they will have to arrange the funds by getting the credit sale bills your accounts receivable
bills discounted from the banks which is again a loss making proposition to the paying firm but
they have to make the payment. So, they say that after cash and marketable securities if the other
asset in the one is not converted into cash other should be converted into cash. But that will be
only possible if they are current assets are more than the current liabilities.
So, it should be 1.33 it is acceptable ratio earlier it was 2:1 I have told you earlier also this ratio
was to his 2:1 but now in such a competitive scenario with the financial cost is a very important
cost for very, very significant cost no firm can be compelled to maintain a level of 100 % more
than the current liabilities to maintain the level of that much level of the current assets because
current assets least productive they are not contributing anything to the profits.
So, nobody wants to keep the current assets but still you want have current assets but not 2 times
its very, very expensive lot of investment will be will have to be made so at least it is 1.33 times .
We calculate the ratio if it is around 1.33 times its good if it is less than that that the firm has to
be asked first maintain this ratio and then will think about you. And if it is more than that then it
is good for the lending firm but not good for the borrowing firm.
Because their cost will increase so this ratio has to be calculated know the further; particular
liquidity position of the firm and there will be able to find out whether there will be having the
sufficient liquidity or not as and when the payment will become due to be made right. And then
we have the other ratio here last ratio is that is the debt service coverage ratio debt service
coverage ratio, so it means we are talking about the three things in the numerator.
We are talking about the profit of profit after tax you are talking about the depreciation and we
are talking about the interest and here we are talking about the interest and we are talking about
the repayment obligations right we are talking about these 5 things in total 3 is numerator to in
the denominator. So, what we have to pay here we have to pay the interest on the loan and we
have to pay the instalment of the pay instalment of the principal amount. So, this is the may be
quarterly, half yearly or annual obligation of the firm payment obligation of the firm they have to
make the payment.
If they are borrowed any money they have to make the payment it may be short term loan or it
may be any other loan maybe the long-term also but still it should be analysed. So, it it is a loan
part which we have to pay we have to regularly every month we have to pay the interest on the
loan and then we have to maybe quarterly or maybe six monthly or maybe annually we have to
pay the principal component also. So, this total makes our obligation of the firm to be made
which is in the denominator and from where it will be paid it will be paid from the numerator.
That is the profit after tax depreciation is there with us but it non cash expense. So, it means that
money is also very good those funds for which we have debited in the profit and loss account
those funds are also not gone out so they can be used in the emergency to service the debt plus
the interest which we have to pay so that will be if you have already debited that in the profit and
loss account so we will add it back to the profit because profit after tax is calculated after
subtracting the depreciation and interest.
If interest is already paid then there is no point making analysis so you will have to find out the
magnitude of the funds available before making the payment of interest and obligation and that
magnitude can be worked out by summing up the three components profit after tax, depreciation
and interest that is the numerator. And in the denominator is the obligation that is the current
obligation and the annual or six monthly or quarterly obligations that is a component of the part
of the principal payment.
For repayment of the principal and interest both these components have to be compared with the
numerator. So, numerator should be sufficiently high normally how much high we talk about
this high should be that is minimum 2 times this has to be minimum 2 times so it means this
should be in Debt service coverage server DSCR Debt service coverage ratio should be
minimum 2 times if it is more than that then it is fine.
But if it is 2 times then if it is minimum 2 times then it is reasonable it is acceptable and there is
nothing to worry about because you there maintaining sufficient as a profit after tax they have
depreciation fund is also sufficient and interest which they are paying is also not very large. So,
means if it is 2 times the numerator is 2 times of the denominator that I think the firm is in a
comfortable position and they will be able to service there that as and when it becomes due both
the interest component as well as the repayment obligation.
So, out of measure this total analysis we can draw here one conclusion that if you want to see the
make some analysis of the firm for the overall performance of the firm. Because you want to
make sure you want to make sure that they are going to the firm this borrowing firm they are
going to stay in the market that firm is a buyable firm that firm is financially say active firm and
their operations are also active.
Their finances are also message say nicely being managed effectively being managed and there
is no likelihood of possibility that they will become another Nirav Modi or maybe Mehul Choksi
or they will be another Vijay Mallya that they want to take the credit from different sources then
you enjoy the credit for sufficient period of time and after that wind the business in and run out
of the country that should not the situation.
May be a small supplier or a big supplier is the credit security is important for everybody and if
you talk about the current security for example the suppliers if you think about in case of big
companies who buy the different inputs the suppliers are very small in size say when you say
talk about the Videocon they are manufacturing the colour TV to buy manufacturing the colour
TV they are not manufacturing anything.
That buy circuit from some source they are buying cabinets from some source and they are
buying say other inputs to the TV from other so different sources. So, it means those sources or
those suppliers who are manufacturing circuits who are manufacturing cabinets for
manufacturing glass part or the screen then very big they are small and their business is a
running that they fully dependent upon the final user of their product.
So, they are ready to give the credit but they want one security that whatever the supplies we are
making to you we will get back our funds on the due date how much credit period we are giving
you how much credit period we are trying to give you or maybe we are giving you that
symbolises should be maintained by the user also so that it not difficult for the supplier also is
not difficult for the user also both are working and tandem to full fill each other’s requirement.
And if the supplier is giving the supplies on credit and buyers using that and further selling the
product in the market and then collecting the dues from the market and making a payment back
to the supplier. So, that way it is a Win-Win situation for both. But if anybody defaults in this
process then entire symbioses disturb and entire relationship is disturbed and finally miss it will
spoil the supplier also it will supply the user is already in the buyer is already spoilt. So it means
is it will harm many players in the market.
Because there are many stakeholders in one business here that is why I was talking to that we
have to make two broad analysis operator structure of the firm and the financial structure of the
firm and with the help of certain ratios we can study the operating structure and the financial
structure of the firm and always make a golden rule that look at the operating structure if it is
good maybe the and for example both the structures are good operating and financial then do not
worry you give the credit.
But if operating is good financial is not that very good then nothing to worry about because the
firm will improve but reverse happens that operating structure is poor and financial structure is
very good never give any credit to that buyer on credit because your funds will not be safe in that
case right. So, this is the point of analysis made here with the help of certain ratios these ratios
are not new but the context share was and which we have used is ratios were important.
That how to use this ratios how to analyse this ratios and finally how to interpret these ratios
after this operating and financial year analysis of the potential borrowers we will be analysing
the managerial structures and industry scenario and how they play the important role in finding
out the as possibility of selling on credit in the market that we will be doing but that we will do
in the next class thank you very much.
Dr. Anil K. Sharma
Lecture-44
Credit Risk Analysis-III
Welcome students so we are in the process of understanding the receivables management and
they are the important analysis required to be done. So, far we have learned about the two broad
parts of the analysis that is operating structure analysis in the financial structure analysis and
their be learned with the help of certain ratios now we will be talking about the next part that is
the say analysis of the managerial structure of the firm
And then we will be talking about the industrial scenario that is also very, very important. Here if
you talk about the managerial structure of the firm I am writing here I got it on certain points like
integrity and honesty then we have track record and then we have organisation structure and
systems when is the expertise competence and level of commitment and then is the perception in
the market important. These are the important five points.
Integrity and honesty that is the first and foremost point to be honest businessman honest
management when we are lending to somebody whether it is lending by the supplier is the
lending of services is an lending of funds say by the bank or maybe other agencies or other
Financial Institutions honesty and integrity is most important. If you are enjoying a good
reputation in the market it means the borrower’s integrity is very high and he his honest and that
takes her this policy of any borrower any company takes them to level where they want to reach
or even sometime beyond that.
So, we have to let the analysis as the supplier because we are not thinking of supplies them once
or twice we are thinking of supplying them on the long term basis and since we are talking of
supplying to a firm who is not maybe in our city or maybe who is not known to us, he is at the
different city on the different location. So, we try to know that if we are going to have the
relationship with them for the first time then how likely it is going to happen that they are going
to make the payment of the deuce on time.
Because I told you something about the symbiosis disturbance of symbiosis in the previous class
is not the case that supplier cannot supply only thing is it is a chain is the total financial chain
because if the supplier is manufacturing some part or they are not giving the final shape to the
product they are giving the input product to the final shape to the other user. So, it means he has
to sell on the credits he has also to buy on the credit. So, if he is buying on the credit he has to
make the payment to his suppliers.
And he can only make the payment to suppliers when his buyer or buyer from him or borrow
from him is paying back to him. That is why I told you sometime back that if there is a credit
period someone firm has given the credit table of 30 days to the other firm and other firm has to
make the payment certainly after 30 days. So, make it a point always that the paying firm should
all be I make it a point that is better for them to pay by the evening of 29th day not even 30th day
morning is better to make the payment on 29th day evening.
But never to delay it to the morning of the 31st day for the paying firm it is a delay of a few
hours rather than paying by the evening of 30th day if they are making the payment after one
night on the morning of 31st day that may be very minor or very small ratio for the paying firm
but for the receiving firm its creating big problem. May be it is possible that the paying for the
receiving firm had to further make the payment to their suppliers and had promised that on 31st
day morning will make the payment to you.
So, if the paying firm is making the payment on 31st day morning then they certainly they will
be making the payment by noon or maybe by the evening of the 31st day and that way that spoil
the repetition of the first firm who had sold to the paying firm and that firm who has paying to
the firm they further had to pay back to their suppliers so it means it disturb the symbioses. So,
we have to be very, very perfect we have to a very, very careful food we have to be very, very
responsible and all these things to a large extent depend upon the integrity and honesty of the
paying for firm.
If they are honest they want to make the payment from anywhere they will arrange the funds
they will be making the payment on 30th day morning they will not delay the payment because
they understand the meaning of the business they understand the meaning of sincerity and they
understand the meaning of not paying it on the due date how much harm it can cause to the
selling firm and even to the buying firm also because it will spoil it will harm their reputation.
If somebody is if somebody is waiting for our payment that we must make sure that this payment
reaches to the; who has to receive the payment. For example you talk about the Vijay Mallya
case he is not running short of money see if he has borrowed money 9000 crore from Indian
banks number one he has mismanaged those funds right with me he was not honest and as per
the integrity is concerned.
Now it is proven fact that his integrity was at doubt people could not understand it in the; at the
time when they should have understood it. He never intended to pay it back he borrowed the
money just to diverted to his other firms and to flee the country and he was not say thinking of
that to pay back that was the reason he borrowed beyond his repaying capacity as a seller we can
easily make out that how much is borrowing how much is borrowing.
And say for example has been made the analysis be completed one ratio here the ratio was that
the other creditors turnover ratio. Out of the total purchase how much purchase is the firm is
making on credit and if it is a very large amount credit purchase amount is very large and the
ratio is very, very small and time in that case is a clear indication that the did not want to make
the payment they want to default.
So, if still we are supplying to them we should be prepared for any kind of the default we should
not expect our payment coming back to us on time or sometime if we should not be surprised if
the firm refuses to make the payment was forever. So, when you are giving debt to a person to a
company or group of companies which is much, much beyond their paying capacity without any
collateral without any security.
The Kingfisher group that total loan given by the banks State Bank and other banks that was
without any kind of the security, without any kind of that collateral and then they were asked and
they were enquired by the different investigating agencies they said that only on the name of
brand name Kingfisher was a very big brand name and by just taking into account the brand
name we extended the credit and when he left the country there is nothing left behind.
May be a few crores are only collectable by selling his house and maybe other some other
companies and something like that. So, it means we have to be careful that the borrower is
borrowing how much what is his behaviour with the other suppliers what is his overall financial
position what is operating structure when you make such a collective analysis in totality you are
able to find out integrity and honesty of the borrowing firms.
For example you see that who default in paying the say credit provided by but by the employees
because when employees work with any company there also giving us the credit to the company
in which they are working there giving at least 30 days credit they expected that after 30 days on
the 1st of every month of 7th of every month will get the salaries. So, they are working on the
credit day one onwards nobody ask for the salary they know that after one month we will get the
salaries.
And Vijay Mallya defaulted in that case also number of people working in his companies they
went without salary. So, it means supplier’s credit is also defaulted employees credit is also
defaulted and financial institutions certainly and it is very clearly defaulted. Talk about the Nirav
Modi he also did the same thing his employees are without salaries he is not having sufficient
stock here he borrowed 12,000 crores of money from a bank and then if you are miss lending to
somebody without any kind of sufficient repaying capacity.
It means either you are not sincere in checking the integrity and honesty of the person or you are
wilfully doing it. So, it means in both the cases the lender is at fault either has to forget his credit
or the people who have committed this blender they should be brought to the books and the
action should be taken but what happens that is the matter of now the future. But for every
supplier weather is a supply of work it is a supply of say you can call it as the material or any
other input or the finance.
We have to be careful about the integrity and honesty for example when we talk about supplying
or selling our product or exporting our product measure the manufacturer in the one country
when the export their product to the buyers in the other country sometimes the most of the time
goes exports are also on credit. But in that case the suppliers ask the buyer in the other country to
send him a LOC letter of credit from his own bank in his own country who is operating in the
exporter country also.
If that LOC comes there is no the guarantee we do not know the honesty and integrity of the
person sitting overseas. But if he able acquires the LOC from schedule bank or the say well
functioning bank then we can make sure that yes now our funds are safe and secured. Because
they are not able to know about it what kind of the borrower he his, what kind of the buyer on the
credit he is. So, there we have to go for the security and that letter of credit provided by his own
country is banker is served as the collateral or the security.
If he defaults we will demand the funds from the banker exportable demand the funds from the
bank and bank cannot afford to default. So, first point is the integrity and honesty second is the
track record, if he is the first time buyer from company X then company X responsibility is to
check it with the other suppliers how he is behaving with other suppliers. If he is doing well with
the other suppliers and he feels making the payment on due date then there is no harm.
Because track record is good and if used for example is a regular buyer from any company who
is because that credit policy is keep on changing sometime the company is make short term
changes we have seen in the past. Sometimes company has long time changes so if you have to
make the credit policy for example you want to sell more to our existing channels of distribution
and for that we have to relax the credit period.
So, relaxing of the credit period will depend upon the track record if the track record of all over
buyers is good excellent that there is no harm in relaxing the Credit Policy so that they can buy
more on credit sell further more in the market and expand help the company to expand its
market. But if the track record is doubtful or he has defaulted sometime in the past also then be
careful not given the credit either from the existing say suppliers or over the years if this
companies are any companies regularly buying on credit from the supplying company.
And the supplying company while making any kind of changes in the Credit Policy they must go
for the track record. Then is the organisation structure and system what kind of the company it is
to whom we are going to supply. Whether it is a one man show or mean to it is a private limited
company or it is a partnership firm or it is a large public limited company. If it is a large public
limited company 1000’s of people are working on 100’s of people are working there is no
problem here credit is secured.
But it is a one man show all it is a partnership firm then we have to be little careful while making
this kind of analysis. For example Maruti manufacturers car’s and they are not manufacturing
anything themselves only there manufacturing is a gearbox that is there technology. Other things
for the steel there depending upon the suppliers, for rubber parts and applying for depending on
the supplier, for the tyres are depending upon the suppliers, for the tubes are depending upon the
suppliers for the any other glass parts there depending upon the suppliers.
And nobody thinks even for a second while extending creditworthy or Suzuki motor out because
it is a Suzuki Motors India Limited because their credibility is proven. There organise structure is
this a multinational company even in India also it is a large size organisation who has about 45-
46% market share right and big multinational company from Japan they have 50% share holding
say in the Maruti Suzuki Motor India Limited.
So, it means you blind fully you can think of extending the credit rather than people will aspire
for we should be supplier for Maruti Suzuki or to this kind of the company. Similarly if we talk
about Samsung it is very good name, LG very good name all this multinational companies we
are supplying to them I think suppliers try to find out the channels through which they can start
supplying on credit even to these companies.
But if you are supplying to the companies owned by Nirav Modi and Vijay Mallya then think
about that it is the one man show and there is no credibility of these people in the market and
even in case of the sole proprietorship honesty becomes important integrity becomes important
organisation structure is matter we have to look for the organisation structure also that if it is a
large company do not worry much.
But if it is a small company or a partnership firm we have to be careful or we should ask for
some collateral and some security. Expertise, competence and level of commitment expertise
competence and level of commitment who is the company from where request as come on buyer
who is seeking the credit what is a standing in the market how long since they are in the market
what product manufacturing and selling in the market.
What product they are manufacturing and selling in the market, what is there life in the market.
If we are going to supply to a new company who has comes in the market for the first time if you
are going to supply to them or maybe a channel of distribution wholesaler retailer who has come
for the first time in the market he want to have the credit and then to sell in the market. I think it
is not possible so competencies very, very important, expertise is very, very important and level
of commitment is very, very important.
For example we talk about new entrepreneurs people graduating from graduating from IIT and
IIM’s they if some of them or any of them want to establish their own industry or their own
industrial unit for their own company they want to start they have to certainly look for the funds
and in that case the person on the group of those students they did not have any other credibility
or any other collateral to give they have only a few thousands in their pocket and a very good
scintillating idea that this idea and if I am allowed to implement this idea give shape to this idea.
Then this can be a very, very useful and acceptable idea in the market the product of the service
coming out of this idea will be the excellent idea and will be the excellent product of the
excellent idea and I should be funded for that. Say for example if he goes to the bank, bank
because he is no track record there is no say known that fact that the person is competent and the
ideas workable or its the product or service coming out of it is saleable in the market, no idea
about it the banks not give the credit to the new entrepreneurs.
Similarly you talked about if they want to come with IPO in the market there nobody will
subscribe to their shares. So, even if they make the public company so that company has to have
some minimum life to become a public limited company and to come with the come up with the
IPO because SEBI rules say that this should be minimum life as your off your existence will be
as a sole proprietor partnership firm a private limited company.
Day one from you cannot make the public limited company directly until and unless it is being
sponsored by some existing group or your promoter shareholding should be very, very high. So,
means equity is also ruled out debt is also ruled out, so in that case these entrepreneurs go to the
then other channel of distribution channel of funding and that is the venture capital, private
equity. Venture capitalist has to be explained about the idea the competence and expertise of the
person who is proposing an idea who is proposing of establishing industrial unit of a company
and his seeking the assistance from the venture capitalist.
Because venture capitalist people venture capitalist they are very, very expert in evaluating
different ideas. His their job everyday they are doing that and even the private equity suppliers
are also very good business people and they can be easily make out what idea one has come with
to them and whether it is workable or not. So, he will have to explain the total idea the total
concept which is here she is carrying in the mind with the supply of the venture capital of the
private equity.
And if that idea is looking workable and that venture capitalist can easily find out then they will
think of funding the business otherwise not and even then if there is that taking decisions in
favour of supporting the firm of the company then even though even in that case interest rate is
very high somewhere that goes up to 40-45% also. Because they are going to take a huge risk for
which they should be rewarded.
So, venture capitalist venture capital in the other name is also called as risk capital. Once they
are going to take the risk of implementing a new idea they are expecting a very high return for
that. So, it means we have to check who is seeking the credit what is his existence what is his
expertise what is his competence? What is his level of commitment in the market?
So, another important point and the last under the manager is structure is perception in the
market. How people perceive about any company. Now when you talk about electronics market
if you talk about Samsung if you talk about LG if it talk about Sony their perception is very high.
But we will talk of Videocon if you talk about Onida their perception was also very high at some
point of time till 2,000 but after that it has seriously fallen down today if you study the balance
sheet of Onida they have to say them that they are in great financial distress.
And they have borrowed money from bank they are not able to repay back they are taking the
suppliers credit and some time for say 6 to 8 months they are not able to pay back to their
suppliers. So, it means what is the reason because your own a same product has become least
level in the market. So, if there is no liquidity with the user of the funds certainly he will default.
But he will not be able to make the payment due date to the supplier.
So, perception in the market is why we are having high perception about the multinational
companies because they have their own credibility they have their own reputation. Similarly if
you talk about the TATA Group or the Reliance or maybe a Birla there credibility is very high in
the market any of their companies and have their companies who are coming out with any
product or service in the market people that do not doubt about that.
So, there is no question of doubting such companies by the suppliers of credit by the supplier of
material or by the by the supplier of services to them it means that perception also works. Third
point analysis as you are talking about is the managerial structure after the operating and
financial structure you make the analysis of the managerial structure.
(Refer Slide Point: 21:08)
And the last part of this discussion is the industry talk about the industry scenario that is the
important consideration here it is look at the competition. If it is a highly competitive industry in
which the company who is seeking the credit works then be careful. Cyclicality of industries if
say the industry is facing the cyclical trends up and down;
For example the trends are going up like this to see that how efficiently is a company has been
able to take care of their the cyclical trends sometime the sales are going out sometime the seeds
are going down. For example the any company manufacturing products based upon the
agricultural material. In case of the agriculture materials when there is a harvest season and they
have to buy the inputs.
For some company manufacturing the wheat flour, so when there is a wheat coming up in the
money is in the market so it means that credit need to go up and then they will store the wheat
and then they will start crushing it and converting into flour selling it in the market and then they
will start paying off certainly they should be supported by the financial institution or the Banks at
the time of the harvest season because they need more capital they need more funds are they able
to pay it back on time or how the help in managing the funds in the past the track record will
have the back to take the decision.
So, cyclicality of industry and how the borrower is managing their business during this
cyclicality of the industry is important consideration. Then is a regulatory now you see that what
has happened in the past in case of the Indian banking scenario State Bank is then say deceived
by Vijay Mallya, Punjab National Bank is deceived by Nirav Modi and his company and his
maternal uncle.
Now the RBI has become very, very careful even the SEBI has also become very, very careful he
converted the controller of capital issues office after the Harshad Mehta scam in 90 and brought
1992 SEBI security and exchange Board of India and after becoming a new regulatory has sharp
teeth SEBI has been effectively able to come to effectively able to control the market and to
prove to be a very effective regulator.
Same is going to be the case with RBI after this banking scams so regulatory risk is very, very
important say for example you talk about this Telecom market we have the TRAI so they are
immediately take action if somebody is not responding to the customer’s needs. So, it is the
regulatory pressure is high you can expect that your borrower less likely to default because a
regulator is going to take the action in case of any complaint or any kind of the problem.
He is the regulatory is going to take the action and then say the company cannot think of say
continuing their business. So, on company who want to say who intend to continue with the
business can take the risk of not making the payment of their credit on time and face the higher
of SEBI or maybe sometime the RBI. So, regulatory market has to be very carefully analysed
technology and obsolescence.
For example industry in the IT industry the obsolescence is very fast we depreciate a computer
system in India at the rate of 33.33 % is one computer system is being purchased today that has
to be that has to be depreciated in the next 3 years. That has to be depreciated in the next 3 years
so it is example of IT industry. Look for that if you are supplying to a company who is
manufacturing the finished product by using the technology which is maybe it is a saturated
technology or to say some upcoming technology or it is still going to its technology is still
expected to have the market or the other life.
If it is saturated technology be careful do not supply to such companies for manufacturing

product based upon that. For example we saw the Motorola case, where Motorola is using
technologies which is out of the market and it became sick company so it has to be taken over by
Lenovo. Lenovo then had to invest a huge money to bring the Motorola is name, name was good
the brand name was good for the technology was old so they had to wind up the businesses in
India.
They have to sell of their business for Lenovo of China so that technology and obsolesces risk is
very, very important. If you are supplying to a company who is not able to then to on the long
term basis sustain in the market because their technology has already become obsolete and they
have not made any further investment to upgrade the technology or their systems then what will
happen the product manufactured by those companies or by using such technologies by this
company.
They would not be able to for the same pass on these products in the market for example you
talked about in 2000 Videocon and Onida about the leaders of the electronics market in the
colour TV segment they were the leader not even colour TV all the segment all the products
manufacturing selling like hotcakes in the market. But when we had when be allowed Samsung,
LG to enter the Indian market so then people saw the difference in the technology, technology of
Samsung and LG and technology of the Videocon and Onida.
Immediately people shifted and the companies which had the highest market share and half of
the market was with these two companies immediately lost the share losing the marker share
after 1999- 2000 and today where these companies are. And today if you analyse a balance sheet
of these two companies is there their short of funds provided by the banks are blocked they are
not able to pay them back to the bank they are not able to service the debt back to the banks and
somehow banks are trying to take that money back from the two companies because they
technology becoming obsolete.
They never try to renovate technology and their product manufactured out of that technology that
became redundant in the market and their sales dropped. So it means anybody who had supplied
credit to these companies their credit is at risk. Then is the availability of raw material and other
inputs and their pricing. That is another important component in the industry scenario we have to
see that availability of the raw materials.
Because for the supplier also we are not thinking of supplying any material or anything analysing
any company as a banker or from the banks point of view, Financial Institutions point of view
and bank is received the request from the company to provide the short term finance for working
capital. The bank apart from analysing their overall financial performance, operating
performance we should also make sure what is the raw material and from where it is coming
what is the source of raw material.
If it is agriculture based product are they able to by sufficient raw material during seasons and if
are not able from where they are buying the raw material and raw material source, labour
availability and labour source and similarly other inputs are going to give you some sense of
security that this company is well managed well-functioning organisation and we should not
worry about anything about the security of our credit.
And lastly risk of substitution we had we are totally see that changed for example you talk about
the telecom Industry that the headsets we are using today a few years back they were not into
existence using those other handset which would have been the buttons and other things. So,
those switch based handsets are out of the market. Then we have you talked about the computers
you have today say one level of the computers then after one year it disappears from the market.
Then the same after sometime the new advanced upgraded product comes in the market. So, are
we able to upgrade the technology to cope up with the market to cope up with the changes
technological changes manufacturing changes so, that the demand for the company's product can
be kept intact that is a very important.
Otherwise it may be possible that we have funded a company who is manufacturing a product
which is substituted or going to be substituted very fast with the new products coming up in the
market. So it means the funds provided or any supports provided by any supplier is at the risk all
these points now we have to be miss you have we have to be careful while analysing the overall
performance because granting the credit it is a very, very important decision whether it is a bank
whether it is a supplier whether it is a worker.
Everybody has to be very, very careful because this sickness of the suppliers health also begin
with the say funding the wrong ventures are providing the short term finance or maybe the short-
term supplies to such firms who are not doing well in the market and we are not able to visualise
their weak overall financial position financial health or their overall financial performance. So,
for that and apart we have to do this detailed analysis starting with the operating structure of the
firm.
Coming to the financial structure of the firm these are the two important analysis and these have
to be supported on supplemented with the managerial analysis of the manager the structure and
the your managerial the structure of the firm and the industrial scenario. Industrial scenario is
also very, very important company important component because when we opened up this
economy in 1990-1991.
Then this new comic policy came up in 1991 before that nobody thought of that suddenly closed
Indian economy protected Indian economy will become the Open Economy all multinational
almost in all the sectors will be allowed to come to India. So, what will happen to the Indian
firms Indian organisations who were not able to face the competition and when it happened most
of the Indian firm had to die.
So, industries scenario is very, very important at the same time we should try to have a close
look in the budget document of the government every year that what are the priority product
industries for the government in the coming one year. Similarly we should look at the economic
survey because they are supplier of the credit we should see what is the future of one particular
industry the different ranges of the industry’s. What their future? What is their performance and
what is their say financial health expected to be in the time to come, because many sectors are
directly or indirectly positively or negatively affected by the budget of the central government of
India as well as the other countries.
So, every where people who are the suppliers of credit or any other kind of input have to be very,
very careful. So, with this analysis we will stop here and next time before the say closing this
part the discussion on your receivables management I will discuss three points with you that is a
Credit Standards and Analysis, Credit Terms and Collection Policy and Procedures but that I will
discuss and these three important components I will discuss with you in the next class thank you
very much.
Dr. Anil K. Sharma
Lecture-45
Credit policy Variables
Welcome students, so in the process of say understanding the receivables management now we
are in the last leg of this discussion and today will have some more discussion about the
receivable management and after that I will close discussion on it and move to the next part that
is the management of the third important current asset that is cash. So, after talking about the
credit risk analysis where we discuss the different four kind of the analysis to be done that is an
analysis of operating structure financial structure then the managerial structure as well as the
industry scenario. Now we will talk about the something called as the Credit Policy Variables
Credit Policy variables
Credit Policy variables are normally 3 credit standards and analysis number 2 is the credit terms
which are two important terms credit period and the cash discount and third is third variable is
the collection policy and procedures for these are the 3 important variables which are called as
the Credit Policy Variables right. Now the credit standards and analysis when we have to grant
the credit or any firm has to start getting the credit or has to grant the credit or start selling on the
on credit they have to set the standards.
Standards can be very stringent they can be liberal or they can be in between the two. Now if the
firms credit standards are very strict in that case only those buyers prospective buyers who enjoy
very good reputation on excellent reputation in the market they will be considered for the grant
of the credit and whose reputation is not very good I would say it is satisfactory ok but not very
good or who are do not do not enjoy good reputation in the market good credit rating in the
market they will not be granted any kind of the credit.
So, as per the credit standards what the company's do they normally divide their customers into
three broad categories.
That is a category A customers, B category customers and the C category customers right. A
category customers are excellent customers, B are in between and C are the at last stage that if
say for example if firm want to pass on it is finished products I means converting the inventory
into the receivables then only it can be thought of, that too if the risk is at the acceptable level
otherwise the firm would like to keep it does inventory and bear inventory cost.
But sometimes firms prefer that rather than keeping anything in inventory holding inventory on
increasing the cost of production because holding the inventory has many cost including
obsolesces. They pass on it to the buyer on the credit and is the agreement between the selling
company and the buying company that you pass on the product in the market to the people the
sell the product finally in the market to the people and after the collection of the sale proceed you
can remit our part to back to the company and the that you can have your profits with you.
So, companies whose credit standards are very good and strict they will only like to give the
credit to the A Customers of customer and not to be B and C category of customers. But say
sometimes what happens that it may not be possible to achieve that targeted sales by simply
selling on cash or selling on credit to the A category of the customers. So, sometime after
reviewing the Credit Policy maybe for the short term basis or on the short term basis are on the
long term basis sometime companies even say liberalise their credit standards.
And sometimes include the B category of the customers also and C category of the customers are
only to be taken into account if there is a problem of selling the product in the market. Now if I
was talking to you in the previous classes sometime that is a Maruti, Maruti is depending for its
most of the inputs from the different suppliers other than the gearbox Maruti is not
manufacturing anything. So it means Maruti is A class buyer because Maruti is never going to
default they may ask for the longer credit period.
And for that created period also they are allowing the seller or the suppliers to load their credit
sales with the interest Factor no problem at all means whatever the sales are made to Maruti
Suzuki or Suzuki India Limited those are fully secured because of the reputation of the company
Suzuki reputation in India or maybe another multinational deputation in India if they are buying
on credit something some reference from the suppliers then they are making the payment of the
due date and their say credit is secured.
If you talked about how the C category I was talking to you about the companies like Videocon
Onida they in the date of today they are the C category of the buyers that if they want any kind of
supplies if they want any kind of supplies in that case there supplies will be or supplying to them
on the credit will be highly risky. They would say that will make you the payment back as and
when the funds are there with the liquidity is there.
So, means they are the C category of the customers because their own performance has become
doubtful in the market. So, even they are selling the final product to the consumers through the
retailers or through the distribution channels on the basis that simply keep the product in the
store and if you are able to pass it on to the people than your relative path to us otherwise you
keep on keeping it.
So, it means simply then the retailer is allowing them the space on the on his shelf to keep their
TV or their fridge or there a washing machine and he is ready to help the companies that much is
good enough for this type of the companies. So, they are not say in a position to to see that they
should be selling to A category of customers are the B category of customers or the C category
of customers for them all are well normally they sell to the C category of customers so it means
if the customers able to make the sales in the market and collect the sale proceeds and then they
will make the payment back to Videocon on Onida otherwise they may not.
So, here credit standard when we talk about credit standards maybe stringent they will be liberal
or they may be in between mediocre standards. So, that depends upon that how we have to set
the standard when the company's product is very, very good you talk about car segment you talk
about Honda car you talk about Suzuki’s car any multinational companies cars in India they are
doing well.
There are some companies for example when talk about say Fiat or when you talk about General
Motors who has the I think closed on its operations in India their products people are not liking
much do they are good products for people are sometimes having the preference for Honda or
Hyundai products or maybe Suzuki products. So, it means is some of the companies were not
able to do the business so for them means their credit standards have to be a liberal their credit
standards will be liberal.
For the company who enjoy a good reputation in the market for example in case of the Samsung.
Samsung is the company who accepts dealers and distributors to do the business on the
company's terms so they ask the dealers and even retailers to send them advanced post dated
cheques and it is not up to the dealer to play is order to Samsung that is I want to have 10, 20 or
30 colour TV’s it is up to Samsung that when they have the surplus stock it is passed onto a
dealer on particular place he has to accept that order and yes to sell the product in the market and
advanced tax used as the payment by the company.
So, in that case they are not giving any credits and if even they are giving the credits that is only
for a minimum period of time and that too only the best quality of the retailers in the market. So,
we have to analyse the borrowers and accordingly we have to set the standard. If the is at the bar
belongs to the A category so for them there is the standard has to be very liberal because
payment is security.
And if C category then in that case the company has very, very strict and they have to analyse
that firm any angle so that the payments secure. Then we talk about the second thing that is a
Credit terms I have talked to you earlier also credit terms means credit period first thing is a
Credit period and second is a cash discount it is a option of a given to the buyer to the buyer do
you want to buy from any particular supplier on credit or you want the cash discount.
So, if you want to buy on the credit so that credit period standard credit period maybe say the
complete the sellers credit period is one month right that credit period is one month. So, this is
the one of option that you want to take the credit so yes I can give you the credit for one month
30 days you buy the product for me today and you make me the payment after 30 days that is one
term.
Second term is the cash discount that if you are ready to pay me cash in that case I will give you
2% discount I will give you 2% discount that you make me payment less by 2% so choices of the
buyer if you had a surplus funds available in that case he would like to buy on cash and enjoy the
cash discount. Even he can weigh the option that if we can borrow the funds from the bank and I
directly make the payment to the company by enjoy the discount of 2% means 2% if it is per
month.
This is the 2% per month so it means per annum will be how much 24% so sometime the buyer
weigh the options that if they from the bank if you go to the bank and bank funds are available at
18% so why not to enjoy this because this is going to lose this 2% discount is going to pay 24%
cost and if he going to borrow money from the bank he is going to pay 18% to the bank so it
means he has to make a choice that whether he has to lose this 2% means if you talk about 24%
per annum gain.
And if he is not in a position if he is having no liquidity or he is not able to raise the funds even
from the bank then he has to go for the credit period and say one month is ok for him . So, in this
case what we have to do is normally as we have seen in the past also but we write here is 2 by we
write here like say 2 by 10 net 30 this way the credit terms are written 2 by 10 net 30.
Here 2 by 10 net 30 means we are not saying that he has to make the payment when is buying on
cash he has to make the payment immediately he can be allowed to make the payment after 10
days that normal credit period of 10 days I will give it to you if you are ready to pay me within
10 days from the purchase from me I will give you 2% discount so this is 2 by 10 otherwise net
discount of the 30 days is permissible to you.
But in that case you will not get any discounts we write that credit terms like 2 by 10 net 30 that
if you are making me the payment within 10 days I will give you 2% discount otherwise normal
credit period of 30 days is there. So, these are the two credit variables a credit terms that is the
credit period and the cash discount. So, these are important and every firm has to decide that
what will be there normal credit period.
Because in India as I told you that I did period ranges between 30 to 45 days in some cases it is
up to 60 days also and if the firm is not very good but now is not very good was very good in the
past in that case the discount credit period maybe more than 2 months also but the normal
average if you talk about it ranges around 45 days, 35 to 45 days and in some cases it is 60 days.
So, the firm who is going to grant the credit has to decide that what credit period normally they
are going to give and that depends upon the say their brand equity their reputation of the
credibility of their product in the market acceptability of the product in the market pricing of the
product in the market or maybe say the quality distribution demand of the product in the market.
If it is selling like hotcakes then maybe hardly minimum credit period and if it is to me some
efforts are to be made of sometimes what happens when the companies have to enter into a new
markets.
When many companies have to enter into the new markets in that case they have to sell the
things initially on credit. So, that is, that depends upon that in the existing market how much
credit period you normally want to give in the new markets how much credit period you want to
give. Sometimes the credit period can be extended also if we have the piling up of inventory. So,
that can be the short-term changes as we have seen and analysed quantitatively that say they
want to normally our credit period is 30 days.
But sometime when the stock is piling up and demand is sluggish in the market so we will have
to relax our standards and would have to increase credit period from the 30 days to 45 days right
or other way around we can have the other option available to be given to the buyers that how
much discount we are ready to give. So, normally discount remains 1 to 2% depending upon the
order. If the order size is very big than 1% discount and if it is small then it can be 2%
depending upon the order.
So, that it was interpreted to the buyer also and this not very, very expensive to the seller also. So
every company has to have this particular variable that is credit terms which are to credit period
and cash discount then we talk about the collection policy and procedures. Collection policy and
procedures collection policy and procedures should be very, very stringent very, very clear very,
very particular. Sometimes what happens that when we are selling on credit then every company
has to create one department which is known as the debt collection department.
This is called as debt collection department and when a sale is made from the sales department
that invoice duly accepted after the receipt of the consignment dual accepted by the buyer is
received by the sales department Marketing department sales department and marketing
department and then the marketing department send this that invoice to the this debt collection
department. This goes to the DCD debt collection department full-fledged department company
has to establish.
And their job is to keep track of that how much credit sales behind made and over different
periods like weeks months fortnights how many or which order is becoming due to be received
this which payment is becoming due to be received against order the supplied in the past they
have make say for example there are the different dates 1,2,3,4,5,6,7 like this we are the dates
and they are making a proper record.
That on first three payments are expected here 5 payments are expected here 4 payments are
expected to this way for multiplying payment on enabled for example 1 lakhs each. So, this
means on 1st 3lakhs rupees should be collected by this department. So, this is only possible if
there are maintaining a proper that debt collection department and the department maintaining
the proper records of a credit sale.
These days the trend has come up in India it is new trend but in the other countries like USA
Europe this kind is already exists that normally firm who sell on credit may take the services or
help of one agency which is called as Factors Factors. Who are the Factors? Factors is a agency
or specialized agents who apart from providing many services to the manufacturing companies
they provide one service that they maintain this department also that is debt collection
department of the companies.
If a company who is the seller who is the manufacturer and seller on credit if they want to
dismantle their debt collection department because we can make a comparative analysis in the
comparative analysis that, collection department has a cost we have to have the people we have
to have the space we have to have the some equipments also and it has a monthly cost and it has
the annual cost for a maintaining the debt collection department which makes our sales very
expensive particularly when we are selling on credit.
So, if we are thinking of that rather than maintaining our own debt collection department DCD
we can take the help of the one agency specialised agency which is called as Factor and Factors
job is that when any firm is when was any company has taken the services of Factor who has
appointed from Factoring firm called as FF Factoring firm. Any company has appointed their as
a service provider is Factoring company has their service provider.
So what they do first thing they do is debt collection department is dismantle that is removed
from the company is the cost they saved. And this job is transferred to this external agency which
is called as Factor. The day when the sales are made by the sales department and marketing
department, marketing department then after getting the invoice duly accepted by the buyer
passes it on to the Factor that invoice is sent to Factor and that invoice is maintained by Factor
till the time that credit period becomes over.
On the due date or maybe one day before the due date a phone call has to be made by the Factor
to the payer that tomorrow your payment is due for this much to this company and we hope that
your cheque will be ready and you will be sending the check to us or maybe making the online
transfers right. And of the due date next schedule make sure that the transfer payment is
transferred by the Factor to the company.
So, there can be to arrangements that the paying company can make the payment to the Factor or
directly the paying company can make the payment to the selling company and Factor can be
informed that yes we have already made the payment of this particular order yesterday it was you
may have already made the payment on that date. So, the Factor can make the say required
entries. But in some cases when for example the payment is delayed by the by the buyer to be
made to the seller if it is delayed then say some notices some legal work or some technical notice
or legal notice as to be done.
First they so the normal and ssimpler things reminding them making a phone call and if they are
not listening then they will give them and simple notice, proper informing them in writing and
still they are not listening then sending them the legal notice and all that. If all these things are
not working then they Factor will inform the company that we are your payment was due from
this particular company in this particular customer on this date and be he has not made the
payment to you till date or in your account.
We tried it at our level best and he is not responding or has refused to make the payment so
please let us know what is to be done. So, means total rights are transferred by this company to
the say Factors and Factors provide apart from so many things as discussed with you the Factors
that appropriate place what are the services the Factors provide but here the important service the
Factor providers that they perform the job of the debt collection department.
And it is not only the debt collection function but they help the selling company by reminding
the payer by writing him the letters by issuing him the simple notices by themselves or even by
giving the legal notices to the extent possible that try to help the selling company to realise the
payment from the buying company and if it is not possible then find the matter reported to the
selling companies that your payment was due and he has not made the payment we have done
this much so you know you see what is to be done.
This service can be taken so it means collection policy and procedure has to be clearly laid down
by every company that is how the payment will be collected whether the payer will be asked to
deposit the payment directly in the bank account or he will be ask to send the cheque and cheque
will be deposited in the bank by the selling company after receiving it or any other way it has to
be collection policy has to be very, very clear very, very even say stringent also.
So, that nobody takes a feeling that if we delayed the payment nothing is going to happen and if
you not make the payment even then nothing is going to happen there should be the provision for
the penal rate of interest also if the payment to be made by a person that the existing buyer, buyer
in the past is delayed he must be penalized for delay in the payment normally that some 2, 3, 4
days the delay may not be very, very significant.
But if it is like a week or 15 days or a month then he should be penalized by charging the penal
rate of interest. So, this is something about the collection policy and procedures these 3 points
make the Credit Policy Variables that credit standard and analysis credit terms and the collection
policy and procedures. With this be complete the discussion on management of the accounts
receivables very important second current assets.
First we discussed at length the inventory management then we discuss at length the receivables
management we had lengthy discussion discussed many things about it and about receivable
management and very important second current assets. And now we will be moving to third
current assets which are called management of cash. Management of the cash is another very
important asset because it is third important assets.
We have to manage the cash very efficiently and sincerely or otherwise it will create problem
and may increase cost. So let us move to the management of the learning about the management
of the third current asset cash management. If you talk about the cash management here then we
will be talking about this cash management and this will be the next part of discussion for us now
cash when you talk about the cash management you think that what to manage in cash is very
simple.
If we have cash then we have the cash and we can keep it with us or what is there special to
manage what we are talking about the cash to be held by the company. As like inventory and
receivables cash is all important third current asset. As I told you that if properly we are not able
to manage the inventory it is going to cause the cost. If we are not able to manage the receivables
accounts receivables it is going to cause the cost.
And it may create a situation where the cost is more than the returns it is contributing to the
company and ultimately we are ending at the loss making proposition right. So, like inventory
like receivables now we have the third important asset which is cash management. Cash
management is again current asset and it has a cost. So, in the firm because when you are talking
about a large sized a company there we are not talking about that 10, 20, 30, 40 lakh cash.
When we are talking about the millions of the cash sometime the collection of the cash is in
millions for example talk about the cold drink companies Coca Cola and Pepsi what is your daily
collection of the cash they are collecting cash daily on the daily basis and cash depositing it in
the banks and banks are managing their cash. So, the collection sometime goes into the million
and crore. So, in that case what part of the total collection has to be kept as cash? How much it
has to be invested into the market into the marketable securities or into the other kind of assets.
And keeping the cash what is the cost involved and if there is a shortage of the cash what are the
consequences what are the outcomes of that part that is very important thing to be taken care of.
So, many things will talk about the cash management but we will start here with that is Cash
Management is concerned with three things.
Cash flows into and out of the firm cash flows into and out of the firm, cash flows within the
firm and cash flows held by the firm at a point of time so cash flow into and out of the firm think
about it this is the cash flow into and out of the firm it is into and out of the firm we will have to
think about when you are talking about the cash flows into and out of the firm we are to be
careful here that what does it mean firm is holding the cash.
It means as I am telling you Coca Cola and Pepsi they collect the cash everyday from their
distributors from their retailers. So, the cash is flowing into the firm and it is going out also when
the payment is made by the company to the suppliers when the company is made payment is
made by the company to the supplier of power to of the water of the salary to the employees
other office expenses or maybe the other kind of the inputs we are buying will be the raw
material these companies are buying.
So, for that also the payment has to be made it say for example for suppliers of bottles do the
product is manufactured by then that powder which they convert it into the cold drink that is
manufactured by them just a patented product but say bottles as you talk about that covers you
talked about and will be the grates you talked about all this is a material which is purchase and it
is on the credit basis and the payment has to be made after some period of time. So, cash flow
into the firm and out of the firm.
How much cash is flowing in on the daily basis weekly basis monthly basis and how the cash is
flowing out and at one particular point of time what is the net balance of the cash available. So,
for this reason every firm makes the cash budget. If they are very efficient and having the
sufficient resources in that case what they do they prepare the weekly budgets they prepare the
weekly budgets they know that in next 6 or 5 days how much cash is flowing into us how much
cash is flowing out on account of the different payments what is a net balance is going to be with
us.
That net balance is going to be surplus may be the receipts are more than the payments or the net
balance is going to be deficit that the payments are more than the receipts. So, if there is going to
be surplus you have to be prepared well in advance how and where that amount has to be
invested. Again that has to go how much we want to keep cash as cash and remaining part he
was very large surplus is there. How it has to be managed and where it has to be invested this
question has to be answered immediately.
So, that you do not lose that I am immediately when you get the surplus cash it goes to the
avenue where it should be invested. Similarly if the situation is reverse that there is a shortage of
cash when we are budgeting when we are preparing the budget for the next 5 or 6 days we know
that there is shortage of the cash in advance because budgeting done only to the say to fix up
road map.
And we know that there will be shortage our payments will be exceeding the receipts, so if we
know that in advance it means we have to make the arrangements well within the time maybe
one week before will make the arrangements that on Thursday next we need this much of the 10
lakhs of the cash flow from where it will come we are not keeping it in beyond level in the firms
we have to arrange for bank or from selling the marketable securities or any other that will be
known to us if we are planning our cash properly.
So, surplus are going to be invested in the market and deficits are going to be made by arranging
the cash for the different sources and finally we are going to maintaining balance so for that you
understand that cash management is important. Then is a cash flow within the firm, cash flow
within the firm will be is like to maintain the liquidity at all levels. Purchase department want to
purchase material on cash. So, they should be provided sufficient cash as and when demanded by
them. Salaries have to be paid to the employees at the end of the month.
So, they should be sufficient cash, utility bills have to be paid by the company at the end of the
month should be sufficient cash then marketing department needs a cash, sales department needs
cash advertising people need cash whom so ever at what point of time how much cash they are
asking for that is the responsibility of the Finance Department to make arrangement cash and to
provide to fulfil all everybody say requirement within the firm.
So, it means cash must be following on within the firm and sufficiently it must be flowing there
should not be any shortage of the cash and there should not be any abundance of the cash. So,
what we have to do is we have to learn here how to maintain the optimum balance of cash. So,
that is another thing they are going to learn by learning the cash management and third important
point in the cash management is that cash balances held by the firm at a point of time.
How much cash you want to know I am emphasising up on I am discussing since we started the
discussion on the cash management that at any point of time how much cash should be there as I
told you more than the required level of inventory is also and more than the required level of
credit sales is also bad and similarly more than the required level of the cash is also bad. So, we
cannot afford to keep the high level of current assets reason being there highly expensive assets.
And if any extra investment is made into these assets that will directly and off with paying extra
cost and the return on these investments between very, very low. So, we have to maintain or
learn how to maintain the optimum level of the cash. So, that needed it is more now it is less cash
is available when we need the cash and cash is not surplus all in abundance so that it is lying
unused and we are not able to make the proper use of the cash.
For example if you look at the balance sheet of two companies like a public sector company and
private sector in the public sector companies large PSU find the huge amount of the cash huge
balance is of the cash and they will show in the balance sheet in the current assets that this much
lakhs or crore or billions of rupees of the cash is there in the balance sheet. Now what that cash is
doing in that company if that cash is not properly managed by the company it means they do not
know how to manage cash.
It should have been not cash should have been shown as the marketable securities it should have
been shown as some other in any kind of the short term investment invested into the treasury
bills or anywhere. So, that that cash is earning something but this it does not belong to anybody
say public money is it government money does not belong to anybody and their management is
also not very, very professional.
So, it means nobody bothers about the management of the cash in the PSU’s. But in the private
sector companies you will be very, very say y curious to know the balance is cash and you will
find at any point of time there is no surplus amount of the cash will find. Their maintenance
optimum amount just to fulfil their regular operations for surplus of the cash or unused amount
of the cash that high amount of the cash will not be available in the private sector companies as
compared to PSU’s.
So, it means cash management is very, very important is a third important assets and you must
learn about it how to manage the better and efficient management of cash remaining more and
quite interesting things about the cash management we will discuss in the next class thank you
very much.
Prof. Dr. Anil K. Sharma
Lecture-46
Cash Management
Welcome students, so now we are in the process of learning about the management of cash, the
third important current asset and in the last part of discussion in the previous class we just
initiated the discussion on the management of this particular current asset, there will be learned
about the cash flow into an out of the firm, how important it is. Cash flow within the firm and
cash balance is held by the firm at point of time.
Now to smoothen the cash management, the firm must, means I have written here that smoothen
the cash management the firm must what firm must do that is the, the firm must do something.
And what the firm should do evolve and establish a reliable forecasting and reporting system,
smooth management of cash, smoothen the management of cash evolve and establish a reliable
forecasting and reporting system, when you talk about the forecasting or their reporting system
this particular thing forecasting, how you can forecast the requirement of cash or the availability
of the cash.
We have to know in advance, well in advance that what is going to be the cash position over a
period of time. I told you in the say previous class that we can use the concept of cash budgets,
cash budgets maybe you can prepare the say depending upon the time horizon or the depending
upon the precision we want in our cash forecasting. We will have to look at the time horizon.
Normally we prepare the monthly cash budgets, some firm prepare fortnightly cash budgets and
the firm who are really efficient and who have the resources, who can afford to prepare, they
prepare the weekly cash budgets. So, the minimum time horizon the shortest time horizon is the
weekly cash budgets, the firms must prepare the weekly cash budgets regularly, frequently. So,
that they know in advance that what is going to happen in the next 5 or 6 days, how much cash
we are going to receive from the different quarters.
And how much cash we are going to pay to the different claimants from there we have purchased
on credit and what is going to the net position of the cash at the end of the week, when you
prepare the weekly budgets you prepare automatically you calculate the daily cash balances or at
least if not daily cash balances if the week and the balance is also going to be known to as, you
can make out that in their particular week if you are falling short of cash.
Then we can arrange cash by borrowing it from different sources either from the bank if we have
the CC limit or we can take the short term loan or we can sell the marketable securities if we
have the surplus marketable securities we can sell them. Because selling of the marketable
security and converting them into cash that also requires sometime, this not that easy that okay,
you say is a saleable is a sort term asset, very short term asset event, still we have to find out a
customer.
We have to complete a process and then only the security can be converted into cash. So at least
a day or 2 minimum it is required to convert the securities into the cash. So we should be
knowing in advance that what is going to happen with regard to the cash in the next 1 week and
do we need to arrange cash as we are going to have the sort we are means having a situation of
the where we are short of cash or we are going to have surplus of cash.
Because if we are going to have surplus of cash even then it should be carefully managing it as I
told you that keeping more than the required amount of cash is not good for any firm, any
businesses. So, if we are say that we are going to have surplus cash at the end of the week. So it
means we should look for that where we can investor or at the end of the week that surplus cash
can be invested where.
Because even today we have the say called deposits for 24 hours we can deposit the surplus cash,
you can earn something out of it or maybe we can make investment in the inter-corporate
deposits. If you do not need the cash, surplus cash for 1 more week or 15 days or 1 month, we
can invest into the some other firms who needs it. So for costing is most important and for
costing is possible with the help of cash budget.
So, if you prepare the efficient and useful cash budgets then we are going to be very cleared
about the cash position in the next 1 week or maybe the 15 days or maximum a month. More
than a month we should not prepare the cash budgets because it is a short term current asset. So,
maximum time horizon could be 1 month and minimum should be 1 week and if we are knowing
in advance the surplus or shortage of the cash.
In case of the shortage we will be arranging the cash and in case of the surplus we will be
looking for forward for the avenues to invest the cash. So, automatically you can say that your
cash management will be smoothen and it will be very effected and we will not have any
liquidity problem, any payment becoming due to the made and we do not have the cash for that,
that situation will never arise.
And if we are going to have surplus of the cash then is going to be a useful of where to know it
in advance and look for the avenues where their surplus cash will be invested and minimum or
the maximum return will be earned. Similarly to improve and streamline the cash collection and
the payment mechanism. Cash collection and payment mechanisms are very very important.
Many companies who are not serious in managing their cash or their say cash resources, they are
failing to streamline the cash collection and the payment mechanisms, say when they have to
collect the cash say these days to some extent we are using the online payments, online transfers
and payments under sheets. But in many cases we are making the payment and receiving the
payment through cheques.
Now the peer has peers responsibility is that we has to make sure that cheque reaches in the
receiver’s office or the selling company receives the cheque from the paying companies was that
cheque is reached in the selling companies office, the responsibility of the peer is over. Now
seller has to immediately send that cheque to the bank and bank has to collect it as early as
possible. There are the miss you can call say that there are the gaps, time gaps, delays.
That we receive the cheque is lying in the drawer of the cashier and he will send their cheque to
the bank maybe after 2 days, 3 days, 4 days, he is not bother about. He feels that we have
received the cheque, we have received the payment but that is not the payment we have not
receive the cash, we have not receive the say the amount, the amount you have received a
document or maybe one instrument.
If that instrument has to be send to the bank, so sending to the bank should not be delayed we
should be able to immediately receive the cheques and send them to the bank. So, quickly if we
are able to do that then certainly I think we are going to further improve the cash collection and
as per as the payment is concern firms normally what they do, they try to miss delay the
payments not by not sending the cheques, they will send the cheques immediately.
And as it when this becomes due and they also know it that their responsibility of making the
payment is over and that on the due date maybe due date is same you can say that is 14 th of
march or 15th of march. So by 14th or latest by see evening of the 14th if it is a 14th and if it is 15
then the by the latest by that evening of 15 th march then cheque must be reaching in the
receiver’s office or the selling companies office and then the paying companies job is over.
Now for example if the selling company whoever received the cheque they are also very active
and immediately they send their cheque to the bank. Now that has to be seen that on which
branch that cheque has to be on which branch of the paying company that their cheque has been
drop. For example you are making the payment to a company say we have a company they are 2
companies located, one is at in Delhi and another company is in say you can call it as Agra, one
is in Delhi another is in Agra.
So, it means a company who has made the payment to a company in Agra, they have send the
cheque the company is received the cheque and but that cheque is drawn on the Guwahati office
of the company who is located in Delhi. And that is the pre-agreement between both buyer and
seller that will make you the payment you will receive the cheque on the due date but all the
payments will be drawn in favour of or maybe at other office at Guwahati.
So, it means what will happen then the cheque will be received by the firm who is located in
Agra from the firm in Delhi. So, cheque is coming from the Delhi but that is drawn against the
branch of the Delhi company based in Delhi their branch in Guwahati office or in the Guwahati.
So, that cheque when will be deposited by the company in Agra in their own bank that cheque
will be sent by the bank to Guwahati office and from there the concurrence of the cheque has to
be obtained and then only the payment can be transferred.
So, if this kind of the situation is there then the paying companies very smart there on the one
side issuing the cheque also, but that is big debited from the paying companies office after next
15 days. So, it means they have say smartly managed collection immediately they are receiving
and collecting the cheques but in case of the payment they are only making sure that the cheque
reaches the receiver’s office.
But as per as the payment transfer is concerned that will take another 10 to 15 days period of
time. So, that is known as basically in the technical terms we call it as float when you say that it
is float. So, what do we mean by float, we have the collection float, we have the disbursement
float and then we have to think about the other things.
So, we call it as what we call it as it is float, float means collection float, this is the collection
float, this is the disbursement float. So, 2 floats are there collection float I am talking about for
example when we receive the cheque we immediately sent to the bank and that within 2 days the
cheque is collected means immediately when it is receive today it is sent to the our bank in Delhi
we are located in Delhi.
We received a cheque immediately it goes to the bank within an hour and within 2 days the
cheque is collected by the bank on the behalf of this company. So, it means within 2 days the
payment comes to the companies account and in case of the disbursement as I am saying that a
company who is located in Delhi and if they are making the payment to a company in Agra and
that is against the company’s Delhi’s companies office in Guwahati.
So, it will take how many 15 days for finally say making the payment actually making the
payment to the company in Agra. So, the company who is in Delhi their account will be debited
after 15 days, so it means they have manage the disbursement float and disbursement float is 15
days collection float for their own payments is 2 days. So, there is something called as net float,
this is called as net float which is here that is how much 13 days.
So, float management is very very important in case of the cash management, but you see this all
is not possible 15 days and writing the cheques against the Guwahati branch that is also not
possible in the normal course. In that case this only happens that when the buyer is or maybe the
supplier who is located in Agra and they are supplying buyer or the buyer is in Delhi, they are in
Delhi and the supplier is in Agra.
So, when the buyer is very strong company it is in a very strong position and supplier is also not
in that very strong position, supplier is depending for his supplies or making his supplies to the
company whose buying it as I was talking to you that for example we talk about the Maruti,
Suzuki or Suzuki India limited, they are buying almost all inputs from the different and sellers
small firms, they are not manufacturing the glass, they are not manufacturing the steel.
They are not manufacturing the rubber, they are not manufacturing the tyres and in some cases
the suppliers are big companies, in some cases suppliers are small companies. But the small
companies they are supplying to Suzuki motors for number of reasons, number one is they are
supplying to a highly secured and credit by the customer and entire production of that unit is
being what regularly by the Suzuki motors.
So they have not to look for any other customers is a long term buying and selling contract
between the supplier as well as between the Suzuki motors limited. So suppliers entrusts that I
have got such a wonderful customer that my payment is secured and if I am giving the credit I
am able to load that credit with interest factor also my payment is also secured and I do not need
to look for any other market anywhere around.
So no problem if there are certain conditions which are not normal, if I have to set some
exceptions abnormal conditions also from my buyer or from my customer I will go by there. So,
that is only possible that Suzuki motor may get say this agreement from the supplier in Agra that
we will make you the payment on the due date. But their cheque will be drawn in favour of our
branch in Guwahati, so you have to accept that.
So, in this case supplier may agree that no problem you give the cheque we will wait for another
15 days and finally the supplier also knows that my payment is secured and he is having multiple
other benefits from say having relationships with this company. So, it means even I have to wait
for another 10, 15 days for getting my cheque collected no problem I accept that because I am
enjoying so many other advantages by dealing with Suzuki motors or any other such credit
worthy buyer.
So, it is not normally possible, for example if supplier and buyer they are offer the same
wavelength or maybe the same financial strength is not only the one parties requirement that they
have to depend upon the other, both are both can reciprocate with each other. So, in that case the
buyer cannot dictate the terms on supplier and supplier could say that if you would not buy it on
my terms, I will not receive any cheque which you are writing in favour of Guwahati office.
We will be giving you this much credit period we have to receive the cheque, you have to make
us a payment on the due date and the cheque should be in say return against a branch or account
in our city only we cannot accept any payment which is say in favour of the Guwahati office or
any other office that is not possible. So, it means depending upon the economic strengths of both
the sides creditworthiness of both the sides.
If both can reciprocate with each other then nobody will accept that any kind of the abnormal
terms. But if the supplier is weak and the buyer is very very strong in the market very very
creditworthy , in that case they can have this kind of the terms and the supplier has to agree
because supplier has he is having the multifarious advantages by dealing with this kind of the
bigger and the repeated buyers.
So, it means this is the concept of float which is a collection float in how many days you collect
your own payments and disbursement float in how many days your payment is made actually
your payment is made to your suppliers and the difference between the collection float and the
disbursement float is the net float. So, net float should be maximum, we should try to maximize
and that float.
So, that by keeping a minimum balance of the cash in our bank account as cash we can do
maximum business. Because if we know that this payment is more going to be finally debited
from our account in next 15 days. So, issuing a cheque of any today does not make any sense
means if it is there we have made the payment, we have send the cheque but only cheque is sent
and payment will be debited after 15 days.
So, it means we can keep on writing the same amount of cheques to the other suppliers also for
the next 14 days because we know that the cheque we issue today that will be presented to our
bank after 15 days. So, do not need to worry about we can keep on writing the cheques knowing
it how many time, how many days are taken by the receiving from to get the cheques collected.
So, it means they can increase the transaction they can do by keeping the minimum balance in
the cash because nobody want to keep in maximum balance of cash in the bank account because
it is a current account and it does not any amount of interest right. This is the second thing is, so
to improve the and streamline the cash collection and the payment mechanism. So, cash
collection means the collection float and the payment means the disbursement float.
So, collection float should be minimum payments disbursement of the payment float should be
maximum. So that the net float is maximized. Then is the optimum savings and gainful
investment of surplus cash. I was telling you in the previous class that if you look at the balance
sheet of the public sector company you will find that huge amount of cash, large amount of the
cash is lying as cash in that balance sheet which actually that not required.
But they do not know how cost your expensive this asset is and it should be effectively managed
knowing it that how much cash is required buyers actually, how much is available with us and if
there is any surplus cash available there should be taken to the market and invested in the market.
For example you have say you talk about the BHEL, BHEL has the 5 or 6 plants in the country.
And at every plant location it is considered as a independent unit and they are having their say
plant labour balance sheets, profits and loss accounts and other kind of the statements and they
are keeping cash at every plant location at the plant level. So, why not they do that total their all
balances cash balances as well as you cannot store inventory or at the Delhi office or at the
corporate office.
And then it will be used by the say Haridwar branch or Bhopal plant but at least cash, cash is
such a thing that these digits can be transferred online. So, they should keep total cash at one
place means beyond a level that cash should be at one place normally the unit should make that
their cash daily cash requirements at their plant level. And if there is any surplus amount left
there should be immediately transfer to the central office to the corporate office.
And from the corporate office by knowing their requirements of the plants, if some surplus cash
is available that should be invested in the market. But nobodies worried about that and nobody
wants to make a proper investment of their cash. Because there their pay-ins increase their and
they are going to gain anything extra out of it, if they have the surplus cash they have to calculate
first of all how much extra cash is there with us or going to with their with us where to invest
have to look for the investment avenues.
And then when the cash is required they have to convert the marketable securities into the cash,
so who will take all these hassle. Whereas this kind of the culture is not there in the privately
held companies. They know that this asset has a cost. So they go for the very clear cut for costing
system budgetary, process, cash budgets, weekly cash budgets, they estimate in advance that
how much cash is required, how much is going to be available.
And if any surplus cash is there, you should be invested in the market. So, it means we should
learn while managing the cash properly we should be knowing it that the optimum savings are
important. And we should go for saving of the cash and gainfully investing it or gainfully
investing the surplus cash in the market. So, these 3 things, these 3 points can help us to say
smoothen the cash management, process apart from the other things.
Now rationale for holding the cash, see you must have say seen elsewhere as well as we have
already discussed the inventory management. And when you talk about the management of the
cash we compare it sometimes with the management of inventory. Cash is as good as inventory
of the raw material or the finish goods, there we are storing the inventory or the goods here we
are storing the cash.
So, like inventory say holding cash also has the similar motives or maybe little one maybe
different, for the other 2 are same say for example to have the transaction balance or transaction
motive to make day to day payments and to ensure that firm is having sufficient liquidity for say
transaction purpose, daily transaction purpose, weekly transaction purpose we have to keep the
cash, so we are keeping.
So, we should only that much of the cash which is required and desired for fulfilling the
transactional requirement not more than that and even not less than that. Precautionary balance
okay after transaction you can increase that minimum is our this transaction level and we have to
keep little more than that as a precautionary balance. Because if sometime our needs fluctuate
sometime more or sometime less then we should keep not exactly as per our requirement but
little more than that to deal with some any kind of the emergency.
So that any payment which is of not anticipated if becomes due to the made or sometime it may
be possible that some of the firm who has supplied to us their credit period is ending 15 days but
somehow if they make us a request that please make us the payment because we need the cash
today. So, sometime it is for our own precautionary purpose and sometime to help our suppliers
also, we have to keep the surplus cash.
So that the payment can be made as and when it is due and then the speculative purpose keeping
more than the required amount of cash sometime is done with these speculative purpose also.
Speculative purpose means that you can invest that cash in the opportunities if some of the
opportunities arise, opportunities are like there for example we are say agriculture based product
manufacturing company and our raw material is agriculture based.
So when the raw material is purchase by these companies, for example you talk about ITC, ITC’s
most of the products are agriculture based they are manufacturing flour, they are manufacturing
even cigarettes they are manufacturing. So many other things consumer products and many of
their products are based upon the agriculture imports or a agriculture material. So, when there is
a harvest season when the crop comes you will have to buy at the time and store it.
Normally there are the prices which are pre-decided or the market decides but sometime they
feel that some raw material is available in the market at the damn cheap prices. So, if we have
surplus cash and we invest it into, so tomorrow means when will require the raw material for
converting that into the finish product. We will get it at means we will be requiring it certainly,
so if it is available at half the price find to buy it.
So, for that speculative purposes we can do it like this or sometime what happens that we have
made or we have say got the supplies from some of the suppliers. And normally thus credit
period which is the suppliers has allowed to the company maybe any company ABC limited that
is say normally it is 30 days. But just after 15 days the supplying company needs cash, so they
give you offer to the buying company that normally our credit period to use 30 days which is
going to end up a after another 20 days.
Because only 10 days are over and after another 20 days you will be making the payment to us
but if you make the payment to us today we will give you 2% cash discount. So, it is a very good
opportunity, company should enjoy it, if they are surplus cash why not to grab that opportunity
and enjoy 2% discount and make the payment immediately. So, all these speculative purposes
help the firm to gainfully invest the cash or to keep the cash for such type of the purposes where
the cash is not required within the firm.
But it can be very efficiently used to deal with the speculative purposes and to earn some
unexpected or extra incomes on this surplus cash.
Now some other important aspects we will be talking about before moving to some cash
management models. So, we will wear building their foundation about the cash management, so
we will be trying to know about some important other important concepts. And these concepts
are 3, one is the cash purchase profit, second is cash flow and the cash stock and third one is the
cash flow presentation.
First one is cash verses profit, you see there is difference between the cash and profit, when you
prepare what is the difference between the cash and profit, say when you prepare the profit and
loss account, profit comes to us from where it comes from the profit and loss account, if I make
this statement in the T-form.
So, here we talk about we are taking here as the all expenses here we are taking all incomes and
then we call it this is the credit side, this is the debit side. And if this side is bigger than this side,
so what is there we have the difference here is to net profit before tax and then is the tax part
here and then it is to net profit after tax or sometime we call it as NOPAT net operating profit
after tax right.
So, here when you are calculating the net profit before tax or the net profit after tax, so this is
only profit. We are saying this is not the cash, this is only profit because why I am saying that
this is not in cash certainly it can be in cash. But certainly it is not I am say in all the cases is it
not required to be in cash because when you are taking the source of this profit is what here the
upper part of income statement and here it is from the sales by sales.
And when you write the figure of sales here less you have the manufacturing expensive like
material, then is the labour, then the overheads and then is the indirect expenses right. So when
you are talking about the sales in the income statement or in the profit and loss account we never
mention that these sales are only cash, we say it is the total sales, total sales can be cash sales
plus credit sales, cash plus credit sales is total sales.
So, it means when the sales are having the cash as well as the credit element similarly the profit
is also having cash and the credit element, part of the for example the this ratio is 50-50, 50% of
the sales are on cash and 50% of the sales are on credit this ratio is 50-50. It means out of this
profit say it is for 100 rupees only 50 rupees profit is in cash. So because 50 rupees profit is on
the credit we have not received that profit yet, so it is on the credit.
So, when you are talking about the cash verses profit understanding the cash management we
must be clear about that cash is real and the profit is nominal cash is real and the profit is
nominal. So out of the profit total profit how much is the cash profit that should be very clearly
known to us. Because when we are going to prepare the cash budgets, we are going to
differentiate normally what happens.
These days when you prepare the income sorry financial statements earlier we were preparing 2
financial statements. First one was the income statement and which is called as P and LA
account also profit and loss account. And second was the balance sheet, we call it as balance
sheet, so these were the only 2 statements. But now we have introduce the third statement also
that has become the statutory statement or compulsory statement which is called as cash flow
statement.
Cash flow statement which also has to be prepared along with these 2, so now the 3 statements
are to be prepared by all the companies, income statement that is the profit and loss account,
balance sheet and the cash flow statement, these 3 statements are required to be prepared for all
the companies why now we are having the income statement also and the cash flow statement
also, income statement is telling us what is the extent of profit.
And cash flow statement is telling us what is the extent of cash profits, this is the difference. So,
we should be knowing that out of the total profits how much profits are the cash profits and if we
are going to have some cash profit how to invest that profit in the market and how to deal with
that profit efficiently because if we are going to have some say surplus profit that is cash. So, we
have to find out the revenues where this cash can be invested.
And if we are going to have the profit but say largely the larger trunk of the profit say 80% of the
profit is nominal profit because of the 80% of the sales being the credit sales, we know that now
the cash profit is only 20%. So understand first that in your firm how much cash is going to be
available and related with the profits but the profits first you calculate the profit figure and then
prepare the cash flow statement. So you will get to know how much is now the cash available
and then you start thinking of the management of the cash.
So, this is the one important point which has to be born in mine that cash is the real profit where
is the profit is if it is only profit then it is a nominal profit. So, we will have to very clear, out of
the total profit how much profit is in cash, how much profit is non cash or it is the nominal profit,
this is one important point. Then they are the 2 other points cash flow and cash stock and the
cash flow presentation with they are also very important and interesting points and we will
discuss this points in the next class, thank you very much.
Lecture-47
Cash Flow Presentation
Welcome students, so we are discussing the cash management and in the previous class we learnt
about the difference between the cash and profit. There we could make out that profit is nominal
and the cash is real. So, how much profit is in cash and how much profit is not in cash which is
nominal part of the profit we should be very clear about that right. So, profit by simply satisfying
our self with the profit is not sufficient.
We will have to understand that is for that the cash has to be there and if the cash is there how to
manage the cash, how to keep cash how much cash to be kept as cash and how much to be
converted into marketable securities short term investments. So, that the cost of these current
assets goes down and they also start earning also.
So, it means cash and profit they are the two different things, so we have to look at the cash
ability of the profit and if there is a high amount of the cash then we also must be careful about
how to manage the investment of that cash. Second important point here is the cash flow and the
cash stock, once we have say known the amount of the cash flow in the firm and availability of
the cash at the firm then how much what part of that cash is flowing.
And what part of that cash is kept as say static amount or stocked amount, you know it well that
cash will earn the income if it is flowing. Because we are using the cash, we are moving the cash
if the cash is kept as cash only that we are stocking the cash maybe as in the form of cash or
maybe in the form of the bank balance. So, even you keep the bank balance in the bank as a
stock of the cash.
The bank balance or the say balance in the bank account of the companies is in the current
account and that does not earn even 4% or 3% of interest which is there on the savings account.
So, we will have to make sure that whatever the amount of the cash is there with us it should be
flowing, it should be moving. And it should not be kept as stock either it should be utilize within
the firm.
So, it means we should use it in the operations for buying the raw material or for buying other
kind of inputs. Then paying the salaries of the workers and we will be using it for paying the bills
of the utilities like power, water and other kind of things. So, how much cash we are keeping and
part of the profit which is in the cash that is being retained by the firm that must be flowing in
the firm from the 1 department to the other department from the 1 unit to the other unit for the 1
purpose to the other purpose.
If the cash is flowing it is in use it is in the working condition, if the cash is kept as cash only in
the stock just you say either we are not aware about that how to use this cash stock. How to
converted into marketable securities at what intern to converted into marketable securities or we
do not know how much cash is required to make the payment, short term payments or sudden
payments or urgent payments.
So, because we are not aware or we have not prepared the cash budgets, so if we are not
forecasting the cash inflow and the outflow. If we are not preparing any kind of the cash budgets.
In that case the cash stock will be kept as a very high amount and if we are not utilizing it for
making the payments if it is not required within the firm. In that case that is lying as unused, so
for that we were talking about and we were discussing that the cash budgeting is most important.
And the budget horizon can be different depending upon the resources of the firm depending
upon the capabilities of the firm to budget like minimum budget horizon should be 1 month but
sorry normally I would say it is maximum budget horizon which is useful that can be 1 month
period of 1 month it can be for 15 days and minimum it has to 1 week. So, the form which are
preparing budgets for the 1 week.
They are keeping lesser amount of the stock they are saving sufficiently hugely on the financial
cost of this current asset managing thus current asset because they are not keeping large amount
of the cash as cash and they know it that in the coming 1 week this much cash is flowing in, this
much cash is flowing out. So, what is the net difference if there is a possibility of shortage of the
cash then we can keep some cash or we can aware about that we have to arrange this much of the
cash from the different sources.
But if we are knowing it in advance that we are going to have surplus balance at the end of the
week. So, it means we should thinking in advance where there surplus has to be invested. So, it
means cash flow or the cash stock 2 important things, so to earn sufficient income from the cash
whatever the cash we have that must be flowing in the firm there should not be retained or kept
as stock otherwise cost will increase.
There will be no returns the financial cost is going up returns are not matching with the cost and
finally we are ending up with loss making situation. Third important thing is the cash flow
presentation as I told you sometime back in the previous class that now apart from the 2 say
statutory financial statements.
One is the income statement One is the income statement and second is the balance sheet second
is the balance sheet, so apart from these 2 these are the 2 other 2 statutory financial statements
for a bill company they are certainly required to be prepared every end of the year or normally at
the end of the accounting period which can be the period of 12 months.
But after 1994 at the international label and after 1997 at the Indian label or at the level of India
we introduce one more statement and that statement is called as the cash flow statement cash
flow statement that has also becomes. So, this is the first statutory statement this is the second
statutory statement and this is the third statutory statement firms are public limited companies
especially even the private limited also.
But in case of the public limited companies because public companies invested, so income
statement is required to be prepared that is profit and loss account. Balance sheet is again
statutory required to be prepared to know the financial position of the firm. And then third
statement which has been made mandatory that is the cash flow statement. So, in 1994 then
international accountings standard committee.
On 1st January 1994 decided that apart from the income statement and the balance sheet every
firm must have the third statement also compulsorily the third statement also and that statement
is called as the cash flow statement, so that did not only make made this statement as statutory
statement rather they device the format also that how now the cash flow statement has to be
prepared after 1st January 1994.
And is not like a simple cash flow statement which were preparing earlier but now will be
preparing a different cash flow statement which will be reporting the cash position of the firm in
a very different and that in a much better way. So, the IASC International Accounting Standard
Committee they decided and in India this decision was implemented in 1997. In 1997 where we
have introduced 1 important accounting standard which is called a AS3 new accounting standard
AS3 was introduced.
And under this AS3 from 1997 onwards January 1997 onwards this statement was made
compulsory also in India in on the Indian organizations that every Indian public limited company
has to prepare 3 statutory statements now, 1 is the income statement, second is the balance sheet
which were already there and third one is the cash flow statement. So, now the cash flow
statement also has become a statutory statement, compulsory statement, required statement under
the statutes at Indian companies at 1956 or 2013 it is a important statement.
And this statement is required or was required or was made compulsory because of certain
reasons and these reasons are very well founded and very valid reasons, for very valid reasons
this statement was made compulsory for all the companies public limited companies. So, first of
all the as I told you that ISA did not only made it compulsory but the rather this, so just at the
format also that now the cash flow statement which is the third important statement apart from
the income statement and balance sheet has to be prepared under the 3 broad categories.
First one is the Operating Activities, second one are the Investing Activities and then is the
Financing Activities. So, clearly they have to divide the cash flow statement being prepared now
into 3 important activities operating activities, investing activities and the financing activities
why it is has been done we want to know by preparing the statement this way that if it is a
manufacturing firm. Then the main source of the cash or the profit number 1 profit and then the
cash should be from where that is from operations.
Main cash should be flowing in from the operations, after operations means source of
profitability and the cash profitability 1 source first and the foremost source is the operations.
Second source can be the say investing activities and third source can be the financing activities.
So, these are to be clearly define because if you know or more to know about the financial health
of a company.
In that case you must be knowing that how much profit or funds or income there earning from
their operations which is a major source of income how much is earning from the investing
activities. And third one is how much they are earning from the third that is the financing
activities, so in this case that is the investing activities and it is the financing activities it may be
possible as I told you that when you talk about the operating activities.
The main source of the operations is that in the income statement when you prepare the income
statement here in the upper part of this income statement, you divide this income statement into 2
parts, 1 part is here that trading account we call it as the first part is the upper part of this income
statement is called as the trading account and second part is called as the profit and loss account.
So, this is the trading account and in the trading account you take this side the sales and you take
here the by all expenses that is the material, labor and the other overheads right and the
difference of this and this side this will be called as say to gross profit. So, this is the gross profit
and then the gross profit goes down.
And when you prepare the profit and loss account you start the profit and loss account with this,
you start here with the by gross profit which is coming from the trading account. Then you
subtract the other indirect expenses and finally your PAT here that is the profit which is called as
the net profit before tax and then is the tax part and then is the to net profit after tax right.
So, this is and then is the total of the profit and loss account are the loss part of the income
statement. Now we want to know about that here the net profit which has been earned from
where the net profit has come to the company larger junk of the net profit must be coming from
the gross profit. If there is a gross profit say for example the gross profit here is I would call it as
say we assume that this amount is 10000.
Now apart from this main source of income firm earned something that is the by investing
income by investing into the some important investments by making in the market. They earned
some income nominal income of 2000 rupees and then by financing income they got an another
1000 rupees and –expensive. So, this became the total amount this became as the 13000 and here
also 13000 right.
And indirect expenses for example in total indirect expenses 8000, so net profit here before tax is
how much net profit before tax is say 5000 net profit before tax is 5000 and P this is the 8000.
So, 13-8 is the 5000 your paying tax as say for example 1500 rupees. So, finally your net profit
after tax will be 3500 rupees. So, main source of this 3500 rupees is this one that is the gross
profit. And gross profit is the output or finally the result of the efficient operations or the income
generated firm or the profit generated firm operations.
So, if this kind of the situation is there, where able to find out that income largely because this is
a manufacturing organization. So, major or the main source of the income of this company
should be that is the gross profit that is from the operations and that is the in a ways called as the
gross profit partly the firm can generate income from the investing activities also and financing
activities also.
But that should be the amount lesser much lesser than the income from operations, if reverse is
happening for example you see here that say we have another situation likes say it is not 10000
here and it is not 2000, this is not 1000 here right. Here you can say that gross profit is we called
it as how much 5000 and investing activities are generally helping us to have say 4000 and this is
help us say financing activities helping to us have the again 4000 rupees.
So, though the income from the operation is more than the investing and financing for put
together this plus this income is 8000 rupees. It means either the companies involved into
investing activities or the companies involved into financing activities their operations which
should have been contributing the largest share of the total profit and cash that is contributing.
But some total of the contribution of the profit and cash from the investing and financing
activities is much higher.
It means it gives the indication the source of cash is not only operations of the firm but larger
junk of the cash is flowing in under the investing of the financing activities. Because this firm is
not a finance company, this firm is not a investment company, this firm is basically
manufacturing company. So, major source of the income major source of the profit must be the
operations and that to be in the form of gross profit.
But gross profit is only 5000 and here you earning this plus this is 38000 it is much more than
the gross profit we have here. So, means there is doubt something fishy about something
doubtful about the operations of the firm. And we have to investing at this firm very clearly that
what are the activities contributing to the profits of the firm and finally to the cash of the firm.
And, if the investing activities and financing activities are contributing in total contributing more
than the operations.
It means either the form has deviated from it is main operations or it is not able to generates
sufficient returns from it is operations product has become less salable in the market, less
acceptable in the market. So, that is why they are using their investments as well as the financing
things or activities for generating the income. So, there you have found out here is that is 3500 is
the total net profit after tax.
But in this 3500 major contribution is from the investing and financing activities total and lesser
contribution is from the operations and this is not the acceptable state of affairs. If any
companies is a manufacturing organization, so for that reason IASC the view and then that is the
international IASC International Accounting Standard Committee beginning and later on ICI
Institute of charted Accountants of India accepted this contention of the IASC that yes it should
be clearly defined in the cash flow statement that what is the source of the cash, whether the
operation of the firm is the cash source of the cash.
Or whether investing activities is the source of cash or whether financing activities are source of
cash or whether total of investing and financing activities is generating more cash as compared to
it is operations. So, it means it will be clearly giving indication that all is not well in this firm and
there is some serious need to look into the problems this firm maybe facing or is facing right. So,
here in this case the IASC has device the format also and they said that the cash flow statement
must be prepared under 3 activities operating activities, investing activities and financing
activities.
And now what are these activities what they have included and suggested to be included in the
operating activities this is the exhaustive list of the operating activities cash flow from operating
activities or you can say it as cash flow from operations that is on the one side they have given
the cash inflow from operations.
On the other side they have given the cash out flow from the operations, so here what will be
included as a cash flow from operations cash receipts from the sale of goods and rendering
service, this is the major business of the company not investing or the financing activities. So,
why cash is flowing more from the investing and financing rather than from operations this is
serious question to be asked or to be answered.
Second thing is cash receipts from the royalties, fees, commission and the other revenues if we
have some technology. We have say rented it out or maybe we are giving some consultancies
services with regard to the product we are manufacturing or maybe we are getting some
commission which is out of the existing business of the process of the existing business, then it is
operating income, cash receipts of an insurance enterprise for premiums and claims.
Because the main business of the insurance company is the insurance receiving the premium and
say cash receipts often insurance company an enterprise for the premiums and claims annuities
and the other policy benefits. So, any inflow an account to the premium and such other inflows
are coming to the insurance company they are operations of the insurance company. Similarly
cash refunds of the income tax unless they can be specifically identified with the financing and
investing activities.
We have paid extra tax because we pay advance tax in India, so if we have paid extra tax and if
at the end of the year when it the settlement takes place. So, if it is found the firm as paid the
extra tax and the extra tax is refunded by the income tax department. Then also it is part of the
operations and then is the last is the one cash receipts relating to future, forward options and
swap contracts when these are held for dealing or trading purposes.
So, if the firm has purchased just to minimize it is risk or maybe say for any other purpose then
that investment or cash inflow coming out of these derivative products future forward options
and swaps these contracts. That will also be known as the inflows coming from operations, cash
inflows generated from the operations. Similarly they have categorically say given a list of cash
outflows which will be treated as the cash outflow from operations.
Cash payment to the suppliers for goods and services when we are buying raw material we are
making the cash payment to suppliers is certainly obviously a operating out flow cash payments
to and on behalf of employees making the payment of salaries even the utilities payment,
electricity bills water bills all these bills. Cash payment of an insurance enterprise for premiums,
claims, and annuities and other policy benefits.
Naturally when they are receiving premium as inflow there when they are paying claims it is out
flow from the insurance companies. Cash payment of income tax unless they can be specifically
identified with the financing and investing, if it is not on accounting of investing and financing if
it is only on account of operations that payment of the income tax is cash out flow on account of
operations.
And lastly cash payments relating to the futures, forwards, options and swaps contract swap
contracts when these are held for dealing or trading purposes right. So these are clearly defined
and devised this income cash flow statement part that is the cash flow from operations which will
specify the cash flow from operations. So, here under these different inflows and outflows
categories, we will have to prepare the cash flow statement calling it the cash flow statement and
cash flow from and to the operations.
And what will be considered as cash flow coming from, inflow coming from operations is any of
the inflows coming under these 5 categories and any of the outflows these under 5 heads. So, that
will be only considered as the operating cash flow shows to have an idea that how strong the
firms operations are larger junk of the cash to the firm must be flowing in from it is operations
because it is a manufacturing firm neither it is investing nor it is financing firm right. So, this is
the detailed list of the say sources which are inflows and the application which are outflows of
the cash.
Then we talk about the next part cash flow from investing activities what will be treated as the
cash inflow and outflow from investing activities and towards the investing activities. Cash
receipts from disposal of the fix assets if you are selling any planned building machinery even
land cash flow generating from these sale of these fix as it is known as the cash inflow from the
investing activities.
Cash receipts from disposal of shares, warrants or debentures in debenture instruments or often
the other enterprises and interest in joint ventures except the receipts from those instruments
considered to be cash equivalent and those held for dealing or trading purposes. Then is the cash
receipts from the payment of advances and loans made to third parties right any kind of the loan
if it is given. Then it will be investing activity except advances and loans recovered by a
financial enterprise.
If any manufacturing firm has given the loan to the other enterprises and if they recover that out
of the reserves they have surplus is they have given the loan and if they recover that loan that
will be also the inflow on account of investing activities. And then is the last one is the cash
receipts from future forward options swaps, contract except when contracts are held for dealing
or trading purpose or the receipts or are classified as financing activities.
If they are for the operating activities or for financing activities then not under this but normally
if they are being use as the investment instruments. If the firm has surplus income or reserves
free reserves available and those reserves are being invested here in these different derivative
instruments. Then those instruments are being purchased not only for hedging of the operational
risk but only for investment purpose.
So, in that case that inflow will also be known as the inflow coming from investments. Similarly
the outflows here cash payment to acquire fix asset when you want to buy land, plant, building
machinery. Naturally we have to sell out ash and that will be the cash out flow on account of
investing activities. Cash payment to acquire shares warrant if you want to make investment in
the shares and warrants of the other companies or other enterprises. Now rather ventures then it
will also be known as the cash outflow on account of investing activities.
Because in that case the firm is investing it is a surplus cash into the say shares warrants or such
other financial instruments or debt bonds of the other companies. Cash advances and loans made
to third parties accept the advances and loans made by the financial enterprises and lastly the
cash payments for the future forward option swaps contracts accept when they are being bought
for the say strengthening or say diverting the operational risk when they are simply being bought
for the investment purpose.
Any cash which is flowing out for making this kind of investment is known as the cash outflow
on account of investing activities. And lastly the cash flow from cash flow examples of the cash
flow from financing activities. So, inflow there are the sources of inflow cash proceeds from
issuing shares or other similar instruments.
If the company is issuing the shares in the market cash is flowing in buy selling or issuing the
shares in the market naturally that cashes being generated for financing is operations for. So, that
is not the operating activity that is basically a financing activity. Cash proceeds from issuing the
debentures loans, so they are the two kind of instruments from where the cash can be generated.
One is the shares and stocks second is the bonds or the debentures, one by buying bonds one the
person who is buying that instrument becomes the honor of the company.
And the second person buying the second instrument that is the debenture of bond he becomes
the say lender to the company right, so creditor to the company or lender to the company. So, out
of cash which is coming in either out of shares and shares and stocks or similar instruments
whether is a equity share or the preference share or from bonds and debentures both these
sources will be contributing or will be known as the financing inflows or inflow coming from the
financing activities of the firm.
And cash out flow is cash payment, repayment of the amounts borrowed if we for example are
buying back the shares and paying back the amount to the buyer from whom we have purchasing
the shares or maybe any kind of the debutant is being paid or any other kind of the payment
which is relating to the shares or debentures is being made that is again the cash outflow on
account of the financing activities.
And this similar to the cash redemption of the preference capital and repayment of buy back of
the shares, so similarly if we are dealing the debentures. Because debentures and bonds and
preferences they are issued only for a limited period of time right there only should for a limited
period of times. After that period of time they have to redeemed or bought back. Similarly equity
shares also can be bought back by the companies.
So, if you are repaying any loan which we have borrowed or be are redeeming any bonds share
that is a preference shares or buying back the equity shares. Any cash is flowing out on account
of that is known as the cash outflow on account of the financing activities. So, very clear cut
division has to be there how much cash is coming from operations, how much cash is coming
from investments, how much cash is coming from financing activities.
So, that 1 can easily make out that what is the source of the major source of the cash, if the cash
is coming largely from operations company's good, companies financial health is good. But if it
is reverse is happening there more cash is coming from investing and financing activities, less
cash is coming from operations that to when a company is a manufacturing concern it may there
is something wrong about that company fishy about that company.
We must need to look into the details and as a creditor or as a lender of the funds to this
company we have to be very very careful right. And then before we close this class discussion
we will like to have some discussion on the liquidity management what you call it as liquidity,
liquidity here be divide into 3 components cash when you keep pure cash as cash then it called as
pure liquidity the firm has a pure liquidity. Sometime what happens that we look forward that in
the next one week or next 15 days or for next 1 month.
We do not require cash beyond a particular amount and if we are going to have some surplus
cash during that period of time. So, we convert that cash by investing into short term marketable
securities maybe call deposits or maybe some say weekly securities or maybe inter corporate
deposits which can be got back in a very short span of time they are called as the marketable
securities or the very short time securities.
They are also liquid as and when you want to convert these securities into cash you can do that.
So, but that is also liquidity but that is called as the backup liquidity, so we make investment into
the securities marketable securities on the basis of expected rate of return and be construct
portfolio where we invest.
These surplus funds or this surplus cash partly into risky securities, partly into less risky
securities or no risky securities, so that income is also managed risk is also managed. So, we
keep either cash or we keep marketable securities or sometime we keep both. We keep cash plus
marketable securities some amount of the cash is kept as cash to pay for the future operations or
maybe the requirement to meet the cash requirements of the firm as and when they become due
and remaining is converted into marketable securities.
So, that maybe maintain the liquidity in the firm in the form of pure liquidity and the backup
liquidity. So, that if we are able to meet our requirements with the help of cash, then fine. But if
there is a shortage of the cash then we can or if there is a surplus cash then after keeping certain
amount of the cash as cash balance will be invested into marketable securities. So, that tomorrow
if cash falls the short for making the payment.
Then we can easily sell the securities in the market convert that cash and we can pay our
obligations. So, firm is able to meet all it is financial obligations. And it is not considered as
technically insolvent. So, liquidity means cash plus marketable securities pure liquidity and the
backup liquidity. So, we must stop here for this class and next time when we meet or we go to
the next class.
Then I will start talking to about the cash management models there we will discuss two
important very interesting models of cash management or facilitating the cash management
which are called as certainty model and the uncertainty models. So, these certainty model and
uncertainty model these models are very interesting and very helping to learn the see efficient
cash management but these models both the models I will discuss with you in the next class,
thank you very much.
Lecture-48
Models of Cash Management-Certainty Model by Baumol
Welcome students, so we were discussing the cash flow statement and in the previous lecture we
discussed that how to prepare the latest cash flow statement which is to be divided over the 3
activities that cash flow from operations cash flow from investments and cash flow from the
financing activities. So, these 3 activities are there to be clearly say identified to be identified.
And then to be say we have to highlight in the cash flow statement that how much cash is
flowing from operations and then from the investing activities and from the financing activities.
So, that it can be clearly found out that, so that we can clearly find out that how much cash is
coming from operations, how much is coming from the other two activities. Because in any
manufacturing concern operations are the major source of the cash should be the major source of
the cash and not the investing as well as the financing activities.
So, we have to verify that and it will help us to find out also that how much of the total profit
debited by the income statement of the profit and loss account is in cash how much is the cash
profit right. After that we talked about something we call it as that is the liquidity management.
And then I discuss with you that liquidity when we talk about the liquidity of a firm liquidity
those border concept but if you talk about the pure liquidity or maybe the backup-liquidity. So, it
has two components that is the cash and then is the marketable securities, part of the cash you
can keep as cash and remaining cash can be invested into marketable securities. So, that if any
amount of the cash is kept idle it will cause a cost to so to avoid that cost.
We will have to keep cash some amount of the cash as cash which is called as the pure liquidity
and the remaining has to be kept as the backup liquidity right. So, while we talk about the backup
liquidity we have to be careful that how much is the expected return from the securities and we
have to construct a portfolio. So, part of the cash you can invest into the risky securities and part
of the cash can be kept in the less risky securities or maybe very low risk securities.
So, that income from this investment is also say managed and risk is also within control, so we
have not only to invest into those securities which are totally risk free. For example if you talk
about the risk free securities that treasury bills, so you invest into the treasury bills because they
are owned by the government, they are issued by the government in the market. So, those
securities are totally tax free.
Because governments securities there that is why there called as the gilt edged securities also.
So, partly we can invest the cash into the treasury bills and partly we should invest into the other
revenues also. So, we have to create a portfolio where we have both the securities risky and less
risky securities. So, that the risky securities are giving the higher return and less risky securities
are giving you the lower return.
And ultimately desired amount of the return or the percentage of the return can be found out
right. So, it means cash plus marketable security should be say managed to manage the liquidity
in the firm right. Now as I told you in the previous class that we will be moving further and will
be talking in today’s class. In this class about the cash management models right we will talk
about the cash management models.
So, cash management models as we see here, we have the two broad cash management models
one is the certainty model which is given to us by one professor called as W.J. Baumol.
This professor is called as the W.J. Baumol and there is another model which is given to us by
the other two professors and they are it is called as the Miller and Orr model. So, if you talk
about the W.J. Baumol one, say this is the called as the first model in the cash management
which is called as the certainty model.
This model is given to us by W.J. Baumol this model we called as the certainty model and there
is another model which is called as uncertainty model. Another model is that if you look at this
model this is the uncertainty model and give it to us by two people that is Miller and Orr. So,
now we will discuss these two models and we will learn how the cash management can be led or
can be had or we can have an idea about managing the cash with the help of the two models.
So, first model is the certainty model which is given to as by W J Baumol and when W.J.
Baumol gave us the certainty model of cash management. He applied the concept of inventory
management and in the inventory management if you remember we use one technique to manage
the inventory that is the economic order quantity EOQ model of the inventory management. He
simply replicated the model, same model EOQ model of inventory management into the cash
managements.
So, he assumed that now we do not have the inventory of the finished or the raw material finish
goods or the raw material now the inventory for us here is the cash right. Now the inventory for
here for as is the cash, so as we are managing the inventory with the help of EOQ why cannot we
mange cash again with the help of EOQ right. So, we will have to we should apply the model of
this EOQ model and Baumol had that idea in his mind.
And then he applied this model which is called as a certainty model, so because of this certainty
concept which he has introduced in this model. This model has lot of limitations but still you
cannot say it is obsolete model or it is not usable or it is not important at all it has many other
properties, it has many other qualities. And we can use the model if some of the assumptions of
the model or held true in any concern or in any firm or in any business organization.
So, let us move forward and try to understand what this model is which is called as the certainty
model given by professor W.J. Baumol. Now while applying the concept of EOQ from the
inventory to cash. Here he has taken some assumptions right and these are some of the
assumptions say taken by professor Baumol and first assumption he has taken here is that
portfolio of the cash and marketable securities.
He says that firms always they do not keep the cash always cash as the cash if you are talking
about the true business maybe a private sector organization. We are not talking about the public
sector companies because there it might be possible that entire amount of the cash is being kept
as cash nothing is being invested in the market. So, there is nothing called as the marketable
security.
But in the truly nicely managed effectively managed business concern maybe in the public or
private organizations we expect that the cash is being managed, this way the assumptions
Baumol has taken. So, he says first assumption is portfolio of the cash and marketable securities
portfolio of the cash and marketable securities, he says that firms keep part of the cash as cash
and then remaining is invested in the market in the form of the marketable securities.
And there is a two way to manage the cash keeping the cash as cash and then partly the cash is
invested into marketable securities. So, firms manage cash in both the ways keeping the cash as
cash and then partly investing the cash into marketable securities generally this I think
reasonable assumption. Because normally the firm should do like this, so he has assumed that
firms are doing like this.
Second assumption he has taken is uniformly divisible securities, he says that when the firm is
investing into the securities in the market they are uniformly divisible securities. For example 1
security of 100 rupees, so he if we want to have to invest 10000 rupees in the market. It means
we have to buy say 1 securities of the 100 rupees. So, it means if we want to invest 10000 rupees
in the market, we have to buy the 100 securities.
So, 100 into100 will be 10,000 rupees for example, similarly the 1 security for 10 rupees then
same way you have to buy 1000 securities from the market. So, that is the second assumption
which sometimes may not be true that when you want to invest in the market the prices of the
security maybe not uniformly divisible that maybe for the different prices and we are talking
about building up of the portfolio.
Then certainly you will not have the securities which are always uniformly divisible right, so but
still he has taken the assumption. Third assumption is every transaction has a fixed cost, so this is
the assumption he has taken here and that is true also that when you convert the cash into
marketable securities and marketable securities into cash certainly we have to pay some cost.
Because there is a cost of the people who are working in the firm and handling the cash and they
are investing into the securities. So, there is a cost for that because we have to place the order we
have to say find out the broker and broker has to find out the security or maybe sometime when
you have to sell the security in the market you have to find out the buyers in the market. So, it
means broker’s commission is also there the people who are working in the cash department
their salaries are also involved.
So, there is some minimum cost is there which remains fixed that this is the broker’s commission
on transaction or conversion of 1 security into cash and cash into security, this much is an
approximate time of the cash management department people being used. So, that is somehow is
to be there and that is there. So, we assume that yes there is a fixed transaction cost when you
convert the cash into marketable securities and marketable security into cash.
Because if you have surplus cash keeping part of the cash is cash remaining you will invest in the
market in the marketable securities right. So, we bought the securities from the market and when
you have when you required that cash and we are running sort of the cash means sufficient cash
is not available in the bank account or with the office shares then we have to sell the marketable
security.
So, then in that case you have convert the security into cash, so that is again very very say
important component of the total cash management it also has a cost. So, conversion of cash into
security and security into cash it has the cost and that is called as the transaction and every
transaction has the fixed cost. So, this is the another important assumption he has taken and I
think it is true it is not a unbelievable or the unrealistic assumption, this assumption is true.
Then is total demand for cash as the periodical at the periodical interval is known, total demand
for the cash at the periodical interval is known. This is some but not fully acceptable because
your, you demand for the cash keep on fluctuating. So, every time you require the same amount
of cash for the business transactions I think that is also not reasonable.
But still means if it is not same if it is deviating little bit even then you can have a broad idea
rough idea by using this model that how much cash we will be keeping as cash and how much
should be converted into the marketable securities. So, not means the totally say you cannot say
it is totally a redundant idea and it cannot be used or it say redundant model it cannot be used
that you cannot say right.
So, it means this assumptions, so assumption out of the 4 assumptions, so far we have discuss.
We first one correct that is the portfolio of the cash on marketable securities. And third one is
also acceptable that every transaction has a fixed cost because it has but the second and fourth
that is the uniformly divisible securities and total demand for the cash at the periodical interval is
known, there is something some doubt about that.
But you see that if we assume the yes, there is a study requirement of cash and the cash
requirement at the different interval is known not 100% maybe correct but it is it cannot be
denied that it is impossible it may be possible also. So, let us accept this model and try to use it
and learn how to calculate the cash balance with the help of this model.
Other 2 assumptions he has taken is cash requirements are steady means over the different in
turbo period of time maybe the firms say time and interval is say 1 week or 15 days or 1 month
you call it as weekly requirements or fortnightly requirements or monthly requirements cash
requirements of the firm are same. This is also some but not 100% true because your
requirements keep on fluctuating.
Sometime you require maybe 50 lakh rupees, sometime you require 40 lakh rupees, sometime
you require 60 lakh rupees, it may be more or less not 100% same not exactly same. So, but still
is to some extend if you assume it that yes cash requirements are steady then yes we can use this
model. And this last assumption or the maybe not last I would say it is a second last assumption
that firms sells security at fixed interval is to replenish cash.
He says that your cash requirements are steady total requirements of the cash maybe over a
period of time you see 1 year is also known. So, it means if the weekly requirement is fixed or
fortnightly requirement is fixed or at least monthly requirement is fixed. So, it means you know
that monthly into12, so your annual requirement is fixed. And how much cash you have to
convert into securities and securities into cash over the months looking at the 1 months
requirement we because the requirement is steady.
So, we can physically convert the securities or convert the cash into physical securities at the
regular intervals it means that everything is certain that everything is known which is still means
not 100 percentage acceptable but cannot be totally rejected also. Then this is again a very valid
assumption ideal cash has opportunity cost yes if we keep the cash as cash it has the opportunity
cost.
Because had this cash when invested in the market it would have earned something for us,
something good for us, some good returns for us. So, it means it has the opportunity cost no
doubt about that, if you keep the cash as cash is not earning anything for you. But if you invest
part of that cash which is not required in the firm into the business then certainly the opportunity
cost can be avoided and we can have some returns from the market.
Because we have invested their cash into the marketable securities, so it is much better than
keeping the cash is ideal. So, yes ideal cash is the opportunity cost yes that is very much
acceptable. Next thing is that what is the focal point of the Baumol’s model, focal point of the
Baumol’s model is determining the optimum balance of the cash that what should be the
optimum balance of cash.
As we have been discussing in this subject all through maybe from the beginning of discussion
that working capital management requires that level of current assets which cannot be brought
down to 0 but should not be very high also. So, it has to be maintained all the current assets
whether it is inventory, receivables, cash or any other current asset that has to be managed at the
say appropriate level or at the optimum level that has to be managed at the optimum level or the
appropriate level.
So, it means we have to see here that yes the optimum level of the cash should be there all the
times. So, that neither it is too high nor it is too low and the cost of excessive cash or managing
or maintaining excessive cash can be avoided. So, Baumol’s model also highlights that particular
fact that how to find out the optimum balance of cash which is neither too high nor it is too low.
So, the firm is maintaining it is liquidity also and firm is not technically insolvent also it means
neither they are keeping high amount of cash. So, they are not subject to pay the high amount of
the cost and they are also not say expected to be technically insolvent. Because they have
sufficiently say the keeping the cash is the sufficient that is why we have to learn from this
model how to maintain a optimum balance of cash which is neither high nor very low.
And this is how the Baumol’s model can be applied and to find out say optimum amount of the
cash. So, after this once we learn this model we will then talk about certain limitations of the
model also. But I think we will see that how this model will work before we move into the
limitations first let us understand the model how this model will work and how the Baumol has
tried to implement this model.
And in this case when you think of a applying this model you have here the say structure. Now
let us prepare a structure that what structure the Baumol has prepared and how that is similar to
the EOQ model. Because as I told you in the beginning that Baumol has applied the concept of
EOQ economic order quantity model of the inventory management. So, here same thing will be
applied same structure is used by the Baumol.
So, we will also be learning how to use their structure in working out the optimum balance of the
cash or the amount of the cash. So, just recall what was the EOQ model of the inventory
management, it is something like this.
This model is something like this here you keep cash and here you keep the time, cash and time
are the 2 important things. And here it is the model works like this it creates a saw tooth picture.
And this picture is something like this it is a saw tooth picture and if you try to find it out here.
Here it is you call it as this is 0, this is C and this you can call it as the average cash balance
which you can say that it is the C/2.
And normally if you do not do anything else we will find that certain things are here that
normally we keep the C amount of cash 0 to C this much amount of the cash we keep that is
from here, here to here or here to here. This much of the amount of the cash we keep at 1 point of
time and we start using the cash.
So, it is start coming down this will starts coming down and when it comes down it when it
reaches here 0. Then immediately then and we do not have the cash means whatever the cash is
available with us, we have used it once it is comes down here then we will sell the marketable
securities whatever the investment we have made in the market, we will sell that securities in the
market and we will convert those securities into cash.
So, it means it will be c/2 or the average sorry this will be the total amount of the cash we are
using that is 0 to C. And we start we keep the cash when we start the business on the first day
maybe of any month or any year. Then we have the c amount of the cash and then we start using
the cash here you have the receipt and payments both. But finally sometime what happens your
payments are exceeding the recedes.
And we our cash balance is coming down and finally it will come down to this point once it
comes down to this point again now you have to arrange the cash. And we will convert the
marketable securities we will sell the marketable securities and again will bring the cash to this
level. And again we will start using the cash and it will come down to this point once it touches
this point.
Then again we will replenish and bring it to here this level then we will use this cash this weight
is coming down now because of the payments are more than the hour recedes. So, again it will
come here and then we will again convert the marketable securities which investment we have
made in the market will convert into cash. And we will again take the cash balance to this level
and then will be again we start using the cash.
And it is the amount we will be then the cash balance will come down to 0 this is the simpler
model but sometime what happens that and all the times for example this much amount of the
cash is assume to be there all the times which is called as the average cash balance. So, what
happens that sometimes what happens that we want to have some lead time.
Because there is a concept of lead time, lead time means that time to be taken that when you
place the order of converting any security into cash. It takes some time is not that easy that you
any time you want to sell the securities into market. You can find the buyers in the market at the
appropriate price and you will be able to sell those security in the market it is not possible. So,
what we with there that broker also needs sometime our cash department also needs sometime.
So, it means they there is a concept of the lead time, so what will happen there we use the
average cash balance concept here that is C/2, C/2 means half of this is the average cash balance
is all the times maintained in the firm. So, when the cash balance reaches at this level then means
it is we are here over the period of time after some period of time we when the cash balance is
reaching here it is coming down and when it is reaching here then what will be there. We will
place the order for conversion of the cash marketable securities into cash.
And this much of the time is available with us this much of the time is available with us that we
have place the order here at this point of time and when the cash balance will become 0. We have
already started the process at this point of time and when will the cash balance will come down
to this level then we will be able to have means again the cash balance by selling the securities in
the market and converting that into cash.
And here again we will be able to replenish the cash with the sale of security, so means this is
called as the lead time this is called as the lead time. Same thing means nothing new same thing
is done in the say EOQ inventory model that is economic order inventory model, sometimes
what happen that means re-ordering level is not the average cash balance level. We keep it low,
say for example this at this level we place the order we see that we will place the order at this
level.
So, it means in this case your lead time will come down, so your lead time will be how much, it
will be this much only. So, this much period will be your lead time, so depending upon that how
quickly we are able to convert the securities into cash and cash into securities we have to keep
the lead time with us. And for example he does not require anytime then there is no point to keep
any this no point of keeping any say lead time when it is C, you keep the average amount of the
cash we keep on using it.
And when it comes here 0, immediately for example today evening if it becomes 0 and tomorrow
morning we are sure that in the night or maybe in the after 5’o clock we will be able to convert
the securities into cash. Then next day morning we will have the cash available with us maybe in
the bank account or in the office desk. So, then there is no need of any lead time what it seldom
happens, it does not happen like that.
We need some minimum time to convert the marketable securities into cash right, to convert the
marketable securities into cash you need the minimum time. So, it means finally with the help of
this model we are able to find out something which is called as C, C is the optimum balance of
the cash we want to have all the times. C is the optimum balance of the cash we want to have at
one point of time or all the times.
So, it means why C it is, why it is C, C means when you are calling it as is optimum balance of
cash. So, this is the optimum balance of cash and how you can say that it is optimum balance of
the cash because here at C total cost is minimum, total cost of maintaining cash is total cost of
cash is minimum, it cannot be lesser than this. So, it is the minimum cost at C level of the cash
the total cost of maintaining the cash or this balance of the cash is minimum.
So, it means what is now how can you find out that it is optimum balance of the cash on the total
cost is minimum I will tell you here let see we have a structure here. Again the second structure
if we see this second structure here put the cost here and put the cash balance here. It is the cash
balance right in the EQ model also you have to type of the cost 1 cost is the holding cost and
another cost is the say transaction cost.
So, means there is a ordering cost, holding cost and the ordering cost there also because when we
place the order for inventory we pay the cost. Because there is a some fixed cost of because the
proper order and then you have to dispatch the order and then make sure that the reaches you. So,
we assume that there is a fixed cost of placing the order which is called as the ordering cost and
second cost is the say holding cost where you have to say pay the interest of the cash invested
into the inventory then the warehouse expenses.
Then the human resources maybe say watchman or maybe the other people who are keeping
taking care of that warehouse or the store of the inventory all these things will have to pay the
cost. So, higher the amount of inventory you are keeping your holding cost is high but reverse is
happening that. If the lower the amount of the inventory you are keeping, so what you have to do
is you have to frequently order the inventory.
Because some side if you are keeping 100 units of inventory and on the other side you are
keeping 1000 unit of inventory. If you are keeping 100 units of inventory then what will happen,
it will be very quickly over and you have to again place the order. So, what will happen many
orders will be placed in a year or in a month and our ordering cost will increase. On the other
side if you are holding high amount of inventory then your holding cost will increase your
interest cost will increase your say a human resource cost will increase, your storage cost will
increase.
So, it means these cost will increase, same is the case with this model when the Baumol has
applied that he has considered that at the place of the ordering cost at the place of the ordering
cost there is a ordering cost in inventory and here he called it as that it is the transaction cost.
That when there you can place the order and here we convert the again here also we place the
order of converting the securities into cash and cash into securities. So, it is a order for the cash
and there is the order for inventory, so this is the same cost. So, he says both the cost are same
whether you manage inventory or whether you manage the transactions. Second cost he says is
the say that is of you call it as the holding cost.
So, holding cost is same in both the cases, holding cost in the inventory also you have the
holding cost, cost of the cash invested as I told you invested into the inventory. So, we have to
pay the interest for that warehouse cost, human resources cost taking care of that inventory and
in this cash management also we have the holding cost because if you are keeping the high
amount of cash then their opportunity cost is very high.
Because you are not investing that cash in the market just say with the fear off that if there is a
shortage of the cash from where the cash will come or maybe we do not know how to manage
the cash and where to invest in the market. So, you are holding high amount of cash, so in that
case your opportunity cost is high. So, there it is a holding cost here it is the opportunity cost, so
that is if you are keeping the high amount of the balance of cash or inventory or inventory of
cash your holding cost will increase.
But if you keep small amount of the cash your transaction cost will increase, so it means we have
to find out a point where we have the total cost are lowest or the total cost is minimum. So, you
say this is the holding cost this moves.
And this is your transaction cost. So, you call it as this is the holding cost this is the holding cost
and this is the transaction cost I would say this is the transaction cost. And here if you draw a
curve here you will find 1 cost which is the minimum cost, this cost is called as minimum cost.
So it means what is this, this is called as C, C amount of cash, C that is why I told you in the
previous discussion that why C is the optimum amount of the cash or the balance of the cash.
Because the total cost of C is the minimum, how it is minimum that when you take on the 1 side
the holding cost and the other side you take the transaction cost, if I draw a curve here it is the
minimum point of the minimum cost, this is the minimum cost and this is the cash balance we
are taking here. It means if you keep this much level of the cash, so what will be your cost will
be this much.
But if you increase the level of cash for example firm C to this point C1 if you make it C1. So,
what will happen this will be the new line. So, in this case your say transaction cost will come
down your transaction cost is coming down but is your holding cost is going high and if you
bring it to this point that is the C2. If you take this point here say for example it is C2, so what
will happen the curve will be something like this.
So, in this case your holding cost will come down but your transaction cost will be very high, so
ultimately this is the point C which is called as the optimum balance of the cash or where we can
maintain the balance of the cash which is called as the optimum where both the cost are
minimum. And that is the point where the holding cost intersects with the transaction cost, so this
is called as the C amount of the cash.
And this is what we have try to find out that is the C amount of the cash Baumol is saying that
this is the C amount of the cash which we normally keep with us. Because the cost of this cash
balance is optimum and when we start using it, it is allowed to come down to this level or
sometime this level or sometime this level. And then we again sell the marketable securities
convert them into cash and again replenish the cash by selling the marketable securities.
So, I think you must have understood by now how to apply the concept of economic order
quantity which is applicable in the inventory management in the management of cash or
managing the cash balances. So, this is the basic model we discuss now but how to apply this
model. I will discuss with you in the next class, thank you very much.
Department Of Management Studies
Lecture-49
Certainly Model by Baumol Contd…
Welcome students, so in the previous class we were discussing the Baumol’s model of cash
management and there we concluded and we discuss then we learn that by applying the
economic order quantity model of inventory management into the cash management. Baumol has
suggested that how the optimum balance of the cash can be calculated. So in that say class, in the
previous class we found out then we have to find out the C amount of the cash.
And why C amount of the cash where the total cost is minimum now the question arises that how
to calculate the total cost of this C or how to calculate the cost of C and to find out that this cost
is minimum. So in this case to calculate the total cost of C amount of cash or the optimum
amount of the cash we use this equation.
So, total cost of we will be using this equation total cost of C or C amount of cash will be how
much b*T/C+i*c/2 right. Total cost of C or the total cost of the optimum amount of the cash will
be calculated how, then we will have to check this and we will have a model. Finally we will
convert that how the Baumol has develop the model and the model which Baumol has developed
here is that what is the b, b has taken the total cost of C=b*T/C+i*1/C/2.
So, what is the b here, b is the fixed transaction cost b is the fixed transaction cost this is b and
what is the T, T is the total requirement of cash, total requirement of cash over a period of time
say a year in 1 year. Because maximum time horizon we take in the current assets is 1 here. So T
is the total requirement of the cash over 1 year this is T and C is the actually we are talking about
the periodical cash balance.
This is the C which is the bone of content should be won’t to find out, this is the periodical cash
or the optimum cash or the minimum cash or the maximum cash we want to keep with us, that is
a periodical cash. So, when you calculate this that total amount of requirement of the cash in a
year divided by the periodical cash balance, this is C. So this becomes the T/C or you can say
that this is the cash turnover ratio T/C is the cash turnover ratio that over a period of time maybe
a year, how many times you have to convert the cash into securities and securities into cash.
So, this is the T/C and there only we have to apply the fixed cost. So, when we have the turnover,
so when you apply the cash turnover with the fixed transaction cost then that will becomes the
fixed transaction cost that is cash turnover into fixed transaction cost and this is the first part of
this equation that is b*T/C. And then is the next thing is the we have C/2 or we talk about the
first i, i is the say opportunity cost of ideal cash, this is i.
And when you talk about the C/2, so C/2 is the average cash balance held at a point of time held
average cash balance held by the firm. So, this is the explanation of this model or this equation,
so total cost can be found out that is the total cost of C will be equal to b*T/C+i*C/2, b is the
fixed transaction cost that when you convert the cash into marketable securities and marketable
securities into cash, you have to pay the fixed transaction cost which I discussed in the previous
class.
So, that is fixed all the times, see 100 rupees to 100 rupees, 500 rupees commission of the broker
and the cost of the people working in the cash department. Then T is the total requirement of the
cash over a period of time and we assume here the period of 1 year, C is the periodical
requirements. So, we keep the cash=1 months requirements for example or 1 weeks requirement
for example, so it means this is the C.
So, it means if you keep the cash as cash=to the 1 weeks requirement, it means you have to
divide that total requirement, with that total requirement the total requirement of year or you
multiplied by the for example you want to keep while weekly requirement of the cashes 10,000
rupees and there are 52 weeks. So, it means you have to multiply by 52 this much of the total
cash requirement is there.
But we do not keep the annual requirement of the cash or the cash required for whole of the year
in one go, we keep on converting cash into securities and securities into cash. So, that is called as
the C or the periodical requirement, so it means and T/C is the cash turnover ratio that will when
you need cash you convert that into say cash from marketable securities and when you have
surplus cash you convert that into the marketable securities, i is the opportunity cost of ideal
cash. If you keep high amount of the cash as cash opportunity cost will be very high opportunity
cost will be very high..
So, it means we have not to keep the high amount of the cash as cash, so it means we have to
lower down the opportunity cause of the cash, C/2 is the average cash balance held by the firm
which we have seen in the structure that average cash balance held by the structure is that is here
that is C/2.
This is the average cash balance we are keeping you see that half of the C requirements we keep
always remains with the firm as the average cash balance. So, we use in the inventory model also
they are using in the cash management model also right.
So, this is the C/2, now once this model is there with us we have to know solve it that how
finally this model will become like that b=say what is the model here that is the b here again let
me write it again.
So, it means total cost is total cost of C=how much it is the b*T/C+i*C/2 this is the total cost
where this is the sum of the total cost becomes of the transaction cost as the less of the
opportunity cost right, converting cash into securities and securities into cash and then is the cost
of the keeping cash as the ideal cash. Now we say if you look at this structure we are saying that
the C will be the amount where both these cost are equal.
Then where the intersect with each other than there the holding cost or maybe the opportunity
cost and the transaction cost, you call it as the opportunity cost also, holding cost means
opportunity cost. So, when they are equal that is the C amount of cash or the optimum amount of
the cash because that this point the total cost of the cash which is C we are keeping with us is
going to be the lowest right.
So, how you can rewrite it you can write it b*T/C=i*C/2 right. So, here it is the b*T/C and then
it is the say i=C/2 or you can write it either way you can take it this side also i*C/2 and b=T/C
you can write it like this also. So, it means this cost is equal to this cost and this cost is equal to
this cost we have seen in the previous structure also that where both the cost are equal, they are
intersecting with each other.
So, it means this is the point where both the costs are equal and that is the point of minimum cost
and that is the point of C also right. So, now if you solve this so what you will do is that is the C
if you solve this say i*C/2 and is equal to b*T/C if you take into account this particular part if
you try to solve it. So, you will find if you are doing something like this that iC= when both the
costs are equal, when you are considering both the cost are equal or maybe you can write to this
that will more easy to understand that i*C/2.
And then is the b*T/c we have written it here, so it if you at both the cost are equal here at this
level both the costs are equal that is the transaction cost is equal to the or if the opportunity cost
is equal to the transaction cost. So, it means if you try to solve multiple means cross multiply it,
so what will become like this it will cross multiply it, it will become we have started with this
i*C/2 and b*T/C.
If you cross multiply it, it will become iC square=2bT, so iC square=2bT we have cross
multiplied it. So, it is the 2bT and it is the C*C is the iC square i is already there, so it becomes
iC square=2bT and C square will be how much C square will be 2bT/i and C will be how much,
C will be the under root of 2bT/i under root.
So, this is the finally the model will become, so finding out the C if you want to find out the C
here you have to it is the C=2bT/i that is the double of the b means transaction cost and total
amount of the cash it is multiplied product of this if it is multiplied by 2 and divided by the
opportunity cost that is i and taken the under root that will be the value of C. So, when you talk
about the C and then you talk about the say i.
So, if you see that C is the cost balance of the cash which we are going to keep it, so it has to be
related now with something like that the i and then it is the b. So, if it is high is the i if it is high
is the i if i that is the opportunity cost is high how much C will be, it will be lower and high is the
b the transaction cost is high then higher will be your C. So, it means with the opportunity cost
this varies inversely.
Because higher the opportunity cost you will tend to keep the lower amount of cash whereas with
the transaction cost this C is moving in the same direction or maybe that is varying directly, there
is a direct relationship between i and sorry there is a direct relationship between the b and C but
there is a inverse relationship between the i and C. Because obviously if the opportunity is high
you should write keep the lower amount of the cash.
So, it means both are moving in the opposite directions, on the other side if the transaction cost is
high, so you have to keep the high amount of cash and in this case we are having it relationship
something like this. So, for example you are talking about this relationship, if we see here that
this is the transaction cost when we are talking about the transaction cost if it is very high, so our
cash balance we are not keeping this, we are keeping this.
So, it means it is coming down to this point and opportunity cost is if you are increasing the cash
balance it is directly going up. So, opportunity cost if you keeping the high amount of the cash is
there opportunity cost is high but if because of the inverse relationship. And if you are keeping
the high amount of the cash your fixed cost is less but if your say fixed cost is less.
But if you are keeping the higher amount of the cash your opportunity cost is very high. So, you
compare this C with the i higher the C we are keeping then there is a relationship that higher is
the opportunity cost because i is high your ideal cost of keeping ideal cash will be very high.
And similarly if the transaction cost is high, so you have to you are bound to keep the high
amount of the cash.
Because sometime what will happen that you are not saving upon the transaction cost you are
saving upon the opportunity cost and transaction cost is so high, that it crosses even the
opportunity cost also. So, it is always advisable to keeping high amount of the cash. So, whether
to keep high amount of cash or low amount of the cash that depends upon the i and b but finally
it is clear from this discussion that you have to use this model which is basically the replica of
EOQ model.
In the EOQ model also we use the same ordering cost and the holding cost and then we calculate
the amount of the EOQ there we call it as not C, there w call it as EOQ, EOQ that is a economic
order quantity and here we are calling it as C. So, C=2bT/i whole under root, this is the whole
case and we are going to have this discussion. So, now with the help of this say model we can try
to find out that how to use the Baumol’s model.
So, for calculating or using the Baumol’s model let us have a problem with us and the problem is
like I will explain you the problem first and then we will use Baumol’s model in solving this
problem. So, problem is likes a firms estimated cash requirement over the year is annual
requirement of cash.
Annual cash requirement of a firm is 567 lakhs 567 lakhs, it is spread over rupees 47.25
lakh/month means this is the total requirement 567 lakh and the monthly requirement is rupees
47.25 lakhs . Now firm if they have surplus cash they invest into the TB’s into the treasury bills
and say to manage the surplus cash and the yield from the treasury bills is assume to be 8%, that
is per annum 8%/annum this is the information.
And transaction cost is which is fixed, transaction cost is that is rupees 900 and that is fixed. So,
we have this information there is a firm whose annual requirement of the cash is 567 lakh whose
monthly requirement of the cash is 47.25 lakhs. If there is a surplus cash that is invested in the
market at the rate of 8% only in the treasury bills and the transaction cash of converting cash into
marketable securities and marketable securities into cash is 900 rupees.
So, this information is available with us then with the help of this information how can you use
this Baumol’s model. As I told you. Now let us use the Baumol’s model we have to find out C
and for calculating that you needed what is the model is that is C=2bT/i whole under root. So,
here is what is 2, 2:2 right what is the b, b is the transaction cost and it is 900 here and T is the
total requirement of the cash in a year that is 567 lakhs.
This is the total product sorry the total equation and then finally dividing it by the opportunity
cost which is annual opportunity cost which is 8% that is 0.08. If you solve this you will get
something is C you will find out is that is the 11000 1129491 or you can call it as for simplicity
that is 11.30 lakh, that is there you can say the value of the cash here. So, it means value of the
cash is 11.30 lakh which b like to have or where you can call it as considering the opportunity
cost.
And considering your say transaction cost the C which works out as is that is 11.30 lakhs or it
was 1129491, so we converted into approximately 11.30 lakhs. Now calculate the cash turn over,
cash turn over or ratio if you calculate the cash turnover is how much it works out as 5 lakhs 67
thousands sorry 5 lakh 67 thousands, so divided by how much we have this, this is the 11,29,491.
So, how much this is ratio this works out as 50 times, this ratio, ratio works out as 50 times, so it
means what is the say C amount or the say monthly requirement of cash if you talk about
monthly requirement of cash is monthly cash requirement, monthly cash requirement is how
much 4725000/50, so this works out as the sorry.
This is not the this is not 50 we will have to divided by something else and this is the C, so if you
divided by this figure that is 4725000 and what is our C, C we have found out here is 11 lakh
sorry, C we have found out here is that is 1129491. So, this works out as how much 4.18 this
works out as 4.18, so what does it mean, means monthly requirement of cash is 4725000, our C
where the total cost means the cost which is because of opportunity cost and the transaction cost
C.
That is say at C where the opportunity cost and the transaction cost is equal or total cost is
minimum that C we have worked out is that comes up as 11 lakh 29 thousand 491 or 11.30 lakh.
Then we calculate is the turn over say we found out the 50 times and then monthly requirement
of the cash we have already known that is 4725000. So, it means if you have the C that is 11.30
or 1129491.
It means in this case what is the monthly cash requirement if you see the monthly cash
requirement and divided by C. So, it means you will find out here is that the cash conversion or
maybe the number of transaction in a year, in a month is going to be how much 4. There are the
4 transactions in a year sorry in a month and 4 times in a month the firm is converting cash into
securities and securities into cash.
Because this 4.18 means that 4 times in a month because monthly requirement was 4725000, C is
1129491. So, this ratio works out as 4.18 roughly you can say that 4 times a year sorry 4 times a
month firm is effecting the cash transactions converting the cash into security and securities into
cash and finally you can say if it is 4 times a month it means weekly transactions are taking
place, a firm is keeping, C means the amount of the C which the firm is keeping.
That is sufficient only for the 1 week cash requirements that is only sufficient for the 1 weeks
cash requirement. So, firm is keeping equal to it is 1 months cash requirements and when that
cash is over then the cash is being brought by converting the securities into cash or cash into
securities, this transactions are taking place.
So, by using the Baumol’s model we have try to find out like the EOQ technique of inventory
management we have try to find out that how we can use into in the management of cash where
rather than finding out the EOQ we can find out the C that is the optimum balance of cash and
that will be that balance of cash where both the cost that is a holding cost or the opportunity cost
and the transaction costs are equal.
So, that the total cost is minimum, when we learn that model and applied it to a company whose
annual cash requirement is 5670000 and whose monthly requirement is 47.25000, 4725000. So,
we found out that by applying the Baumol’s model and whose opportunity cost was 8% per
annum and the transaction cost is 900 per transaction. So, when we applied the Baumol’s model
to find out the C amount of cash we could find out that C=11.30 lakhs.
And if you use this much of the cash if you keep this much of the cash with you then keeping
into account your monthly cash requirements approximately 4 times a month. Because monthly
requirement is 4725000 and C has been worked out as 113000. So, it means almost 4 times a
month we have to effect the cash transactions or convert the securities into cash or by vice versa.
So, it means it is weekly balance equal to maximum 1 week’s balance firm is keeping as a cash
remaining is being invested into the securities. And when there is a requirement of the cash need
for the cash that is being converted, securities are being converted into cash and the cash is being
brought in by selling the securities in the market. So, this is all happening once a week or 4 times
a month. So firms C is equal to how much if there is annual requirement of 567 lakhs and
monthly requirement of the 47.25 lakhs.
Then C=1 weeks requirement and this is very optimum amount. If the firm is able to run the
show by keeping the 1 weeks cash balance as cash remaining in is being invested into marketable
securities then it is a wonderful way of managing the cash. And we are sure that this way the
total cost of the cash will be lowest and the firm will be not wasting any cash or not losing any
income by not managing it is cash effectively.
But here are some of the limitations of this model as I talk to you earlier that here are some
limitations of this model and these are say 2 major limitations. First limitation is the specification
of the cost, if you talk about the total cost we have working out, transaction cost we have
working out. Then it can be divided into 2 parts, variable cost and the fixed cost. So, it means
variable cost and the fixed cost.
If you have talk about the opportunity cost that can be found out because it is a interest rate, we
are expected to earn from the market and when we are not investing the cash in the market. We
are losing that interest, so you are easily able to find out but what about the transaction cost. In
the transaction cost some part is fixed, for example placing orders to security brokers, physical
storage cost of the securities and secretarial cost, cost of the people working in the company's
office.
So, it means sometimes it is very difficult to find out the fixed cost because these people who are
working in the cash department who are stay involved into converting the cash into securities
and securities into cash. They are doing so many things in the total time span of 8 hours in a day
right. So, how much time of their total times of 8 hours they are investing for this particular thing
to find out this is sometime very very cumbersome is very difficult but it is not impossible it can
be found out.
So, variable cost is easily possible to be found out but the fixed cost basically on these 3
accounts placing the orders to brokers, physical storage of securities and the secretarial cost it
creates problem but we can still do it because we do it in case of the EOQ or in the inventory
management also. So, we can do it here also. Second major limitation this is a major and serious
limitation of this model is that model says that usage of the cash is steady.
That is steady usage of the cash means the cash requirement of the firms all the times remains
steady or remains the same, say for example in this problem we have found out that annual
requirement of the cash is 5670000 it will remain fixed over the years, it will not increase or
decrease is hard to believe. And check and his assumption here he has taken in this firms
problem is that monthly requirement is 47.25 lakhs or the 4725000 which is the monthly
requirement.
So, it means it is steady it is fixed, it does not change, so it means change also means practically
it may change also it is not 47.25 it can be 48, it can be 49, it can be 50, it can be 45. So, this is
the second major limitation of this model that steady usage of the cash cannot be there, there is
always element of uncertainty in the cash balances as well as the requirements of the cash.
So, sometime you are requirements were fluctuate go more or less or at the same time there is the
say fluctuations in the weekly balances, in the monthly balances, in the annual requirements of
the cash and specification of the cost when you talk about is also sometime difficult. But the first
limitation can be done away because we can easily find out the fixed cost also at the fixed
transaction cost where is the variable is easily found out.
And in case of the steady usage this is a major limitation of the model whereas a cost
specification of the cost part is not very serious it can be easily done away, we can easily find out
the cost. But even despite these 2 limitations of the model, this model is very very useful and if
we are able to a certain to extent that are we are able to identify our cash requirements over the
period of time, over the different intervals.
First you start with the year, then come down to month, then come down weeks, if some extents,
some fluctuations might be there but if larger amount of that requirement is fixed. Then I think
this model is very useful, very thoughtfully has been used by Baumol by using the EOQ model
of inventory management. So, you cannot reject the model as a whole it has some limitations we
have already identified those limitations.
But despite those limitations if we are able to find out the C amount of the cash here as in this
case we have been able to find out that their monthly requirement is we know that is 4725000.
Annual requirement is 567 thousand sorry 567 lakhs and if their opportunity cost is 8% and if
their transaction cost is 900 per transaction. Then the optimum amount of the cash balance which
the firm should maintain that is 11.30 lakhs, so that is equal to 1 weeks requirement.
Now you see in the practical sense it may not be 11.30, it maybe 11.5, it maybe 11.2, it maybe 12
also. But at least if you are keeping if you are following this model in the laterrance period you
have got this figure of 11.3, you do not keep 11.3, you keep 11.5 or you keep 12 or you keep 11.
If we are able to reach up to the nearest point also of the actual requirement of the cash even then
we are not at a loss as compare to situation where we not know at all.
As compare to situation where we do not know at all how much cash balance to be kept, for
example your requirement is 11.3 lakhs, you are keeping 20 lakhs, it means you are paying extra
cost for 8.70 lakhs, other way round your requirement is 11.30 lakhs or 11 lakhs, you are keeping
5 lakhs, you are running short by 6 lakhs. So, anytime if we have to make the payment you do
not have the cash at that time.
So, be careful and manage your cash by using this model which is based upon the certainty we
say that there are certain limitations in-built in the model but model is still usable. And we
should use this model. So, this is the model why we call it as the certainty model because it is
assumptions indicate towards the certainty and when you talk about the certainty here the model
is saying that portfolio cash and marketable securities uniformly divisible securities.
And then total demand for the cash at the periodical interval is known which may not be known
that is why we call it as certainty because it is same at with certainty that requirement is known.
And then cash requirements are steady means all the times you require the same amount of cash
and then ideal cash is opportunity cost. So, it means and firms need cash at the regular intervals
or the fixed intervals that is also sometime not believable.
But to a larger extent the model is not completely the one which can be redundant, it is still
usable model and it takes you to a point or able to find out or helps you to find out the balance of
the cash which is nearer to the actual very nearer to the actual requirement of the cash. So, if you
still do not use any other model if you use this model even and try to find out the C with the help
of this model you are doing a great job.
And you are saving your ideal cost also, ideal cost of the cash also and you are saving upon the
transaction cost also but as a improvement over this model as a improvement over this model
there is another model we will discuss in the next class that is the Miller and Orr model and that
model addresses the this element of certainty here into they convert it into uncertainty. That if
certain things are not there means some things are uncertain then how to work out the balance of
cash.
And how to calculate the balance of the cash, so that is called as the second model that is the
uncertainty model of cash given to us by MH. Miller and Daniel Orr. So, that model very say
another interesting model that model I will discuss with you in the next class, I stop here, thank
you very much.
Dr. Anil K. Sharma
Lecture - 05
Approaches of Working Capital Management – II
Welcome students. So in the last part of discussion we were talking about the different
approaches of financing of current assets or say fulfilling the working capital requirement and we
discussed 3 approaches under which the current assets can be financed. So these approaches
were like conservative approach, aggressive approach and hedging or matching approach which
is in between the two conservative and aggressive.
So we saw that the 2 approaches that is conservative and aggressive approach have 2 extremes.
In one the cost is very high so profit is less. Risk is also low. In the second approach say
aggressive approach cost is low, profit is high, but the risk is also very high. So we saw and we
could understand that following either of the two approaches will take us to on the one extreme
and that is not desirable, that is not required.
And we should try to avoid the extremes. So we have to find out the middle path and for the
middle path I told you that we can follow the hedging or matching approach and that way if you
do that, then the current assets will be pure current assets, that is a fluctuating current assets will
be financed from the short term sources of funds and the permanent current assets as well as the
fixed assets they will be financed from the long term sources of the funds.
So there is a complete hedging. There is a complete bifurcation as far as the assets are concerned
and the sources of funding these assets are concerned. So that is the one thing in this case now
we will be taking going further and when we go further we will be talking about that how to
utilize these approaches effectively in the say day to day decision making and how different
sources of the funds depending upon the their cost, their flexibility, risk, and some other factors
is going to affect our financing decision.
As I told you in the previous class also that since we are talking about the short term finance, it is
a management of the short term finance, it is a management of working capital. So if we are
going to pay extra cost on managing the working capital or the current assets we are going to
increase the cost of production because financial cost is going to increase. So total cost of
production of the product is going to increase and the margins as well as the selling price will be
affected in the market.
But if you are able to manage the financial cost by resorting to the say appropriate sources of the
finances starting from the spontaneous finance and then short term finance and then if the need
arises finally then we can say in very few cases we should go for the long term sources of the
funds. In that case, whatever the saving on account of the financial cost we are able to have that
will directly translate or that will add up to the increased profitability.
Immediately that adds to the increased profitability because there is no leakage of the whatever
we have saved because time period is very short. We are talking about say days, weeks,
fortnights and maximum months. So within a few months or within a few weeks or say fortnights
the cost which is saved here that does not go here and there. We are able to save the cost and that
cost directly adds to the profitability of the firm.
So now we will see that how it happens and how it works. So we will take a say an example a
situation not example I would say it is a situation and then we would try to find out that if we are
going to say save the cost, maybe we are going to have the funds from the optimum sources
means without following any kind of extremes. Either we are following the conservative
approach nor we are following the aggressive approach.
We are having a trade-off between the two that is in terms of the trade-off you can say trade-off
in terms of the profitability and risk. So we can say that we are going to take the moderate risk
and we are going to have the moderate profitability or the optimum profitability because by
taking extreme risk you can increase the profits but the risk is going to spoil the firm if the firm
is technically insolvent.
If they are not able to pay its obligations on time then what will happen that it will spoil the
overall financial reputation of the firm. On the other side if we are not able to save up on the cost
it means say we are resorting to the long term sources of funds. Cost is increasing then profit is
going down maybe the risk is also going down, it is also decreasing. So now in this case we see
that we have to go for a middle path or the middle approach and that is why we call it as the
trade-off between the profitability and the risk.
When you call it as the trade-off between the profitability and the risk, so how to have that trade-
off right? So let us see a situation I would discuss a case, small case or situation with you and
before moving to that case or that situation we will have to assume certain things right? When
we are talking about the management of working capital one thing I would like to share with you
that working capital is largely required in the manufacturing organizations right.
We require the short term finance or management of working capital in the manufacturing firms
because in the manufacturing firms only we require the working capital. Say for example you
talk about the services sector. In the services sector we require working capital but not that much
as we require in the manufacturing sector. So management is not that much required in the
services sector. Say for example when we try to have a service from some service vendor or
service provider we pay him part of that service in advance.
For example we want to book a say say a caterer for a particular function or maybe a tent house
owner for a particular function or something like that. So in that case when we go to him for
booking he would say okay on this date or something like that I will serve you, I will fulfill your
requirements. So just to say have a you can call it as a confirmed order please give me say maybe
50% or maybe sometime 30, 40% in advance.
So he takes money in advance from us and that money which he takes advance from us he uses
that as the working capital right. But in case of the manufacturing sector when we are going to
buy a color TV or we are going to buy a refrigerator, we are going to buy a car or we are going to
buy a computer, we are not going to provide as the buyer or as the customer. We are not going to
provide the working capital to the firm.
No firm ask for that if you want to buy a computer you give me half of the money in advance
and then remaining half of the money you can give me when the computer will be delivered.
That does not happen. That product is readymade. It is available in the shop. Go there buy it and
start using it. So you buy the product 100% and paid for the 100%. But during the manufacturing
process the working capital is required along with the long term funds.
So in the services sector you do not need the working capital as such so we need the say working
capital in the manufacturing sector right. So when you need the working capital in the
manufacturing sector that is in the large amount so it means there is a need to manage the short
term funds, the working capital as there is a need to manage the long term funds right. Now to
discuss this case we will take 3 important assumptions.
First assumptions, first assumption is that we are dealing with a manufacturer, manufacturing
firm. Means if you are studying the working capital management study it in the perspective of
manufacturing industry. Second assumption we are going to take here is current assets are less
profitable than the fixed assets. As I told you in the previous class I told you that current assets
are less productive as compared to the long term assets or the fixed assets.
So we should invest as minimum as possible. We have seen in the previous classes or in the
previous discussion that inventory is not producing anything, credit sales is not producing
anything. So there is no return or very less return and there is a cost. So you can say that when
you compare the say current assets or short term assets with the long term assets or with the fixed
assets the current assets are less productive.
Either they are not at all productive or if they are productive they are less productive as
compared to the fixed assets so this is the second assumption we are taking here and the third
assumption we are taking here is that short term funds have less cost than the long term funds. So
I have already told you that in India also we are following the term structure of interest rates and
term structure is means term structure says that the interest on the loan is directly linked to the
maturity period.
Longer the maturity period, you have to pay the higher rate of interest. Shorter the maturity you
have to pay the lesser rate of interest. So since for fulfilling the working capital requirements or
the short term funds requirements we are borrowing the funds for the shorter period, maybe for a
few months or maybe sometimes for weeks even. In that case we are paying the lesser cost of the
funds.
So it means this is our third assumption that short term funds are less costly as compared to the
long term funds and in the working capital or to fulfill the working capital requirements we
always use the short term funds or the funds from the short term sources, spontaneous sources
and we hardly resort to the long term sources if means if it is possible to manage the show with
the spontaneous and short term sources of funds is much better.
So we are taking the third assumption that we use the short term funds for meeting the working
capital requirement and these funds are less costly as compared to the long term sources of the
funds. So these are the 3 assumptions. On the basis of these 3 assumptions we will be discussing
this case. So we have taken these 3 assumptions right and once we have taken these 3
assumptions so on the basis of 3 assumptions we will test a case.
And we will try to see that how the trade-off between the say long term and the short term
sources helps us to manage the cost of funds, profitability, and the say the risk. Here now to
understand this case properly and clearly we will start with say a ratio and this ratio will help us
to understand the effect of the level of current assets on the profitability risk and a trade-off
between the two right? So it means what should be the level of current assets?
As I told you the our assumption is that current assets are less productive as compared to the
fixed assets. So it means lower the extent of current assets lesser the say magnitude of the current
assets in the firm, more profitable the firm should be and more higher the magnitude of the
current assets in the firm lesser profitable the firm should be or will be right.
So we will have to see now the effect that if you are given a certain level of current assets in the
balance sheet then we will see what is the profitability of the firm, what is the liquidity position
of the firm and what is the net working capital position of the firm. If we increase the level of
current assets so it means when we are increasing given the level of total assets remaining the
same if we increase in that total say amount of the current total assets if you have the given level
of the current assets what is the profitability?
What is the net working capital? If you increase the level of current assets by not increasing the
total assets then whether the profitability is going down or not; as per our assumption it should
go down and if you decrease the level of current assets the profitability of the firm should go up.
So whether it happens or it does not happen just to check this particular situation we have a case
here and in this case we will start understanding this situation by working out a ratio and that
ratio is the here we have to have this ratio which is given to you here and this ratio is the, the
ratio of current asset to the ratio of current assets to total assets.
This is the ratio of current assets to total assets. So what is the extent of current asset to total
assets right? It may be possible that this ratio is say 0.5 is to 0.5 out of the total assets so it 0.5:1.
So if it is 0.5:1 it means you can say that 50% of your total assets is the current assets. This ratio
can be say even 0.4:1. So it means 40% of the total assets are the current assets.
So depending upon and if it is say beginning is this and we are reducing it to this level or if you
increase it to this level that is 0.6:1 so you can say that it will have a different situation. So
ultimately you have in the beginning you have this ratio then we reduce the level of the current
assets the profit should go up and when you increase the level of current assets profits should go
down.
So studying the say impact of level of current assets on the profitability we will start or we will
understand with the help of this particular ratio and this ratio is current asset to the total assets.
Now if you understand this ratio then we will move further and let us take a situation that first of
all we will study the effect of increase. We will we are given a level of current assets. Then we
will increase the level of current assets. Then we see the impact on the profitability.
Then in the second case we reduce the level of current asset then we will see the impact on the
profitability. We will keep the level of total assets same. Only we will change the proportion of
current assets will increase, will decrease, and then we see how much impact it has on the
profitability right. Now for example this is the balance sheet.
In this balance sheet we are given the say two kind of the assets on the asset side. This is giving
you the asset and the liability side. We have the liabilities like we have the share capital which is
say 6000 million rupees you can say. Then it is a long term debt or the long term loans which is
4800 millions and then we have the current liabilities that is somewhere 3200. So it means total
amount is 14000 million rupees millions that is the liabilities.
And in the asset side if you look at we have the fixed assets. We have the current assets, two
components and fixed assets are 8600 million rupees and current assets are 5400 million rupees
again making it as a total of the 14000 million rupees as the total asset. So the balance sheet is
balanced right. Now let us take this assumption that company earns 2% on the current assets and
company earns 12% on the fixed assets right.
Company earns 2% on the current assets and company earns 12% on the fixed assets because
current assets are less productive as compared to the fixed assets so we have the we have
assumed this much rate of return because even the company in the real sense in the real scenario
the company has not even earned 2%. As we have seen in the previous discussion how much
companies are earning on inventory. How much companies are earning on credit sales.
How much companies are earning on the advance payments. Companies are earning only on the
marketable securities. Companies are not earning even on the cash but still we are taking the
assumption that current assets are helping us to earn 2% and fixed assets are giving the return of
12%. Now this is the case so now we will see that on the balance sheet which we had, look at
this balance sheet.
On the basis of the extent of current and fixed assets and on the basis of the rate of return there
we have you see that now what the company is earning and what is the ratio of current asset to
total assets and what is the net working capital situation. So if you see here in this the ratio of the
current asset to the current assets are here 5400 and total assets are 14000 so this way if you
calculate the ratio this works out as say 38.6%. The ratio of current asset to fixed assets is 38.6%.
We have calculated the ratio. We will begin with calculating of the ratio of the current asset to
the total asset, that is 38.6% and on the basis of the rate of return which we assume 2% and 12%
if you work our the profit company’s profit on the total assets we have worked out the
company’s profit on the total assets and that profit is say 1140 million rupees or dollars whatever
you call it as. So this is 1140 millions.
Now this is the ratio 38.6%. This is the company’s profit 1140 millions and net working capital
is 2200 million dollars. Net working capital is 2200 million dollars. So it means we have the total
situation is clear to us that we have this much level of current assets and fixed asset. Total is
14000, earning is 2%, 12% and then we have calculated 3 things that is the profit on the total
asset 1140 million dollars.
Then current asset to total asset ratio is 38.6% and the net working capital now. Net working
capital means because how we calculate the net working capital? We have seen is that is the net
working capital is equal to current assets minus current liabilities. Now in this case current assets
minus current liabilities. We have seen the current asset level is 5400 and current liabilities level
is 3200. So it is 5400 and it is 3200. So the net working capital is dollar 2200 millions.
This is the net working capital. It means to finance the total level of current assets that is to the
extent of to the tune of 5400 this much amount is coming from the spontaneous as well as the
short term sources of finance and remaining means we are fully exhausted spontaneous finance
we have fully exhausted the short term sources of finance. It means the remaining amount that is
to the tune of 2200 million dollars will come from the long term sources of the funds.
Net working capital means it is the it is synonymous to net working capital means that the long
term sources of the funds. How much funds are coming from the long term sources that is called
as the net working capital. If the net working capital is zero so you can say current assets are
equal to current liabilities. If the net working capital is negative so you can say current assets are
less than the current liabilities.
But when the current assets are more than the current liabilities so it means current liabilities that
is spontaneous and short term finance will provide certain amount to fund the total current assets
and remaining balance if still required that will come from the long term sources. So we have
seen this situation and we are here without making any changes to the balance sheet having the
composition of the current asset that is 5400 million dollars and fixed assets 8600 million dollars
and this is the profitability.
This is our net working capital and this is the ratio of the current asset to total assets. Now we
make a change to the current assets. When you make a change to the current assets we add in the
current assets some amount of 600 million from the fixed assets. We change the composition.
We are keeping the total as the same and the total is that is 14000.
So it means now what we are doing we are increasing the level of current asset from the 5400 to
6000 by adding up 600 million dollars more. So it means what will happen now? The current
assets will become here if you talk about the current assets will become now 6000 and the long
term assets will come down to 8000, total remaining the same and now the ratio will change. If
you now see the ratio sorry total assets will remain the same.
It is not 8000 but 14000 means this is the fixed asset is 8000. So the total asset is 14000. So it is
the ratio between 6000 and the 14000 and if you find out the ratio works out as how much that is
42.9%. This is the new ratio that is the 42.9% is the new ratio. We have changed the level of
current assets and current assets are now 6000 and total assets remaining 14000. The balance is
the fixed assets. Earlier it was 5400 and 8600. Now it is 6000 and 8000.
Total remaining the same as 14000. Now you look at now you have changed the ratio between
the current asset to total assets extent of the current assets has been increased. Now look at the
impact up on the profitability. The profitability which was say earlier some you can see that the
what was the profitability earlier? This was 1140 million dollars and now the profitability has
come down to 1080 million dollars but the net working capital has improved.
Earlier the net working capital was 2200 million dollars. Now it has become 2800 million
dollars. So our net working has improved. Liquidity has improved but the impact of this
increased liquidity is that your profit has come down. Risk has also come down. Profit has come
down. Liquidity has improved and ultimately it is impacting your profitability. So it means
because of the change in the this ratio your net working capital has also increased.
Earlier only this 2200 was coming from the long term sources. Now the contribution of long
term sources to meet the short term requirement of the current assets the requirement has gone up
by 600 million dollars and this has now become 2800 million dollars which will come form the
long term sources. It means when you are increasing the proportion of long term sources it
means you are increasing the cost. When the cost is increasing ultimately the profit will go down.
We have seen in this case the profit has come down from the 1140 million dollar to 1080 million
dollar however this liquidity has improved. So choice is ours. Now in this case if you reduce the
now the ratio say from 6000 it was 5400, we increased to 6000. Now you can bring it down by
600. If you bring it down by 600 so what will be the level of your current assets here? The level
of current assets will be 4000. Total assets remaining same. It will be 4800.
So 4800 divided by the 14000 now the ratio will change. If you change the ratio, so the new ratio
will be here if the new ratio will be 34.3%.
Now this is the new ratio and if you change this ratio this is this ratio is 34 point we have already
calculated this ratio, 34.3%. This is the new ratio 34.3%. So earlier it was the ratio, after increase
this is the ratio and after decrease this is the ratio. Once you have decreased the level of current
assets in the total assets or in the total basket of the assets so it means current assets being less
productive, less profitable your profit should go up but the net working capital will go down.
Earlier the net working capital was 2200 means 2800. It was 2200. We increased it to 2800 and
now we are going to decrease it and when you are going to decrease it, it means you have
reduced the level of current assets by 600. So it is going to reduce by the same amount and your
now net working capital is going to be 1600 million dollars. So what is happening? Liquidity is
going to go down. Liquidity is going down it means the risk is increasing.
When the risk is increasing so ultimately the profit should also increase and if you look at the
profit certainly we have seen, we have calculated if you it is calculated there. So it means the
profit has gone up and the profit here is that is which was initially 1140 million dollars. It had
come down when we increased the level of current asset. It had come down to 1080. But once we
have increased, decreased the level of current assets it means now the profit has gone up and the
say extent of the profit on the total assets is 1200 dollars.
So it means you can easily find out that if you increase the proportion of costly assets your profit
will go down but risk will also go down. Net working capital increasing so risk will go down.
But if you decrease the say the extent of costly assets in that case your profit will increase but the
risk will also increase. So we have seen the situation in the balance sheet. Initial value we had
seen that the net working capital was 2200.
We increased the net working capital to 2800 and then we decreased to 1600. Our profit which
was initially 1140 million dollars that went down when we increased the current asset to 1080
million dollars and it has gone up when we decreased the extent of current asset and the profit
has increased to 1200 million dollars. So by changing the ratio of current asset to total asset you
can see that profit is increasing and decreasing.
Net working capital is increasing and decreasing consequently decreasing or increasing the
liquidity and at the same time your risk is also going up and going down because net working
capital is getting changed. So this is how the extent of the proportion of the current assets impact
the profitability of the firm and since it is a very short period of time so any saving which we
make on account of the financial cost does not going to drain or say to be misused on any front.
Directly you are going to add up into the increased profitability of the firm because time period
is very short and there is no possibility of any leakage. Now we see the next part that is the say
change in the your current liabilities level. I told you that change in the current liabilities level
when you increase the level of or change the current liabilities level we have seen that current
liability or the funds coming from the short term sources they are less productive sorry less
costly.
Not productive I would say productive is the relative to assets. So funds coming from the short
term sources or the from say spontaneous and short term sources they are less costly as compared
to the funds coming from the long term sources because in India as I am repeating that we have
the term structure of interest rates. So because of that reason now we will see that if you have
more funds from the short term sources in that case your profit will increase because cost of the
funds will go down, your financial cost will go down.
But if the funds from long term sources is coming more in that case your profit will go down and
ultimately it will impact many things. Risk will also be impacted, the profit will also be
impacted, and the other things will also be impacted. So we will see that how it happens. So till
now we have seen it from the perspective of the current assets and now we will see it from the
perspective of the current liabilities.
And when you see it from the perspective of the current liabilities an increase and decrease in the
proportion of the sources of funds; if more funds are coming from short term sources say we
have seen the aggressive approach. By using the funds from short term sources we are using the
say short term funds to fulfill the even sometime the long term requirements and when you are
doing this we are saving a lot on the cost of the funds.
When you are reducing the cost of the funds ultimately your profitability is going to increase but
the say you can call it as by product of that is that the risk is also going to decrease because sorry
risk is going to increase because you have to be very careful because short term sources of the
funds become due to be repaid back to the source very quickly. So we will have to maintain the
sufficient liquidity also.
And if you are not able to maintain the liquidity we would not be able to make the payment of
these short term funds on the due date and the firm may default and that will be called as the
technical insolvency for the firm. But as we have seen in case of the current assets they are less
productive. So it means if you reduce the extent of current assets in the total asset the profit is
going to increase.
Now we will see the reverse is going to happen in case of the current liabilities. Short term funds
are less expensive as compared to long term funds and when you increase the extent of the short
term funds into the say funding of the total assets so you will see that the cost of funds will go
down. Financial cost will go down and the profitability of the firm will increase and if you
increase the component or sorry if you decrease the proportion of the short term funds into the
total funds required for the firm so in that case what will happen.
Your cost will increase because more funds are coming from long term sources and long term
sources being more expensive more costly impact the profitability of the firm. So now how it
will happen we will see by changing the proportion of or the contribution of the funds coming
from the different sources and in this case we will have to do means do the same case means
same balance sheet, the balance sheet which we had.
The balance sheet is the initial balance sheet we had and the same balance sheet we will be
using. Till now we have seen the impact of change in the current assets. Now we will see the
impact of change in the say current liabilities especially the sources of funds and then we see that
how the profitability of the firm is impacted. But this all we will discuss in the next class. Thank
you very much.
Lecture-50
Uncertainty Model by Miller and Orr
Welcome students, we are in the process of discussing and learning about the cash management
models. In the previous we discuss the model which was called as the or which is called as the
certainty model given to us by W.J. Baumol and there we applied the concept of economic order
quantity considering the cash also like inventory as same as inventory and then we applied the
concept of the economic order quantity to find out the optimum amount of the cash, which was C
indicated it is EOQ.
But it will it was indicated as C there and we try to find out that C, so that we can find out that if
we keep the optimum level of cash balance with us then certainly the cost is also under control
and the firm is not going to technically insolvent. But the limitation of that model was that it
assumes that everything is certain cash inflows or certain outflows or certain requirements or
certain an annual requirement is also means we are able to pre-decide and that is also certain.
So, in case of the cash these things may sometime not be possible, sometime that element of
certainty may not be there as per as the management of the cash is concerned, sometime we end
up with having more cash, sometime we end up having less cash. So sometime we need to
borrow or arrange funds and sometime we have surplus funds. So all those uncertainties are
there, so I told you in the previous class as such that.
Now in this class we will discuss about another model given to us by M.H. Miller and Daniel Orr
that talks about or that models name is that is the uncertainty model and that takes into account
the limitations of the first model that we called as the certainty model given to us by the W.J.
Baumol right. So we will discuss in this class the model given by Miller and Orr and we will
address the element of uncertainty that we understand that yes cash flows are sometime
uncertain.
And if there is element of uncertainty and everything is not certain then how to take care of that
situation. So here is the model which we call as the uncertainty model given to us by M.H. Miller
and Daniel Orr and this model is based upon certain assumptions and if you compare these
assumptions with the previous model we discussed. So, you will find that the limitations of that
model or the assumptions which were unrealistic in that model are not existing here.
So, let us see the assumptions taken here and then we try to understand the model given by these
2 academicians. So, first assumption is portfolio of cash in the marketable securities.
So, the same assumption was there in the certainty model also that normally a firm should not
keep all the amount of cash as cash that should be divided into 2 parts, cash and the marketable
securities. So, this assumption is here also, this assumption was there also at both the places
assumption is same. So, it means no doubt about that this this assumption is acceptable.
Second assumption is every transaction has a fixed cost, it was there also in the other model also,
in the certainty model also that assumption was there also that every transaction has a fixed cost.
That when you convert the cash into marketable securities and marketable securities into cash
then it has a fixed cost in terms of broker commission, in terms of the storage of securities, in
terms of say secretarial say cost.
So all this cost can be easily identified and can be worked out per transaction, so every
transaction when you are converting cash into securities or vice versa it has a fixed cost. So,
these first 2 assumptions are same in both the models. Now let us talk about the third one ideal
cash is the opportunity cost, this assumption was there in the other model also. In the certainty
model also Baumol also has assumed almost a same thing.
That if you keep the cash as ideal which is more than your requirements which is not required in
the firm in the normal course, in that case that has the cost, that is going to increase the financial
cost of the firm. And if we are not able to draw or earn sufficient returns on that in that case the
cost is going to out way the benefits and the firm is going to incur the losses sometimes or maybe
there is a profit then profit is going to go down.
So, first 3 assumptions are same in both the models, now what is different, total demand for cash
at periodic interval is unknown. There this assumption was that total demand for the cash at the
periodical interval is steady and it is known. The demand at the periodical in turbo Baumol says
that it is steady but here these 2 people say Miller and Orr say that this is unknown, this is not
means the steady it is not same, it is not stable, it is changing and it is not known so easily.
Because of the element of uncertainty in the cash flows or influencing the cash flows right. Then
cash requirements fluctuate, there we assumed that cash requirements remain the same, over the
different periods or different time interval cash requirements remain the same that does not
change, but here we are assuming that the cash requirements change. So, it means we have
introduce the element of uncertainty here.
And because of this element of uncertainty we are addressing these 2 means we have assumed
these 2 assumptions that total demand for cash at the periodical interval is unknown and the cash
requirements fluctuate, firm buys and sells securities whenever required. So, it is naturally it was
same assumption is there also in the other model that we convert the cash into securities and vice
versa means securities into cash as and when it is required.
So, it means we have the surplus cash we buy the securities and when there is a shortage of the
cash we sell the securities in the market and convert them into cash. So, it means there is the
same assumption in these 2 cases. So, other assumptions are different but the assumption number
4 and 5 are different as compare to the previous model and here in this model we are assuming
that cash flows are affected by the uncertainty and we must be prepare to address that
uncertainty.
And still we should be able to find out how much cash is there, how much cash is required, how
much cash is surplus, how much cash short. So, if there is a surplus think about investing that in
the market. And if it is short then think of arranging it firm some sources, so because of this
assumption number 4 and 5 this model becomes different as compare to the previous model and
we will now try to understand what the model is right.
So, as I told you that Baumol and this Miller and Orr have given this model of say addressing the
element of uncertainty here. So, they have used the concept of control theory and on the basis of
the control theory or by using the concept of control theory they have developed it is stochastic
cash management model. Because in control theory we set up the 2 limits upper limit and lower
limit and in between there is the something which keeps on fluctuating right.
So, we do not do anything but when it reaches up to the upper limit and when it reaches the
lower limit then some actions are taken place. So, stochastic model when we are talking about,
so we are addressing by say using the stochastic model we are addressing the element of
uncertainty in cash balances or the cash requirements or cash balances and cash requirements.
So, how this model is working and how this model has been developed let us see that how this
model works first of all say I will draw the structure of the model and then I will explain it to you
that what this model means and how they have applied the concept of the control theory and
worked out a stochastic model of the inventory management.
So, if you talk about this part right again this is the up lower control limit and this is the upper
this is upper control limit, this is the return point. So, we call this as the 0 this is z and this is h
right. Now how the cash hooks here, cash behaves something like this, then when it touches this
point it will be brought down then it will be going up like this, so sorry it will come down like
this, it will be behaving like this.
And when it reaches this point we have to make this line as the dotted line right, this line should
be dotted line.
So, this will come up to this point and when it comes this point then it will be taken back state
way to this and then it will go up to this level then it will come this level and it will move like
this. So, this is how the final structure of the cash movement, we had this much balance of the
cash here right, then we started receiving the cash and then we started going up we reached up to
here then we use the cash.
But it is not at the z point still it is above the z point it went up like this and when it touch the
upper limit for example this amount then step back was taken is that this z means h-z amount of
the securities were purchased. So, immediately this amount of the cash must again brought down
to this level and for this amount z is the h-z amount of the cash the securities are purchased.
And this much of the surplus cash is invested in the market, then again we started receiving the
cash and cash started going up then we started using the cash should went down again it is going
up which is going down and when it came down to this level that is the control limit that is the
lower control limit it means it became a 0 level, when it be reach at this 0 level immediately we
took action and sold the securities in the market.
And then we replenish the cash level back to the z which is called as the z point and after that it
starts fluctuating. So, sometime it is going up coming down and now it is going up right, so
means maximum level of the cash will go up to h and the lowest level of the cash will be allow
to go down to o or 0 you can say and then if there is any things like that when the cash balance at
reaches our edge immediately the action will be taken.
And this much amount that is h-z amount of securities will be purchased and again the cash will
be cash level will be brought down to the z level. And then we will start again using the cash we
will receive the cash also we will pay the cash also and finally when in any case if there cash
reaches at this level that is a last level lower control limit then it means now the cash level as
totally come down means cash balance is have fully depleted.
So, it means will take action or again we will bring them that level, so it means z o amount of the
securities will be sold in the market and then we will again bring the cash amount here back to
the level z and finally means again it will start fluctuating. So, these are the 2 control limits,
upper control limit and the lower control limit and this is the return point. So, when there is a
surplus of the cash it is z h-z, so it means we have to buy the securities and invest the surplus
cash in the market.
And when there is shortage of the cash that when the cash level is reaches at the o level then we
will have to immediately sell the securities and bring the level of the cash back to the level of
return point that is z. And when the cash is between these 2 limits that is the h and o then no
action will be taken let the cash fluctuate because we know it that this much of the cash can stay
with us and we have to keep this much of the cash with us and we have to say we require this
much cash for our day today transactions.
So, there is nothing to worry about what when it touches z or it is sorry it touches h or it touches
o, then certainly we will have to take action in case of h you buy the securities and in case of the
o you sell the securities. So, sometimes what happens expert say that some improvements are
there that this level lower control limit should not be at o level.
Because if it is at the o level then the balance of the cash will come down to 0 and once the cash
balance become 0 and if we have to make certain payment to somebody to save the situation of
the technical solvency then we will be in a trouble. So, what we see that there should be some
minimum cash balance maintained here and we should be up to this point. So, it means if we are
up to this point it means this is the o but we have created a point above o.
And here if you talk about that when the cash level will come down to this point, this particular
point again the action will be taken and then the securities of this amount will be sold in the
market. So, that by the time this cash reaches here then we have sold the securities in the market
and we have converted those securities into cash and brought back the cash level at the z point or
the return point and we are safe.
So, some people say that a margin should be added here, so it means it will not be allowed to the
lower control limit but sometime before that lower control limit we should take the action and we
should sell the securities and replenish the cash say level of the cash back to the z level. So, that
we are safe we have sufficient cash and we can easily make the payments in the market whom or
whenever it is becoming due to be made.
So, you call it as this margin is called as the cushion, this you called as the cushion that if there is
some requirement then you can say that some cushion should be kept. So, that there is we are
safe and without this cushion if the cash is reaching into 0 and if it is taking time to convert the
securities into cash. Then certainly there might be a problem for the firm maybe temporary for a
few hours or a day.
But that problem will also come and there should not be allowed to come. So, cushion is a
required some margin is required and then we should take action at this level and not at this
level. But at the upper limit no cushion is required and when it touches at this level up to this
level when the cash reaches goes no action will be taken up to say little before that. But when it
touches the control limit then certainly we should take action and then we should buy the
securities and bring the level of the cash back to the z point.
So, this is basically the crux of the model and how we apply this model or what we use this
model about. So, now the question arises the million dollar question arises here is how to find z,
how to find h and z-0 is that is the minimum balance which is already there us. So, after say
thorough and the careful analysis and research by these Miller and Orr.
They have come out with a model to find out the value of the z and the value of the z can be
found out as (3√3bs2/4i) this is the cube root. So, this is the (3√3bs 2/4i) and this is the value of
the z and what is the value of the h, h will be equal to 3z, 3 times of the z will be the value of the
h. So, this way you can find out the amount of the z which is the return point or normally we
have to allow the cash to revolve around z.
And if it is reaching at h then only the action will be taken or if it is reaches at the over the
minimum level then the action will also be taken. Now in this model what is b, b is same that is
the when you talk about the b, what was the b in the previous model the b in the previous model
was is the fixed cost of security transaction or you can call it as the fixed cost of transaction for
converting the cash into securities and securities into cash, that is called as the b.
And what is i, i is the opportunity cost of the daily cash balances. Now this is the difference you
have to mind, that there was the opportunity cost of the ideal cash we will keeping. Here now we
are taking it on the daily basis very minutely we have to work it out and we have to calculate this
i that this is the opportunity cost of i is opportunity cost of holding, cash balance on the daily
basis that i is that balances is on daily basis not on the monthly or fortnightly or weekly basis, it
is on the daily basis.
So, what is the opportunity cost for that and now we talk about the s square, s square is basically
what you must be understanding what is s square. So, s square is basically the degree of
fluctuations in the daily cash balances, degree of fluctuations in the daily cash balances and how
we have to calculate that it will be specified by the s square means variance of daily cash flows
which is the variance of s square.
If it is only s or sigma then it will be standard deviation but it is the s square that is the variance
of the daily which is specified means that is the daily fluctuations specified by the variance of the
daily cash flows and that is signified by s square. So, in this model you have got b that is a fixed
transaction cost, i is the opportunity cost of the ideal cash on the daily basis that is i that is the
opportunity cost of the holding cash balance you can say how much cash balance we are holding
that is the opportunity cost of that on daily basis.
But and then s square is the fluctuations in the cash flows and that has to be measured in terms of
the variance of the daily flows. So with the help of these 3 important inputs that is the transaction
cost and the opportunity cost or holding cash on daily basis and the variance of the daily cash
balances if you take the cube root after solving this. If you take the cube root of that you will get
the value of z right that is the return point.
And multiplying the z with the say with 3 then it becomes the 3z but here we talk about is when
you calculate the z sometimes what happens is I told you that we need to have some cushion.
Here we are talking about that here this cushion is required when I was talking to you with a
cushion.
If that is the case then how the model will be changed say for example we are keeping a cushion
of 10,000 rupees that minimum 10,000 rupees of the cash will be kept. So, the model will
become that is the 10,000+3√3bs2/4i, now it will be like this right. So, this will be the total, so
what with the amount comes up here in that amount, in that balance you will add this cushion
amount 10,000 and that will become the total z point right.
Now 1 point of caution here is that when you calculate h, you will do again the same thing, same
thing means that when you are saying that z, z is now this z is 10,000 plus this the output of this
model. But when you are going to multiply here you have to do the same thing here that is the
actually because the value of z is this much not this one right. We are adding it up to find up only
z.
But when you are trying to find out h in this case again you have to do is that is 10,000 plus
value means the 3 times of this z that is this. So, this 3 time of this we have to do not this entire
of this total amount we are not do the 3 times, so this will be again remain again will be
segregated if you are here only up to z then you calculate the value of this model output of this
model and then you add into that 10,000 this becomes the z point, return point.
But you want to calculate the say h, so h will also while calculating h only you will calculate first
to know the z value. So, multiplied by 3 and then add 10,000 into this, otherwise what will
happen you are making your cushion level also 3 times. So, it maybe in this case if you do it like
this that is the total of this if you multiplied by 3. So, what you are doing, you are not taking the
cushion as 10,000 but you are taking the cushion as30,000.
And that is not correct, that is wrong, so we have to again be cautious here the 10,000 plus z
value of the z and then when you are calculating h again 10000 plus 3z. So, with the help of this
model or these values or these different items required in the model you can easily find out the
value of z and you can find out the value of h and if you have both the values with u then you
can easily fix up the control limits minimum cash we know and the maximum we are able to find
out, return point we are also able to find out.
So, we are means in a position to find out that yes we can calculate these 2 limits or the balance
or the 2 limits and then we know that what action has to be taken. Now let us move further that
we try to understand this model implementation of this model with the help of an example or a
small situation, so what is the situation say for example a company there is a company for
example talk about it is xyz limited right.
This is the company xyz limited and it is daily net cash flows are something like this we put it
days here and then we write here the cash forecast, this is the cash forecast right, this is the days
and this is the cash forecast and this amount is rupees in lakhs right. So, if we have the days like
1, 2 here it is 3, it is 4, it is 5, it is 6 and it is 7 and cash flow here is that is the cash flow forecast
we are talking about is cash flow forecast is basically make it cash flow forecast.
This is the cash flow forecast is we are writing here that is +24 lakhs we will have that means
cash balance+13 lakh on the 7 second day we will have +13 lakhs then it will be -16 cash flow
we are talking about that is the daily cash flow. So, it will be -16 then it is -12 and then it is +36
and then it is +4 and then it is -28. If this is a situation 1, we have got the daily cash balances we
are going to have +24 means the positive balance + means positive balance we are going to a
surplus, we are going to have.
So, in the first day we are going to have a surplus of 24 then second day we are going to have the
surplus of 13, third day we are going to have the deficit of 16 lakhs, fourth day we are again
going to have the deficit of 12 lakhs. Then fifth day we are going to have the surplus of 36 lakhs,
sixth day we are going to have the surplus of 4 lakhs and then seventh day we are going to have
the deficit of 28 lakhs right.
This is the basic information given to us and the minimum cash balance for example this is the
minimum cash balance, minimum cash balance forms want to maintain is that is the 10000 that is
the cushion . I was talking to you about is that is the cushion of 10000 the form want to have that
is all the times right. And fixed cost is that is b we were talking about fixed cost of security
transaction is say rupees 1600 right this is the fixed cost of security transactions.
And ROI return on investment in the marketable scurrilities is that is somewhere you can call it
as 10% per annum. If this is a situation available or this is the information available with us then
what should we do, here we have the daily cash balances 1, 2, 3, 4, 5, 6, 7 we have now the cash
flow forecast and forecast is we have 24 surplus, 13 surplus, 16 deficit, 12 deficit, 36 surplus, 4
surplus and 28 is the deficit on the seventh day.
Minimum cash balance we want to maintain all the times is 10000 cushion that is a cushion we
want to keep, fixed cost of security transaction is 1600 rupees and ROI is the that is ROI of
investment that is the investing the surplus cash in the from ROI from the marketable securities it
means investing the surplus cash in the marketable securities is 10% per annum right. So, now let
us now try to find out the z point out of this information, h point out of this information and let
us see how we can solve this particular situation or in this particular situation what we can do.
So, what you have to do here is that as we are saying that these are the daily cash balances and if
this case you have to find out is first of all what is their requirement of the model, requirement of
the model is that is 3bs square 4i right you are given i also you are given the b also not need to
find out your i is how much, your i is 10% and then your when you talk about the i is 10% this is
per annum.
So, we have to convert it into daily opportunity cost by dividing it 365 and then we are given b
also which is 1600.
So, in this model what you want to find out, you want to find you want to have the 3 thing, you
want to have b, you want to have s square, you want to have i, you are given b, you are given i,
you can calculate i because it is per annum. So, divided by 365 it will be daily opportunity cost
but you have to find out now here is s square, that is a variance of the daily cash balances or the
daily cash flows.
So, we will calculate the variance of these daily cash balances or the cash flows and then we will
be trying to find out that what is the z point or how to calculate it right. So, in this case say in this
model or this as means looking at this model.
And the information given here from this what you have to do is you have to calculate the s
square that is the variance of the cash flows and once you calculate the variance of the cash flows
put the all these fixed things in this model that you have 3b into the variance of the cash flows,
daily cash flows divided by the 4 into the daily opportunity cost until the cube root of that, that
will be the value of z.
So, with this information we have kept this information here, I have stored this information here
and in the next class we will learn how to calculate the z point and then to the h point and how to
interpret that and how to understand the different cash limits and the implementation of the
uncertainty model given to us by Miller and Orr. So, I stop here at the moment and let us discuss
this remaining or the solution of this particular problem to find out z and h point in the next class,
thank you very much.
Lecture-51
Miller and Orr Model contd. and Cash Management Techniques
Welcome, so we are in the process of learning about the implementation of the uncertainty model
and how to calculate the z point and the h point. So, in the previous class I gave you this problem
that we have say if 7 days in the daily balance is we have positive some balances are positive
some balances are negatives, sometime we have surplus sometime we have deficit and then we
have the minimum cash balance which will be required to maintain this 10,000 fixed cost is 1600
rupees.
And return on the marketable securities 10% per annum, then how to calculate the z point so, for
that now we as I told you in the previous class we have the 2 values that is b and i is available
with us. But s sqaure is not there that is the various we have to calculate., So we have to calculate
the variance of the daily cash flows or the daily cash balance is which will capture the your
fluctuations.
So, in this case we will be and let us write all these balance is again it is 24 access 24 then it is 13
it is -16 then it is -12 then it is 36 and then it is 4 and it is 28. I think these are the balance is let
me cheque the balance is again 24, 13, -16, -12, 36, 4 and -28 this is -28 right. Now you have to
take the sum of this to calculate the variance we have to calculate so, this is the x and if you take
the sum of this, this works out is how much this will be something like this say 21 I think the
sum is 21.
So, you can say that is sigma x is equal to sigma x is equal to 21 so for calculating now the bar
you can call it is x bar you have to calculate the x bar so, for calculating this you divided by 7
number of n means that is the x divided by sigma x divided by the n. And that is x bar is 3. So, if
you calculate this you means you are able to find out the x bar is 3. And means now we have to
take is the x-x bar.
We have to calculate the variance x-x bar is equal to simple variance is nothing new about that.
So, but you have to take is but this is in the lakhs of rupees. This is in the lakhs of rupees
240000, this is in the lakhs of rupees I think I have written here that is in the lakhs of rupees so, it
is lakhs.
So, we are not signifying lakhs here we have to signify the lakhs so, x-x bar so, how we are
taking it here that is x-x bar is 20 x is 24,-x bar is 3. So, it is 21 and has to be signified as lakhs
so, 10 rise to power 5 here in this case it is 10 into 10 rise to power 5 here in this case it is going
to be how much it is 19 and again 10 rise power 5 signifying lakhs. Then it is 15, 10 rise to
power 5 and then we have to take here is this is the 36 x-x bar is so it is not 36, but 33.
So, this is 33*10 power 5 and then we have 1 is here in this case you would take it is 1*10 power
5. And here in this case it is -31 10 rise to power 5 right. So, this is x-x bar, now you have to
calculate the x-x bar square if you square it up then what would you do is you will have to square
up everything. So, it means in this case will become how much 441 power 10 rise to power 10,
here it is 100. So, it is again 10 by power 10 then it will become how much 361*10 power 10,
this will become how much that is 225*10 power 10.
It is now the says square of the lakhs also and then it is 1089 10 power 10 and then we have 1*10
power 10 and then we take as the 961. This is the 961*10 rise to power 10, if you sum it up x-x
bar square this works out as how much 3178*10 power 10 right. This is the total square you can
call it as and for calculating the say s square but you have to do is that is sigma x-x bar whole
square x-x bar square by n.
So, it means here if you take the n here so, what is this sigma this will be something like this
3178*10 rise to power 10, 3178 10 rise to power 10 n divided by 7. So, this will work out as how
much that is 454 10 rise to power 10 right, this will be 454 10 rise to power 10 this is the value of
S square. This is the value of S square. So, this is the variance of the daily cash flows we have
found out here.
And now let us find out put these values in the model and the model is what for calculating the z
the model is something like this that is the cube root of 3 b s square what is the b value of the b is
1600 and what is the value of s square, value of the s square is 454 10 rise to power 10 right. And
then you divided by something 4 into daily opportunity cost that is 0.10 that is 10% and divided
by 365 to find out the daily opportunity cost.
So, if we solve this if you take the cube root of this if you solve this that is 3*1600*454*10 rise
to power 10 divided 4*0.10/365. So, it works out as how much this will be come out as z will be
something like this. So what was our distribution whether it is nearer to the distribution or not. It
must be nearer to our distribution because we have the highest value of 36 and the lowest value
of 4.
So, it means the variance which we have found out and some of the balances are negative some
of the balances are positive. So, once we have calculated the value of z here that is 281796 that is
seems to be correct. But now to find out the value of z here finally we have a question also, we
have assumed that we will have a question. So question means 10,000+2817696 this total will
become the value of z that will be 2827696 this is the value of z right.
Now when you calculate the value of h it will be again something like this 10,000+3z. So, you
have to take the multiplication of this 3. So, it is 10,000+3*2817696. So it will becomes
something like 10,000 plus how much is the product of this, the product of this will be something
like 8453088 right. And into this if you added it up so value of the h will be finally 8463088
rupees.
This is the total the upper control limit this is the value of the h. So, it means here we have all the
things now we found out the z first of all for that we have to find out the variance of the daily
cash flows, once we found out the variance of the daily cash flows transaction cash flows with us
then in similarly your opportunity cost of the daily cash balance is was with us. So we put all
these values in this model.
And finally we found out that s, what is the value of z the value of z came here that is without
maintaining the minimum balance. And here when we put the value minimum balance of the left
hand side it was 10,000+2817696 should be came 2827696 and if you want to calculate z I was
questioning you that z sorry h for calculating h you have to take again the minimum balance out
10.000+3z and that 10,000+3z is that is 2817696 multiplied by 3. So, this works out as 8453088.
And again 10,000+we have to do is it is a 10,000 so, do it + so, it becomes 8463088 so, this is
how we can calculate these limits which were there in this model.

And these limits you can find out in this case you can say that is the your final limit is that z is
the sorry h is the 8463088 this is the upper limit this is rupees in terms of the rupees you call it as
this is here z point is how much z point we have found out here is that is the 2817696 this is
rupees and this is the minimum cash balance we are keeping here is that is 10,000 right. So, if the
cash goes up to 840000 or 846300 roughly or 17000 roughly.
You will not take any action you will allow the cash to go on and on this side when the cash
reaches down to up to 10,000 rupees means only then the action will be taken, on the upper limit
when the cash reaches 840000 then the action will be taken and here the z-h amount or h-z
amount of the securities will be purchased. And in this case when the cash balance reaches not 0
but 10,000.
Then we will take the action and we will purchase the sell the securities that is to replenish the
level of the cash to the return point to the z point. So, in this case finally this model works out
how this model works out we have seen it here and it addresses the element of uncertainty and it
helps to understand that in the genuine case when there is a fluctuation in the daily cash balance
and it is not possible to find out the daily requirement of the cash.
Then how to work out the level of the cash or that optimum level of the cash. So, the optimum
level of the cash and in this case we have found out is that is 2817696 and but it will not be the
only one level, we will allow the cash to fluctuate that is between 10,000 and 840000 or 84 or
850000 even up to 850000 and after 850000 we will become active and take action and on the
lower level means the 4 cash drops below 10,000.
We will take action and we will say either by the securities or sell the securities and bring down
the level of cash back to the level of 2817696 right. So, this is how this model works and to the
difference between the 2 models that how the certainty model works, how the uncertainty model
works and the limitation of the certainty model given to as by WJ. Baumol have been done away
in the second model given to as by Miller and Orr that is the uncertainty model and we have seen
it that here we are not only calculating the one level of the cash to be maintained.
We are fixing up the limit that is the minimum and the maximum limit of the cash and if it is up
to maximum limit or above minimum limit no action will be taken. But if it is crossing the limits
going up or going further below then action will be taken. And normally the return point will be
that every time we will try to maintain the level of the cash around 280000. So, that we are clear
about that looking at the other transaction at the value for daily transactions.
And the fluctuation in the daily transactions how much is the requirement of the cash balance to
be maintained and where we are safe. So that firm is able to maintain the liquidity also and firm
is not say keeping extra amount of the cash also. So, cash is also optimum and the liquidity is
also at the acceptable level, cash balances are also the acceptable level. And the firm is safe in
terms of the technical insolvency also and in terms of the return on the investment of the surplus
cash also right.
So, these are the 2 models of the cash management that is the certainty model and the uncertainty
model. Now we talk about certain other things about the cash management and these are again
important things. Cash management techniques we will be talking about here something about
there will be throw the light on the cash management techniques and when we will throw the
light on the cash management techniques.
So, we have to learn 3 important points that is the cash flow synchronization, speeding up the
cheque clearing process using float and acceleration of the receipt. So, cash flow synchronization
is that we should create a situation in the firm that we are not required to borrow the cash on a
very urgent basis. You should that is why I say that synchronization can be ensured by preparing
the cash budgets.
If we are not able to prepare the cash budget for say normally what happens that if you want to
achieve the accuracy and precision in the cash budget in terms of the cash flows then the time
horizon of that cash budget should be as short as possible. So, normally we prepare for monthly
budget then fortnightly budget and then weekly budgets. So, weekly is the ultimate time horizon
which every firm should achieve.
But initially if it is not possible then we can start with a monthly budgets. So, if we are able to
bring it down to weekly budgets. So, what will happen in that case we will able to know in
advance that how much cash we are going to receive and how much cash we are going to pay
and what is going to the net story that is the we are going to have the surplus of the cash or the
say deficit of the cash.
So, there is complete synchronization and we should try to create a situation that inflows are
sufficient to pay for the outflow of the cash and automatically we are creating a situation that we
are say how much we have to pay as a cash almost same the amount we are receiving or
automatically the receipt and payment processes taking place and know some on the urgent basis
nothing has to be done no urgent extend has to be taken.
So, we have to ensure that proper synchronization should be there and that is possible with the
help of the cash budgets. Speed up the cheque clearing process was speeding up the cheque
clearing process means as I told you sometime in the previous classes also that when the cheque
comes or when the cheque is received by any firm from any payer.
When any payer makes a payment and the payment is received by the firm then sometime what
happens be remain careless, we become careless and most of the days number of days the cheque
is lying in the drawer of the cashier or may be the person or the clerk who has received that and
who whose responsibility is to send it to the bank. So, most of the time it remains there and
nobody bothers about, nobody cares for sending it to the bank.
So, in this case we are because of our own limitations and not understanding the importance of
the cash we are not sending the cheques immediately to the bank. So, one cause of the delays at
the level of the people who have received the cheque but not sent it to the bank, second thing
could be that is I told you sometime back that there are the 2 firms 1 is in Delhi and another is in
say Agra and Delhi firm is the buyer, Agra firm is a supplier of the material.
But the Delhi firm is powerful firm is a big buyer. And Agra firm does not want to spoil a
relations with them. So, Delhi firm gets it means accepted from the Agra firm that we will make
all your payments after say 45 days or 50 or 60 days of the credit period. And all the cheques
will be issued buyers by the Delhi office but they will be payable against the Guwahati branch of
our office right.
So, it means why they are doing so that the cheque will be issued and will be reaching in the
Agra firm office of the due date. Then Agra firm will deposit their cash into the bank and bank
will send it by post to Guwahati. So, they want to put it at a place which is the forecast. So for
example in this process say receiving the cheque and after depositing the cheque by the Agra
firm in the bank.
If it goes to Guwahati and comes back for example in the courier it takes 15 days time. So, Delhi
firm has made the payment also and payment has not been deducted or debited from their
account for the next 15 days also. So, it means they are say creating a situation this kind of the
situation to the Agra firm. But the Agra firm is not that say powerful economically or may be the
customer wise they do no to lose such good customer.
So, they are agreeing for it. So, normally what should be done Agra firm should try to find out
the ways and means way are they are able to Delhi firm agree that please make as the payment
firm Delhi office only and on the say payment should also be against the Delhi branch. So, that
when we deposit the cheque in Agra then immediately within 2-3 days the payment is transferred
to our account this should be done.
So, that only can be done when both the sides are at the equal level or the equal footing
otherwise that situation will be there and firms will be say dictating the terms and maximizing
the disbursement float that is called as the disbursement float. So, now next thing we are coming
up is the using floats, float means as I told you that when we have disbursement float as I am
telling you that say when any firm has to make the payment or disburse.
So, it means cheque is issued on dates a for example on first of March right cheque is issued on
that for cheque is finally going to be debited form the firms account is on 10 th March. Because in
this processes for example cheque is going to Guwahati, coming back which is going to 10 th
March. So, this is called as the disbursement float right. This is the disbursement float and
second float is called as collection float that is for example of same firm. They received a cheque
on 1st March it was in the nearby office within 2 days.
It is in the say 2nd March the cheque is collected by the firm who has received it so, it means in
this case it has taken only one day in collecting the cash. So, it means collection float is how
much this is called as collection float so, collection float is 1 day that we received a cheque today
and we or the payer paid the cheque on 1 st March and the firm sent into the bank immediately on
the 2nd March payment was collected.
So, maximize the 1 day float is there where as for making their own payments that was debited
from their account after 10 days. So, it means this is how much, this is 1 st March and 10*9 days
right. This is the disbursement float, we call it as DF-collection float or you can call it as this is 1
day and this is called as collection float CF. So, it means what is the net float, net float here is
that is 8 days.
It means the firm the giving the cheque on 1st March for example that is for 100000 rupees and
every day if the firm is issuing the cheque worth rupees 100000 right. So, it means the firm can
do how much time 8 times more business by without keeping any cash in the bank account.
Because a no that the cheque which we are issuing on 1 st March that is being present it to the
bank and the amount is being getting deducted or debited in our account on the 10th March.
So, it means the second day cheque issued will be presented on the 11 th March, third day will be
on the 12th March, then 4th date on the 13th March. So, this way they are issuing the cheques on
the different dates, they are not keeping balance in the bank. They are keeping only 100000 is the
balance daily, they are not keeping. So, they are issuing the maybe you see that if you talk about
the on the 10th of the March how many cheques have be issued.
They issued the 1 cheque on 1st March, 1 on the 2 nd, 3rd, 4th, 5th, 6th, 7th 8th, 9th, they have issued 9
cheques of the 100000 rupees each by keeping only 100000 rupee in the cash account or in the
current account in the bank they know it that it is not going to presented in the bank for the
before 9 days on the 10th March. And on the 10th March also the cheque we have issued on the 1 st
march will be presented it means we have issued the other 8 cheques or 8 more cheques.
And they will be going to the bank over the next days. So, it means every day we will maintain a
balance of 100000 rupee. So, that when the cheque comes it is pass it is on and we are issuing the
cheques but we are keeping the minimum balance. So, we are issuing the cheques for the next 9
days by keeping the balance equal to the 1 day. So, they are means they are managing the show
very efficiently there they are considered is a good pay master also that they have made the
payment on the due date where as in the realistic situation.
They have only keeping the minimum balance it is one 9 th or one 10th of the balance in the of the
total cheques value one 9th or 10th of that and with that they are running the show. So, it means it
is a very clever way very smart way of managing the cash that by keeping minimum cash in the
current account in the bank, you are issuing the maximum cheques and that you are able to do it
because your net float is very high.
So, it means in this situation but may be possible you are not even say spending even say
spending even a single money from your own pocket whatever the cash requirement is there that
is being fulfilled from the cash receipts and nothing is coming out of the pocket of the company.
So, they are not to borrow any cash from the bank, they have not to invest their own cash
whatever they are receiving from their buyers.
They are part of that they are keeping in the bank account they are issuing the cheques to their
suppliers and simply such beautiful synchronization of the cash that inflows are coming and
outflows are going out. So, you can see it is a true way of managing the cash spontaneously is a
spontaneous way of the managing cash that without evidence in the investing even a single
penny.
You are managing the cash show and this no problem at all is we are issuing the cheques also on
the due date cheque is reaching. Because responsibility of the payer is to make sure the cheque
reach is in the office of supplier that is all, if the cheque has reached to the office of supplier after
that it is his responsibility there forms the responsibility when to send that cheque to the bank
when to get it collected and how much time will it take that is not the headache of the issuer of
the cheque or making firm making the payment that is the responsibility of the firm who has to
collect the payment.
So, here we talk about the 3 floats disbursement float, collection float and the net float. So,
disbursement float is that maximizing the number of days that is the difference between the date
of issuing the cheques and actually the cheques are being debited on the account of payer
collection float is minimizing the number of days that is between the receipt of the cheque and
collecting the cheque by sending it to the bank.
Today you received the cheque today it has gone to the bank within 1 or 2 days cheque will be
collected and the amount will be transferred into the receivers account and net float is that is the
disbursement float that is in the previous case we have seeing 9 days collection float is 1 day. So,
net float is of the 8 days. So, when maximizing the net float means if you are able to maximize
the net float.
You are able to maximize your savings upon the cash and run the show without investing even a
single money from your pocket, stop all the payments are being managed or being made from the
receipts we are making from the our buyers. And payments are automatically going o the
suppliers, then we have the other way one more thing to be talked about is acceleration of
receipt, yes that we can use number of ways that lock box plan can also be used.
And payment buyer or automatic debit can also be there, this is a latest thing happening that we
are using the online transfers, but in the business online transfers are not very popular. Because
the payer also knows that payment will be immediately debited form his account and the receiver
also knows that payment will be receipt. So, payer does not want to make the payment and
receiver maybe insisting for it.
But online transfers are not encouraged very much in the business is most of the payments are
through cheques and when the payments are through cheques it means float will be there. And
the payer would like to maximize the net float where as in his case of collection he will try to
minimize the collection float. Then we can have the lock box plan, lock box plan is basically a
system of say putting the lock box in the different setting, if any form is working in Delhi.
And they are applying their material to the different places for example number of buyer of the
firm are in Agra. So, for example there are 10 buyers of the same firm in Agra so, they are
supplying them to on the credit and the payment terms are say 45 days. So, it means after 45
days all the 10 people on the different dates of purchase in at the end of the credit period. They
will have to make the payment. So, if it is through the cheque system.
So, it means cheque reaching Delhi means first they will post the cheque it will reach the Delhi
office. And then Delhi office will deposit in their own bank account it will go to Agra. So, it will
increase the say collection float. So what they can do is they can open up their account in Agra in
one branch. And they can put a box there. So that all the firms go to make to this firm payment to
this firm which daily based they can deposit, they can drop the cheques on the due date.
In that box in the branch of the same companies supplying branch in the say supplying branch
account supplying companies account in the Agra branch. And then those cheques will be
deposited by or will be dropped in to that box by the different payers on the due dates. And this
is telling instruction to the branch that every day evening please open the lock box take out the
cheques and credit those cheques in our account.
So, that pay you have minimize the collection float that say cheque is also drawn on Agra branch
and it is being collected in the Agra is not means wasting any time say on cheque is coming and
then going back. So, it means very quickly, very smartly the firm has collected the total cash. So
all the payer is given the instruction that you go to that branch in Agra. There is a lock box we
have put in place, you drop your cheque and the firm and the bank authorities or the bank branch
authorities have the rights to open that to take out the cheques deposit in the Delhi based firm
account.
And same day or maximum means the clearing time which is taken. So for example the cheque is
deposited today in the or dropped in the lock box and it is a local drawn. So maximum within I
think today if the cheque is dropped and taken out by the bank say people the same day then
maybe not tomorrow but day after tomorrow the bank payment will be collected from the payer's
account and we will be credited to the receivers account.
So, it means without wasting any time and by having minimum collection float the total
collections are made by the firm based in Delhi and on the periodical basis firm itself can
operated say account online and they can transfer their payment back to their Delhi account. So it
means that is in their hands to transfer the payment firm the one account to other account online.
But if you want to make agree the buyers on credit that you make as the payment on online for
sometime means for that particular thing there remain reluctant that why should be make the
payment online. They want to make the payment through cheque and enjoy the floats
disbursement float. So it means you put the lock box system in the every city where we have the
number of buyers and then you ask them to deposit the cheques in that branch lock box.
Branch people will take it out every evening send it for the clearing if it is drawn on the same
bank then the same bank will be immediately crediting it to the Delhi firms account. But it is
drawn on the other firms then no problem it can be easily you can say that it can be easily
collected and maximum on the third day the payment will be collected and transfer to the
supplying firm account which is Delhi based.
So, this way we can improve the cash management these are some of the techniques of the cash
management that is cash flow synchronization, speeding up the cheque clearing process using the
floats and maximizing the net floats and acceleration of the receipts that is why insisting for the
online payments or for the installation of the lock box systems. So, with this we say complete the
discussion on the cash management.
And we have learnt something about the cash management is about that cash should be flowing
in the firm not as I just talk there is difference between the cash profit and the cash stock or profit
and cash. So, we should not means get satisfied with the profit. But with the cash profit and to
deal with the say balance of the cash to be maintained or the amount of the cash should be
maintained that is optimum amount of the cash should be maintained.
We have the different models we have seen 1 model is called as a certainty model, then the other
model is called as the uncertainty model and the limitations of the certainty models are done
away in the uncertainty and they are with the help of certainty model we can have the range of
the cash which is economical to the firm that if that range of the cash falling within that range no
action will be taken.
And if it is crossing that then immediately we will convert that surplus cash into securities and if
it is below that then we will sell the securities and convert the securities into cash. So, this is how
we can manage the entire cash in the firm and we can keep the optimum amount of the cash
balance were the cost of funds is also not very high number 1 the cost of funds is also not very
high to the firm or maintaining the cash is also not very high.
And second thing is that firm is also not technically insolvent. So firm is maintaining liquidity
also and firm is managing it is financial cost also. So it means financial cost within control cash
cost means cost maintaining cash is within control and the say your technical solvencies also not
going to be there. Because firm is maintaining the sufficient liquidity also. So, I will stop here
with the discussion on the cash management.
I think we have done the sufficient discussion on the cash management so, for we have had the
detailed lengthier discussion on the management of 3 current asserts that is the inventory, then
receivables, account receivables and then the cash. So, these are the 3 important assets, how they
should be managed we have learnt till now and in next class onwards now I will stop talking to
you about the management of the current liabilities.
And in the next class we will learn about something about the payables management which is the
suppliers credit as well as the expense credit and how to manage those current liabilities that we
will learn in the next class, thank you very much.
Lecture-52
Measures of Liquidity
Welcome, so in the previous class we were discussing the models of cash management and we
talked about the 2 models that is a certainty model and the uncertainty model and we try to learn
that how to find out the optimum balance of cash or maybe say range of the cash where the firm
will be comfortable and means both the objectives of maintaining sufficient liquidity.
And avoiding the technical in solvency can be achieved. I told you in the previous class that now
will be moving to the payables management or the management of accounts payable that is the
say current liabilities but before that we will discuss some more things with regard to this cash
management or especially call it as liquidity management.
We have talked about the liquidity earlier also and where we talked about that to manage to
maintain the liquidity sufficient liquidity in the firm. The firm must have pure cash and the
backup liquidity. So that is in terms of the marketable securities. So, that is say okay that yes we
can have cash and we can have the backup liquidity in the firm of the marketable securities.
But there are certain other important concepts also to deal with the liquidity and to say
understand the liquidity position of the firm and that we will talk today liquidity management
little more about the liquidity management and 1 more thing I will talk to you, I thought that it is
important to talk to you is about the window dressing that is with regard to the say again say
studying the liquidity position of the firm, sometime firms indulgent to the window dressing.
And with the help of window dressing they improve the ratios, so we should be careful and we
should be capable of finding it out whether the firm has improved is current and quick ratio just
by window dressing or by really say they have that much of the liquidity which is depicted by the
current ratio and the quick ratios. So, we will talk these 2 things before we move to the
management of accounts payable.
So, when you talk about the liquidity management we normally study 3 ratios and these 3 ratios I
think you have already discussed these ratios at length in the past also and the quick means
review of the liquidity position of the firm can be had with the help of these 3 ratios.
That is the current ratio then this is the first ratio then we go for the quick ratio and then third one
is the super quick ratio we call it as super quick ratio or sometime we call it as cash ratio also.
So, these are the 3 ratios we calculate, we try to calculate the current ratio where the rule of
thumb is that is 1.33:1 earlier it was how much 2:1 but now it is revised and it has been brought
down from the 2:1 to 1.33:1.
So, this is the current ratio we have discuss this ratio at length many times then we have the
quick ratio, quick ratio earlier means the current rule of thumb is that is 1 sorry 1:1 this ratio
should be earlier rule was 1.5:1. And the super quick ratio is now the current rule is earlier rule
was it the current rule first we discuss that is it is 0.5:1 earlier the rule was 1:1. So, we have
changed the rule of thumb for the interpretation of this ratios are understanding the liquidity
position of the firm.
But say these 3 ratios are not sufficient to defect the liquidity of the firm say for the example in
the current ratio we take all current assets divide them by current liabilities and try to find out,
how many times are current assets are of the current liabilities. Simple quick ratio be subtract
from the current total current assets only inventory and then we see that other than inventory how
many quick assets are there which are called as quick asset not current asset.
So, how many are what is the amount of the quick assets in the firm divide them with the current
liabilities and then we calculate the ratio and in the super quick ratio we normally take the pure
liquidity and the backup liquidity. That is cash and marketable securities and dividing them by
the current liabilities. So, we assume that 50% of your current equal to the 50% of the total
current liabilities firm must keep cash plus the backup liquidity in the form of short term
securities, very short term securities which are called as marketable securities right.
So, these 3 ratios normally we calculate workout while we try to study the liquidity position of
the firm, apart from that there are certain other liquidity ratios also. So, for example receivables
turnover ratio we calculate the receivables turnover ratio where we calculate the turnover of the
accounts receivables and for calculating that receivables turnover ratio what we do is that is we
take the say sometime the credit sales or we take some time we take the total sales.
And on the basis of that we calculate thee ratios, so when you calculated with the help of the say
receivables turnover ratio we take gross sales right and divided by the average receivables
opening and the closing balance of the say accounts receivables. So we divide the gross sales and
we interpret that higher the ratio better it is, higher the amount of the numerator that is a gross
sales as compare to the denominator that is average accounts receivables.
So, we presume that the firm is maintaining sufficient liquidity, similarly we have the other ratio
that is called as the inventory turnover ratio. We also studied under 2 parts that is under the
source turnover ratio also and sometime we studied under the liquidity ratio also. Because
liquidity of the firm can be studied with the help of this inventory also how quickly we are
converting our inventory into sales or cash.
So, we call it as inventory turnover ratio inventory turnover ratio and for calculating this we take
the C. O. G. S divided by the average inventory. Normally we take the inventory of finish goods
but sometime we can take the total inventory also of the raw material then the work in process
and then the finish goods. So, this is another ratio we study or work out for studying the liquidity
position of the firm and this is with regard to the assets, current assets.
Because accounts receivable is also a current asset, inventory is also a current asset and to know
the liquidity position of the firm we try to calculate the creditors turnover ratio or accounts
payable turnover ratio where we take the purchases or maybe sometime we take the total
purchases. If the credit purchase is not possible to be taken then you take the total purchases and
then is you take care is the average accounts payable right.
So, these are the say 6 ratios 1, 2, 3 sorry this was 4 this is 5 and this is 6 ratios. So, these 6 ratios
we have been talking in the past also and while studying the say financial structure of the firm
we have refer to these some of these ratios at that time also. So, till this date might be you have
studied or understood that by say for studying the liquidity position of the firm.
We should calculate these 6 ratios starting with the current ratios and then say knowing about the
turnover of the accounts receivables and the inventory and then the accounts payable and apart
from the current ratio we calculate the quick ratio and the super quick ratio. And the rule of
thumbs are better descried in the literature, so this gives us the overall liquidity position of the
firm.
So, I would add here 1 more ratio which experts suggest financial experts suggest that apart from
studying these 6 ratios. We should calculate 1 more ratio to know the liquidity of the firm and if
you calculate that ratio that will give you the better picture of the liquidity position of the firm.
So, you go for these 6 ratios or you calculate these first 3 ratios, current ratio, quick ratio and
super quick ratio.
And apart from that you calculate 1 more ratio which I am going to discuss with you now and
then that will give you the better picture and as I say further analysis if you want to go for then
the turnovers of the inventory receivables and payables can also be studied. So, this total bunch
of 7 ratios will make the say study of the liquidity position of the firm possible and that will give
you much better idea that any supplier if you want to supply to the firm.
Or say any bank want to say extend the loan, working capital loan or maybe through CC limit if
they want to extend the financial help to the company. So, that will be possible but they want to
make sure that yes firm should be able to pay off at our obligations as and when they become
dues. So, there should be sufficient liquidity, so to study that liquidity position or to understand
the liquidity position of the firm, we can study this total bunch of the 7 ratios.
So, which one is now the seventh ratio that seventh ratio is called as the NLR, net liquidity ratio.
Net liquidity ratio is what this can be calculated with the help of cash plus marketable securities
plus unused CC limit minus this is all the numerator trade creditors means creditors and
outstanding expenses or the expense credits, outstanding expenses this all means total of cash
plus marketable securities plus unused CC limit minus trade creditors and outstanding expenses.
That is called as expense credit to be divided by total assets, if you calculate this ratio and try to
understand the liquidity position of the firm which is called as the net liquidity ratio. So, will be
able to know more about the liquidity and this will be helping us to understand the net liquidity
position of the firm net liquidity position of the firm. Here now what we are taking we are taking
extra item here is that is the unused CC limits.
We have discuss the concept of CC limit at length and say for example there are 2 balances in
the CC limit there can be 2 balances when any bank sanction the CC limit. For example say we
call it as 10 lakhs right. So, this is a 100000 limit is there, so in this limit means this account is
open by the bank in it is own branch companies account is open that is a CC limit account.
And condition is that firm now will not have any other current account in any other branch
maybe of same bank or the other banks. Whatever the total receipt and payments of the firm will
be now there will be routed through this account right. So, for example you have say 10 lakhs
limit is sanction by the bank it means 10 lakhs rupees will be available to the firm anytime firm
can write the cheques against this balance and they can make use of this money.
For example firm rights ahead say first cheque of rupees say how much 2 lakh rupees right. So,
now the balance of the firm will come down to 8 lakh rupees right. Next day the firm receives 3
lakh rupees that is the from it is buyers on credit. So, the balance of the firm will become 11 lakh
rupees right. So, this way the balance of the firm keep on or balance of the CC limit account
keep on fluctuating sometimes it becomes more than the sanction amount.
If the receives are more than the payments sometime it is less than the sanction amount when the
payments are more than the receives. So, for example if there is a CC limit sanction to the bank
by the bank to the firm which is 10 lakh rupees firm has used only 2 lakh rupees and this 8 lakh
rupees is still available with the firm. It means this should also be added into the total current
assets which are cash assets I would say not current assets, cash asset cash is cash, marketable
security is the backup liquidity or near cash.
Similarly the CC limit is also the near cash, so we should count this also because this is as good
as cash or as good as the cash lying in any bank account. If the firm has to make any payment to
anybody and if this 8 lakh rupees is available in the bank and no other source of the funding is
there, no other source of finance is there then firm can simply write a cheque of 2 lakh rupees, 3
lakh rupees up to 8 lakh rupees they are not need to worry about.
Because they have the CC limit and a positive balance say sufficient balance of the 8 lakh rupees
is available in the CC limit account right. So, expert say that while calculating the NLR net
liquidity ratio cash plus marketable securities plus unused CC limit should also be added. And
from that whatever the current liabilities are you subtract that, that is the normally the current
liabilities are 2 only salary creditors and the expense creditors.
Expense creditors are say wages of the workers, salaries of the employees say outstanding bills
of the electricity, water maybe sometime taxes also. So, they all should be which are short term
in nature should be subtracted. So, what you will be left with finally if you do like this, you will
be left with the net current assets divided by total assets. So, what is the ratio of the net current
asset to the total assets.
If you interpret this ratio from the point of view of the lender then he wants that this ratio should
be as high as possible. Level of current asset should be as high as possible as compare to total
assets but from the point of view of the firm itself they would say that yes we are ready to
maintain a level of NCA net current assets but it should be we should be allow to maintain a
optimum amount of the net current assets.
Because again you are maintaining cash, you are maintaining marketable securities. So, cash is
almost not generating anything. However marketable securities generates some return and
unused limit is not causing any cost. So, they would like to make maximum use of the limit, they
would like to have maximum return from the marketable securities and they would like to keep
minimum balance as the cash.
So, from the firms point of view if you interpret the ratio, if you are the borrower tomorrow and
if you go to the bank and bank ask for this ratio NLR then you say that yes we are maintaining as
sufficient handsome and NLR net liquidity ratio. But if the bank insists for more then we can
convince the bank that is not in interest of the firm to have high level of the cash because it is
unprotected.
And if you are a lender then you should insist for that the NLR should be sufficiently high, so
that there is a sufficient liquidity prevailing in the firm and that liquidity can be used at any
particular point of time as and when that is of any requirement right. So, this is the NLR we
should calculate and interpretation will be depend upon if you are a borrower it will be different,
you are lender then it will be different.
And how you have to interpret it I have discussed with you just now right. Now there is 1 more
ratio before we close the discussion on the liquidity there is one more ratio which should be
calculated and this ratio is called as adjusted current ratio adjusted current ratio.
Till now we have been calculating is simple current ratio then the simple current ratio what you
do is current assets/the current liabilities and we say that the ratio should be 1.33:1 right. This is
the simple I am talking about this ratio is this is the simple current ratio and when you talk about
the adjusted current ratio now how you have to calculate the adjusted current ratio.
We have to adjust all individual current assets and current liabilities to their turnovers, having
inventory in the balance sheet, having receivables in the balance sheet, having cash in the
balance sheet does not give you as simple picture or a very a picture which is easily
understandable. So, we should relate these current assets to it is inventory sorry turnover ratios,
you are keeping inventory nothing wrong in that.
But how quickly we are converting the inventory into cash or sales and sales into cash, you have
accounts receivables, credit sales no harm we can have it. But how quickly we are converting
those credit sales into cash, you are having the cash but what is the turnover of the cash how
quickly you are using this cash. So, in case of inventory especially in case of inventory and
receivables they are working out their turnover is most important.
And if you adjust the all individual current assets according to their turnover then that will reflect
the much better picture. So, how we have to calculate the adjusted current ratio for calculating
the adjusted current ratio I will give you a model let we have to use this model. So, you can say
adjusted we have to adjust the individual current assets and the current liabilities.
So, it means for adjusting that we have to calculate the adjusted individual current asset oblique
current liabilities current asset oblique current liabilities and how to adjust that. That will be
adjusted in a way that is current asset or current liability right it can be current asset or it can be
current liability and put a bracket here and that is 1 minus1 by turnover of asset or liability sorry
I would write it here as the current asset or current liability.
We write it here as the turnover of the current asset oblique current liability and close the bracket
here right. So, you have to adjust the current assets to their turnovers similarly the current
liabilities to their turnover. So, the real value will be reflected after adjusting these current asset
individually all the current assets and the current liabilities and after that whatever the value of
the current assets you find you have to calculate the current ratio.
Then you will be able to find out that what is the actual realizable value of these current assets
we are keeping inventory but how you are converting this inventory into sales that is a million
dollar question. And similarly the accounts receivables, how quickly we are converting that into
cash that is again the very important question to be answer. So, use the turnover say of these
assets.
And once the turnover is available then you can make use of current asset and current liabilities
and then you can calculate the current ratio. So, how to adjust the individual current assets, we
have seen it, this is the model available here. So, I will take a small example here say for
example we have accounts receivables we take here as rupees 1200 and we have the accounts
receivables turnover ratio.
And that is 24, how you calculated that is the gross sales we calculated gross sales divided by
average receivables. So, for example here I am taking your gross sales are say 3000 and your
average receivables are 300. So, it means say your receivables turnover ratio is how many times
we can say here it is that is this 10 times right, this is ratio is 10 times.
So, we can calculate, so this way you have to calculated, so we have for example assumed here
that accounts receivables balance here is 1200 and accounts receivables turnover ratio is 24 that
is 24 times. Here we calculate this ratio in terms of times, this is 24 times, so how we can adjust
it, you will have to see the model sales, current asset or current liability, it is a current asset now
1200 into that is 1minus1 by turnover of the current asset, accounts receivables is how much 24
right.
And then it is this value, if you solve this how much it comes at as 1200 into 0.958 and if you
multiply this it will work out as 11 50. So, it means when you adjust your current assets to it is
turnover the real value will be realizable value will be reflected and those current assets which
were in the absolute firm were shown in the balance sheet as 1200 rupees, if you have adjusted
that against the turnover of your accounts receivables.
Then we have found out is that if you relate it to the turnover then it should not be counted as
1200’s what it should be counted as 1150 right. Now for example if you are say turnover
changes, if the turnover comes down to 12 times, if it is 12 times how much it will become it will
be something like 0.916 and if you multiply it this will become how much 11 rupees 1100 right,
this is 1150.
So, it means higher the turnover more will be the value of the current asset adjusted value of the
current asset, lesser the turnover of the current asset lower will be the value reflected after
adjusting the current assets. So, when the turnover was 24, your value was when your gross sales
level is very high right and your average means average receivables accounts receivables is quite
low.
So, we can interpret it that as compare to the gross sales of the firm credit sales amount is very
very low. So, that is acceptable nobody can do the business entirely on cash right but when the
ratio is 12 as against 24 then we would say that the level of credit sales as compare to the total
sales is very high. So, the firm who is force to sell more on the credit rather than on cash they
raises a doubt raises a doubt that the firms overall credibility is not good in the market.
So, their liquidity position is questionable, so rather than taking the plain current assets or the
current liabilities, you take the adjusted current assets and current liabilities and then try to find
out this ratio and that ratio will be reflecting the true liquidity position of the firm rather than a
plain liquidity ratio rather than a plain liquidity ratio. So, it means that is very important to adjust
these ratios against your turnovers right.
Similarly you can adjust all current liabilities, you just accounts receivables, you are just the
expense credits which are true current liabilities and then you try to find out that what is my now
the net current ratio. That is adjusted current ratio after adjusting it to the turnover after adjusting
it to the turnover. So, this is a 1 more new development recently has taken place that rather than
calculating simple and plain current ratio you calculate adjusted current ratio and adjust all
current assets individually.
So, you will adjust here now the accounts receivables we have found out is say 1150 right maybe
if you adjust the inventory maybe say actually it is say 1500 but that may work out as 1300. So,
what will happen your current assets will be changing their value will be reflecting as the lesser
value as compare to their say value which is appearing in the balance sheet and same thing you
can do in case of the current liabilities.
And then you adjust the individual current assets, current liabilities and then current calculate the
adjustable current ratio and then interpret it and in case of the adjusted current ratio also rule of
thumb will be again that is a same, that is 1.33:1 that will not change simple that differences in
case of the simple current ratio you are not adjusting the current asset and current liabilities
whereas in the adjusted current ratio, you are adjusting the current assets and current liabilities to
it is turnover.
And then you are calculating the current ratio to understand the true liquidity position of the firm
whereas in both the cases the rule of thumb of 1.33:1 will remain the same right. So, these are the
2 important ratios to be studied while understanding the liquidity position of the firm. One is the
net liquidity ratio and second one is the say your adjusted current ratio, so and other ratios we
have already talked about that is these ratios we have talked about is that is your say current
ratio, quick ratio, super quick ratio.
Then is the receivables turnover ratio, inventory turnover ratio, creditors turnover ratio. So, here
I would add here that is a current ratio or you can make it not 7 we are making it a list of seventh
one is NLR net liquidity ratio and rather than in case of the current asset along with the current
ratio, you calculate the adjusted current ratio also. So, this way the current ratio as plain and
current ratio as adjusted you calculate these ratios.
And then you will be able to find out what is the real liquidity position of the firm. So, in the
practical situation, if you calculate these 7, 8 ratios you would be through with the liquidity
position of the firm and would be very easy for you to understand that whether the firm will be
able to pay off it is obligation on time as and when they become due or there will be the
possibility of technical insolvency.
Because every lender wants it whether he is a lender of funds or he is a lender of material or a

lender of services, every lender he is ready to do business on credit, he is ready to extend the
credit, he is ready to extend the supplies on credit, he is ready to lend the same services on credit.
But his payment should be secured and that is only possible when the liquidity position is okay
or acceptable.
So, for example in case of the Kingfisher airlines sometime back it happen that suddenly it say
become bankrupt and even the salaries of the employees were not paid. So, it means it was a
question of employees who never means ever had thought about that such a good brand name
Kingfisher will fall flat suddenly and they will not even getting their salary they will be losing
the job and whatever the time period they have worked for.
They will not get the salaries for that, say for example if they any of them had even Iota of doubt
they would have gone for the say studying the liquidity position of the firm and they could have
come to know that overall liquidity position of the firm is not good and they are not means they
should not expect even the payment of their salaries and their job is at the stake. So, similarly if
any companies overall financial behavior seems to be undesirable.
In that case also we can do one thing that we should say because balance sheet is very open
document, balance sheet is open document is a public document it cannot be hidden document,
nobody can hide that. So, you maybe as a employee maybe as a supplier or maybe as a lender as
a banker easily can calculate these ratios and in many cases these ratios are not to be calculated
by the suppliers or the service lenders or by the say lenders.
This task is left to the firm itself, when any firm goes to the bank with the request that lenders the
funds CC limit or working capital loan or maybe the long term or maybe the discounting of the
credit sale bills. Banks asks them that you calculate these ratios and give us the total liquidity
analysis after doing it give us the total liquidity analysis, bank employees or bank officials only
look at that analysis how they have done it.
Then they compared with the balance sheet and if both the figures are comparable means details
are available, everything is available then we can understand that yes the firm is the reliable is
liquidity position is acceptable and we can go ahead with the extending of credit to the firm that
is quite possible. So, in case of the bankers, firms do it and then after doing this analysis they go
to the bank.
In case of suppliers relationship suppliers when they are say quite say you can call it as
financially sound and they do not have only reason to depend upon the company who is asking
them to buy from any supplier on credit. In that case bigger suppliers ask the potential or the
prospective buyers to do the liquidity analysis themselves of their liquidity analysis themselves
and then finally say come with that analyzed balance sheet.
And calculate these ratio sum of the ratios and then they will look at make the analysis. So, it
means you should have an idea just you do working capital management, how to study the
overall liquidity position of the firm, you should have a clear cut idea that we should calculate
these 7 ratios and especially should be able to tell the person concerned that we should not rely
upon a plain current ratio.
But we should calculate the adjusted current ratio right, so this is all about the liquidity position
and understanding the liquidity position of a firm and how to do it these are some ratios which
may help us, this is one. Now the second thing will talk today is that is about the window
dressing, I just talk to you about the window dressing that sometime to maintain the pseudo
liquidity by the firms and to fool the lenders they go or they take the help of the window
dressing.
Now how what is the window dressing, how the firms do the window dressing that all I will
discuss with you in the next class, thank you very much.
Lecture-53
Window Dressing & Management of Current Liabilities
Welcome, so in the previous class we were we discuss the concept of liquidity at length and in
this class will be talking about the window dressing and certain other things. And then after that
will proceed further to the management of the current liabilities. And the first current liability we
will discuss is the accounts payable and the expense credit but let us learn about the window
dressing.
So, when you talk about the window dressing window dressing you call it as something like
window dressing means artificially managing the liquidity actually the firm is not liquid or firms
liquidity as it is shown by calculating certain ratios is not that much it is much less. But if you
only look at the ratios then that will be say you can say the deceptive picture it will present a
deceptive picture.
And it will not be good for the lender, so lender should be clever enough to understand that no
window dressing has being done by the borrower or by the prospective borrower by the potential
borrower and he is the genuine buy, he is the genuine company and having a genuine liquidity
and as and when our payment will become due to be made, they will make the payment. So, now
how to understand the concept of window dressing let us have a balance sheet here where I have
taken only the lower part of the balance sheet which talks about the working capital.
And there we take the current assets in the current liabilities, so we take here as the say this is the
balance sheet I would say this is the balance sheet if you prepare in the T form. So, we have a no
talking about the upper part we are talking about the lower part and here it is the current assets.
And here we have the current liabilities right these are your current assets and current liabilities.
So, in this we take here something like say first of all in the order of liquidity.
I am writing that is cash and bank balance the firm has cash and bank balance in the amount is 55
may be you can call it as 1000 crores, lakhs then we have the marketable securities and your
marketable securities are say 55. Then your sundary creditors, we take here as the sundry
creditors and the sundary creditors amount is say 60 right. And here we take the inventory the
last most in liquid current asset and the inventory is 25 right.
So, how much is the total we will see here then we talk about this side we have the current
liabilities and then we have first current liabilities as sundry creditor right sundry creditors. So,
this amount is 65 and then we have the bank overdraft right we call it as bank overdraft OD and
BOD is 60 and then we have expense credit and expense credit is how much expense credit is 5
right.
So, this is the expense credit it is 5 total up it up how much it is, it is the 55+15 in is how much
70, 30 and 1 25 is how much is 155. Here how much it is this side if you take it as that it will
work out as 65 and 65 is 130. This is your balance sheet right from this balance sheet you now
calculate the current ratio right if you let us calculate the current ratio here we have the current
ratio.
So, what is the current ratio if you calculate from these figures current ratio will be 155 divided
by 130 it will be how much 1.19 right. And what is the quick ratio, quick ratio will be the current
assets minus inventory. So, what is the current assets minus inventory that is 130 and current
liabilities are to be taken as 130. So, the quick ratio is this 1.19:1 and this will be say 130 divide
by130 this will be how much 1:1 quick ratio right.
Now quick ratio is 5 that is 1:1 but the current ratio is less than the standard rule of thumb and
that is the standard rule of thumb and that is the standard rule of thumb is how much 1.33:1. So,
if with this balance sheet if the firm goes to the bank or to any supplier, bigger supplier, wealthy
supplier then they would say that your liquidity position is doubtful we cannot lend you the
credit.
Because you are not maintaining the sufficient liquidity ratio and since your ratio is 1.19:1 which
should be 1.33:1. So, either you improve the ratio or we will not be able to lend you because our
funds may be at risk right. So, this is the balance sheet which is a genuine balance sheet which he
is a borrowed is presenting a genuine balance sheet he is saying that I have this state of my
current liabilities 130.
And my current assets are 155, so think about me what the bank says no because your current
ratio is less than 1.33, so we will not be able to lend you any money. Now what he does, here
you prepare another 1, he does 1 thing that he pays here from this say he is the sundry creditors
he pays how much 50 out of it if he pays 50 out of it how much is left this balance will be left as
5 right.
And from here this side how much we paid 50-50 if you are paying, so your balance will be left
how much that balance will be again sorry it will be left as not 5 but 15 sorry. This is the balance
will not be 5 but it will be, so let us write it again we have here how much was the balance here
that balance was 65 here we had 65 right 65. So, what he will do to improve this is a window
dressing what he will do he will pay off the say sundry creditors he will pay off the say sundry
creditors this is actual original amount is how much 65 right.
He will pay how much 50 he will pay, so how much is left now he is left with a sundary creditors
of 15. So, and this side he has paid he has paid the from the 55 lakhs or rupees or crores of the
balance 50 are gone. Because this 50 is paid, so 50 is reduced from the cash, so how much is left
with he is left with only 5 right. Now you look at the new balance sheets totally is much if you
look at this side new balance sheet totally will be here.
If you put it, it will be how much 15 and 5, 20, so it will become how much this will become 80
this balance sheet will this side will become 80. And this side will become how much because he
has paid use some of the cash available, so it is 20, 80 and it is 125. So, it will become 25 it will
become 105 right.
So, this is the new balance sheet he will change the balance sheet once his first balance sheet is
rejected by the bank. He will change the balance sheet, so now his liabilities have come down by
500000 and his cash is as also come down by 500000. Now you calculate the ratio again if you
calculate the ratio again what is the current ratio. If you calculate the current ratio that is 105
divided by 80 this is how much if you calculate this ratio that is 1.31:1.
And what is the quick ratio, quick ratio is minus inventory, so it is how much it is 80. So, 80 by
80 will be how much 80 by 80 will be 1:1. So, your quick ratio is same it was 1:1 earlier, now it
is also 1:1, current ratio has improved it was 1.19 earlier and now it is 1.31. So, he would say
that now I have better balance sheet, improved balance sheet my ratio is nearer to 1.33 which is
1.31, so it means you give me the credit and accept my balance sheet.
Because my liquidity position is has improved, I have improved my liquidity position and I
should be given the credit. Now as a student of working capital management or student of
finance you analyze this new balance sheet earlier the liabilities current liabilities were 50 65
means sundry creditors were 65, bank overdrafts was 60 and expense credit was 5. So, total was
130 but in this side the cash position was quite strong.
They had the cash and bank balance of 55 marketable securities that is a back-up liquidity of 15
sundry creditor as 60 and inventory as 25. But now when the cash worth 50 lakh has gone out
they are left with only the 5 lakh rupees of the cash which is the pure liquidity. Earlier we had 55
lakhs of the cash. Now we are left with the 5 lakhs of the cash only and the 15 lakhs of the say
back-up liquidity is there in the form of marketable securities.
And the other are the less liquid assets sundry creditors and inventory is the most less liquid or
the least liquid current asset. So, in this picture now as a student of finance you can easily
understand though the ratio has improve though the current ratio has improved from the 1.19 to
1.31. But the liquidity of the firm has gone down if you look at the absolute values given in the
balance sheet.
It is better to have 55 rupees as a cash rather than only to have the 5 lakh rupees of the cash
because these sundry creditors which he has paid just now they might have not become do it. So,
he has earn the cash discount also and he has paid of this liability also without investing anything
from his pocket. He has improved his liquidity position without investing even a single money
from his pocket.
He has improved his liquidity position is only the change in the balance sheet figures. There is no
change practically, no cash is infused. no cash is invested, no additional investment is made, no
inventories created, no sundry creditors are created, no marketable securities are created rather
whatever the cash was there he paid off part of the obligations out of that cash or with the help of
that cash.
So, in that way your current liabilities have come down by 50 lakhs but the cash has also come
down by the same amount and overall if you look at this balance sheet then you would say that
liquidity position of the firm has detoriated rather than it has improved. Though the ratio has
improved, so we can say that if the banks look at only the ratio. Then they will accept it but if
they are looking at the absolute values also.
Then they will be really wondering that what this company has done and this is a clear cut case
of the window dressing. So, it is a point of caution for all of us that as a student of finance
tomorrow if we are working in the market as a lender and even as a borrower if we are working
as a lender be careful do not only believe in ratios. You believe in the absolute values also and if
you are a borrower you should do you can do this kind of things.
But be careful that these things can be say observed or can be seen or can be found by the lender
also. And if the lender finds that without even investing even a single penny from your pocket,
you have improve the liquidity of the firm which is a clear cut case of the window dressing that
may not be a appreciated by the lender. And lender may for the reject the case, so this is the
window dressing how we go for it.
So, it means you can say the conclusion here is that these ratios are also amendable to the any
kind of changes or adjustments or fluctuations anytime you can change these current ratios
artificially managing the liquidity and that is to be clearly seen that if any lender is clever if any
supplier is clever enough smart enough he will be able to find it out that what is happening in the
firm but towards in the original balance sheet what is now it is in the change balance sheet how
much funds the firm has invested from it is pocket.
And how much see how they have try to improve the liquidity position of the firm. So, be careful
about the window dressing, in both the cases as a lender also as a borrower also right. So, with
this we complete the discussion on say the cash management, to the liquidity management and
we have learnt sufficiently that how to manage the cash, how to maintain the liquidity how to
manage the liquidity in the firm and how say the firm's financial cost can also be kept under
control.
And the technical insolvency you can also be avoided right it technical state of the technical
insolvency can be avoided. So, it means firm should keep optimum amount of the cash all the
times neither too high nor too low and they should be able to capable of making the payment to
all it is obligations or towards it is all liabilities as and when it becomes due. So, with this I will
stop here and after this because we have discussed sufficiently and all the 3 major current assets
we have discussed at length on inventory management.
We have discussed at length on the receivable management we have discussed at length on the
cash management including liquidity management. So, after these 3 current assets these are the
major current assets need to be managed in the balance sheet of a firm or buy a firm right other
current asset like advanced deposits prepaid expensive there is hardly anything to manage. So, if
you are able to manage these current assets efficiently and effectively.
And now the current liabilities some of the current liabilities then I think we will be in a position
to have a better short-term funds position in the firm and manage it effectively. So, after
discussing at length the 3 current assets inventory receivable and cash. Now we will move
forward to the other side of the balance sheet and learn about that the management of the current
liabilities right or the same.
You can call it as payables management or the current liabilities management, so when you talk
about the payables management or the management of the accounts payable. We talk here about
many things and when you talk about the payables, what are the payables what are the current
liabilities. It can be many things right many prepare the balance sheet it can be sundry creditors,
it can be expense creditors.
It can be bank overdraft, it can be your tax liabilities, it can be your dividend liabilities many
liabilities will be there. So, we are going to talk about all these liabilities but more discussion and
attention is required here in case of 2 important current liabilities. And these 2 account important
current liabilities or accounts payable how to manage your accounts payable, I am not talking at
at the movement about all the current liabilities.
We will be moving according to the importance and the first set of the current liabilities is trade
credits may the sundry creditors and the accrued expenses.
These are the 2 important outstanding expenses as we say trade credits means suppliers credit if
any supplier is supplying raw material or anything. Then how to manage it and accrued expenses
are say expense is of your power bills, water bills then say wages of workers, salaries of
employees because everybody is extending a short-term credit of the firms. So, it has to be
properly managed because it will become due to be paid.
Salaries and wages become due to be paid after 30 days or 1 month similarly in case of these
utilities power and the water expenses we have to pay or bills we have to pay normally once in
month. And then even the sundry creditors as I told the standard credit period in India is 30 to 45
days. So, that will also become to be paid, so we are ready to borrow money in the form of these
expenses and in the form of say sundry creditors.
But we have to pay that also and that will become due to be paid within very short span of time,
so we should be careful about that right. So, when you talk about the accounts payable it includes
2 things that is trade credits plus accrued expenses right. And we call them spontaneous sources
of finance. I told you in the beginning if you remember when we started discussion on this
subject especially I told you that there are 3 sources of finance not 2 sources of finance.
We do not have only long-term and the short-term sources of finance rather we have 3 sources of
finance long-term sources of finance, short-term sources of finance and the spontaneous finance
right. Now we are going to talk about the third source and that is called as the spontaneous
source of finance why we call accounts payable are the spontaneous source of finance because it
is self-adjusting kind of a source of finance.
Once the agreement is or terms are agreed by the supplier and the buyer. When both the sides
have agreed upon the common terms, then automatically have material keep on coming in,
payments keep on going on, on the due dates. And everybody adheres to those terms and
conditions nobody thinks of disturbing this symbiosis. If anybody disturbs supplier defaults in
sending the supplies or buyer defaults in making the payments.
Then this symbiosis can be disturbed otherwise this symbiosis cannot be disturbed or should not
be disturbed. So, it means once we have the agreement with the difference suppliers that is
normally long-term agreement. So, that you will supply as the material you will give us the credit
for 45 days, on the 45th day it will be ever responsibility as a buyer to make your payment to
have to make sure that the your payment reaches in your office.
So, it means whenever there is a need of material you place the order and as and when the
payment becomes due you send the cheque. So, no need to arrange special finance we know it
that for inventory for your these expenses we need not to worry about. For example you have to
talk about the salaries of employees do employees go for every month the special agreement to
be entered between the company and the employees or the workers.
Once it is settled that your salaries this much you will be paid after 30 days or 31 days or maybe
at the end of the month or maybe in the first week of every month no problem. Employee keep
on coming he renders the services and then automatically in the first week or at the end of the
month he gets the salary that is transporters account same is the case with the powers supply
companies, same is the case with the water supplying companies that when the supplier has the
power.
This supplier has the water we do not ask them time and again after how much time I have to pay
your bill. Bill automatic comes after 1 month or 2 months according to the payment terms. And
we send the payment and that way that system is going on, same is the case with the suppliers.
So, suppliers once that term is accepted by both the sides or terms are accepted by both the sides.
It means that is naturally it is going on that is processes naturally going on, so it means there is
nothing to worry about or think about anything right. So, this is called as the management of
accounts payable we call this as the ongoing source of finance or provides these accounts
payable provide finance to the business on the ongoing basis. And that is why it is called as the
self adjusting or the spontaneous source of finance.
Now how much say how to manage the accounts payables how to manage your most important
current liabilities that is called as account payables, how to manage the accounts payables. I have
written here actually originating from the production budget payables appear on the books of
accounts.
When materials are received and taken to the store right, then materials are purchased and taken
to the store, so then the payables appear in the balance sheet. So, if you talk about this originally
emanating from where production budget then you prepare the production budget you know it
that what is your material requirement from where it will come, it will come from the supplier
and once the supplier makes the delivery gives invoice.
Invoice is accepted return back to the supplier and material reaches in the warehouse or in the
godown then automatically once the material is receipt and invoice is accepted 1 copy is retained
another copy is given back to the supplier. It means in your balance sheet this current liability
will appear, that is the accounts receivable.
So if you compare it in the accounts receivable and payable accounts receivables appear in the
balance sheet as an asset once that supply of the material has been sent to the buyer. And
payables appear in the balance sheet as a liability when that material has been received from this
supplier right. So, difference is in the 1 case we are receiving the material, in the other case we
are sending the material.
And in 1 case we have to receive the payment which we have talked earlier and in the other case
we have to make the payment right. And payment terms are pre-decided they are standard means
standardize or there are the standard payment terms. Now we have to talk about some important
aspects of management of see this accounts payable. We have normally 2 things that is the terms
of purchase and stretching accounts payable.
Terms of purchase is, it include terms of purchase include what credit period and cash discount
terms of purchase credit period and cash discount, how much credit period of firm can ask from
the supplier and cash discount. If we are ready to make the payment on cash or maybe within a
minimum credit period. For example within 10 days he is saying that okay if you make me the
payment within 10 days, I will give you discount of 2% otherwise the normal credit period of 35
or 40 days I am giving you.
So, that is the choice of the firm he has given both the terms supplier has given both the terms
that if the payment is made to him within 10 days automatically he will give us the cash
discount. So, we need to pay him say total invoice value-the discount amount but if we payer is
not able to make the payment within 10 days. Then what will be done normal credit period of 35
or 40 or 45 days will be there.
Both the sides will agree that yes now this credit period is there, so terms of purchase include 2
things credit period and the cash discount. Then stretching accounts payable here point of
discussion is or point of interest is they have 2 parties. One is the supplier another is the buyer
objective of the supplier is that he should get his payment back as early as possible and objective
of the buyer is that he should delay the payment as much as possible.
Because objective in the payer’s mind is that he wanted to minimize the net % value of the cash
is paying to the supplier as much as possible means if he is paying 10,000 rupees actually he is
paying 8000 rupees. Because if he delays the payment if you calculate the 10,000 if paying paid
first on today that will be 10,000 but 10,000 paid after 30 days that will not be 10,000. So, the
objective of the buyer is that he should minimize the net present value of the payment he is
making to the supplier.
But on the other side objective of the buyer supplier is that he should maximize the net
percentage value, so, to give the minimum credit period. So, supplier want to give the minimum
credit period, buyer want to give have the maximum credit period and somewhere they have to
agree on the common terms that is the common credit period as well as the cash discount.
But if you recall I have told you sometime back in case of the receivables management that there
is a limitation of time and because of the say loading factor even the buyer wants to extend the
credit or credit period he cannot he want like to extend it he would like to make the payment and
get free from his obligation. He wants like to extend the credit why because when you are asking
for the credit from the supplier.
He would load the credit sale bills with the certain interest factor or certain interest amount and
that is called as the loading factor. For example 2:% per month it means 24% if you delay the
payment for 30 days you will have to pay the interest at the rate of 2% per month. If you delay
the payment it will become 4% if the delay the payment for 2 months then it will become 4%, so
it means it is 24% per annum.
So, what happens borrower or the buyer makes a cost benefit analysis he says that if I borrow
money from the bank and pay him in cash to the supplier in cash. How much interest I am paying
to the bank and if he is I am allowing him to load his credit sales with the interest component or
the interest factor, how much interest he is charging on the supplies on credit right, so both the
things are clear.
He has to make a cost benefit analysis that cost benefit analysis of an accounts payable policy
will rest in the minimizing the net percent value of disbursement is clearly return here. So, if for
example if the borrowing from the bank is expensive and borrowing from the supplier is say
much cheaper. Then certainly he would like to go for borrowing and extending the credit period
for example that is certain up to one particular point of time that is say for example up to 30 days
you compare the 2 interest rates.
Then the suppliers in interest rate is lesser than the banks interest rates if you make it 45 days
then both are coming closer but if you make it 60 days than it may be possible that supplier is
loading it is becoming 2% per month. It means it is becoming 4% he is loading with the 4% it
becomes 24% per annum where as bank is ready to give you the credit at the rate of 18% per
month it means it is much better for the buyer to borrow from the bank.
If he can borrow from the bank that is also precondition bank should be ready to land him. If he
can borrow money from the bank then is better for him to borrow at 18% rather than allowing
him to load the credit sale with 24% and then to make him the payment on in cash. But that does
not happen in all the times because there should be a reason for the buyer to seek the credit from
the supplier.
And if there is a the interest rate of the bank is lesser than the suppliers, interest rate then the
buyer would convince him that your charging more than the bank why should I buy from you on
credit. So, I have to look for the another supplier, so to some extent of time the supplier would
say that if you are seeking a credit of 30 to 45 days. I will charge you the interest or load my
credit sales with the 1% per month interest it means 12% I will charge.
And if you go to the bank you have to pay 18%, so naturally the buyer would like to seek the
credit from the supplier and allow him to load the credit sales with the 1%. But if he extends the
credit period that maybe the second part of the condition. If he extend the credit period from 1
month or maybe 45 days to 2 months or 3 months. Then he says that my interest will also go up
and that will become 2% per month, 24% per annum whereas banks interest rate is again 18%.
So, naturally automatically buyer would not like to extend it beyond 30 or 45 days up to which
the interest is only 1% per month after that for him seeking credit from the supplier will become
useless. So, it means the objective of the buyer is to minimize the NPV of the payment he is
making and objective of the supplier is to maximize the NPV of the recedes is going to have
from his buyers or from the prospective or from the potential buyers.
So, this is the say crux of the discussion here just we have initiated the discussion on the
payables management. So, we have discussed so far that what the payables are why the payables
appear in the balance sheet and what are the terms of purchase and what is the meaning of
stretching of the accounts payable more interesting concepts relating to the management of
accounts payable or accounts management of the accounts payables, I will discuss with you in
the next class, thank you very much.
Lecture-54
Management of Accounts Payable
Welcome students, so in the previous class we were talking about the say stretching of the
accounts payable and I discuss with you that it will depend upon both the sides. Because we
know that if we stretch the payment then certainly the seller would also like to load the credit
sales with something which is called as interest factor. So, the buyer will make a cost benefit
analysis that where it is beneficial for him to buy on credit.
Because loading factor by the seller and borrowing from the bank and then paying in cash to the
seller he would make a comparison of both the options and if borrowing from the bank cheaper
as compare to the loading factor the seller is using. In that case it could be advisable for the
buyer to buy say on cash or maybe up to that extent he should be expecting to stretch the
payments till their means till the point at is beneficial for the buyer to stretch the payment.
Because borrowing from the bank will be expensive rather than borrowing from the seller right.
So, these were the certain things we talked about that some important aspects of the management
of the accounts payable and we talked about the terms of purchase and then the stretching of the
accounts payable. Now I will talk to you say in this class some other things like limitations of the
stretching of the payment limitations of the stretching of the payment.
That is not that you can stretch the payment unearningly or anywhere you can go up to that you
can make the payment after 2 months, 3 months, 6 months, 1 year or 2 years that or maybe
sometime do not make the payment you buy it and then you do not make the payment that is not
going to happen. So, if we are seeking the credit which is normal as per the market conditions or
the market situations then it looks good.
But when we stretch the thread beyond the level then it is get broken, so we should not allow this
kind of situation to come because is stretching of the payment has certain limitations. And these
limitations should also be known to us as a student of working capital finance that if buyer
stretches the payment then he has to face many things and all these things will not go will not be
in the interest of the buyer.
First thing is the provision of the penal interest, it remains the provision in the agreement
between the buyer and the seller that if you pay me within the standard credit period I am
allowing you, I will charge you this much of the interest maybe 1% per month or 1.5% per
month or maybe 2% per month but beyond that if you stretch the payment I will charge a penal
rate of interest and that will be very high.
So, for example in case of the credit card it happens, that when you buy things through credit
card in the market. So, for certain period of time maybe 28 days or a month the that say payment
made through the credit card remains free to the buyer or to the purchaser whose making the
payment through the credit card. But if you stretch the payment beyond the permissible credit
period allowed by the credit card company or the credit card bank.
Then they say leaving the penal interest rate and that spoils a image of the say borrower also
because you say never become a good paymasters. So, that will be the problem, so that will
happen same thing here will also happen that penal rate of interest will be charged and if penal
rate of interest is label then the fun of enjoying the credit purchases will be far less than loosing
the reputation or the goodwill or the credibility in the market.
Second thing is ethical issues, if you say for example if the buyer is in a strong position as
compare to the seller. Now I was talking to you sometime back about the say big companies who
manufacture the cars or maybe electronics or maybe other automobiles. So, say for example we
are talking about the Suzuki India limited. Suzuki India limited is a big company say very strong
buyer and say very large size buyer.
And they buy almost all inputs rather than the gearbox from different suppliers right. So, when
they buy the different inputs maybe you have talk about the say glass part or the say rubber parts
or maybe the sometime you call it as the even tires and tubes and say any other accessories you
talk about seat covers or anything you talk about. So, they not manufacture all these things
themselves even steel, they are not manufacture all these things themselves.
But rather they buy from the market from the different suppliers and only gearbox Maruti or
Suzuki manufactures itself. So, say for example if there is a small supplier to Suzuki and their he
supplying rubber parts, rubber bands which are use to tighten the glasses in the car. So, if he is a
small manufacturer and he is supplying it to Maruti and Maruti is unendingly stretching the
payment or delaying the payment then it is unethical should because the buyer is doing all these
things because seller is not in position to take action against the buyer.
He does not want to lose a big buyer, so Maruti or the Suzuki India limited is spoiling that
relationship for creating this kind of the situation. Let us say big ethical issue that rather than
supporting the small suppliers they are say exploiting the supplier, they are harassing the
supplier. So, kind of thing should not be allowed those kind of thing should not be allow to
happen.
So, ethical issues also another important limitation that it may be done by the buyer or it may be
done by the seller both the sides should say act something which is which looks descent which
looks within the limits and which looks say maybe say as per the status of the buyer or the seller
then there is no harm but if we stretch the payment beyond the level then it is unethical also.
So, this is the second major limitation, third is the disturbance of the symbiosis, I have talk to
you many times that when we make the payment to somebody it may be possible that he further
has to make the payment to somebody right. It is a chain it is a supply chain right, 1
manufacturer is supplying say may finish product to the other, other is supplying to other and
other is supplying to the one who is manufacturing the finish product right.
So, for example if the final manufacturer of the product finish product he has to make the
payment to the third level suppliers and he has to make to the second level supplier and he has to
make to the first level supplier. So, if the fourth level that is the manufacturer or the user of the
finish product, final product for the manufacturing of the finish product. If he is delaying the
payment maybe by a day then what will happen, the supplier at the second level will get it means
delayed by 1 day.
So, he also will be delaying it to the second level and second level will be delaying it to the third
level, so what will happen, total sum buyers among these 4 channels or these 4 buyer and sellers
would be disturbed. So, do not think that delaying the payment by 1 day or by some hours or
maybe some days does not make a difference, it makes a difference. So, I told you many times
that all the times make it a discipline that if the payment is due to the paid on the evening of any
day try to make it make the payment in the morning of that day or 1 day before that.
But never allow to it to be paid in the next day morning or maybe evening because that disturbs
the total symbiosis because they chain and everybody is depending upon 1 or the other, say if 1
is disturbing the chain all others are getting disturbed and the whole market feels the
repercussion of that. So, that kind of thing should be avoided, so this is a disturbance of
symbiosis the another limitation and then is the no long term relationship.
If you do once then fine but if you do it regularly stretching the payment or delaying the payment
or say using your very strengthful position in the market or you maybe your hegemony kind of
the position in the market then what will happen, this will not allow any of the supplier to have
long term any of the suppliers should have long term relationship with any buyer maybe how say
mighty or maybe strengthful or powerful he is.
But every supplier will look for the alternative they are supplying to this company does not make
any sense because they delay the payment, they not make the payment on say on the time say it
is spoiling the others reputation also. So, what happens this keep on supplying only till the time
they get the alternative, if they get any alternative order or some other buyer who is more
discipline who is more responsive to the market, who is more careful to the need to the smaller
suppliers, then it is really maybe say they will be certainly looking for the alternative.
So, it means long terms relations are also not possible, so it means notice the cost benefit
analysis is not the question of minimizing the NPV by the say peer to the seller they are so many
other important issues also which are recognized as limitations of stretching the payment. And
these are the 4 important limitations I just talked to you that is the provision of the penal interest
and then ethical issue then disturbance of the symbiosis and no long-term relationship.
These are also the limitations of stretching the payment, so NPV is the direct minimizing the
NPV’s are direct effect but these limitations are indirect effect and because of these limitations
the reputation name of buyer also gets spoiled in the market. So, we should avoid this kind of
situation that this kind of the situation never emerge and people work in tandem with each other,
fulfilling each other requirement and helping each other to attain their business goals right, so
this is the say one more part of the accounts payable.
I
Now I will discuss with you something interesting that is the say code of ethics say code of the
practice I would call it as not ethics. Code of practice which was say evolved by the
confederation of the British industries, it is popularly known as confederation of the British
industries code of practice which was say adopted evolved voluntarily by the bigger buyers and
manufacturers of different products in UK, in Britain right.
And they themselves say evolved this code of practice, you can say it is a code of ethics that we
will make one thing sure that when we have to make the payment over suppliers we will never
delayed, we will always honor their say our commitment towards them we will never think that
we are mighty and very strengthful buyers and suppliers cannot think of not supplying to us or
they cannot think of looking for the alternatives.
And they want get the alternatives of the size and strength we are. So, it is our say you call it as
right or provocative as and when we wont to wake the payment we can make the payment we
can make the payment means this is not going to say stop the supplies by the suppliers to these
bigger and mighty buyers but this is somewhere creating the problem in the long run.
And every supplier could look for the alternatives and they would look for that rather than
supplying to the company X, if company Y or company Z or A, B, C, D any company is a better
paymaster making the payment on the due date. So, they would certainly keep on looking for, so
these bigger manufacturers of the finish product in the different industries they evolved a code of
practice that we would support our suppliers.
We would support our say ancillary manufacturers and as and when their payment become due
to made we will make the payment. And on the same basis later on drawing a clue from this code
of practice of the confederation of the British industries, code of means this kind of the code was
also developed later on by the confederation of Indian industries that is called as CII, CII also
understood this fact that sometime it becomes unethical to say through stretch the payment to say
lengthen the payment period.
To stretch the payment period by the bigger manufacturers or users of the different inputs
towards their suppliers. So, we will also do the same thing how this code by the confederation of
the British industries has done. So, what is this code that was popularly called as the say code of
practice which was evolved by the confederation of the British industries what that code is, what
are the different points of code I would like to share these different points with you.
And main slogan of this code was that prompt peer is good company, prompt peer is good
company means if any peer who has to pay to it is suppliers pays on time, pays promptly, pays
on or before the end of the credit period. Then that company will be categorized as a good
company. And maybe that company can be avoided also rewarded also because say very good
paymaster taking care of the needs of their small suppliers.
And they would be say they their effort would be recognized they are say practice would be
recognized and that pay even the suppliers would also appreciate that. So, what for the important
points the main issue was a responsible company should, a responsible bigger company who is
buying different inputs from the different say suppliers small suppliers should number 1 have a
clear consistent policy that it pays bills in accordance with the contract whatever is entered into
the contract between the buyer and seller, amount, date, discount, credit period all these things
remain mentioned in the contract.
And these bigger buyers of small inputs or dif inputs from the small suppliers would honor their
commitment and they would clear the payments or make the payments or clear the bills in
accordance with a contract or in accordance with the conditions lay down in the contract which
has been entered between the supplier and the buyer because every supplier and buyer enters into
a long term contract.
In the beginning when they start say doing business with each other, so whatever the terms and
conditions are as per this code and who is a member of the confederation of the British industries
they will have to say adhere to these different clauses of this code of practice. So, first clause is
of the first condition is have a clear consistent policy that it pays bills in accordance with the
contract to the suppliers or the smaller suppliers who are not very strengthful and their payment
will not be delayed.
Second point is ensure that the finance and purchasing departments are both aware of this policy
and adhere to it fourth in the bigger company the buying company bigger company who is
buying the different inputs from the different suppliers. They will make sure their own finance
and their purchase department is knowing about this code of practice and they would know it that
as and when any payment becomes due to be made.
They will make the payment on the due date and due time and they will not delayed it will be
responsibility of the purchase department, it will be the responsibility of the finance department.
Purchase department after purchasing and receiving the material and the invoice they will
immediately send it to the finance department. And finance department will release the payment
on the due date agree payment terms at the outset of a deal and stick to them, whatever the terms
are where in the contract agreed by both the sides supplier and the buyer.
Once they are agreed once the document is signed, in that case nobody will deviate from that,
nobody will go against those say points and they would whatever the credit period is mention,
whatever the cash discount is there, whatever the payment terms are, what is the say order size is
all this things remain return in the say agreement or in the contract and both the sides supplier is
naturally because they are small in size.
So, they cannot think of say violating the code of means the terms of the contract but the bigger
strengthful mighty buyer who is buying the inputs from these suppliers, they would also adhere
to the terms agreed upon in the contract and they would follow it, they would honor it, they
would honor all the terms and conditions.
Not extend or alter payment terms without prior agreement, no side maybe the supplier or maybe
the buyer nobody will have the right to alter the payment terms without the prior permission even
supplier if they want to minimize the credit period whatever the credit period they are offering or
they are currently giving if they wont to reduce it they will inform it to the buyer. On the other
side how many means days or the how much time is being taken by the buyer to make the
payment.
If they want to delay the payment for any particular order they would inform the supplier there
this time because of any reason maybe the liquidity or maybe other reasons. We will make you
the payment after 5, 10 or 15 days and they may allow the supplier to load that additional credit
period also with the interest factor.
So, it means both of them will be informing each other nobody will violate any of the terms and
conditions, provide suppliers with clear guidance on the payment procedures, how the payment
will be made, from which branch the cheque will be issued, which branch of the cheque will be
drawn on and after how much time the payment will be debited from the paying companies
account and credited to the receiving companies account all these this payment procedure must
be clearly communicated to the suppliers.
So, that he knows that what will be his float that if he receives the cheque on any particular date
and immediately he transfer or sends that cheque to the bank then after how many days that
cheque will be credit to his account. And which branch will be honoring that cheque against
which branch of the buying company the cheque will be drawn on and once that cheque reaches
there they will honor the cheque, they will allow the payment to be made.
And bank will collect the payment on behalf of the supplier and by debiting the buying
companies account they will be crediting or sending the payment to the supplier. So, procedure is
clearly lay down, this is another important condition in the code of practice. Ensure that there is a
system for dealing quickly with complaints and disputes and advise suppliers without delay
when invoices or parts of the invoices are contested.
If there is any dispute that you means agree to give us 6 month credit period, now you are giving
us 45 days credit period, you agreed to give us 2% if we make the payment within 10 days. So,
now we have made the payment within 10 days why do not you give us discount all any kind of
the dispute is there on the terms and conditions return and agreed upon in the contract that will
be if there is any dispute that will be speedily addressed.
There might be dispute because they are the 2 parties and when there are the 2 parties, there is
ought to be disputation were dispute there can be a dispute and if there is a dispute immediately
that will be sorted out by the supplier also, it should not be the case their supplier buyer keep on
thinking that I am very strengthful buyer. If he misbehaves with me then there is nothing to
worry about with change the supplier.
That does not give a good reflection, good feeling means to the supplier also and to the general
market players also. So, both the sides could be responsible both the sides could take interest in
resolving their problem and resolving that complaint dispute quickly as quickly as possible. And
both the sides will remains the disputes will remain settled and they will quietly calmly helping
and supplying to each other.
So, these are some of the conditions which are there which are some of the you can call it as this
is the terms of the reference, 6 terms of the reference are there in this. So, 1 is regarding the say
clear and consistent policy second is the say information to the say finance in the purchase
department third one is that say payment, terms that say how that payment will be made.
And then will be the next thing is that not to alter and extend the credit period and then is say
clear guidance over the payment procedure to the suppliers and then if there is any dispute that
we will resolve it as quickly as possible and we will not allow this any kind of the dispute to be
there right. So, same code of practice or you can say is a code of ethics was decided to be
evolved by the confederation of Indian industries, it is already evolved almost same terms and
conditions are there in that code also.
And they also agree that being the bigger buyer, strengthful buyer, mighty buyer, we should not
harass our suppliers as and when any payment becomes due to be made after the credit period is
over. We will make the payment to the suppliers and we will keep them in the good humor, so
same code and the practice is also very good, very healthy practice and this way both the sides
remain happy they feel encourage they feel to say feel good to do business with each other and
fulfill each other requirements.
Now we come to the next part, next part is the cost of stretches, I was talking to the cost
stretching sometime in the previous slides. Now we will clearly discuss upon that what is the
cost of stretching, if you stretch the payment because certainly the buyer would like to stretch the
payment and the supplier would like to not to stretch the payment by the buyer. But certainly
because as we have agreed in the beginning of discussion on this subject that no business is
possible only on cash.
So, it means we have to give the credit, we have to sell our production or services on credit but
when we are selling on the credit then how much credit period should be allowed and what is the
responsibility of the buyer to make the payment. And for example if the misbehave known it that
buyers objective is to minimize the NPV of the payment whereas the sellers objective is to
maximize the NPV of the recede is going to make on account of his credit sales.
So, buyer wants to have maximum credit period and the seller want to give the minimum credit
period but when the credit is given and taken. There is certainly the cost to the buyer who buys
on the credit because even you go to the market if you like to buy any product on cash certainly
you are going to pay the different price. But when you seek credit or request for the credit to the
supplier or any shopkeeper then certainly he would say resist and they he would say that okay.
If you want to buy it on the credit and want make him as the payment up to 15 days, 20 days or 1
month, I will charge you this much price. So, it means he is charging with the cost of extending
the credit, so certainly there is has to be the cost. Because both the prices cannot be same, the
credit price cannot be same as the cash price otherwise everybody would love to buy on credit.
So, when you talk about the cost that yes cost of credit is there, cost of stretching is there, cost of
delaying the payment is there, cost of buying on the credit is there, so what is the cost, how to
calculate their cost.
So, there are the 2 cost involved in it, one cost is the direct cost, direct cost is the penal rate of
interest that when there is a clear cut contract between the 2 sides buyer and seller that I will sell
you at this price and the buyer says I will buy you buy at this price and this much of the credit
period will be given and taken by both the sides. And if anybody any buyer if stretches the
payment beyond that permissible credit period, then he has to pay the penal rate of interest.
So, first thing is the direct cost which is in the monitory terms which is in the financial terms that
is the direct cost because you have to compensate the seller for delayed payment by paying him
the interest cost of that fund which is invested or those funds which are invested in the amount
which are the production which is being supplied by the supplier to the buyer. So, that is a direct
first is the penal rate of interest or the direct cost, I will discuss with you the direct cost and there
is a model how to calculate the direct cost.
There is a clear cut model for knowing it and apart from that there are the indirect cost, so I will
discuss with you now the model that is about the direct cost. So, how to calculate the direct cost
we can calculate the direct cost with the help of 1 model and that model is called as you can say
that this model you can understand under the title of economics of stretching the payments
stretching the payments.
So, this is a model developed by some people and how to calculate the say the cost, cost of
stretching the payments. So, you can say that is the cost of stretching the payment, so this model
is here C=V capital V then 1+D/1+Tsk and then is +i right. With the help of this model we can
calculate the direct cost that penal rate of interest that would be charged and is a direct cost for
delaying the payment.
So, here C means, what means the C that is the cost of delaying the payment cost of delaying the
payment that is to the buyer. If he delays the payment he has to pay the cost in terms of the
interest then we have the V, V is the value of order, how much size of the order, how much
payment is delayed because buyer places the orders, different kind of the orders and that every
order has to be received and supplied by the supplier and received by the buyer.
And there is a credit period associated to that on the end of the credit period the payment has to
be released, so what is the value of that order, this is the V, D is the direct cost, direct cost of
delayed payment calculated on rupees 1 on each rupee of the order. That is a direct cost that is D,
Ts is the number of days number of days the payment is stretched number of days the payment is
stretched and i is the indirect cost of stretching the payment right. So, almost we have addressed
all the factors here and if we use this model with the help of this model.
You can easily find out the direct cost of stretching the payments that is C=V*1+D/1+Tsk+i. So,
C is the cost delaying the payment, V is the value of the order, D is the direct cost of delayed
payment calculated on rupees 1 each rupee, Ts is the number of days the payment is stretched
and yeah one more thing I think we have left here, payment is stretched, i is the indirect payment
and k is the yes what is k, k is the daily opportunity cost of the firm who is delaying the payment
on rupees 1. Because if they are delaying the payment it means they have to pay the penal rate of
interest they should be paying the penal rate of interest.
If they are investing that money by not paying it to the supplier they are investing it elsewhere
and they are earning more than the penal rate of interest then it is justified that okay. If you are
being paid, charge the 2 rupees 2% per month interest, it means you are paying 24% annually.
But that funds which were not paying it to the supplier you are investing elsewhere in the market
and you are getting 36% then it is justified okay you earn 36% from there and you pay 24% here,
so you still have the 12% gain.
So, that opportunity cost we will have to calculate and that to the daily opportunity cost on each
rupee of the order we will have to calculate. So, almost everything we have factored into this
model that is the cost of delaying a payment, value of order, direct cost of delayed payment
calculated on rupees 1, Ts is the number of days the payment is stretched, I is the indirect cost of
stretching the payment and k is the daily opportunity cost of stretching to the firm.
You can say like this that cost of stretching to the firm who is stretching, the firm who is
stretching the payment to them there is a cost opportunity cost. So, they can stretch the payment
and there is no harm to them of stretching the payment. So, this is how we can calculate the
direct cost, here it is the indirect cost, I is the indirect cost. Indirect cost is also there, what is the
indirect cost now.
We can think here that what is the indirect cost, indirect costs are the points of indirect cost are
listed here. Number 1 is gradual erosion of the goodwill, if you time and again there is a
payment, how big you are, how strengthful, how mighty you are, financially strengthful you are
in the market, your goodwill will be going down day by day because your reputation will be
reputed as very bad paymaster or delaying the payment, defaulting the payment.
So, no good people would like to do the business with you, this is the 1, poor credit rating. So,
your credit rating will also go down as a buyer and not making the payment on time, it is a high
cost and maybe next time anybody want to give or extend any kind of the credit to this company
who is dealing the payment they would think means 10 times whether to say extend credit to
them.
Then sours the relationship between the buyer and the suppliers, in a relationship will not be that
good as if it is that if you are making the payment on time and you are not delaying the payment
at all in any case. Loss of supplier’s flexibility that is a major issue, loss of the supplier’s
flexibility because I told you that there might be chain like that if there 1 supplier.
Then he is supplying it to number 2 and he is supplying it to number 3 and this is the 4 who is
the manufacturer of the finish product, this is the chain. So, it means this person is making the
payment to him, he is making the payment to him, he is making the payment to him. So, when
the payment is delayed here when there is a problem here or somewhere , so it means when this
payment is delayed certainly this problem will reflect in case of the 3.
And it will reflect in case of the 2, so it means this total chain is getting disturbed, it does not
mean that if 1 person is delaying the payment. So, the only say is a affect upon the 1 means 1
supplier only because they are in the chain, 1 is manufacturing at the 1 level then he is supplying
into the other, then he supplying to the other, then he supplying to other and then the third one is
supplying to the fourth who is manufacturing the finish product.
So, it means total relationship is spoiled and this symbiosis is disturbed, so supplier’s flexibility
also because supplier also have the limited credit to give. If you do not make the payment to
them on time from where will they bring the funds, they will not be able to bring the funds and to
say keep on supplying to somebody unendingly or investing the funds from their pocket because
your financial strength is also limited.
So, that will be another indirect cost and then is the delayed supply of materials, there will be the
delayed supply of materials. Somehow means if this kind of the situation emerges, first the
supplier would look for the alternative if we getting the alternative then fine if he does not get the
alternative then he would start supplying to more than 1 buyer right. So, he would see that I will
first supply to the 1 who is making with the prompt payment.
Then if some material is left it will go to the second and some material is left it go to the third
and if some material left it will go to the fourth. So, it means what will happen the buyer who is
delaying the payment or who is disturbing the symbiosis or who is not a good paymaster he will
get the supplies in the last. So, what will happen suppliers will start delaying the supplies and
that will also be another issue that will also be a another problem.
So, it means we have both the cost one cost is the direct cost and another cost is the indirect cost.
So, direct cost we can calculate with the help of the model we have just discussed here this is the
model and the indirect cost number of points are there of the indirect cost here erosion of the
goodwill, poor credit dating, souring of the relationship with the supplier, loss a supplier’s
flexibility and the delayed supply by the supplier to the buyer.
So, this is the indirect cost which also should be factored into this model somehow quantitatively
but for example if we are not able to factor this indirect cost in this model. Then still we are able
to have other components which are the components of direct cost or causing or making the
direct cost and they are something like that is the value of order, direct cost of stretching D. Then
is the number of days the payment is stretched and then is the daily opportunity cost of the
amount each rupee of the delayed payments.
So, all these factors are there and there is a direct cost in terms of the penal rate of interest he has
to pay and that cost is the one which he has pay to the or he has to make the payment to the
means to the supplier and that will be called as the direct cost and so, it means there is a cost of
stretching the payments not all ways the benefit to stretch the payment. If you stretch the
payment to acceptable level every would you would accept it.
But if it is beyond the level then it will not be possible and if should not be done so, it means
what we have to do is we have to stretch the payment to the level which is acceptable to both the
sides right which is known to both the sides which is acceptable to both the sides. Then only it is
possible otherwise it is not possible. So, after this so, say today I will not discussing any problem
of this model whatever the model I have discussed with you.
I will only means discuss conception be the model with you next class I will be discussing once
small case small problem that how we can use this model and how to calculate the cost of
stretching that is c so, if we have some say imaginative figures we can use those figures and we
can say know how to use this models. So, in the next class I will certainly do that so, today we
discuss the cost.
And we learnt it that this is the cost of stretching which is both direct and indirect cost apart from
that there are some other issues also involved that is say you can call it as float management is
the one concept. We have discussed to some extent the float management but I will again throw
light on this in the next class.
And there are some other points to be talked about the say accounts payable about the other
accruals that is salaries variable and fixed expenses taxes and dividends and some points about
the over trading as evolved of caution. So, all these things I will discuss with you in the next
class thank you very much.
Lecture-55
Cost of Stretching Accounts Payable-I
Welcome students, so we are discussing today as well as in the previous class we have been
discussing about the management of accounts payable and in the previous class I assured with
you that when we stretch the accounts payable or delay the payment of our dues or the say say
delay the payment to be made to the creditors or to the say suppliers or the expense creditors.
So, we have to pay the cost for that and when we were talking about the cost we I told you that
they are the two kind of cost one is the direct cost and other is the indirect cost. I discuss with
you the say causes of the indirect cost or the indirect cost the firm of indirect cost that how the
indirect cost the payer has to pay where we talked about the gradual erosion of the goodwill.
Then we talked about the poor credit rating then we talked about the source relationship with the
suppliers and loss of suppliers flexibility and then delayed supply of the materials right. So, these
are the some issues which are involved with regard to the indirect cost and then I told you that
the direct cost we will discussed sometime later. So, today I will discuss with you at length that
what is the direct cost, how is cost to the say the payers are who have borrowed or who have
purchase the material on credit or who have to pay to the different interest groups in the firm
who are associated to the firm.
So, if they delay the payments then certainly especially it is in case of the suppliers, suppliers
credit is not free and when we buy on the credit certainly we have to pay some interest for the
period for which we are seeking the credit from the suppliers. So, we have discussed that yes two
cost direct and indirect cost. So, today I will discuss directly and clearly with you the direct cost
that what is the direct cost.
And how it can be quantified and how say here has to decide whether he should he would like to
pay this cost or he would like to avoid this cost. Because it has many other repercussion also 1 is
the penal rate of interest then we delay the payments and other issues are also involved which are
in the form of the indirect cost right. So, let us see that how we can measure the direct cost to the
say payer or to the company who has purchase a raw material on the credit from suppliers.
And if they are delaying the payment and they have to pay the direct cost then how to say
calculate that cost there how much that cost comes out to be because the purchasing firm the
buying firm has to make the analysis whether it is advisable for them to delay the payment or not
to delay the payment right. So, as I told you that in case of the purchase terms when we talk
about the credit terms.
We have certain things to be taken care of and in the credit terms, terms of purchase we have a
two important things credit period and cash discount. If you ask for the credit period then
certainly forget the cash discount and but if you are the prompt to payer if he want to make the
payment early then you can expect some cash discount to from the suppliers. So, the choice is of
the firm who has to make the payment to the suppliers whether they want to enjoy the extended
credit period or they want to enjoy the cash discount.
So, everything has a cost and that is the direct cost in terms of the money we have to pay this
cost and when we have to pay this cost. So, after learning the indirect cost or the reasons or the
causes of the indirect cost let us now discuss and learn in detail the causes of the direct cost. So,
in the previous class I shared with you a model that how we can quantify, how we can work out
the direct cost that will be the cost to the suppliers.
And the cost can be calculated with the help of this model and we have discuss this model in
conceptual form that how this model works. And what this model means where we have seen
some of the inputs have to be given to quantify the direct cost. So, we had this model with us that
C=V*1+D/1+tsk*I capital I. So, C is the cost of delaying the payment cost of stretching the
payment.
This is the 1 we want to calculate and then is the V value of the order that what is the order size
which we have purchase, the material which we have purchase from the suppliers what is the
size of that order, what is the value of that order. D is the direct cost of delaying the payment
calculated on each rupee that is on the rupee 1 that is 1+D that is the direct cost means a penal
rate of interest that is the penal rate of interest.
We have to pay if we delay the payment and that to on the each rupee of the order then is the ts
number of days the payment is stretched or delayed, how many days for we are delaying the
payment or stretching the payment. And then after that we have the k that is the daily opportunity
cost of the firm on the rupees 1. Because we will delay only that if there is a opportunity cost
means if you do not make the payment to the suppliers on time we delay the payments certainly
we have clear that we have to pay the penal rate of interest.
So, it means there must be reason, there must be logic that we are not paying to the suppliers
where that money is going, where that money is being invested. And that money if where we are
investing that money if the rate of interest we are earning from that investment is more than the
cost we are going to pay to the suppliers. Then certainly makes a sales to some extend that he has
we are delaying the payment.
Because we are using these funds elsewhere and then when we will recover these funds from that
investment then we will make the payment to the supplier and for that reason there is no point.
We can delay the payment and we are ready to pay the penal rate of interest. In this case what
happens I would like to share with you very interesting story that all these big companies say for
example you talk about the automobile sector or may be in the electronic sector or in the any
other sector.
These large companies they force their suppliers to extend the credit beyond the certain period of
time which is normally beyond the permissible limit of the supplier means the bearing capacity
of the supplier. These firms insist upon that you give as a extended period of the credit and they
all the times agree that he has if you are giving as a extended period of credit, you load your
credit sales with the interest.
You are going to pay to or with your opportunity cost or your the interest which you are going to
the pay to the bank or with your opportunity cost. So, there is no problem to these companies to
pay the interest to the supplier and if the supplier is getting the interest then he is also he also
does not mind that why should I delay the say accept the delayed payment.
But since he is getting the interest on that, so it means they also not mind about it. So, why these
companies insist upon for extending the say credit period. Because when you talk about the
supplier he is a small firm, he is a small size company, he is a small size firm and to whom he is
applying he is a big company is a large sized unit or maybe the company belonging to the large
sector right.
Now in India the rate of interest to be charged by the loans for the loans by the banks the that
rate of interest is different when the loan is given to the small scale buyer and borrower. And the
loan is given to the large scale borrower right say for example if because small scale sector
comes under the priority sector. So, there is a concession in terms of the interest rate to be
charged by the banks on the working capital finance being provided by the banks to these small
suppliers who are called as ancillary units.
They will onto the small scale sector, so what happens that if say any big company for example
you talk about the Suzuki India Limited who manufacture cars or the Honda CL who
manufacture the Honda cars or any other Hyundai motors you talk about who manufacture the
say Hyundai cars as a Korean company. So, if they borrow money from the bank maybe through
say your CC limit or maybe through the working capital loan.
And then make the payment to the supplier on time, so it means on their borrowings the interest
they have to pay to the bank is very high. But if they borrow money through supplier means if I
think you are able to understand it, so what happens that they ask the supplier that we will not
borrow money from the bank, you borrow money from the bank and you fund your credit sales
to us.
Because if you borrow money from the bank and you say fund your credits sales verse by using
that money that help from the bank or that loan from the bank. You have to pay say 12% rate of
interest this is for an example not actual 12% rate of interest. But if we borrow money from the
bank and for draw money from our working capital limit or maybe from the working capital loan
maybe we have to end up paying the 18% rate of interest.
So, it means what you do is you borrow money from the bank you sellers on the credit and
whatever the interest you are paying plus your administrative cost. You are paying 12% to the
bank, so load your credit sales to us which you are making to us with 13 or 14%. We are ready to
pay you the 14% rate of interest or 13% rate of interest but we want the extended credit period.
So, it means in this case what is happening is a company who is a large sized buyer.
He they are saving 4 to 5% interest on the borrowings they are making from the bank through the
small scale manufacturer. Because if they themselves borrow from the bank and pay to the
supplier in cash after the normal credit period. They have to pay 18% interest, but if they ask the
supplier to extend the credit and borrow money from the bank to fund the credit sales he has to
pay 12% interest.
So, in that case you can say in India indirectly that small scale credit which is available from the
banks under the priority sector is going to the large scale companies. And many a times many
experts have recommended to the government that this interest rate differential which is provided
to the small scale and tiny and cottage industries that should be withdrawn or the limit or that
percent of that out of the total credit.
The credit is going to small scale sector should be lowered down. Currently the as per 1 estimate
around 40% of the total working capital finance from the banks should go to the priority sector
or to the small scale sector. So, it means that 40% is indirectly going to the large sector and large
sector is saving heavily upon the interest. So many committees including Narasimham
committee very famous committee on the working capital finance as well as the bank reforms.
They were recommended to the central government ministry of finance that this type of the
concession should be withdrawn. Because this credit is indirectly being enjoyed by the large
scale manufacturers for this as not happen and this practice is still continuing. So, still we are we
will be talking about the cost and 1 has to pay the cost if they delay the payment or they stretch
the payment and here is the model how we can calculate that direct cost.
Now I will with the help of a small problem I will discuss with you the things that how we can
calculate their cost and how we can I have brought a small problem. So, we can solve this
problem and with the help of this problem we can try to understand the direct cost which is
involved in this. So, with the help of this problem I have try to find out a problem which can help
us to understand the direct cost calculation.
And here is the problem we have small problem and we will evaluate the cost to the cost to this
particular company. If they delay the payment under the different situations say for example if
you read this problem say the problem is like electric circuit buys the basic inputs from general
electric. General electric offers credit terms of 30 days they generally do not mind if the payment
is delayed by say 10 more days.
But beyond that they impose a penalty of 1.5% on the invoice value for every month of delay
right. You could understand it well that normally the credit period is 30 days but they do not
mind if the payment is delayed for another 10 days it means if you make the payment up to 40
days from the date of buying the say goods on credit. They do not mind and you want to have to
pay anything extra or any penal rate of interest to the supplier that is the say general electric by
the electric circuit right.
But if the payment is delayed beyond 40 days then for the entire amount of that period that is for
say we can assume that payment is made for say after 2 months 60 days. So, it means then they
have to pay the cost for the entire period of the 2 months and that say say you can call it as the
float of the 40 days will not be allowed by the supplier to the payer. It does not mean that okay
you delay the payment for 40 days.
And then you make the payment after say 60 days or maybe on the 60 th day, so you will be
charge the penal rate for the 20 days more. That float of the 40 days will not be there and we
have to pay the penal interest on the total period of 2 months right. The finance manager of
electric circuit is trying to evaluate the alternatives of stretching the payment the firms stretching
the payment right.
The firms opportunity cost of capital is 15% means if they do not make the payment to the GE
general electric if they use at money elsewhere. So, they earn 15% their opportunity cost is 15%,
so let us see if the opportunity cost is 15% order size we will see here and the normal credit
terms are 30 days. But delayed by 10 more days means up to 40 days general electric does not
mind but beyond that if you delay the payment.
You have to make the pay say interest for the total period for every month of delay, that is the
total delay and that cushion or that float of the initial 40 days will be withdrawn by the supplier.
Now what we have to do here is required whether means advise whether electric circuit could
stretch the payment for 10 days. If the average invoice value of the firm is 10,000 to 30 days if
the average invoice value of the firm is 10,000 means should they delayed for 10 days.
So, that to make the payment on the 40th day or they should delay the payment up to 60th day 2
months order size is same. The value of the order is 10,000 only but they are evaluating it that
what should they do looking at the 15% opportunity cost. If the payment is delayed for by 10
days it means if the payment is made on the 40 th day how much is the net outcome and what is
the cost and say if it is paid on 60th day means initial 30 days credit is enjoyed.
And additional 30 days credit is enjoyed means rather than enjoying the credit of 10 days the
credit for additional 30 days is enjoyed it means the payment is being made after 2 months. So,
whether it will be worth file for the electric circuit to make the payment to GE this is these are
the two conditions in the first option, second how do you react if opportunity cause rises to 30%
per annum means same thing delay of the payment by 10 days or by 30 days two cases.
First case is that opportunity cost is 15% and the second case is opportunity cost is 30% though it
is very high. But we can assume right and third option is advised if GE offers a 2% cash discount
if the payment is made within 10 days right otherwise normal credit period of 30 days is
available 2/10 at 30. That for example they do not enjoy any credit period they say no we do not
wont the credit period we are ready to make you the payment within 10 days from the date of
purchase the movement receive the goods from you within a period of 10 days will make you the
payment.
And GE also offer that okay if you make the payment not even stretching to 30 days or 40 days
right, if you make the payment us up to the 10th day from the date of purchase then we will give
you a discount of 2%. So, these are the 3 situations we will have to evaluate, whether they should
delay the payment for 10 days means make the payment on 40 th or on the 60th day. When the
opportunity cost is 15% or they should delay make the payment on 40 th or the 60th day when the
opportunity cost is 30%.
Or they should enjoy a cash discount by making the entire payment within 10 days enjoy the
cash discount by 2%. So, what is better for the company electric circuit who is the payer or who
is the buyer on the credit from the general electric right. Now let us try to understand how to
evaluate this problem and for evaluating this problem we will take the help of again the same
model this model I will be using and with the help of this model will give the inputs to this
model.
And try to calculate that what is the cost to the electric circuit, if the payment is delayed by the
certain amount of time. So, first of all what we have to do is we have to calculate the daily
opportunity cost.
And what is the daily opportunity cost we have to calculate that the say k is the daily opportunity
cost given in the model. So, daily opportunity cost is how much that we have to calculate in the
problem we have given that opportunity cost of the firm is how much 15% right. So, that is
annual, so what is the daily opportunity cost that is 0.15/365 we will assume the annual days,
days in a year 365.
So, that works out as how much that will be something like this 15/36500 and that is value will
come out as how much that is 0.00 sorry we will have to see 0.000411 this is the daily
opportunity cost. If the annual opportunity cost is 15% then how much is the daily opportunity
cost that works out to be 0.000411 right. Now we evaluate the first option be the help of this
opportunity cost let us evaluate the first option.
So, what was the first option that if the payment is delayed by 10 days only normal credit period
is how much 30 days and if the payment is relayed up to 10 days 10 more days and the payment
is made on the 40th day. So, it means what will be the cost to the payer to the electric circuit
means the total cost or you can call it as the net persent value of the payments the electric circuit
is making to the general electric.
So, let us calculate the C here for calculating the C what is the value of the order that is given to
as is 10,000 and here it is 1+what the models is 1+D direct cost up to 40 days the direct cost is 0.
We are taking the direct cost is 0 then 1+then what is the model what is the time of stretching
time of stretching is 1+time of stretching is 40. We are stretching it for 40, so it means how much
it is, it is 0.000411.
This is the total cost of stretching and we are taking here is and we are closing the bracket we are
not say counting here or factoring for the indirect cost. We will we can quantify the indirect cost
also that we can add +i but I am just for the movements skipping that I am taking the direct cost
first the direct cost. So, direct cost will be that be the payment is made on the 40 th day but
delaying it for the 10 days.
And the opportunity cost is 15% what is the cost if you calculate this cost how much it works out
as this will work out as rupees 9838.26 right. If you solve this you will get this figure 9838.26 it
means the net present value of the 10,000 rupees which are being paid. On the 40 th day after
purchasing the goods from general electric by the electric circuit they are actually paying though
they are paying 10,000 but the net present value of that payment today is that is 9838.26.
This is the NPV because as we discuss in the beginning that the purpose of the payer to delay the
payment is to minimize the net present value that how much payment he wants to may that he
wont to pay as minimum as possible though is paying 10,000. But the net present value will
come down if the time period is delayed, so we are delaying the payment by 40 days without
paying any penal rate of interest.
It means we are actually paying 9838.26 rupees against the total value of the order of 10,000
rupees. So, by paying 10,000 actual payment is 9838.26 this is the 1 option, number 2 is if the
payment is made on the 60th day. If the payment is made on the 60th day maybe after enjoying 30
days and then the 30 more days.
Then what will happen the permissible float of the 30 days initial 30 days+10 more days will not
be allowed. So, what will be there then he has to pay the penal rate of interest on the entire
amount and how much that will be calculated. So, we have to calculate the C here again, again
the order size is how much 10,000*that is 1+0.015 and divided by again 1+60 how we are ts is
how much 60.
And the opportunity cost will be how much that is 411 right and you close the bracket now. So,
we have know added here something which is called as the penal rate of interest or the direct cost
that is the D means direct cost of stretching the payment calculatetable on each rupee of the
order. So, it is we are adding here 15% that is the 0.0 that is say not 15% sorry this is not the
15% but this is 1.5%.
That the opportunity cost we were saying here what was the opportunity cost we will look at the
problem here. That they generally do not minding the payment is delayed by say 10 more days.
But beyond that they impose a penalty of 1.5% on the invoice value for every month of delay
1.5% per month it means how much 18% per year right. So, it means the we have added here that
if the payment is delayed beyond 40 days.
Here we are assuming the time period which the company the payer electric circuit is enjoying a
60 days then making the payment on 60 th day. So, they are paying it with the penalty and the
penalty is 1.5% per month right and we have taken here the 260. So, we have already factored it.
So, now in this case if you talk about then we will see here that what is the outcome here if you
calculate this outcome if you see what is outcome here that is rupees total amount will work out
as how much 9905.72.
This, so one is this net present value another net present value is this much if we are delaying for
40 days we are actually paying not 10,000 but 9838.26. But if we are delaying for 60 days then
how much we are paying we are paying it with penalty that is 1.5% per month. And actually the
net present value of that payment of 10,000 rupees goes up, because penalty has been added that
is 9905.72.
So, now you can think of what is your choice you want to pay after 40 days or you want to pay
after say how many 60 days. Now if you say for example if you pay after 60 days then how
much you are paying you are paying more than what you are paying after the 40 days right. We
are making the payment which is more, so in this case what is happening we are net present
value is also increasing.
We are paying the penalty, so because of that the net present values increasing and when the net
present values increasing. So, it means it an apart from that we have number of other outcomes
that we have to say pay the indirect cost also. So, it means we are paying increased NPV of the
10,000 rupees as compared to delaying for 40 days. And we are paying the indirect cost also
because this will not be light way anybody that though you are paying penalty.
So, it can be allowed even after the penalty this kind of the things are not liked by the receivers
or the companies who are suppliers. So, in this case what will be there this type of the things
should be done by the payers when there is a serious liquidity problem. If they do not have the
funds then they can take the risk of delaying the payment rather than paying on the 40 th day.
They can pay it on the 60th day and with penalty they are paying.
So, it means they can take this chance this risk if there is a serious liquidity problem that they do
not have the funds available or the opportunity cost is otherwise very high. Normally it should
not be done because it erodes the goodwill of the payer suppliers will start looking for other
buyers from them. And this will means create a problem not in the short run but in the long runs
what should be done if there is a seriously liquidity problem. You can do this kind of things and
that to once in while not on the regular basis., So, this is the one case we have evaluated here
now if we talk about the second part then we can see here that what is the second condition.
If you look at the second condition here, then in this case what is the case that if the payment is
delayed say 30 days, 10days and 30 days. When the opportunity cost is 15% and second option is
how do you react if the opportunity cost rises to 30% per annum. Now let us see evaluate that
option also if the opportunity goes to the say 30% when you talk about the opportunity cost is
going up to opportunity cost of the firm is 30% when the opportunity cost is 30%.
Then what is the outcome we will evaluate it, now let us see the first option, option-1 is that is
say in this case we have to the C. So, if you calculate the C here what is the value of the order
again it is 10,000*1+what will be here sorry let me rewrite it if you see here option-1 we will go
for the option-1 here, so what is the c, c is 10,000 is the value of the order and then again will
take 1+that is 0.
Because 40 days for the opportunity cost is high now that is 0 and then we will take here is how
much that is 1+ how many days 40days. And what is the opportunity cost, opportunity cost is
double now. It is 0.000822 we have to take here and close the bracket, if you calculate this then
what is coming out here is that is 96 rupees 9681.67 is the outcome and then if the payment is
made after 2 months on the 60th day then what will happen.
We have to pay the penal rate of interest at the rate of 1.5% per month. So, what is the C in this
case this is 10,000*1+now we will we taking here is that is 0. 015 divided by 1+ 60 we have
taking here into how much 0.000822. So, we have added the penalty here, so when we have
added the penalty here it means now the NPV will say go down, when you are talking about
NPV will be say further we will have to check here that the NPV will be how much.
That is the finally if you calculate the NPV here that will be something like 9672, 9672.93 this is
the NPV of the order. So, now you calculate both the situations if you look at if you see the this
situation here what is happening we are if making the payment on the 40th day we are ending up
paying 9838.26 rupees against the order value of the 10,000. And if we are making the payment
on the 60th day actually what is happening we end up paying more than what we are paying here.
We are paying now actually 9905.72 because opportunity cost is 15% only and penal rate of
interest is 18% right, so it means we are paying because penal rate of interest is 18% per annum
and the opportunity cost is less than that it is 15%. So, what has happened as a result of that your
payment net payment of the net present value of the payment which we are making on the 60 th
day is more than the payment we are making on the 40th day.
But here in this case if you look at it has reverse has happen why it has happen that if you are
making the payment on the 40th day. We are ending up paying 9681.67 rupees against order of
10,000 rupees but if we are delaying the payment by another month and paying on the 60 th day,
then we are say actually paying 9672.93. So, in this case you can say that this option is better
than this option but what is the net gain.
Here you are paying almost what is the net gain that is almost of how much 9 rupees net gain is
in the NPV net gain in the NPV is how much that is rupees 9, you are paying you are saving 9
rupees. So, would you like to say pay the huge indirect cost just for the saving of 9 rupees that is
not possible means we should not delay the payment just for mere gain of 9 rupees rather than
paying 9681.67.
If we delay the payment after 2 months you are ending up paying 9672.93 we are only gaining 9
rupees. But the loss indirect loss to the credibility to the reputation of the buyer to the payer
means reputation of the payer is very very high right and why this has happened. In the other
case when we have seen when you are paying in the 40 th day you are ending up paying 9838 and
when you are delaying the payment and paying the penalty or ending up paying 9905.
And here in this case reverse has happened that when you are delaying it for 40 days you are
paying 9681.67 but when you are delaying for 60 days. Then the net present value has further
gone down from 9681 to 9672.93 this has happened because here the reverse is there that
opportunity cost is less that is 15% say opportunity cost is very high that is 30%. But the penal
rate of interest is say that is 1.5% or the 18% per year.
So, when the opportunity cost is very high that is 30% as I told you in the beginning if the
opportunity cost is very high and penal rate of interest is lesser than that. Then we can think of
defaulting on the payment but otherwise also that number1 here in this case just for a small gain
of 9 rupees they should not be done maybe if you look at the real perspective of the companies.
Then we have to see how much is the net gain what is the saving in the net present value of the
payment 1.
And what is the indirect cost we are paying in the market we have to clearly evaluate both the
options and in this case. If from this information only if we have to take the decision I think I
would advise that the option one should be taken into a account that if the opportunity cost is
15%. Then I think they should make the payment on the 40 th day not to wait or delay the
payment, so is to save in terms of the indirect cost as well as the direct cost.
They will be saving on both the cost but anyhow if the opportunity is very high that is 30% then
they can think of delaying the payment. Because there is a net gain after paying the 60th day
means on the 60th day rather than the 40th day. But still we have to look at the gain and the
indirect loss to the credibility of the firm. So, I will stop here giving the options to you that is
what should be we do that if there is a opportunity cost of 15% and 30% in the penal rate of
interest say 1.5% per month or 18% per year.
These are the 2 outcomes we will continue the this discussion means the remaining part of this
problem we will continue and the remaining options whatever the options available are in this
particular case I will discuss with you in the next class and then we will take the decision in the
holistic sense, thank you very much.
Department for Management Studies
Lecture-56
Cost of Stretching Accounts Payable-II
Welcome students, so we are in the process of learning about calculating the direct cost on
accounts payable that is stretched then what cost we have to pay and that say direct cost we
are learning with the help of one small say problem we were talking about that problem in the
same previous lecture also. So all again just I recall that prefer to be talking and discussing in
the previous class.
And now what you have discussed in the previous class and what we have to go for now, now
we have to take decision, so this is the problem already discussed with you in the previous
class and here we are evaluating 3 options that if a company who is buying from general
electric were inputs electric circuit. If they want to delay the payment then what should I do,
and how long we should stretch the payment.
So that ultimately the net present value of the payment they are making to the general electric
is minimum. So they have to keep into account many things that there is a reputation is also
not affected the credibility is also not affected and finally they are able to say enjoy the
stretching also as well as cementing reputation also. So in the previous class we discussed the
valued options that will be have the opportunity cost we say like 15% and 30% right 15% and
20% per annum.
So we found out that when there is opportunity cost is 15 15%, so we have seen ah here we
like to find out that what was the outcome and in that outcome I would like to share with you
that we calculated the let we calculate we calculated those figures that in case when there is a
no stretching means normal credit period is the first option was not that the normal credit
period is 30 days.
But the company general electric does not mind if the payment is delayed by another 10 days
but after that they charge or penalty or the level up in the rate of interest at the rate of 1.5 %
per month is 18% per annum. So you have to think about that whether you would like to
delayed beyond 40 days or would not like to delay beyond 40 days. So when the valued is
evaluated options available to us be calculated that the cost that is we call it as the say C.
The cost of stretching the payment will be calculated in the first case was that when the
payment was made after 40 days on the 40th day without paying any kind of penalty we found
out that what was the NPV, NPV was 98381.26 rupees right and when the payment was
delayed beyond 30 days and it was made after 2 months. So it means there will be no float
available as a discuss with you that one should delay even you make the payment of the 41st
day.
Then the entire this float available for the 40 days will be over and for that complete period of
2 months one has to pay the penalty and if you talk about the penalty here that is 1.5% per
month. So we have same here that what was that value is the payment is made on the 60th
day is the payment is delayed by 30 days then in that case we have calculated that the cost to
the firm was how much that is 9905.72 rupees right.
So it means here the result is very clear, that if you make the payment on 40th day no penalty
no penal rate of interest of 1.5% you are enjoying a credit period of 1 month and 10 days and
the NPV of that payment we are making of the cost of the payment of 10000 rupees which we
are making that is 9836.26 this is a net present value of the 10000 rupees when the payment
is made after 40 days or on the 40th day.
And when the payment is delayed by 2 months and payment is made on the 60th day
instantly the firm has to pay the penalty and the penalty is at the rate of 1.5 % per month, so
we have calculated that penalty and in that case when you talk about the penalty here it
means we have calculated the penalty what was the model views we use the penalty only that
is the 0.015, if means penalty say.
At the firm has to pay that is for the delayed period which means what was the normal period
allowed, normal period allowed was 30 days, that if you make the payment that is 30 days
you are given the credit period is 30 days. But if you are not making the payment in 40 days
10 more days it means 40 days. So what is there for the say general electric does not mind
take care, they do not mind.
So in the company does not find the delay if it is up to 10 days but if the payment is made
after 40 days then this float of 10 days this float of 10 days that will not be available between
normal credit period of 30 days that is free but if you are delaying it rather than doing it for
10 days even if you are delaying it for 11 days then this float will not be available and for the
entire 1 month second month you have to pay the penalty at the rate of 1.5% firm right.
So when we calculate that in the previous class the cost for that is a cost of same to the firm
for the delayed payment when we calculated the net present value of that 10000 rupees we
found out that that value was 9905.72 rupees it means net present value of that 10000 rupees
paid on the 40th day that is 9838.26, but if it is paid on or after 40 days if it is paid on after 40
days and up to 60th day.
So that then these float will not be available and the firm pain from has to pay the penalty for
the entire second month means 1 month right. If you delayed for 2 months means if you make
the payment at the end of the third month then what will happen you will have to pay the
penalty for 2 months right. So the first month is free but after that beyond 10 more days
means after 40 days you have to pay the penalty.
So we are calculated here the penalty when we apply the modern be calculated the net present
value of that 10000 rupees are being paid and we found out that that value was 9905 which is
more than this value. If you calculate the first value that is 9838, but now we are ending up a
9905.72 which means the cost to the firm has increased, the cost of penalty and here if you
look at the penalty amount that is how much 18% per annum, 1.5% per month is 18% per
annum and what is opportunity cost that is 15% per annum, opportunity cost is 15% per
annum.
So now you can see because of this opportunity cost being lesser than the penalty the firm is
pay on the delayed payment the finally this payment which is being made along with the
penalty that net present value of that has increased it will cost to the firm is increased. So this
is a direct cost mind it. This is a direct cost that now you are paying more by say 9838 which
means how much extra we are paid.
We are paying extra 62 plus 5 almost 67 rupees we are paying extra here, this is not all 10000
rupees but I think about when the order says rules of the rupees bigger order think about the
bigger companies say for example Suzuki is buying say rubber parts or maybe tyres and tubes
may be sometime the glass parts or even the steel, sometime when the Suzuki motor is
buying steel from steel Authority of India Limited from the Jindal steel.
It might be a condition there and there of example in a month, say by the steel for say 20
crores or may be 100 crores. So there if you talk about the penalty that will go again ran into
not even cross that not at least crore 40 lakhs. So you have to pay more and that is one thing
that is a direct cost you are paying but at the same time you will have to pay the indirect cost
also and that is a very heavy cost it is a very big cost.
So we should avoid this kind of situation that when we are getting you float of 10 days after
30 days we are getting the addition of lot of 10 days then why not to make the payment on
40th day why to delay, I told you that this can be done by the firm but you are very rare
situations that if there is a serious liquidity problem or the opportunity cost is very high. For
example here the opportunity cost is 15 and penalties 18.
But in the next case you have seen already we have discussed that the penalty was 18% and
the opportunity cost is 30% then you would see that even after delaying for 2 months your net
present value rather than going up after 2 months of that 10000 rupees and NPV will come
down because the opportunity cost is high and the penalties less. So still there is a profitable
proposition that even you delayed.
So you are paying the penalty but the net present value of that payment is still less as
compared to if you make the payment on for 40th day. So what we have to very careful
because in the business relations this creates a problem and vision solutions is so slowly and
steadily and sometime when we become the frequent default in the process that what happens
at the supplier was start looking for the alternative.
And they also start feeling that this buyer is not a good paymaster. So we have to look at the
alternative, so that should not be done. So here we evaluated both options in case of the when
opportunity cost of 15% and then we were evaluated options when the opportunity cost was
that is a second case, then the opportunity cost was how much 30% so we have seen that
when the option 1 was what I am just repeat again just as I recall it.
Because in the option 1 when the payment is made active on 40 th day what was the NPV,
NPV was 9681.67 rupee right. So far against the payment of 10000 rupees firm is paying
10000 rupees electric circuit is paying 10000 rupees, but actually they are paying after
adjusting for the time value of money they are paying 9681.67 rupees right. They are not
being 10000 rupees.
So it means that is the point that they are delaying the payment because payment made on the
day of purchase and payment made after 40 days there is a difference because of the time
value of money so it is 9681.67 and in the second option we have seen that when there is a
penalty when the payment is made on the 60 th day after 2 months, so what was the value of
that order that value of that order ahead for the gone down 96.72 9672.93 right that is the
point.
So it means if you look at this is the 9672. 9672.93, so earlier go 9681.67 and now it is
9672.93, so again it is also 10000 same order but you are making this payment after some
period of time. So you are making the payment here in the option 2 you are making the
payment of the 60th day, in the option when you are making the payment on the 40th day,
when you are making the payment of the 40th day when the opportunity cost is 30% in the
penalty is 1.5 % means 18% per annum.
Option 1 you are paying 9681.67 and the option 2 you are paying 9672.96 which means is
this second amount option to is still less even after paying the penalty you are paying lesser in
the real terms by how much almost we can say 8.509 rupees almost nine rupees you can see
or maybe yeah around 9 rupees we are paying less when we had making the payment on 60th
day we are making the payment of penalty also.
But we are the NPV of that is less, so why just become reverse light has gone reverse know
as compared to the previous case because opportunity cost is 30% and the penalties again the
18%. So your opportunity of earning this amount elsewhere is very very high which means in
this case when you are calculating the opportunity cost we have calculated opportunity cost
daily opportunity cost of divided it by the amount that is. 0.000822 not 0.000411.
So since opportunity cost has gone up even after making the payment on 60th day your NPV
is still lesser as compared to the payment your making on the 40th day. So but that seldom
happens because opportunity cost 30% is a very high we have just assume the situation you
just assume the situation that opportunity cost is 30% is double the opportunity of right still
point of concern is what is the difference how much is the extra gain to the firm by delaying
the payment for 1 month is just rupees 9 only just rupees 9.
If you look at this amount only 9 rupees, so just to save 9 rupees or maybe if it that order of
rule it may be say yes to save 9 lakh rupees or maybe somewhere lesser that less than that we
can we are losing many other things I told you that apart from the direct cost there is a
indirect cost also. So we are becoming a delayed pay master and nobody will like this
behaviour because it has many repercussions like it disturb the symbioses and it creates many
other problems.
So though the direct cost is 9 only sorry the direct cost is still less 9 so just for a mere gain of
9 rupees in this case in this order would you like to default miss this there is a gain if you are
defaulting you should be defaulting it for a very large gain. Then there is a very good thing
but if the gain is also very small and say why you are delaying the payment you are losing a
reputation, you are losing your name also.
So in that case it should be avoided you should not be done, so we have evaluated till now the
options that is the 2 option, when the opportunity cost was 15%, 30%, payment was made on
40th day, payment was made on the 60 th. Now you see there is another option available to us
and that option was what is that option that option is here, it is clearly given to us that what
was that electric circuit good stretch for payment for 10 days.
So the average invoice value is 10000 and 30 days if the average invoice value of the firm is
10000 again, how would opportunity cost rises to 30% per annum. So we have evaluated both
options. Opportunity cost is 15%, opportunity cost is 30%. Now let us go to third option,
third option is advise GE of 2% cash discount if the payment is made within 10 days.
Otherwise normal credit period of 30 days is available that is 2/10 net 30right.
So now let us see value of this option and when you evaluate this option so what will you say
that 2% cash discount cash discount, if you take the 2% cash discount how much works out.
This works out as 10000*2/100, how much it is 200 rupees, it means rather than paying
10000 rupees we are paying how much 9800 rupees, we are paying 9800 rupees. We are
assuming that the normal opportunity cost is 15%.
If the normal opportunity cost is 15% then what is the value of the payment we are making if
it is on the 40th day we are paying 9838 and if it is on the 60th day we are paying 9905. So if
you see that only possibilities of the 15% opportunity cost, 30% opportunity cost cannot be
accepted it is ruled out, then the decision is very clear that we should I avail this discount of
200 rupees.
And if you are making the payment after 10 days availing the discount of 200 rupees you are
paying the minimum when the opportunity cost is 15% and the cash discount is 200. So it
means we are only paying 9800 rupees and if you say for example you are losing this
discount for a minute you see that if you are losing their discount then how much in
percentage you are losing this can be calculated this way that is 365/30 per month.
If you calculate this works out and how much 24.83%, 24.83% so your loss is 24.83%, so it
means the opportunity lost is or the opportunity cost of the losing that discount or not availing
that discount is about 25%, we have lost 25% gain which you could have enjoyed are you
could have responded after 10 days and not waited for 30 days you have responded after 10
days and you have make the payment on the 10th day.
So you have got the discount of 2% it means you are making the payment of 24 about 25%
you are saving and that is 200 rupees your paying only 9800 and you are saving 200 rupees.
So it means there are 3 situations per minute if you forget that 30% opportunity cost is ruled
out then we can say that only 2 things are left with us. First thing is that is the opportunity
cost is 15% and even in that case say you made the payment on 40th days.
So how much actually you are paying, you are paying 10000 rupees but the NPV of that
payment is 9838 and in the second case if you are making the payment on the 60 th day
opportunity cost is 15% how much you pay your pay something like 9905 or 06 you can say.
72 is also there. So it means you are paying in both the cases you are paying in the both the
case you are paying more than the discount amount or means when the payment is being
made after availing the cash discount of the 9800.
So in case cash discount of 200 and the payment made is 9800. So we have to see that these
are the 3 options available to us that either you make the payment on the 40th day you make
the payment on 60th day or you always the cash discount and make the payment on the 10th
day right. So if the opportunity cost is 30% then there is a point to thing that yes we should
not avail the cash discount and we should make the payment after at least 40 days.
If you make the payment after at least 40 days no loss to the firm, firm is not paying any
penalty, firm is not delaying the payment say inappropriately and their NPV is 9681.67 or
9682 right which is much less as compared to 9800, if the opportunity cost is it means is
opportunity cost is 30% no point discussing the discount. There is no point consider in
discount.
But in this case also is opportunity cost 30 you should not go for the option 2 by paying 9672
or 9673 as it is 0.93. So 9672 because just for a mere gain of 8 or 9 rupees you are losing say
bigger amount of reputation, credibility and standing in the market I think which is much
more expensive as compared to the say saving you are making by delaying the payment
which is just 8 or 9 rupees right.
So this is how we evaluate the order and how we look at things that how we can evaluate the
situation and how we can say calculate the direct cost of stretching the payment delaying the
payment. So we have seen that true costs are there direct cost and indirect cost and indirect
cost we have already talked about that what is indirect cost.
And that is the indirect cost talked about that is what is the indirect cost and that is the
indirect cost we have already talked about that is the gradual erosion of the goodwill, poor
credit rating, source relationship with the supplier, loss of suppliers flexibility, delayed
supply of the materials. So these are the some outcomes of the in terms of the indirect cost
had been to talk about the direct cost that is rate of interest.
And that we have discussed how to calculate the direct cost with the help of a small problem
and we have seen that how to factor the opportunity cost, how to factor the penalty, how to
factor the cash discount. So in every case you have to take into account that what is the loss
what is the gain and what is the cost of delaying the payment, that is a direct cost which can
be quantified.
And if you look at the model, when you see the model here, so in that model we have said I
already have discussed with you that in this model what all you have to add something here
for I also that is indirect cost, so to be saw that the direct cost was in terms of increased NPV
when we are paying the penalty plus you have to add in this case I. So I if cannot be
quantified still you can make out that I is there.
Indirect cost is there that is in terms of the loss of reputation and the soaring of the
relationship and delayed supplied by the suppliers to the company. So that is itself but we can
quantify that also if there is a measure of the model can be developed and that indirect cost
can also be quantified. But even without quantification you can make out that a part of the
direct cost, there is also the indirect cost of stretching the payment right.
Now we will move to the some other important concepts with regard to the table management
and these important concepts are like float management we will talk about the float
management. So here we have already talked to you about the float management. So here we
talk about say expanding or see increasing the length of the disbursement float. So
disbursement float means that I have given to you some introduction of some day something I
have discussed with you already.
But let us just quick review of the disbursement float and the disbursement float can be like
that say for example where are the 3 company, Wipro company is one is that this companies
who is the supplier, x is the supplier and y is the buyer and this is the company who has to
supply to x and is the payment firm as a supply to y and so to receive the payment from y.
So the material is going this way and payment is coming this way right. Now for example
when the Y is very strong in the market and x does not want to lose their relationship without
the good relationship with buy. So in that case Y may exploited position in the market or
maybe the big position of X in the market. So what will happen there is a place so we can say
that x is an say Agra.
I talk to you earlier also and y is in Delhi right their plant is in Delhi, material from Agra to
Delhi is coming right and then when the material is coming from Agra to Delhi and for
example the credit period is say 30 days, credit period is 30 days that I will supply Agra
company etc Agra will supply the material to company in Delhi and they will use that
material after 30 days.
They will make the payment to the payment back to the company in Agra right, this is a
arrangement but Delhi company in Delhi they have their head office wear corporate office
everything and delivery plant also near Delhi with the material is going but they put a
condition here that we will be regularly buying from you all over inputs will come from you,
whatever condition is that our payment will be made to you after 30 days from our office
which is in you can call as Kolkata right.
Our office in Kolkata or Guwahati or any far distance place, so it means on the 30 th day when
the payment with this Kolkata office this invoice will be from Delhi office will go to Calcutta
will be communicated online on 30th day Kolkata office will make sure that on the 30th day
payment the cheque of this about see amount to be against the order is of 10000 rupees.
10000 rupees cheque reaches at Agra office of or the companies office in Agra who is the
supplier.
And that is issued by the Kolkata Branch of the company whose office and plant and
everything is also in Delhi. So it means because Agra and Delhi it takes only maybe one day
or 2 days in the transit. So when the cheque will be issued by the Delhi. So on the 30 th day
cheque must be reaching from Delhi to Agra if it is from Delhi, payment is made from Delhi.
Then in this case Agra branch or Agra office of the supplier will be receiving the cheque.
They will put the same date in the cheque in the bank and bank will send the cheque back to
Delhi by post for the confirmation and what is the confirmation is here back to the Agra. So
that will be released. For example this entire process takes how much 4 days is which takes 4
days, but when payment will be made from the Kolkata office of this company in Delhi, then
what will happen though the cheque is reached on 30th days of Kolkata office is free.
They did not delay the payment, they have not default, but no from this Agra this cheque will
go to bank right, the cheque will be deposited in back and the bank will send the cheque back
to the Kolkata office of this company from where the cheque has been issued for verification
for clearing and then it will go back and the payment will be made to this company in Agra.
For example in this case the total time taken is 10 days.
So which means rather than having the disbursement float of 4 days if the payment is made
from Delhi the company is enjoying your float top 10 days by making the payment from
Calcutta there is nothing wrong in this software can uses mighty position in the market and
supplier is also known minding this because they see that we have got a very good customer
who is a regular buyer from us.
So there is a problem of the dispersion float no problem, so at least this payment rather than
coming collecting after 4 days we are collecting it after 10 days but we are otherwise
enjoying because you have not to look for any other by them not to spend on the advertising
we have not respond on the relationship building, we have not to look for the other customers
we have only 100% production is going to the single company.
If it goes to say for 4 companies or 3 companies or 5 companies small buyers, so in that case
the packaging expenses your distribution expenses your supply expenses transportation
insurance is possibly increase. So the supplier is also happy, buyer is also happy and this
situation when we are talking about making the payment not from Delhi to Agra, but from
Kolkata to Agra. This process is called as the disbursement float.
That we issue the cheque and we make sure that the cheque reaches in the Agra office, but
cheque reaches in the Agra office, but ultimately the payment has been debited from this
company's office in Kolkata after 10 says right, which means you can issue this kind of
cheques, you know that it this takes 10 days period of time. So please issue the cheque that
will come back after 10 days, tomorrow you show against another cheque that will also come
back after 10 days.
So with me is the cheque issued today will come on the 10th day, cheque issued tomorrow
will come on the 11th day, cheque issued or day after tomorrow will come out the 12th day,
which means by keeping a small single balance of 10000 rupees if order size is the same what
you are doing is you are doing a business of many 1000 or cores, you are not giving any
balance in the bank.
Because you know at any particular day only 1 cheque will be presented and that much of the
balance we have in the account other than keeping the balance of all the cheques your recent
Delhi you know that our average disbursement float is of 10 days is equal to 10 time more
business, because on the cheque issue today will come after 10 days, cheque issued will come
tomorrow will come after 11 days which means you have a float of 10 days displacement
float of 10 days.
So tables management requires that is possible this was many floors can be used is not an
ethical is not illegal it does not destroy the reputation of the firm it does not create the
situation which is not expected on unwanted in the market it is very useful situation and it is
win-win for both supplier is getting a big buyer and buyer is getting the sufficient
disbursement float credit period also plus disbursement float also.
So there enjoy both are enjoy nobody minds this kind of the process. So disbursement float
can be used and payment can be stretched and without paying any kind of the cost any kind
of the penalty this kind of the relationship, this kind of the situation can be created. But here
we have the point of caution is that we have to see the relationship between the buyer and
supply that should not be at the stake.
We should not exploit the supplier that we are the bigger buyer, we are the simple buyer, so
we can do whatever you want to do that should not be the situation. This should be done with
the due permission of the supplier that we want to make you the payment centres we are the
centralised payment office at Kolkata, all the payments go from Kolkata only. So you also
will get the payment from Kolkata if it is acceptable to you.
You have the supplier relationship with us, otherwise you look for another buyer, so that is a
prime with the importance the think of prime importance that the supplier and buyer
relationship should be with cordial and it should not be disturbed. So we finally what is the
disbursement float payment to a particular supplier is made from the place with the longest
mailing and clearing times.
So it means for this company maybe not from Delhi but the Kolkata may be having the
longest long mailing and the clearing time. So that is why all the payments are being made
from the Kolkata office whosoever is a supply and maximum disbursement float is being
enjoyed by the paying company. So this is the one ethical way different way of say delaying
the payment and enjoying the float in a legal and the important pay.
Now I discuss certain other things with you that then another accruals also and some with the
point of caution in terms of the overtrading, so I think both these things I will discuss with
you but that in the next class, thank you very much.
Lecture-57
Other Accruals and Overtrading
Welcome students, so this is the final lecture about the management of payables and after that
we will move to the other sources of finance short term finance. This is the first source of
spontaneous as a short term finance of the working capital, that was a spontaneous finance we
talked about we learn about, that first of all that finance which comes from the suppliers and
from the expense creditors.
That is the first naturally the first source of finance which is generally free of cost which is
only free of cost. So there is nothing to worry about it, it is free of cost which means we
should resort to this first as much as possible and was just source is fully exhausted that will
look for the look forward for the other sources of finance like the short term sources of the
finance and ones that short term sources of finance is over then we should we go for the long
term sources of the place to meet the short-term requirements.
So this is the last part of discussion on the spontaneous finance or the tables management that
is the management of the current liabilities in the form of the sundry creditors and the
expense creditors. So we discussed at length that how we can manage the sundry creditors all
the accounts payables, apart from the creditors and accounts payable they are the other
sources of the spontaneous finance.
And these are the other sources of spontaneous finance which we call them as other accruals
are the expense credit. Other accruals are the expense credit for employees salaries and wages
of employees and workers variable and the fixed expenses taxes and dividend like debits. So
we all do that bought in any company so there we work for 1 month 1 month and we get the
salary after 1 month.
So what we are doing there, we are providing the spontaneous finance as an company of that
organization, we are providing them the spontaneous finance we are not asking the salaries in
the beginning of the month, we are expecting the salary at end of the month, we are not
asking the salary of everyday evening, we are asking the salaries after 30 days and what are
the term payment or payment period is and normally the terms of payment or the payment
period is 30 days that is normally 1 month right.
So it is for example any company 1000 employees are working and they are being paid on a
average say 1 lakhs or 5000 rupees per person the average salary was 50000 rupees per
person, so please you can make out that how much rupees of the finance is required if you
have to pay them in the beginning of the month or if you have to make the payment to them
on daily basis that in the every evening you have to make the payment to them.
And tomorrow they will come for the work was there paid for the previous day's work, it
means you can see that is 1000*50000. So that amount will be how much you can find out
that that amount will be some where I can find out that is how much that is 5 crores you have
to arrange. But when they are not asking for the salary it means that salaries and wages which
we are paying at the end of the month that 5 crore rupee we are paying at the end of the
month it means that what is that.
That is spontaneous finance that is nobody is coming to us asking for that money and you are
automatically getting it. Similarly you talk about these input companies you can say the
power companies are you can say that water companies or maybe some other small a
suppliers maybe some lubricants or some other kind of not very significant material, but any
significant material but useful material.
So they are also asking for the payment normally the electricity companies in India the
payment period was 2 months 60 days. Now it has been in the most of the states it has been
brought down to 30 days 1 month, water supplying entities also charged their price, after 30
days of some time it may be 2 months also. So it means you are getting the virtual credit of
the spontaneous finance on account of the salaries and wages that dissolve supplies inputs
without asking for it.
It is a natural agreement is a long term agreement once you get the power connection is
assumed that you will make the payment to the power company when the bill will come and
bill will come after 1 month or maybe in some cases it may be 2 months also right. So this is
in another source of the spontaneous finance or the say you can call it as a self adjusting
source of finance means we know that we have to pay the power bill.
So automatically make the provision of the day of the funds to be paid nobody ask power
company does not enter into an agreement every month that condition is that we will send
you the bill after 30 days and you have to make the payment accordingly. So we know it this
apply the keep on supplying the electricity be keep on paying them and it is a long term say
unwritten agreement or maybe the agreement forms we have applied for the power
connection.
That time I think there must be some terms and conditions we have signed on, so that might
be at that time and that once for all goes on. So these are very very important you can call as
source of the finance. Then variable in the fixed expenses for example your telephone
expenses must be use the postpaid telephone landline and only postpaid connections was used
the telephone their partly the rent is fixed and the call charges are variable.
There also be not make the once we make the payment at the end of the month variable and
fixed expenses they are also to be paid at that some period of time and what they are paid or
we have incurred them we not need to look for these expenses to be incurred again right. So
this is other self adjusting source of finance. Then we talk about taxes, taxes case another
important source of sometime spontaneous finesse.
Normally people say it is not it is not the source of finance that is say how the taxes are there
in India why it is not because when you talk about the taxes in India we have that advance tax
payment system in India the tax payment system is advance tax payment system, we have
advance tax payment system, we pay taxes in advance, normally prepare the quarterly taxes
to the government.
Our company's, our corporate pay the quarterly taxes to the government and that is paid in
advance in the beginning of the quarter on the basis of the estimated sales estimated profit
estimated revenue and estimated profit the firm has to pay the text to the government right.
But sometimes what happen that estimated tax which works out as here is that is 10000
rupees per quarter, so into 10000*4 so that will be how much total tax the company will be
depositing over the ear is that is 40000 rupees.
Advance tax and then the first quarter 10000 in the second quarter 10000 third and 10,000 in
the 4th quarter to total tax will be deposit for 40000 rupees, but this is on the estimation basis,
sometimes what happened your sales go up very high unexpectedly the sales god very high
and actual may be possible the tax word in all the tax component was not 30,000, but it was
40000 sorry it was not 40000.
But it became 80000 but we are you expecting that sales will be as there was a sales in the
previous year have a revenue say profit will be accordingly and will be paying almost this
much amount of the tax to be asking that quarterly in equal four instruments but in the sales
have exponentially gone up which was not expect when it is totally unexpected. So it means
your tax component which was expected to be 40,000 it has become 80000.
So which means how much we paid in advance we have paid in advance is only 40000 and
remaining 40000 will be paid at the end of the year. So that amount you are using for the
period of one full year that is the 12 months period, when it will be possible that the actual
tax this much that is 40000 rupees. We have paid advance tax is 80000 rupees. So the firm
will get back is the balances 40,000.
Firm will get back when the total final adjustment of the tax will be made at the end of the
year when the form with file the return and they will show that this much of the tax was to do
tax was 40, we have deposited 80 and we have deposited 40000 extra so it means the 40 will
get back. So in both the case if the view was more deposited is less than the firm deals and
that difference from uses for meeting is too short term requirements.
If reverse is there then which firm loss that firm has deposited more due was less so firm will
have to get the say refund of that, but that to after the say one year when the adjustment will
be done tax adjustment will be done and the returned by the firm will be filed right. But tax
can be one source of spontaneous finance if the due is more and deposited is less it may be
possible but not always.
Now we talk about the other company other important components dividend, dividend is a
very important source of the spontaneous finance for which firm does not arrange or firm
does not look for any other way or you can call it as source to look for but it provides the
spontaneous automatic source of the finance spontaneous source of the finance and in this
case how to works it works out as dividend.
You see when the dividend is paid what we do if we prepare the profit and loss account. For
example this is a profit and loss account and here we calculate the net profit to net profit after
tax, net profit after tax say net operating profit or sometime we finally when we calculate the
profit we say that it is the net profit after tax and their net profit after tax is here for example
it is say 1 lakh rupees.
We have calculated this is 100000, 100000 rupees this is a net profit after tax this the profit
and loss account right. After this we prepare profit and loss appropriation account. When you
pay the profit and loss appropriation account but you do it by NPAT net profit after tax this
becomes 100000 rupees here and now you have to distribute this profit. For example this
profit is distributed as a to dividend to to the shareholders.
We talk about that 50% will be distributed as dividend. So this will be the dividend 50,000
will be dividend and to retainer means will be the remaining will go to the balance sheet will
be added in the capital and that is 50000 rupees. So your 100000 equal to 100000. This
100000 equal to 100000, 100000 equal to 100000 right. This is the this is how we apportion,
this is called as profit and loss appropriation account.
So we are debating it to dividend this is our 2 dividend 50,000 dividend to the shareholders
500000 retained earnings is 50000 rupees. So with this 50000 rupees of dividend we have
provided we have calculate we shown in the profit and loss appropriation account, but this
dividend the last day of the operating period or that accounting period. For example last day
of the accounting period is we can say that is 31st December of any.
Because accounting period of the firm ends up on is secondary year that is a January to
December should there accounting period ends on 31st December. So it mean 31st December
can we prepare the profit and loss account, they decided that this year the dividend will be
how much that will be given to be paid to the shareholders is rupees 50000 rupees right this is
50000 rupees.
But that 50000 rupees dividend is not immediately transferred to the account of the
shareholders, that is not required to be transferred to the accounts of the shareholders
immediately, fund can transfer this amount or can pass on this amount to the shareholders
within a period of 3 months next 3 months. So this on the 90th day total all the cheque of the
dividend must be sent must be reaching to the shareholders and they cannot to retain it
beyond that.
But they can pay it within a period of 3 months, so they do not in firms normally but they do
they normally delay the payment of the dividend and use this amount of the dividend
declared for their short term purposes, has a spontaneous finish, so how it happens that no
this is a balance sheet. In the balance sheet this is the shown as proposed dividend, this is
shown as a liability.
This is the proposed dividend 50000 rupees, we have taken this amount out of the profit
through profit and loss appropriation account and it is shown in the balance sheet is a liability
and unless it is paid actually to the shareholders it is transferred to the shareholders account.
So this is 50000 rupees remaining in the balance sheet. So this is taken out through profit and
loss account from the profit.
The firm has earned during the year it is the shareholders share it has to go to the
shareholders versus there is a time period allowed under the Indian companies act 3 months.
So within 3 months at the end of the third month is this amount should be reaching. So here
this amount is available for the firm to use for a period of 3 months. Not entire amount this
start sending that cheques maybe in the third month may be in the mid of the third month.
So they have clear we use this 50000 rupees for 2 and half months and even that because of
the disbursement float and all that if you work out this can sometimes can see make this this
funds available for the complete period of 3 months amount. So this amount is available at
this amount can be used at this amount becomes a spontaneous source of finance. So firm is
using after 3 months it has to be transferred to shareholders.
So it cost them is it safe and its money which free of cost available to the firm and every firm
using this money every firm using this funds for the short-term purposes for the working
capital requirements in the firms you look at when which are of very large size this dividend
amount is runs into crores that runs into millions. So when it is into millions you can make
out that how much is that amount and without looking for any external source of short term
finance within firm they have generated sufficient amount.
And this is easily available to the firm, so dividend is also the one source which provides a
spontaneous finance to the firm. So we have seen here that apart from the creditors suppliers
we have the expense creditors and these are salaries and wages than your utility supplying
company that variable and the fixed expenses taxes and dividends. But here in case of the
taxes flexibility is also limited.
In case of the dividend flexibilities limited you cannot use it and ending, in case of the
dividend you can do you can use it maximum for a period of 90 days. So limit is there is the
possibility that but with limited flexibility what the firms who want to make proper use of
these firms, they are free to do that they can do this. But in case of the taxes if you delay the
payment of taxes, want of liquidity then say to you have to pay the penalty.
Similarly in case of the dividend if you delay the payment of the dividend beyond 3 months
you will lose many things may not be directly but indirectly in terms of the credibility, in
terms of the reputation, in terms of the financial you can call it as rating or reputation or
credibility you have to lose. So we can use these sources taxes and dividends especially will
limited extent.
But still these are the important sources of the spontaneous finance right, then before we
close the discussion on this accounts payable and the expense credits we will discuss
something about which is void of caution about overtrading in sometime what happens that
things are available free of cost means no free of cost currently we are not paying anything
and they are available on the current, they are available on credit.
So we think that ok if the material is available on the credit goods and services are available
on the credit we are not to pay today we have to pay after 2 months or maybe sometime 3
months or in certain companies case after 6 months. So keep on purchasing placing the order
is buying it at sometime we buy on credit to that much extent which is much more than
buying capacity of selling capacity of the buying firm selling capacity of the buying firm.
That is really I was a very disastrous thing for the firm who is buying on credit, if example of
the buying on credit but they are not able to convert that material into sales in the market or
for example therefore the sold in the market and to on the credit and their credit got stuck in
the market but you have to make the payment to supplier. So in that case it creates are very
very often called as a picture which is not acceptable to normal trader.
So we should be very very careful, here things are available on credit they are not available
on free, we have to make the payment one or the other day if you do not make the payment
you become a defaulter, for you talk about we talk about electronics industry, electronic
segment, if you talk about the company for manufacturing the world class products like
Samsung, LG, Sony, there might not be any credit period available from them or they are
giving the minimum credit period of 10 days, 15 days not more than that.
So you even very careful, very very obedient, very very disciplined with these companies but
says these companies have the good reputation, good standing in the market. So you are
compensated that you buy the product and immediately their product goes out of your store
and that is sold in the market. But there are the companies like Videocon, Onida whose
products has less acceptability in the market these days less acceptability in the market these
days.
When these companies interact with some of the distributors and dealers they say that ok you
are normally not interested to sell our product and you also feel that there is more easily
available market for our products and our company's product in the market, people are not
intending to buy it, but we will give you some incentives, number 1 keep the product in the
store, provide as the shelf space and in return to that will give you a credit period of 6
months.
You keep the product on the shelf, try to sell it, Samsung is giving you 10% profit I will give
you 30% profit number one, second thing is samsung is giving you 15 days of the credit
period I will give you 6 months of the credit period, you sell the product in the market and
pay me after 6 months. They are giving you 10%, I will give you 30%. So you will be load in
that case, that is very good.
If I am getting extra margin, if I am getting extra credit period then what is the harm in
keeping the product, but sometimes you rather than ordering and keeping a few items of this
kind of the products you say order too much and store too much of the products without
keeping in your mind that this supply is only on credit and the profit will be available to me if
I sell the product in the market.
Therefore that selling of this product in the market how much efforts have to make that you
also must be aware about that, the dealer must be aware of about those effects, customer is
very very smart, he would not be easily convinced that I should buy this company's product
not he will not be he has come up with a mind makeup that I would like to buy a colour TV
Samsung, LG or Sony.
So you if you want to change his mind set on the Samsung to Videocon you have to make
numerous efforts, is it possible to make that much of the efforts and convince the customer
number 1, second thing is this then only 30% will be available to you, second thing is that
you have to keep the product and for example this product is 6 months old there is a risk of
the obsolesce is also, product coming today from the company, product coming 6 months
back from the company, you are keeping in your warehouse in your godown.
That loses the quality, that loses the prices, that loses the say and their source, so it cannot be
possible for us to sell that product ultimately after 6 month Videocon will send you the
reminder, that our payment is due please make a supplement, Onida will send you the
reminder our payment is due please make a payment. If you have sold the product in the mark
the product list is stuck with you, you cannot do anything.
At that time you have 2 options to do, you need to return the product back to the company or
to make the payment to them, returning the pack product back to the company is also not a
good practice and not making the payment is also not a good practice and if you make the
payment from your own account then what you are expecting is a profit of 30% or you are
thinking of selling this product in the market.
I think if 10% of this kind of the product becomes unsalable on the normal market price, I
think entire your profit of 30% will be wiped out, entire profit will be wiped out you had got
say 25 colour TVs, you could sell only 15 and 5 are not sellable, still not sellable, the normal
market price, you have to say those products at 50% price. So how much is your profit 30%
and you are selling it at 50% it means already you are paying 20% from your pocket.
So the profit you are getting for the 15 sets and profit your losing the entire 50% you are
losing of the five sets, if you see the net gain is not 30%, if you lose somewhere 5, 10%. So
be careful that when we are thinking that product is available on the credit number one if
there is unlimited credit and undue credit and unexpected credit then there must be something
fishy about.
The product is not easily saleable in the market as compared to the one where there is even or
credit or the very limited credit of 10, 15 or 12 days. So here the point of caution is to
maintain your credibility to maintain the reputation in the market you have to avoid
something which is called as overtrading, do not buy too much, do not store too much, don’t
be say greedy too much that I will get a profit of 30%.
So buy and number one is not to make the payment now I have to make the payment after 6
months. So we will see after 6 months you ultimately have to make the payment of 6 months
to be careful about that. So here the 3 important points are there, validation to avoid
overtrading, validation when any back load of materials comes to you, you compare with
your orders, whether this order was place by us right.
And this is valid order acceptable order then only accept order otherwise sometime what
happens we have place the order for 20 colour TV which company sends 40 colour tv so
return immediately the additional 20 colour TV that I am not ordered for this 40, I have
ordered for 20 I will return only 20 and 20 should go back. So your only answerable for the
payment of 20 CTVs not 40 CTVs.
So validation of that receipt of the material is very very important if we have ordered receive
it if we have not ordered then you simply return back. It is sometime the tendency of the
companies were not able to sell their product in the market that they normally supply more
than what we have ordered but ultimately we have to make the payment at the end of the
credit period. So validation is the one important point.
Then scheduling of the payment is very important we can use the cash budget approach I told
you many times and if you are very efficient company you use the cash budget for one week
or 15 days or maximum 1 month. So that in that 1 months period you know how much I am
going to receive how much payment I have to make what is the net difference.
If you have scheduled all your payments you want me at any point of time under pressure that
my payment is do I have to make the payment but I do not have the liquid for so how to meet
this commitment. So scheduling is very important that as and when the payment is due you
think of from where the funds will come, I need to have the liquid funds and I will arrange for
that and third is outsourcing.
scheduling sometimes becomes expensive, preparing the budgets and keeping a proper track
of the receipt of the material and then the due date of making the payments and then same
sending the payments all these things in sometime cause a huge cost and large amount of the
profits which we are expecting from the sub standard companies that may be offset by
spending on maintaining the say the payment letters.
So we can use here the concept of outsourcing of our payment ledger, outsourcing of our
payment ledger means there are the different companies different say expert companies who
deal in managing your credit sale bill and one such company or one such say agency is called
as factor that is a very important source of short term finance also and factor is very
important source to manage the credit sale ledger also. What the company can do rather than
maintaining your own credit sales management department.
You have to have the employees, you have to have space, you have to have stationery, you
have to have a computers you have to have so many expenses only maintaining your sales
ledger. So that when material was received when the payment is due to be made, when the
payment is to be received all these things. So you outsource all these things to the company
called as factor.
This agency which is called as factor, the day we receive the material we accept the voice our
copy of invoice, you keep the Xerox, the company should keep the xerox and other copy
should go to the factor, you hire the factor or factor will maintain all your payment record this
company's payment records with them and as and then the payments are due to the different
suppliers maybe after 2 month, 3 month, 6 months.
They will automatically keep on sending the cheques you have the authority to write the
cheques, on at least if they have not authority to write the cheques that they can inform the
company that is this is famous add you in the next one week please prepare the cheques and
maintain the liquidity or in the next 15 days or next 1 month, maintain the liquidity prepare
the cheques and send it to them.
So they keep on maintaining the credit sales ledger and reminding the company and helping
them that to make the payment as and when it is due. So factor is a very important agency it
was not there in India, but now has come after 1991 once we have a liberalise this economy
factoring is very much possible and it has come to India also many companies are there who
are providing the factoring services.
So we can take the help of the factors, this is this is save the cost of maintaining the credit
sales ledger and that will help us to have the efficiency also show that any payment which is
due on any particular date that can be made as and when it becomes due. So as a point of
caution overtrading should be avoided and to avoid trading we should validate the order when
we received anything any order you should check whether we are placed order or not, second
thing is scheduling of the payment is important.
So that we never default in making the payment and to say schedule the payment properly all
the payments properly and regularly and make the payment on the due date without any kind
of default. We can compare whether it is advisable to have in house credit sales department
or this service or this particular activity can be outsourced to agency which is called as factor
right. So this is all about the spontaneous finance or the management of accounts payables.
They will discuss the management of sundry creditors and the expense creditors and
something you learnt about the overtrading because things are available on the credit. So
keep on buying it but mind it is not is only on credit not free. We have to make the payment
will be after any length of the credit period, apart from these 3 important sources of the
spontaneous finance we will discuss some other important sources of the short term finance
and that I will discuss with you in the next class, thank you very much.
Lecture-58
Bank Finance-Introduction
Welcome students, so where the process of learning about say working capital finance and till
now we have discussed that after we access the current asset requirement in terms of
inventory that credit sales that's accounts receivables and cash then we move to the part that
from where these current assets requirements be funded and where the funds will come. So
we saw that first and the foremost are the most important or you can call it as the most
prioritized source of finance should be the spontaneous finance.
We should try to generate maximum funds are we should try to reach maximum working
capital with the help of spontaneous finance where we learn about the management of
accounts payable as well as expense credit after we in the spontaneous finance now we will
be talking about the next part other the next source of finance and that is the short term
finance, next source is the short term finance that was the spontaneous finance is over.
And we fully made use of it and there is no other possibility to expand the source of to make
use of it that we should resort to the source of finance in the order of priority and that second
source of finance is the short term finance. When you talk about the short term finance should
we have 8, 9 sources of the short term finance, but in the Indian scenario in India the most
important source of the short term finance for the manufacturing sector especially is the bank
finance.
Bank finance in India so easily available that other 7, 8 sources or other say remaining
resources they are not that important for the borrowers of the manufacturing sector and they
do not pay and he towards the sources all the sources for if you talk about the 1991 scenario
the liberalized economy scenario at that time only bank finance for the most prevalent.
Because it was only available source of working capital finance.
But after 1991 we have number of other sources is drawn from the others say economies like
developed economies and in the other economies bank finance is the least popular source as
compared to India is unlike India it is least popular source . In other countries or other
important sources are the popular sources of the short term finance of the working capital
finance are your commercial paper factoring, then forfaiting then say investment finance
institutions.
Similarly the derivative finance all these are the different inter corporate deposits then the
public deposits all the sources are important popular in the other countries . For example
when you talk about US bank finance is the least popular source of providing the working
capital finance as most expensive also. Their terms and conditions of the bank to lend the
industry for the short term requirements or in the short term basis of a meeting their current
asset financing requirements or source in it.
That industry do not like to an industry never likes to go to the banks and they resort to the
other sources the used commercial paper the use factoring the use forfaiting the use public
deposits use inter corporate deposits they use now even derivatives, but they means not like
to go to the banks but in India contradiction to the say global scenario in India bank finance is
the most popular sources. Other sources are available.
But if you look at the total quantum and the say the amount of the value of the funds that
have been drawn by the different players in the industry that is not very high, is not very big.
So you can say that other sources in the bank finance are not very very popular. So bank
finance is the most popular source in India, quite is most popular source in India and how
firms are making use of it for meeting the short-term requirements.
I will discuss with you in this class, so as we see that when you talk about the say liquidity to
be maintained right. We should see that because liquidity is very important factor to maintain
the credibility, to repay the short-term finance back to the source and when you talk about the
liquidity part we first of all talk about the cash, how much cash be had then how much back
couple equality means in terms of marketable securities we have how much accounts
receivables we have and how much is inventory.
Ant lending source including the banks when they lend to the manufacturing sector to fulfil
their short term funding requirements they look at the liquidity of the firm and they are more
concerned about whether the firm will be able to repay their funds back on time or not and
that is only possible if the firm is maintaining sufficiently quality correct. So we see here
bank normally see here that when we apply for the working capital finance may be any other
means any way maybe one is one most popular station days the cash credit limit.
Then is the say working capital loan and third is the another popular source is a discounting
of the credit sale bills. So under these 2 sources banks are more concerned about that we are
ready to give some funds to the industry, but since it is being given for the short-term very
short time period of time same time for a few months or maximum for a period of 12 months
1 year.
So the question is that whether the firm will be able to repay to the bank or not for that banks
check the liquidity, at the notion of the liquidator for the banks is in this form first of all the
check the cash marketable securities accounts receivables and then they see the inventory.
Because inventory is the least liquid source social is liquid assets the lead lesson the
inventory where is accounts receivable marketable security and cash they are much light
ways of looking at the liquidity of the firms by the banks and second important thing is that
apart from checking the liquidity banks would like to make sure the security of their funds
right, banks would like to make sure the security of their funds.
And for that purpose I have told you many times in the past also that it is the banks
requirement that the current ratio is required to be 1.33:1 that is the banks requirements for
anybody else requirement. So the current ratio has to be 1.33:1 and why that 1.33:1 because
banks want cushion after this 1991 even after the 1975 banks in India are not supposed to ask
for any kind of security or collateral formed from the industry while providing the short term
finance.
So it means if no collateral is being taken no securities been taken then how to ensure that the
funds given for the short-term requirements will back banks, so for that reason banks want to
see that firms all the borrowing unit must have sufficient current assets that is all these four
current assets this should have sufficient cash, they should have marketable securities, they
should have accounts receivable.
They should have inventory and that level of current assets must be more than the level of
current liabilities must be more than current liabilities. So earlier if you talk about the 1991
scenario current ratio 2:1 right current ratio was 2:1 the requirement of the current ratio was
that is current ratio was 2:1.
So it means that is the requirement of the banks was that the current assets should be 2 times
of current liability, current assets should be 2 times of the current liabilities why because they
see that part of the current assets should be in the form of cash, current assets must be the
form of cash then part of the current assets must be in the form of the that is in the form of
cash.
Then part of the current assets must be in the form of marketable securities and then part of
the current asset will be in the form of the accounts receivables and then part of this will be in
the form of inventories right. So number one is any firm when any loan becomes due to be
paid for would like to make use of the available cash. Once that cash is fully utilised and it is
fully exhausted then the firm would like to go for use of the marketable securities and was the
marketable securities are also over then firm would like to raise funds from the another asset
current asset that is the accounts receivables.
Either they would impress upon the credit buyers or buyers on credit to pay the bills at the
earliest possible or otherwise they can discount this credit sale bills to the banks and at the
fourth level the inventory is there with it was all four sources are exhausted, then the fourth
one inventory is the one which has to be used to pay back the bank's loan. So please in this
case banks wanted that if the current assets are more than the current liabilities.
And in any case if some of the current asset is not convertible into cash as and we wanted
then there should be some other alternative asset available which can be easily converted into
cash. So for that they want a cushion and if for example if a current ratio is just 1:1 right if
you just 1:1 it means your current assets are the equal to the current liabilities and if all the
current liabilities become due to be paid at the same point of time then.
And if current assets some of the current assets for example we have seen the current asset is
inventory and that inventory is not convertible to the cash as and when we wanted. Similarly
that your bills receivables are not convertible into cash as and when we want it. So what to do
in that case, so in this case means if you are keeping the current asset more than the current
liabilities, if one is not convertible into cash other will be converted into cash.
And even 100% of the current liabilities become due to the paid at the same point of time still
the firm has more than the 100% level of the current liabilities means a level of current asset
is more than the 100% level of current liabilities. So it means question of a illiquid does not
arise means all the time firm will have sufficient liquidity and the firm has sufficient liquidity
then the firm will be able to pay off his debts as and when they become due.
So for that purpose this cushion is required and you look at this cushion this is the reason you
look at this region if you talk about this is a region where we can say that your level of the
current asset is this is a current asset is total assets and this is the level of the say that current
liabilities right. This is a level of current assets, we also have the fixed assets and the current
assets this is a level of the current this we can call it as the long term sources of the fund,
short term sources of the funds.
And we are saying that this is the level of the current asset, total this is the level of current
assets I would say that is not at below yellow line this is the current assets and above this is
the fixed assets right. So it means we have seen here that this particular part if you talk about
this is the level of current assets from this line to this line up to yellow line this is the level of
current assets and means up to this we have the total current asset decide if you look at this is
a level of current liabilities it means current liabilities of an part of the current assets and
remaining current assets are being funded from the long term sources where form the long
term sources.
So it means that the current assets are more than the current liabilities and part of the current
assets are only funded from the short term sources from the current liabilities and then
remaining is funded from the long term sources. So it means when you are investing the long
term sources to fund the short-term requirements. So firm liquidity is more because long term
sources will not become due to be paid immediately right by the firm.
They will be sometime will be available to the firm and after that period of time this funds
repaid back for that the sufficient arrangements can be paid, but current liabilities because we
have the level of current assets more than the current liabilities. So it means any time any
asset is becoming not convertible to cash other will be available. So it means this region if
you talk about if you see that how is the current assets adjust equal to the current liabilities.
So what will happen your current ratio is one is 1:1. So it means net working capital how we
calculate net working capital current assets minus current liabilities is the net working capital
right, this is the net working capital and where it is going to happen when the current assets
are 1.33 minus current liabilities are 1. So it means this is 0.33 is the level of the current
assets or percent of times is a level of current assets.
And this is this region that this is region that particularly that this is the excess amount and
this region from this line to this line this is called as the net working capital, this is end we are
seeing net working capital. net working capital is that part of the current assets which is
funded from the long term sources. Because up to this level when you talk about the short
term liabilities it means small spontaneous as well as the short term sources of the funding
fully utilised up to this point.
And we are finding this much level of current assets, from this much level of current asset to
this much level of current assets we are funding from the long term sources. So we are
investing long term funds to fulfil the short-term requirements and in that case all the current
liabilities are secured and they can be paid as and when because current assets are more than
the current liabilities.
So liquidity of the firm is not at all at risk, but problem to the firm is that when they are
investing the long-term funds to meet the short-term requirements in that case what is
happening the cost of long term funds is very high return from the short of the current assets
is very very negligible or sometime nil 0. So in that case say financial pressure on the firm
that they are using the expensive source of funds to meet short term requirement, the current
requirement.
So the cost is very high return is either very negligible or nil, so it means firms profits will be
affected negatively. So we should try to maintain the current ratio, but see we can even run
the show with the negative working capital also with the current liabilities are more than the
current assets but that will not be possible if you want to make use of the bank finance and
90% of the firms in India are using the bank finance to fulfil their working capital
requirement.
So in that case you have to maintain the current ratio that is 1.33:1 otherwise banks not
entertained the request of the firm for providing the working capital finance. In that case the
net working capital has to be certainly 33% of the total current liabilities. So it means that is
why the xx 1.33 when we are talking about, so that is 0.33 is the net working capital and that
part of the current assets is be funded from the long term sources.
So this is a requirement of the banks can otherwise also it is popularly said that current ratio
is invented by the banker's because they want to make sure that their funds are safe and
secured and they have sufficient reason to believe that anytime our funds will become due to
be paid by the firm, firm has a sufficient liquidity because your maintaining the level of
current assets more than the current liabilities.
Earlier this was this ratio was required to 2:1 where the current asset should be 2 times of the
current liabilities, but now this ratio has been brought down 1.33:1 right. Now we talk about
the say some recent development in the say bank finance in India, see when you talk about
the bank finance or financing the working capital requirement by requirements by the banks
in India till mid 70s.
So getting the working capital finance from the banks was very very difficult job in India for
the firms because most of the banks before for 1969, most of the banks for private banks and
they were all the transfer asking collateral or security. If you want to have the short-term
boring you have to give the security or collateral and is the firm doesn't have anything to give
the security of little later then you would not get the working capital finance.
So just not because of that but this was also one important purpose in 1969, 14 big public
private sector banks were nationalized by the government of India, they were brought under
public sector and public sector umbrella and government owned these banks after 1969. So
one reason was nationalising this 14 big banks was to provide easy finance, easy working
capital finance to the industrial to the manufacturing sector.
But that process even continued even after the national of the banks asking for the security
collateral and no funds will be available to the industry, if they do not give any security little
later, so then on the complaint or maybe of the suggestions I would say rather of the
manufacturing sector in India government of India appointed 1 ministry of finance appointed
1 study group under the chairmanship of Mr P.L Tandon in 1974.
And that task of group was to study the present state of working capital finance in India from
the banks what is the current state, what is the current scenario and how it can be improved
right. So this working good for this committee which is popularly known as a Tandon
committee, that was formed in 1974 this committee submitted its report in August 1975 and
that committee is after the recommendations of that committee which was totally accepted by
the government of India.
The bank there was total change in the bank say banking finance or the say bank finance or
providing the bank financial the manufacturing sector. There is a landmark changed it was a
landmark say development or change and you can call it as this Tondon committees, say
setting up and the recommendations are considered as landmark recommendation in the
history of the working capital finance.
And history of working capital finance and after that the banking scenario has totally changed
as far as the working capital finance to the manufacturing sector is concerned right. So let us
discuss now how it has changed then how the Tondon committee has helped the
manufacturing sector to get liberal finance from the banks in India. After studying the say
that then prevailing scenario in the Indian manufacturing sector.
And Indian banking sector Tondon committee started it thoroughly during 1 full year and
they observed four important things the raised four important issues was that replacement of
the networking base catalysed financing by need based financing they relies themselves that
till days working after finishing provided by the banks to the industry on the basis of the
collateral on the basis of security.
And if any industries not able to any firm is not able to give any kind of trader there
networking is not sufficient in that case there are there been denied the liberal working capital
finance right. Second issue there is was best security for the known as a well functioning
organisation, they said that why should be asked for a security in terms of some fixed asset or
maybe some current asset.
When firm is a well functioning organisation and banks are going to lend money only for a
few months are maximum for a period of one year 12 months not more than that. So whether
the form will repay the funds back within that period of time or not is not very difficult to
understand of to know, it can be done so why there is a need for the collateral. So it means
and the best security should be in the committees view that the bank should ensure by
different kind of analysis of parameters or at the firm is well functioning organisation.
And if the firm is existing sustaining in certain they will return back your working capital
finance they will not say no not to pay to their will not be any kind of liquidity problem.
Third issued there is once bank finance only for a part of barrow working capital requirement,
they themselves also agreed. They also agree Tondon committee also agreed that we also not
recommend that 100% of the working capital finance to the manufacturing sector should
come from the banks.
It may be partly coming from the banks and that should not exceed in any case more than
75% of the total working capital requirement of the total say the building up of the current
assets maximum 75% should be funded by the banks. Fourth issues the rate was borrow
should less and less depend on the banks to find their working capital needs means currently
you provide the liberal finance for 75%.
But at the same time borrow should be taught a lesson also that they should depend lesser
lesson the working capital finance from the banks and slowly and steadily this should resort
to the other sources also and other sources are like inter corporate deposits public deposits
funds from the investment finance institution and maybe that time commercial paper was not
allowed in India.
At that time factoring was not allowed in India at that time say forfaiting was not allowed in
India even the derivative finance was also not exist day but there was over the other things
that have the working capital finance not only from the banks may be inter corporate
deposits, maybe public deposit part of the long term funds to be the short-term requirements
that should be done by the industries.
So these were the four important issues raised by the Tondon committee after these 4
important issues and studying the banking sector as well as the visible the manufacturing
sector and their working capital requirement, Tondon committee give the four, seven
important recommendations, first recommendation was assessment of the need based credit
requirements on a rational basis that is on the business plan basis.
That banks should assess the firms requirements based upon their needs or based upon their
actual requirement and they should be asked the borrower the potential border should be
asked to submit a business plan to the bank that how they want to use the funds provided by
the banks in providing by the bank and what is their business plan for the next maybe one
quarter or maybe for next 6 months for next 1 year what they want to do.
How much production they want to have, how much cash they want to keep, how much credit
sales they want to have, how much inventory they want to have, how much marketable
securities they will be having. So it means what is your business plan that should be asked by
the bank from the potential borrower and made the make the analysis of the needs of the
financial needs of the borrower.
Number 2 supplementary to the borrowers resources means it is not that 100% percent of the
funds coming from the bank is not ultimately the banks responsibility, it is a borrower
responsibility and borrowed needs can be to some extent fulfilled by the banks also. So bank
should be providing the supplementary finance not as a complementary finish. First firm has
to raise the funds from the other resources like spontaneous finance like inter corporate
deposits, like public depositors.
And at the same time if there is any then banks also gets supplement that provide some part
of the total requirements they can expect something from the banks also, not to finance 100%
of the borrowers requirement. I already said that one of the important after the four issues
they said that maximum funding from the banks to the manufacturing sector should be up to
the extent of 75% of the borrowers total requirements right. In no case the funding should be
100%.
That should not be that habit develops among us the banks that you are providing the 100%
funding It is not good habit develops from amongst the borrowers that banks are providing
100% working capital finance and borrow has not to look for any other alternate, ensure
proper and use of the creditors, that is another requirement of the banks this should check
from time to time that the funds provided by the banks have been properly utilised by the
borrower.
And there is no access points lying in the account which workout sanction but not utilised at
all. Finance will be provided as per industry wise norms, banks should develop industry wise
norms, Tondon committee also develop their industry some industry wise norms and this
suggested the banks but banks issued themselves also device industry wise norms and this
should decided that how much credit should be given to the industry.
And to one particular industry and how it has to be distributed among us the different
borrows working in one or in the same industry right and next one important recommendation
was carried it may be made available and different components I have told you sometime in
the bag that there can be 3 components of providing the working capital finance by the banks
to the industry to the manufacturing sector.
One is the CC limit cash credit limit, second is by working capital loan and third one is a
discounting of the credit sales bills, just I am recalling it that CC limit means and amount is
sanctioned and an account is opened in the branch of the bank in the name of the borrower
and a certain amount sanctioned and transfer to that account and within that sanction amount
the borrowed is given a permission that as and when they need the funds formation and
payment of any order or any process of material of payment of salary and wages.
That will withdraw funds from this account and whenever they receive the sale of their
finished product or any other source that should be deposited in the account and interest is
charged only for the amount borrowed by the firm and for the period the firm has borrowed
the amount. This is a CC limit account. In the loan part loan is also sanction amount and is
sanctioned for the borrower for meeting the short-term requirements at certain rate of interest.
But in that case the difference is that once the loan is sanctioned whether the loan is utilised
by the borrower or not utilised by the borrower fully or maybe in any proportion he or the
firm has to pay the interest of the entire amount, that will not be like CC limit that you are
going to pay the interest only on the amount which you have utilised and other amount you
are not paying than interest on.
Here in case of the loan can have to pay the interest on the total loan amount which is
sanctioned irrespective of the loan is weather the loan is utilised by the firm not utilised by
the firm once it is sanction the firm has to pay the interest on that and third is a discounting of
the credit sale bills that if you sell on credit you will have invoices credit sales bills and
anytime if you need funds you can discount this bills with the banks.
And raise the finance for the temporary requirements for the short while and as and when you
get the first you can you tell the funds back to the bank and get your invoice back. So that the
means these are the 3 important sources how the bank finance can be provided to fulfil the
working capital requirements of the industry and then the last one is regular information for
the close watch.
Tondon committee also suggested that banks should be keeping a close watch and regular
information should be shot from the industry with regard to that how much funds was
sanction to them in the form of CC limit of the loan as well as say credit sale discounting of
bills especially in case of the CC limit the banks should keep a proper record that how much
funds was sanctioned.
How much for the use, but what part of which part of the CC limit was unutilized by the firm
and if there is no proper reason for not utilising the funds then next time for the next quarter
when you are sanctioning the CC limit then or making the CC limit operative out of the total
limit, then that which part of the fund which remained unutilized in the previous quarter that
should be withdrawn or that should not be allowed to be withdrawn.
Because in that case the firm has got sanctions the funds more than their requirements and
today not utilising it so banks funds going based and bank is not getting any in interest on
those funds. So these are the seven important recommendations and after these
recommendations this committees or this recommendations are considered as a landmark in
the history of bank finance for fulfilling the working capital department of the industry by the
banks.
And after that most of the banks accepted is started say following the recommendations of the
community and after raising the 4 issues and giving second recommendations 7
recommendations, third important thing that in a committee has done is that is that they have
suggested 2 methods of sanctioning working capital finance, providing working capital
finance by the industry, by the banks to the industry.
So they suggested that banks should follow either of the 3 methods while providing the
working capital finance to the industries. So what are these 3 methods and how they can be
utilised by any bank that I will discuss with you in the next class, thank you very much.
Lecture-59
Recommendations of Tondon and Chore Committees
Welcome students, so we are discussing the bank finances one important source of providing
working capital to the manufacturing sector by the banks and in the previous class we discuss
the something that is the basics of the bank finance and Tondon committee's formation as
well as their important issues they have raised and their 7 important recommendations apart
from this as I said in my previous class.
Apart from this 4 issues and the 7 recommendation, Tondon committee that is why it is
known as a landmark in the history of Indian banking, they have suggested 3 important
methods to the banks for working out the working capital finance to be provided by the banks
to the industry right. So let us now have an idea about these 3 different methods that what
was the crux of this committee and their recommendations.
That how the working capital changes will be calculated should be worked out by the banks
to be provided to the industry or to the manufacturing sector. They introduce the 2 important
concepts, one important concept is the concept of term finding out working out the working
capital gap WCG and second thing they point out kind of the concept was MPBF maximum
permissible bank finance.
So they say Tondon committee says the first the bank should work out the WCG the working
capital gap and on the basis of that gap and factoring some important components they should
decide the maximum permissible bank finance to be provided by the banks to the industry or
to the firms belonging to the manufacturing sector. Now how to calculate that or what is the
process of determining the working capital finance by the banks.
So MPBF maximum permissible bank finance should be worked out by the banks on the
basis of the working capital gap. So for calculating the working capital gap this is called as
the WCG working capital gap, how to calculate the working capital gap, first of all the firm
should be asked to present the level of current assets they want to build up that syllable of the
gross current assets without subtracting the current liabilities.
That is called is gross working capital of the gross current assets. So how much cash they
want to keep, how much credit sales they want to have, how much inventory they want to
have, how much marketable securities they want to have, how much prepaid expenses they
want to make. So all these current assets, gross current assets should be asked by the banks
from the firm to be built up.
And on the basis of that the firm should be asked that out of this total requirement of GCA
cross current assets how much funds they can reach from the spontaneous finance that is from
the accounts payable. Because as I told you earlier that first and the foremost requirement is
funds coming from the spontaneous finance that consider as a cheap almost free of cost
source of finance and firms should make maximum use of the accounts payable.
So first of all they should be asked to tell the bank that what is the working capital gap means
what is the level of current assets they want to build and how much funds are coming from
the accounts payable, and in this case for calculating the working capital gap how did have
done is number one gross current assets less current liabilities other than the bank finance,
current liabilities other than the bank finance means in 1975 or 76 or even in the beginning of
80s.
Other than spontaneous finance only one source as the short term finance source available in
India was the bank finance. So if you subtract the current liabilities other than the bank
finance we are subtracting only the accounts payable and expense credit nothing else was
there, no factoring, no forfaiting, no derivative finance was there, so which means current
liabilities other than bank finance have to be subtracted.
So gross current assets-current liabilities other than the bank finance you are left with
something which is called as WCG or the working capital gap, this is the most important
thing they have to work out that working capital gap has to be there for example you can say
that your and total current asset.
You wont to build up is for 100 rupees and thus accounts payable are available as 30 rupees.
So, your working capital gap will be 70 rupees. So, you have to build up this gap you have to
find out that how much gap is there right once that gap is found out.
Then you have to follow either of the 3 methods first method is that is you can call it as that
in this method maximum finance banks will be providing. If any firm is very good firm very
good paymaster, very well disciplined financial, very well disciplined organisation, then they
can be provided funds working capital finance by following the provisions is just under the
method number 1.
And method number1 is what there that how to calculate maximum permissible bank finance
under the method number 1 it is suggested here. Gross current asserts how much gross
current assets you want to have in the next one year or one quarter or 16 months fine tell the
amount less other current liabilities other than the bank finance. You subtract that so
whatever you are left with this that is a working capital gap out of that working capital gap
25% should come from the long term sources.
And remaining amount will come from the working capital finance from the banks this is
called as the MPBF maximum permissible bank finance 25% from the long term sources
must be there. So, it means your requirement is 100 rupees and current liabilities other than
the bank finance are 20 rupees. So, it means you have now the your gap is 80 rupees and out
of that 25% means 20 rupees should come from the long term sources.
And bank can provide 60 rupees so, it means out of this total you can say that 60 rupees is the
bank finance 20 rupees is a spontaneous finance. And 20 rupees is the long term finance that
way the funds have to be provided under the first method suggested by the Tondon
committee for sectioning the working capital finance. But this method is considered as the
most liberal method of calculating the maximum permissible bank finance.
And very few companies or firms are there in the market who are eligible to be considered
under this method right, then the firms were moderately efficient moderately acceptable
means maintaining acceptable level. Then that is the second shot of the firms and the second
method of Tandon committee norms are suggested by the Tandon committee for working out
the working capital finance should be followed.
So, this is under this method what we do is normally GCA gross current assets we create the
gross current assets and 25% of the gross current asset should come from the long term
sources, first means earlier in the first method what was their GCM-current liabilities other
than the bank finance. In this case 25% first have to be subtracted or brought in from the long
term sources and then less current liabilities other than the bank borrowings.
And the balance will be considered as the maximum permissible bank finance. So, it is more
stringent because funds coming from the long term sources will be under this method both as
compared to the funds long term sources under the method number 1. And then we talk about
the third method this method is stringent most and has to be followed by the banks for
sanctioning the working capital finance.
In case of the firms who are not very very financial discipline who are not very good players
in the market and whose liquidity as well as the credibility position is under doubt right. So,
under this method what we have to do is we have to know again take the level of GCA from
the firm. And from that we will have to calculate RCA gross current assets and then minus
real current asset means we have to find out from the gross current assets.
We have to find out the real current assets. So, how to find out the real current assets from the
gross current assets we will have to subtract something which is called as the core current
assets which are considered as the core current assets, core current assets means which are
always maintained by the firm. That much level of inventory always remains that much level
of credit sales always remained that much level of cash always remains.
So, it means if you are maintaining that minimum level of the current assets it means why do
we call them as current assets there almost as good as the fixed assets. So, they are called
CCA core current assets. So for working out the MPBF maximum permissible bank finance
from the gross current assets. You subtract the core current assets and then whatever is left
with the says that is considered as the RCA real current assets which are now eligible for
calculating the MPBF.
Now for this RCA for this level of RCA 25% of RCA should come from the long-term
sources. After that you have to subtract the current liabilities without bank finance which are
means available and after that whatever is left with us is that is MPBF maximum permissible
bank finance right. So, under the first method if you see long term sources will be coming
will be billed should be utilised where if you talk about long term funds should be coming as
25%.
But of what current gross current assets minus funds coming from the current liabilities other
than the bank finance should means that 25% will not be of GCA. But that will be of the
gross current assets-current liabilities, second method if you see 25% coming from the long
term sources should be of GCA so, certainly this 25% will be bigger than the 25% of the
method number 1.
And in this case 25% should be certainly of the RCA that is real current assets. So, it means
you have to means contribute from the long term sources first out of the GCA when you are
talking about CCA, CCA should be funded from the long term sources because it is as good
as a fixed asset not current asset 1 and out of RCA is also 25% should we coming from the
long term sources.
So, it means very small amount is left which can come means after that you have to subtract
the current liabilities not only very small amount is left which will be funded by the banks in
the form of maximum permissible bank finance. So, these are the 3 methods suggesting by
the committee Tondon committee.
And if you look at these three methods anyway you calculate you follow the method number
one, you follow the method number 2, you are you follow the method number 3 maximum
limit of the maximum bank finance to be provided will never exceed the 75% of the GCA
gross current assets. And that was the basic recommendation crux of the recommendations
Tondon committee that bank finance should be supplementing the existing sources that
should not be complementary the existing sources.
And maximum bank finance that can be provided even to the best of the best firms operating
in the market should be only 75% up to 75% not more than 75%. So, under these 3 methods
also anyway you workout you maybe or follow the first method second method or third
method maximum permissible bank finance will work out as only maximum 75% and that is
their major recommendations also right.
So, these are 3 methods, so till now we have learnt about that Tandon committee has given us
certain important things 4 important issues there is 7 recommendations they give and 3
methods of calculating the maximum permissible bank finance. They gave long back in 70s,
now when we talk about when this committee was formed and on the basis of this
recommendations of this committee.
Banks had agreed to lower down the current ratio from 2:1 to the level of 1.33:1. So, it means
on the date of sanctioning the working capital finance maybe CC limit or anything. If the
level of current asset is not 1.33:1 but it is more than that for example it is 1.50:1. So, it
means on the date of sanctioning the working capital finance give the current ratio is 1.50:1
not 1.33:1 so after sanctioning the working capital finance.
This ratio should not be allowed to lower down to the level of 1.33 means that ratio the firm
has to maintain all the times and no slip back of this level of 1.50 should be allowed to be
brought down to 1.33 that is not permissible under any circumstances. So but some special
cases they found out that normally it should not be allowed to be slipped back but if there are
some certain important issues.
Then yes that limit can be brought down from the level of 1.50 to 1.33:1 in what case
expansion and diversification. If the firm wont to expand and diversify their business then yes
that level of current assets from the existing 1.5 it can be brought down to 1.33, second firm
fullest utilisation of the capacity. If there is some capacity and utilised and firm out to make
fullest use of this unutilised capacity even in that case also.
The threshold level can be brought down from the 1.50 to 1.33 of the current assets increase
demand of working capital due to abnormal price rise, sometime when there is it changes in
the prices in the economy and this more demand for the working capital in that case also it is
not desirable to keep the high level of current assets. So, that limit or that ratio can be brought
down from the existing 1.50 to 1.33.
For investment in the allied concerns with the concurrence of the bank if they want to invest
some part of their funds in the sister concerns or in the allied concerns then also the slip back
is allowed. In case the reduction in public deposits is necessitated under statutory
requirements. If the firm has raised some working capital or part of the working capital from
with the help of public deposits.
And if they have to be redeemed if they have to be paid back and firm needs liquidity firm
needs funds. Then in that case also part of the current assets can be brought down and rather
than keeping 1.5 the level can be brought down from 1.5 to 1.33, for repayment of foreign
currency loans or other term loans. In this case also the limit can be brought down for
rehabilitation revival of the weaker units in the groups.
If there is a need to rehabilitate or revive the weaker units in the group even in that case also
the threshold level of the 1.50 can be brought down from 1.50 or the existing level of the
gross current assets which is existing means maintained by the firm that can be brought down
to the level of 1.33:1. But in no case it will be allowed to be brought down from the 1.33 to
any other lower minimum level of the current ratio.
The banks firms have to maintain all the times is that is 1.33:1 after that how to this Tandon
committee second important level depend in the history of bank finance has for the working
capital is concerned was another group which was called as chore group under the
chairmanship of Mr K V Chore another group was just to review the situation created or
maybe the position of the working capital finance by the banks.
On the basis of the tondon committee recommendation which came up in 1975 but
immediately implemented, what has happened after that government established another
study group under the chairmanship of Mr K V Chore which is popularly known as the chore
group of observations Chore group of working capital finance. So, chore group studied that
how the now the banks are providing the working capital finance, how the firms are utilising
it.
And what is the working capital finance from the banks position in India. So, they started the
committee was established in April 1979 and they give the report in August 1979. And their
observations were also as follows number 1 shortcomings of the cash credit limit, cash credit
limit means that was the main observation of the Chore group that whenever the firms are
applying for the cash credit limit to the banks.
They are accessing their requirements actual requirement for example is of 1 million rupees
they are asking for the 150000 or 1.5 million rupees and with the bank is sanctioning 1.5
million rupees. So, it means half of that limit is remaining unused and that amount is lying
waste and that is a pressure on the banks. So, there are some limitations of the CC limit which
need to be reviewed.
And they found this gap also the gap between the sanction amount and the used amount
utilised amount why there is a gap they found some causes of that gap also and the causes of
that gap was peak level borrowing at the different times that when firms present their
requirement or their case to the bank. They portrait the requirement as well as the peak level
requirements but all through the year the level is not at the peak.
And the requirements keep on changing so when we are not at the peak of our production and
selling in the market. Then we need working capital much lower much lesser than the actual
amount. So, it means there requirements are worked out for all through the year at the peak
level where is the peak level is not being maintained or through the year. So, there is a gap
between the sanction and utilised amount inflated requirements by the burrowers.
Borrowers are also asking more actual requirement is less but there inflating the requirements
mind set of the bankers. Because the borrower knows that the banker will apply a cut. So
already means at the time of application you apply for the more funds and even after banker
applies the cut you will get the size of an amount of the funds still to ensure against
unwantable any kind of unforeseen situation in the market to deal with that situation.
We are the firms normally tend to ask for the higher levels of the working capital finance, all
the seats through credit line account, this one important reason. Because when any bank
sanction CC limit cash credit limit to the business, then they put a condition that whenever
you need funds, you can have funds from us but when you have a surplus or your receiving
the funds from your credit sales or any other source.
You have to again deposit in this account. So, some time that account rather than going into
minus or withdrawing or maybe if 10,0000 are sanctioned and for example 500000 are
withdrawn. So, it means the balance in the account should be 500000 but it may be possible
that the balance was 500000 then the firm got collection of 600000 rupees. So, 5 plus 6
became 110000 rupees. So, that amount became surplus rather than going down then to from
the100000 rupees.
And then last one reason was imperfections in the movement of economic variables because
of any economic change, economic variables maybe the demand supply position or sometime
the availability of the raw material, sometime availability of the labour the working capital
requirements and their use might change. Second thing they suggested was that working
capital loan should be popularised.
And it was their recommendation even RBI has also accepted after that it any working capital
loan or any working capital requirement of any manufacturing concern which is of the order
of 10 crores or above. Then 80% should be provided in the form of the working capital loan
and 20% should be provided in the form of cc limit as well as the bill discounting facility.
And third thing is purchase and discounting of the bills they said chore committee said that
yes this should be the very important way and popular way of providing working capital
finance. But due to some reasons this is not getting popularized and people are not borrowing
funds through this route. So, their recommendations what they gave 3 important
recommendations, abandoning the core concept that this core concept which was say
suggested into the method number 3 by the Tondon committee.
They said that nobody has worked out the core level of the current assets, this concept has not
been used. So, this concept should be dropped means there should be nothing like the core
current assets only should be gross current assets and then the funding the gross current assets
partly from the spontaneous finance, partly from the say short term finance including bank
finance and partly from the long term sources.
And third thing is this suggested that banks must say initiate for start the quarterly
information system. So, that banks are aware about what is actually the sanction amount of
the working capital limit to 1 particular firm, how much of that they have used, what is the
gap and how miss that gap has to be taken care of in the next quarter while sanctioning the
limit for the next quarter of for the next 6 months.
So, these are the 3 major recommendations of the chore group. So these are important 2
committees in the working capital finance that first committee is that Tandon committee,
second committee is the chore committee. And these 2 committees have really changed the
banking capital finance in the area in the country and today when we talk about banking
working capital finance.
We cannot even think of not talking about the recommendations of the Tondon committee
and the recommendations of the Chore committee. But there are certain more recent
developments after 1991. After 1991 economic policy are the liberalized economic policy,
now it is no more mandatory for the banks to follow the Tondon committee norms are the
methods of sanctioning the working capital finance.
New methods have been devised, new methods have been followed or found out and these
new methods are also means to some extent are quite acceptable, quite scientific and quiet
help the banks to say find out the working capital, say limits for the different industries units
what you see that those these methods are there in vogue or in practice or in existence. But
even today most of the banks draw many clues while say sanctioning the working capital
finance from the Tondon committee recommendations.
So official it is not required it is not compulsion till 1990 96, 97 sorry monetary policy
Tondon committee was a compulsion. But after 96, 97 October this monetary policy was
announced in October 1996, 97 after that it has been totally withdrawn. And after that this
modern methods are available post liberalization you can say the methods of sanctioning
working capital finance.
But apart from these methods some banks even today are also making use of the Tondon
committee methods and most popular method of the Tondon committee is even today is the
second method of working out and sanctioning the working capital finance. But anyhow let
us have a discussion upon that what are the other methods which are now suggested which
are post liberalisation for sanctioning the working capital finance.
These are the 3 methods first method is projected balance sheet method, every firm should be
asked to prepare a projected balance sheet for the next 1 year right by the banks means every
firm by the banks should be asked to prepare a projected balance sheet for the next 1 year.
And that next 1 year should be divided into different quarters quarter number 1, 2, 3 and 4
and then on the quarterly basis.
The firm should be asked to prepare the quarterly balance sheets and in the quarterly balance
sheet it should be found out how much is there total asset requirement, how much funds are
coming from the spontaneous finance and the other sources of the working capital finance
including long term sources. And what is actually the requirement of the bank finance this is
1 important method.
Second method is a cash budget method, this is the second method of providing working
capital finance cash budget method. The firm should be asked to prepare the cash budget and
in the cash budget it should be clearly known that how much cash is required, how much cash
is available and how much cash is actually expected to come from the banks. And third
method is projected yearly turnover method, for calculating the projected yearly turnover
method total annual gross sales that is cash sales plus credit sales plus excise duty have to be
taken.
So projected yearly turnover means that is the total annual gross sales including cash is credit
sales and excise duty should be taken into account and as a percentage of the projected yearly
turnover the working capital finance should be worked out and should be provided right. So,
this is the methods of say lending by the banks has the working capital finance to the industry
post liberalisation 3 methods are there.
Projected balance sheet method, cash budget method, projected yearly turnover method but
again I would like to reemphasize that though these methods are there and many things have
changed post liberalisation. But Tondon committee methods are even relevant today and
many a times bank take a reference of those methods and most popularly second method is
used by the banks for working out to the working capital finance of the different units.
Then we talk about the policy of the providing working capital finance. So, we divide to learn
about what are the policies of the banks to provide the working capital finance. Normally the
borrowers are divided into 2 broad categories small scale borrows and the non small scale
borrows is large medium and large scale borrowers. In case of the small scale borrowers we
talk about the limits up to 5 crores.
If the limit is up to 5 crores if the working capital requirement is of the 5 crore up to 5 crores
then the simple assessment should be done means the same. When you talk about the total
size of the, it is not the limit for the size of the firm. If the size of the firms asset is up to 5
crores then the simple assessment of the firm should be done if the firm is of the size of the 5
crores.
Then the simple assessment should be done means by simply assessing the total availability
of the assets and liabilities and requirement of the working capital finance can be done. And
the funds can be sanctioned but if the size of the firm is more than 5 crores then projected
balance sheet method should be followed by the banks. Firms should be asked to prepare
projected balance sheet. And then there should be on the basis of the projected balance sheet
the finance should be sanctioned to them.
Now this is amaze I would talk about is that is the major important components of the bank
finance so, we talked about the initial say discussion about the bank finance. And we talked
about the 2 important committees Tondon committee, Chore committee and then the methods
of sanctioning bank finance for fulfilling the working capital requirement which are devised
post liberalisation and apart from these important things.
I will discuss certain 3, 4 important other things also that how and the how and in what way
the bank finance can be provided to the different borrowers and to the different sectors. For
example here is now another thing is that export credit. In case of the units who are working
in the export sector, who are manufacturing the products in India maybe say governments,
handlooms handicrafts anything.
If they are manufacturing in India and their production is being exported large it is being
exported so they are considered as the export houses, they are manufacturing and they are
exporting. So for them the export credit it is a suggestion of the RBI that out of the total
working capital finance available with the banks are been provided by the banks 12% should
be going to the export sector, 12% should be say provided to the firms who are involved into
the export of products from India.
And 12% credits should be added should be given to the export sector units who are involved
in to the exporting of the products loan component. When we talk about the loan component,
as I told you earlier that out in the say total loan, if you talk about if the working capital
requirement of any unit is say 10 crores and above. Then 80% of that 10 crore should be
provided as the working capital loan and only 20% should be provided in the form of the cc
limit right.
So, it means now say focus is that Indian industry on Indian industry units should be
disciplined more they should try to learn how to generate funds for the working capital
requirement from other sources rather than slowly depending upon the bank finance and
within bank finance also through CC limit which is the least expensive source. But it is a very
expensive and say a cause of cause of pressure on the banks also.
So, now RBI want to discipline the borrowers that if you want to have the working capital
finance take more in the firm of the working capital loan rather than the CC limit. Then
consortium indication, consortium means when the working capital requirements of any unit
are very high in that case is not advisable for any single bank to fund their total requirement
rather some more than 1 bank should form a consortium.
And they should fulfil the working capital requirements of that firm or that group right. And
syndication means the difference between the consortium indication is under the consortium
the consortium partners will be decided by the one bank who is approached by the borrower.
And how much what proportion and who other banks will be there the borrower has no say.
But that was not light by the barrower over a period of time and then the system was
converted from the consortium to syndication. And in this case also the borrower will contact
one bank that our requirement is this much and then the bank will consult the other banks
they will form a syndicate. The borrower will be informed that these are the other
participating banks to fulfil your requirements.
And you should have the freedom to look at it whether you are comfortable with these
partners or not comfortable and how will be the total means what will be the terms and
conditions of the total syndication. So, that difference is there that under consortium borrower
has no say informing the consortium. But under syndication the borrower has the say
informing the consortium the syndication and involving.
The Other banks into that syndication and then knowing about the terms and conditions that
syndicate will be imposing upon the banks, exposure limit, now it is a very important
question exposure limit is that out of the total bank funds how much should be provided as a
working capital finance, how much can be provided as the working capital finance by the
banks to the industry.
So, there is means different estimates can be there are practically the situation maybe
different but as per the RBI guidelines that to 1 single 1 single firm, 1 single company not
more than 25% of the bank funds should be provided as a working capital finance to 1 single
company up to 25% of the capital fund of the bank. And what is the capital fund of the bank
that is the equity capital plus retained earnings without taking into account the revaluation
reserve.
So, it means the equity capital plus retained earnings why can call it as equity capital retained
earnings plus free reserves. I would say yeah so, it is equity capital+free reserves is the
capital fund of the bank and 25% of that maximum can be used to provide the working
capital finance to 1 single company. And if it is a group of companies in that case the
maximum limit is 50% of the capital fund of the bank again that is the equity capital plus all
3 reserves.
But normally it has been seen that banks exposure in Indian scenario is not more than 1 or not
more than 10% of their capital fund to one industry. And that is also divided in one industry
to the different number of firms. So, it means banks do not tend to lend 1 single firm or say
few firms or maybe few group of firms rather their approach has been found as that they tend
to cover many players.
And to help many small medium and the large firms as well as the say meeting their working
capital requirements is concerned. And last but not the least is lending to priority sector,
priority sector is a small scale units cottage and tiny units. So, as per the directions of RBI
even the government is the directions are also there that 40% of the total working capital
finance available with the banks should go to the priority sector that to the including
agriculture sector.
Agriculture small and tiny units cottage industries that is a priority sector where which
generate employment with generate more say not very large income. But more employment
and create the units which are self sustaining. So, they are considered as units belong to small
scale sector cottage and tiny sector as well as even the agricultural sector. So, 40% of the
total working capital finance available with the Indian banking sector should go to the
priority Sector though it is being means utilised.
I have told you sometime in the past that this is this finance through the short-term players it
is going to the large scale company's players in the market. But this is still continuing many
committees including very popular famous committee called as Narasimham committee has
also recommended to the government that this limit of 40% should be brought down to 10%.
But nothing has happened and this is a guideline to the banks that out of the total finance
working capital finance available or being provided to the different say manufacturing sector
units in India or companies in India manufacturing sector companies in India 40% should be
going to the priority sector. So, this is the means as per the extent limits are the guidelines for
practically banks are looking at the comparative use of the funds.
And their providing the funds to the different units are looking at the requirements and as per
the availability of the funds with the banks. So, with this I say summarise up on that the bank
finance is the most popular source of providing working capital finance in India though we
have 7 at other sources also. But even today despite the existence of those sources bank
finance is most popular source.
And it provides 80 to 90% finance to fulfil the short term or the working capital requirements
of the industry or the manufacturing sector units. And other sources are there but not utilise to
much larger extent. So, what are the other important sources of providing working capital
finance to the manufacturing sector in India what are the other important sources means in
this countries manufacturing sector that I will discuss with you in the next class, thank you
very much.
Dr. Anil K. Sharma
Lecture - 06
Trade-off between Profitability and Risk - I
Welcome students. So in the last part of discussion we were talking about the effect of change in
the level of current assets. As we have seen that if we increase the level of current assets your
profitability goes down and if you say decrease the level of current assets profitability of the firm
increases. Similarly, there is a change in the net working capital and the risk profile of the firm
but we can see that less current assets are less productive.
So we should try to keep the extent of current assets as low as possible in the firm as compared
to the long term assets or the fixed assets because real profit of the firm comes from the fixed
assets or the long term assets. Similarly, now we talk about the other side of the balance sheet
that is the liability side of the balance sheet. As we have been say discussing and I told you many
times that in India we follow the term structure of interest rates.
So in this situation, the term structure of interest rates, shorter the duration or the short term
sources of the funds which are borrowed for the shorter duration we have to pay the lesser cost or
the lesser rate of interest. If you are borrowing the funds for the long term or for the longer
duration we have to pay the higher rate of interest. So it means if we are using the long term
funds for the short term purposes for funding the current assets our cost of funds is increasing
which is not advisable.
So we should do is as I have told you earlier also that most of the funds to finance the current
asset or to fund the current asset should come from the spontaneous sources and the short term
sources. In the very rarest amongst rare situations we should use the long term sources of the
funds for funding the current assets because if you have the more say the larger magnitude of the
short term funds the funds coming from the current liabilities to fund the current assets your cost
of funds will be under control.
But if you are increasing the extent of the long term funds to fund the current assets then the cost
will go up. Now let us see how it happens. We are going to I am referring you to the same
balance sheet what we discussed in the previous case and case of the to understand the change in
the current assets. Same balance sheet we are talking about and here is the same balance sheet.
Earlier we were focusing upon the asset side of the balance sheet where we had the total asset
that is the fixed assets and the current assets.
Now I will take you to the liability side. Here you look at the total liabilities that is again the
14000. So 6000 million dollars is coming from the share capital. Long term loans are
contributing 4800 million dollars and the remaining that is 3200 million dollars is coming from
the current liabilities right. Now in this situation the extent of current liabilities is 3200. So how
to say understand this situation.
Again you have to say work out a ratio. As we worked out a ratio earlier that ratio was the
current asset to total assets. Now to understand the change in the current liabilities we will have
to start with the ratio.
And that ratio now is the current liabilities, current liabilities divided by the total assets. Not
liabilities total assets. Current liabilities divided by the total assets and then we see that how this
ratio works out. Whatever the ratio is there now for example we have seen that we had the
current liabilities in the original balance sheet is 3200 and total assets are 14000. So we can
calculate the ratio of this. Now in this case means what this ratio is indicating.
This ratio is indicating that if you calculate the ratio here then the ratio will be 32000 divided by
this. So this ratio is 32:140 the total assets that is the current plus the long term asset or the fixed
assets. So we will have to see that the total assets or the 14000, total assets or the 14000 to what
extent they are financed from the current liabilities or from the short term sources of the funds,
short term sources of the funds.
How much what part of the total assets has been financed from the current liabilities. This is we
are going to work out with the help of the ratio and if you calculate the cost of total funds we are
going to use to fund the total assets of the 14000. In this case let us take the assumptions like we
took the assumptions in case of the current assets we will take the assumptions here in case of the
current liabilities also.
And we are saying that since short term funds are for the shorter durations under term structure
of interest rates they are cheaper sources of the funds. So we are assuming that current liabilities
or the short term sources of the funds that is current liabilities are having the cost of 2% that is
the cost of funds is 2% and the average cost of the long term funds, average cost of the long term
funds is 8%. Cost of long term funds or funds from the long term source is 8%.
We are assuming these 2 things. Short term funds are at the rate of 2% available at the rate of
2%. Long term funds are available at the rate of 8% right. Now in this case if we use the more
amount of the short term funds to fund this total say magnitude of 14000 total assets your
financial cost will go down. But the risk will increase because short term sources mature quickly.
You have to repay these funds as early as possible or as quickly as possible so that risk would be
there. But if you see here what will be the financial cost.
We have calculated here if you look at the presentation if you look at the say ppt we have
calculated it there and we have seen that in the original balance sheet the total cost of the funds
is, the total cost of the funds is equal to how much that is 928 million dollars, 928 million dollars
we have calculated and the net working capital we have calculated is NWC we have calculated
here is that is $2200 millions, $2200 millions that is the net working capital.
How we have calculated it is that is the say the balance sheet original balance sheet here we have
seen in the original balance sheet your current liabilities are 3200 and current assets are 5400. So
5400 minus 3200 is the 2200 as the net working capital from the original balance sheet and there
the magnitude of the current liabilities was 3200 and the total assets are 14000 and we have on
the basis of that we have seen the cost of the funds is 928 million dollars and the NWC is 2200
million dollars.
Now we make a change like we change the ratio by adding up more amount that is plus 600
million dollars coming from the short term sources.
So it means now the short term sources will become how much 3800 and total assets are 14000.
What is the new ratio if you calculate the new ratio here that is 27.1%. This is 27.1%. So this is
the new ratio now 27.1%. We have increased the magnitude of the funds coming from the short
term sources or the level of current liabilities which was earlier 3200, now it is 3800. Total assets
remaining the same that is 14000. Again, now if you calculate the total cost.
On the basis of the cost of short term funds 2% and the long term funds 8% your total cost here
is how much in this case that has come out as $892 millions. This is your cost now. Cost has
decreased because you have increased the proportion of the cheaper funds to the to fund the total
assets that is the level of 14000 and if you see the net working capital but the negative effect of
that is net working capital has come down to 1600 million dollars.
So it means your liquidity has been affected. Your liquidity has been affected. That net working
capital is that is 1600 million dollars. It means when the liquidity goes down when the net
working goes down your risk increases. So we are increasing the risk by reducing the cost. And
now take the next case if you change the ratio again you now rather than adding up 600 here you
minus do that is you subtract the - 600 right. That is - 600.
So how much will be left here. That is 2800. You are left with not 3200 but 2800 or 2800 and if
you have brought it down to 2800 so it means now the ratio is 18.6%. The ratio is 18.6%. This is
18.6%. This ratio is 18.6%. Earlier the ratio was original ratio was how much 22.9%. Then when
we increased the contribution from the short term sources the ratio went up to 27.1% and when
we say increase the or sorry decrease the extent of the current assets or the funds coming from
the short term sources then the ratio has come down.
We have decreased here so now that is not 3200, 2800 and the ratio has come down to 18.6%. it
means when the funds from the short term sources are being decreased the funds from the long
term sources are automatically increasing because you have to fund the level of 14000 as the
total assets. So now what will be the impact of it if you are reducing it. Short term sources of the
funds are being reduced so what will happen?
Your net working capital will increase but when the net working capital increases liquidity
increases, risk decreases but at the same time profit also decrease because the cost is going up,
cost is going up. So if you see here now the total cost is here 928, it was earlier total cost and
now this cost is going to be how much, originally it was 928 millions. Then it became 892 and
now it is 964. Now it is becoming $964.
This is the cost 964 and then your net working capital is also increasing. It was 2200, 1600, and
now it is 2800 million dollars. It is 2800 million dollars net working capital has increased. So it
means you can see that the impact of this total cost it is something, gone down. It means profit
will increase. Here the cost has increased as compared to this level. So the profit will decrease.
Net working capital is 2200. It went down.
Then we increased the extent of the short term finances. It further increased when we decrease
the say contribution of the short term sources of the funds to fund the total assets. So it means
there is a reverse relationship. If you increase the level of current assets your profitability will go
down. But if you increase the level of current liabilities then your profitability will go up because
the cost of the funds will go down.
So now we have to take a decision that we should have the optimum level of current assets. We
should have the optimum level of current liabilities. I would not say that you maximize the funds
coming from the short term sources or from the current liabilities because that will make the
organization highly volatile, highly fragile you can say and when the fragility increases so what
will happen?
Ultimately any time the firm may collapse or it may become technically insolvent and firm
maybe unable to pay its obligations on the due date. So ultimately it will be called as a defeat,
debacle and it will be the spoil spoiling the reputation of the firm, spoiling the name of the firm
which should not be done. But we should try to find out that the level of current assets should
also be at the acceptable level.
Liabilities, current liability should also be at the acceptable level. If both are at the optimum level
your working capital is managed efficiently and properly. Now here we see that how the total
impact of the situation is here.
Look at now the situation we have calculate here already if you look at the ppt you will be able
to find out on this presentation on the slide that we have done 2 things. One is that we have
decreased the level of current assets and second thing is we have increased the contribution of
the short term funds or the current liabilities right?
And both the steps taken both the measures taken by the firm or by the finance department of the
firm you see that they have contributed to the increased profitability, decreased net working
capital and ultimately increase in the say risk of the firm and if it is manageable if the firm is
going to take or taking the manageable risk then there is no harm in it.
Now you look at it that for example that when we say decrease the level of current assets or the
ratio of the current asset to total asset was say down and we decreased the level of current assets
by say 600 million dollars. Net working capital changed by the 600 million dollars but the
increase in the profits we could find out is by the 60 million dollars.
And when you increase the level of current liabilities to fund the total assets by 600 million
dollars your net working capital also chased by 600 million dollars and there is a contribution to
the profit by 36 million dollars. So in total the profitability of the firm has increased by 96
million dollars; 60 million dollars because of the decrease in the level of current assets, 36
million dollars because of the increase in the funds coming from the current liabilities. So total
increase is 96 million dollars and in this case if you look at new net working capital is new net
working capital is 1000 million dollars that is the 1000 million dollars and then if you look at the
say initial profit of the company. Initial profit of the company was how much? We had 1140 and
the cost was how much? This was the profit and then the initial profit was, cost of the funds was
$928 so the initial profit of the company was $212 millions, $212 millions.
And when you profit after decrease in the current asset that was that we increased it by say 12
when you decrease the current assets the profit became 1200 and when you increased the current
liabilities the cost after increase in the current liabilities has gone down to 892, 892 million
dollars. So it means there is a total change in the cost by 36 million dollars and finally you can
call it as if you look at the net effect.
If you look at the net effect of this you can say that the net effect is that is 308. Now this is the
net effect that is 308 million dollars and this 308 is why because we had how much? 212 million
dollars already the profit was this much and how much you added into this that is 96 million
dollars and this plus this is equal to this figure. This is $308 million dollars. So it means net
increase in the profit is how much?
Net increase in profit if you see that is $96 millions and thus has been simply done not by doing
anything not by increasing the production or decreasing the production or anything. By simply
changing the composition of current assets and current liabilities we have added up 96 million
dollars more and your profit which was 212 million dollars earlier in the original balance sheet
when we changed the composition of the balance sheet from both the sides we have added up 96
more million dollars and then the profit has gone up from the 212 million dollars to 308 million
dollars.
But you see here is one you can call it as say one limitation of this approach or one serious
limitation I would say of this approach and that limitation is that we are following here the
extreme approach. We have taken the extreme step. We have disturbed the balance sheet from
both the sides. From the asset side we have reduced the level of current assets and in the liability
side we have increased the level of current liabilities and in a way you can call it as this is the
aggressive approach.
This is the extremism or the extreme approach which I think to some extent may not be viable in
the real life situation because either you can decrease the level of current assets keeping the
current liability same. Or you can increase the extent of current liabilities by keeping the level of
current asset same. But if you are changing both the sides it means you are fully say squeezing
the the sources which are increasing the cost.
But if you are managing the cost and you want to maximize the profitability for that there are so
many other things to be taken care of because by doing so the firm’s insolvency can be affected.
So it means I would say it is a extreme situation. So what we can do is rather than going up to the
extreme situation or following the aggressive approach to minimize the cost and maximize the
profits and revenues and profits let us have a trade-off between the two.
Means not to follow the say conservative approach. Not to follow the aggressive approach. We
should have something in between and that two we call it as the trade-off between the say the
two sources or the two approaches that is the conservative as well as the aggressive approach and
once you go for the trade-off what results we can expect that we will be able to balance the
profitability. We will be able to balance the cost.
We will be able to balance the risk because net working capital will be balanced. Now how to do
that? Let us consider another example or the another situation.
We have here in this slide in this presentation we have the case of a company called as
Hypothetical Limited right and we have worked out the total short term funds requirement of this
company and if you see the total short term funds requirements of this company it is given to us
here. Look at the slide and look at the total requirement of the funds. Look at the permanent
requirement of the funds we have given that is the total funds required, permanent requirement of
the funds, and the seasonal requirement of the funds.
So if we have this situation should we follow conservative approach, should we follow

aggressive approach or should we follow the approach in between. On the basis of these 3
approaches which we discussed in the say previous lectures let us apply those approaches here
and try to find out the answer to the question that whether extremism is good, to go for the
conservatism, towards conservatism or towards the aggression or we should have something in
between.
Now look at his company. If you look at this company the total finance requirement of this
company over a period of 12 months is given to us and if you look at this requirement you would
be able to find out that maximum requirement of the company is in the month of October that is
to the extent of 9000 Rs and the minimum requirement of the company is in May that is to the
extent of 6900 Rs right. This is the minimum and maximum requirement.
Out of that we have means when you say the permanent requirement is other way around you
can call it as the minimum requirement. Minimum requirement is in the month of May that is
6900 Rs and we have assumed that, that is the permanent requirement. Short term funds
requirement of this company is not going to decrease at all lesser than or lower than this level of
6900 Rs, dollars or whatever it is you call it as.
Now this is the permanent requirement. So if it is a permanent requirement every month require
6900 Rs as minimum so what is the fluctuating requirement. Fluctuating requirement we have
worked out over the different months. Say for example we have seen that sometime it is 1600 Rs,
sometime it is 1100 Rs, sometime it is 600 Rs, then it is 100 Rs. In the month of May there is a 0
seasonal requirement or fluctuating requirement and in some month in October if you see the
seasonal requirement is 2100 which is maximum right.
Now let us apply 3 approaches to this particular company in this company’s case and try to work
out the cost of the funds under the 3 approaches. If you follow the 3 approaches let us follow first
of all the conservative approach.
Under the conservative approach say we assume that the total requirement of the funds of the
company is, what is the maximum requirement? Conservative requirement means more funds
will come from the long term sources. Maximum funds will come from the long term sources.
Somewhere fraction of the funds will come from the short term sources. We assume that the total
maximum requirement of this company is how much that is 9000 Rs in the month of October.
And this is the maximum and we may take here 2 assumptions. The assumptions are that the cost
of the short term funds is 3%, cost of short term funds is 3% and the cost of long term funds is
8% right. Cost of short term funds is 3%, cost of long term funds is 8%. If this is the situation,
under the conservative approach we assume that total requirement which is a permanent
requirement of the company, means the maximum requirement of the company that is 9000 Rs or
the 9000 dollars that is coming from long term sources.
So how much cost is going to be there, 0.08. If you see that zero point so 9000 is 0.08 that is
rupees how much 720 is the total cost of the funds under the conservative approach. We are
assuming that the all the total funds are coming from the long term sources and nothing is
coming from the short term sources because the approach is conservative. Now we follow the
approach that is the hedging approach.
We go for the hedging approach. We follow a we talk about the hedging approach and if follow
the hedging or matching approach, hedging or matching approach in this approach we assume
that there are 2 sources of the funds. Partly the funds are coming from long term sources. Partly
the funds are coming from the short term sources and in this case how you have to work out is
that you have to see here that what is the long term requirement of the company.
It is clear that is the permanent sources of the funds and that is 6900 multiplied by 0.08. This
much is coming from the long term sources plus you have to calculate here something that is the
this is the cost of the long term funds and if you calculate the cost of long term funds it is how
much that is $500 or Rs 500 we say that Rs 552. This is coming, this is the cost of the long term
funds. Now the cost of the short term funds.
Cost of short term funds is we have to calculate we have to find out now the average short term
requirement and what is the average short term requirement? Total short term requirement is
total short term requirement is 11600 divided by 12. So how much is long term requirement?
This works out as the average requirement here it is 966.67 Rs. This is the short term average
monthly requirement and the short term funds cost is going to be how much?
Short term funds cost is 966.67 multiplied by 0.03. This works out as how much. This is the
dollar or rupees we would say Rs. 29. So the total cost of the funds is going to be how much?
Total cost is under the hedging approach is going to be 29 plus 552. This is going to be how
much? That is Rs. 581. This is our total requirement that is 581 and here we assume that
aggressive approach is not easy to be followed. So we have calculated the 2 cost.
One cost is say here that is 720 under the conservative approach if all the total funds come from
the long term sources and if you are following the matching approach, in the matching approach
say this is this part is coming from the long term sources. This part is coming from the short term
sources. This is the cost of long term fund, this is the cost of the short term funds. So total cost is
the 581 Rs, million rupees or whatever it is. So this is the cost.
So it means when you have increased the that the proportion of from 0 to some percent under the
matching approach under the hedging approach your cost has come down as compared to this
cost. Now we see again we are following here some kind of say you can call it as say extremes.
So can we have a trade-off between the two? Let us have a trade-off between the two and we can
have some plan.
That just to find out that what is the trade-off so that we remain more comfortable and any kind
of the risk if we are going to take that can be avoided. So there is a we are talking about the
trade-off between the say matching as well as the or the hedging as well as the conservative
approach and to calculate the cost under this trade-off let us see here that how to work out this
trade-off.
The trade-off will be worked out as say maximum funds requirement plus minimum funds
requirement divided by 2. So what is the maximum funds requirement here, 9000 plus what is
the minimum funds requirement 6900 and it is divided by 2. So what is now the new
requirement? We have worked out is that is the trade-off, result of trade-off is result of trade-off
of is we have worked out here that is 7950. This is 7950.
So if it is 7950 which is little more than the matching approach, hedging approach and less than
the conservative approach. This is Rs 7950 right? Now we assume that under this approach,
trade-off approach we will say that this much amount will come from long term sources LTS and
the balance from the short term sources. Now let us calculate the total cost. So cost of long term
funds that is 7950 multiplied by 0.081 and then this is the cost of short term funds.
This is how much, the balance? If we have to work out the balance, how to calculate out the
balance? If we calculate the balance here so that balance over a period of time is to be worked
out and we have already worked out the balance over the different months.
And if you look at the balance here the balance is 2700. Earlier the balance the total requirement
was 11600, seasonal requirement. Now the seasonal requirement has come down to 2700 and
2700 if you divide by how much 2700 to be divided by 12 so this works out as how much that is
rupees 225 is the monthly requirement multiplied by 0.03. So this will be one cost, this will be
another cost.
And if you see the cost here this cost works out as Rs. 636 million rupees or maybe rupees itself
and if you look at the second cost this works out as Rs. 6.75. So what is the total cost now? This
is 642 Rs, 642.75. So we have now the 3 costs right. One cost is under the say conservative
approach. This cost was how much, Rs. 720. Am I right, 720 or 720 millions or whatever it is.
Second approach we had and if you talk about the second approach under the second approach
which was the matching approach and under the matching approach the cost had come down to
Rs. 581. The cost has come down to Rs. 581 and if you talk about the third approach so under the
third approach which is the trade-off approach cost is little more that is 642.75 but what is there?
This cost is less than this but this cost is more than this, 581, it is more than 581 right.
But here we have many comforts. This is most comfortable. First approach, conservative
approach is the most comfortable but the discomfort is cost is very high. Though liquidity is also
very high risk is very low but at the same time profits will also be very low. Under this approach,
this is hedging approach. So it means short term sources will short term funds will come from the
short term sources.
Long term funds will come from the long term sources and it means in that case net working
capital level will be how much that is 0 is again a risky situation. Means keeping the net working
capital situation 0 it means any time. If any short term source of fund becomes due to be paid and
any current asset is not convertible into cash firm is bound to default. So we should have some
cushion to have the net working capital. Maybe it is not very large amount.
But current assets should be literally more or something more than the current liabilities. So just
looking at this risk of having the 0 net working capital we thought of moving to the third
approach that is called as trade-off approach so we increase the level of say investment from the
long term sources rather than investing only 6900 Rs we increase the level coming funds coming
from the long term sources from 6900 to 7950 and remaining was coming from the short term
funds.
So when we calculated the cost, cost had gone up more here but your net working capital level
has increased. There is a cushion. The risk has gone down though the cost has little increased but
it is much less as compared to the conservative approach. It is something more as compared to
hedging approach but it is increased cost is giving you the another benefit that risk is under
control.
It is manageable and because risk is controlled manageable because the liquidity of the firm is at
the optimum level or at the acceptable level. So this is how, this is how the level of current assets
and current liabilities impact the overall financial cost of the firm, liquidity of the firm and the
profitability of the firm. And we have 3 approaches that is the conservative approach, aggressive
approach and in between there is a hedging approach.
And finally we can have the trade-off. Out of these 3 approaches so you can call it as trade-off is
the fourth approach. So sometime we say that aggressive approach normally is not possible to be
followed by the majority of the firms so we are left with the 2 approaches, conservative approach
and hedging approach and in between these 2 approaches is the trade-off approach which we
have seen in the case of the this company Hypothetical Limited.
And we have seen how the cost of the funds is changing, risk is also changing, profits are also
changing. So we have to decide from where we want to have the funds, long term sources, short
term sources, how much profitability we want to have, how much liquidity we want to have. So
today I will stop here and the remaining part of discussion we will take up in the next class.
Thank you very much.
Lecture-60
Deciding a Suitable Mix
Welcome students, so we are meeting for the last lecture today and in this lecture, in this class I
will discuss with you the forms of credit and financing of working capital requirements in the
previous classes I have talk to you about the bank finance. So, bank finance is also the one of the
sources of the funding working capital and apart from the bank finance there are so many other
sources also 7, 8 other sources also which I will talk to you not in detail but in brief.
And for the detailed reference you can consult the book that is working capital management by
hrishikesh bhattacharya prentice publication. So, but let us discuss about the other forms of the
credit or the other sources of the working capital finance other than the bank finance right. So, I
will just take you back that I told you many times that normally we have 3 sources of funding
working capital requirements.
That is spontaneous sources, short-term sources and long-term sources. So, emphasis here is that
we should use largely the spontaneous and short-term finance and long-term finance should be
used as minimum as possible. So, if you look at this equation given here that when you talk
about the working capital we talk about initially we talk about the gross working capital.
And the gross working capital is a sum total of the current assets which are on the asset side of
the balance sheet on the lower part of the balance sheet and funding of those assets inventory,
credit sales, cash prepaid expenses then marketable securities. So, we first decide that say to how
to create current assets and what should be magnitude of the current assets in the balance sheet.
And then arises the question of funding these current asset right, so if you look at these equation,
I have again say written it clearly that it is the gross working capital means when you talk about
only assets then it is called as the gross current assets or the gross working capital. And the gross
working capital can be funded from 3 sources, that is your accounts payables we have discussed
and short-term finance which one we have discuss that is bank finance.
And others we are going to discuss in brief and then is a networking capital, networking capital
is that part of the working capital which comes from the long-term sources right. So, if you look
at this first of all what we have do is, we have to create or calculate the working capital gap that
what is the working capital gap. So, first of all to find out this gap we will see that the gross
current assets.
First of all will be funded from the first and the almost free source of finance that is accounts
payable which we call as the spontaneous finance and then after that the remaining working
capital that gap which comes up gross current assets-accounts payable is called as the working
capital gap. And this gap will be say fulfilled from short term plus long term sources. So after
that accounts payable the next priority should be to the short-term sources that is the bank
finance as well as the other sources.
And then whatever is the remaining need after fully exhausting the accounts, payable and the
short-term sources which would resort to the long-terms sources of the funds. So, finally
networking capital is gross current assets minus accounts payable minus short term sources. So,
in net sale you can say that networking capital is basically the funds coming from the long-term
sources right.
Now here I will take up small situation where we will talk about that how we can make use of
the accounts payable or the spontaneous finance and it may be possible that without even using
the short-term sources and the long-term sources only with the help of the spontaneous finance,
if the firm wants and the firm is efficient one then only with the help of the spontaneous finance
they can run the show.
And here we are assuming a situation that for example there is a firm which say buys on credit
worth rupees 1000 per month and on the credit period of 3 months when we buy today some raw
material when we buy today, we buy it at a credit period. So, selling from the supplier gives to
the firm is question credit period for 3 months. So, every month how much we are buying, we
are buying for 1000 each right.
So, we are buying in the first month, we are buying for 1000, second month we are buying for
1000 and third month we are buying for say 1000. So, after 3 months how much balance will be
there total purchases of the firm 3000 rupees. Now the credit period is how much that is 90 days,
so after 90 days how much payment will be due to be made by the firm, this first 1000 rupees
that is in the beginning of the fourth month, it means they bought for 1000 rupees in the first
month, 1000 for the second month, 1000 for the third month.
And the credit period is for 3 months, for the first month of purchase 3 months for the second
month of purchase and 3 months for the third month of the purchase right. So, first month of the
purchase is will become due to be paid to the supplier in the beginning of the fourth month. On
the other side the firm is very efficient and it is a very say you can call it as having a competitive
position in the market or very strengthful position in the market.
So, in this case what we are doing here is they are selling their finish product in the market, 1000
rupees again worth 1000 rupees again but on a credit period of only 1 month not for 3 months.
They are getting the credit for 3 months and they are selling their output in the market on credit
but on a credit period of 1 month. So, it means first months production will be converted into the
finish goods and will go to the market at the credit period of 1 month.
So, it means what will happen after 3 months this balance sheet will emerge like this, you have
total trade credits at the end of the 3 month that is 3000 rupees, total amount will be 3000 rupees
here.
And in this side also we will have the total of the assets that is 3000 rupees. So, it means this is
the liabilities we have created 3000 and total assets are also for 3000 rupees and we are
recovering first month sales at the beginning of the second month. So, in this second month that
is a cash available with us, then the second month sales are there which we are making that will
come in the third month, so we have that accounts receivable.
And then the third months purchases are still with us in the inventory, so we have 3 assets we
have created inventory, accounts receivables and cash. So, it means total of the asset sides is
3000, total of the liability side is 3000, so it means in the beginning of the fourth month how
much is due to be paid by this firm to their suppliers only 1000 rupees and that 1000 rupees cash
we have right after that this accounts receivables will be converted into cash.
So, in the fifth month this accounts receivables will turn in to cash. So, this cash will be available
and in the sixth month then this inventory will be again turning into the accounts receivables and
then in cash. So, this process will continue, so this happens that the firm gets the credit period for
the longer duration and from gives the credit for the shorter duration. Then without even
resorting for any amount from the short-term sources as well as from the long-term sources.
Firm is running the entire show with thus spontaneous finance without investing even a single
penny from either borrowing from the bank or from their other sources. So, this can be done, so
if this is a situation in this case you will have that the networking capital will be 0. Networking
capital means no funds are coming from the long-term sources everything is coming from the
short-term sources your assets are equal to the liabilities.
Here if you look at your current liabilities at the end of the third month is 3000 rupees, your
assets are 3000 rupees. So, current assets are equal to the current liability is or vice versa,
networking capital is 0. So, it means you cannot say that this cannot be possible this is possible it
can be done provided the firm is having very strengthful position, mighty position in the market
and they can have a or they can create a situation where they are buying on a credit period of 3
months and they are selling on a credit period of 1 month.
So, it means without resorting to short-term or the long-term sources only with a spontaneous
finance they are carrying on the entire business.
Then we talk about the other sources is spontaneous finance we have already talked about which
we are talking here as the trade credits. Trade credits means credit coming from the suppliers and
under bills payable or the management of the bills payable, I have already discussed with you at
length that how to manage the trade credits and how we can make maximum use of the trade
credits in the form of the spontaneous finance.
Similarly we talk about the next thing is accruals these are basically the expense credit, expense
credit is we know it that is the salaries, wages, power companies bills, water companies bills and
all that. So, they also give us the credit, so that credit comes for a minimum period of 30 days or
1 month. So, with that also we can run the show, so spontaneous finance or management of
payables, bills payable we have already talked about. So, I will talk here again and now we will
talk about the other sources and these other sources are like the sources of the short-tem finance.
And here are you see that we have almost 9 sources including bank finance, so bank finance I
have talk to you in my previous class at length. So, I will not discuss the bank finance in this
class other then bank finance what are sources of the short-term finance they are available here
and we are going to discuss these sources in a summarised form. So, first thing is that what are
these other sources 8 sources rather than the bank finance, short-term loans from financial
institutions.
Then rights debentures, then factoring, then forfaiting, public deposits, inter-corporate deposits,
commercial paper and financial derivatives, these are 8 more sources we can arrange the short-
term finance from if the firm wants depending upon that if the bank finance is not available or
bank finance is not sufficiently available. Then after say borrowing sufficiently from the bank
other sources can also be used and these sources will help the firm to fund their short-term
requirements or their working capital requirements.
So, let us know about these other sources in a summarised form and try to understand what these
sources are.
First thing is the short-term loans from the financial institutions other than the banks we have
many financial institutions like life insurance companies, general insurance companies, mutual
funds and investment institutions right. So, investment banks also now insurance companies also
and mutual funds are also sometimes giving working capital finance, short-term finance to the
manufacturing sector firms.
Earlier it was not possible before 1991 or especially before the monitory policy of 96, 97 these
institutions per not allow to invest into the short-term requirements of the firms, manufacturing
sector firms. And for that these firms had to look towards only towards the commercial banks but
now there is a totally complete independent and free scenario banks can provide the long-term
finance.
And these institutions which are you can say that to some extend that they are investment finance
institutions which have been providing the long-term finance in the past. Now they can also lend
for the working capital or the short-term requirements of the firms. So, some conditions are there
and in this case we will have to see that if we want to have the working capital finance from
these financial institutions including insurance companies.
Then there are certain conditions put forward by the RBI as well as the other important
departments of government of India. So, what are these conditions, these conditions have to be
fulfilled before borrowing the funds from these financial institutions say first thing is funds from
these institutions are only available to the manufacturing sector firms. And manufacturing sector
firms only require the working capital, unsecured loans on demand promissory note.
These institutions also cannot ask for any kind of the security or any kind of the collateral from
manufacturing sector firms only on a demand promissory note that is on the DP note. These
funds can be provided and to make sure the security of the funds these say lending institutions or
these financial institutions can make the thorough analysis of the firm and they can make sure
that this firm is a well functioning organisation, loan only for 1 year extendable by 2 successive
terms of 1 year each, maximum duration of the loan can be only one year.
And it can be availed by any organisation, any firm maximum for the 3 times. So, they should
keep it reserved that when the funds are not available from the spontaneous sources or from the
banks. Then they can think of make a use of this source and they can say have some financial
help from the financial institutions other than banks. After repayment of a loan a gap of at least 6
months is must, it cannot be possible that you borrow for this year, you return the money.
And then next year again you borrow between the 2 borrowings there should be a gap of 6
months. Interest is charged on stipulated rates with quarterly rest with the quarterly compounding
and some incentives these financial institutions can give to the manufacturing sector firms that is
up to 1% in the interest means if they are charging 12%, they can charge 11% interest if the say
borrowing from is the prompt paymaster.
If they are paying making the payment on the due date or sometime before the due date then
some concessions can be given by these financial institutions to the manufacturing firms for
being financially very discipline, very responsible and making the payment on time or sometimes
before time.
Then we talk about the next source that is the rights debentures to fulfil the short-term
requirements to some limited extend firms, these manufacturing sector firms can issue the right
debentures also, you must be aware about what are the rights debentures. Rights debentures are
basically the bonds which are issued to the adjusting shareholders sometimes when there is the
shortage of the working capital finance or the short-term funds then these companies can resort
to the existing shareholders.
And they can request the existing shareholders that you provide or some additional finance on
the basis of some right debentures we will issue you some debentures, some bonds you give us
the funds that is only for a shorter period of time maximum 1 year after 1 year that debenture
will be or those debentures will be redeemed by the firm and the funds will be return back. So, in
this again some conditions are put here by the RBI.
And in this case what are these conditions that total amount of such issues should not exceed
from what from 20% of the gross current assets plus loans and advances minus long-term funds
currently available for financing the company’s working capital requirement, 20% of the gross
current assets plus loans and advances which they have given to somebody. So, sum total of this
gross current assets plus loans and advances-long-term funds they have currently invested in the
firm to fulfil their short-term requirements, 20% of the total paid up share capital whichever is
lower.
So, out of these 2 whichever is the lower, either 20% of the share capital paid up share capital or
20% of gross current assets plus loans and advances minus long-term funds whichever is the
lower of the 2 can be arranged or can be generated by way of the rights debentures. The debt
equity ratio including the amount of the proposed issue should not exceed 1:1, that is a very
important restriction.
Because normally the manufacturing sector firms can have a debt equity ratio of 2:1 but when
they are using the rights debentures there debt equity ratio will be very very stringent and that
has to be certainly 1:1 including the current issue. Such debentures will have to be issued first to
the Indian residential holders on the PRO-RATA basis, any company can have 2 kind of
shareholders, Indian shareholders and the foreign shareholders.
But if these debentures have to issue then of the PRO-RATA basis on the basis of the number of
shares being held by them, these Indian shareholders can be issued the rights debentures.
Then we move to the next source and this very very important source not much used in India but
it is very much used in the other countries like US, Europe. It is very popular source in the other
countries but because of easy availability of the bank finance in India this particular source is not
used to the desired extent. So, what is a factor, first let us understand what a factor is and kind of
the services the factors render.
And how the manufacturing sector firms can make use of this particular source of the funds, I
have refer to use sometimes back about the factors that factors are the firms who buy the say
credit sale ledger or who handle the credit not buy would who handle the credit sale ledgers of
any manufacturing sector firms. So, when we start selling on the credit rather than maintaining
our own debt collection department we can pass on our debt ledger to the factors.
And factor can manage our ledger they can collect our credit sales, they can do the necessary
correspondence for collecting the credit sales and that way whatever the commission we are
paying to the factor that can be compensated by not having a bills collection department in the
firm itself. So, let us understand what the factoring is or what the factor is, a factor is a financial
institution rendering services pertaining to the management and financing of sundry debtors.
And say such service is known as factoring means who are taking care of your sundry debtors,
who are handling the credit sale ledger, who are taking care of the sundry debtors. And who are
financing the firms requirement while the firm is selling on credit because when the firm is
selling on credit it means we need to have some funds from some source and factors provide the
funds that you sell on credit, we will refinance your requirement.
So, that by the time the buyer pays back to the firm, factor will support the firm and when the
buyer pays back to the firm then the firm will pay back to the factor for which the factor will
charge, commission, factor will charge administrative charges and factor will charge the interest
for the amount lend right.
So, salient features of the factoring are here like, factors accept accepts factor, accepts the sundry
debtors accounts on selective basis and that too within a certain limit stipulated by them for each
account. Normally what happens, that is when we go to the factor and we request the factor to
provide us the funds for meeting our short-term requirements and purchase our credit sale bills.
So, in that case what the factor does, factor divides our credit sales into 3 categories A, B and C.
A category of the factors those credit sales are which are very good accounts, which are highly
credit worthy accounts. There is not even iota of the doubt that on the due date the firm or the
buyer will not make the payment or the firm selling from has to make some efforts that kind of
thing is not there. There these buyers are having a very good credulity they are very strengthful,
they are very powerful buyers.
So, it means this is a A category and C category are the once who are means literally doubtful,
we have sold to them on credit or whether they will pay us on the due date or in any case
whether they will pay us back even after the due date that thing is doubtful. And in between there
is B category of the buyers who are moderately strengthful, trustworthy and having the
credibility right.
So, what happens A category of the bills the selling firm or the manufacturing firm does not want
to discount with the factor because it becomes expensive. C category of the bills factor does not
want to buy, so it means finally it is the B category of the bills which the firms discount from the
factors or with the factors and factors are also happy because here the security of the factors
funds is moderately acceptable right.
So, categorization is A, B and C, so B category is the kind of the bills which are largely saleable
by the firms to the factors or discountable not saleable you would say discountable by the firms
from the factors. Factoring without recourse to drawer or with recourse, factoring without
recourse and with recourse you must be knowing it little factoring without recourse means that
when the credit sale bills are got discounted by the selling firm from the factor.
Then on the due date the buyer has to make the payment to the factor not to the firm because
firm has already got discounted from the factor and now the invoices with the factor and the
selling firm informs the payer that now you have to make the payment to this company who is
offer factor we have already got the bill discounted from the factor. So, finally now you have to
settle the payment with the factor.
In this case for example the buyer defaults, he does not make the payment or he delays the
payment or finally it maybe say found out that he will not make the payment or will not get the
payment and that loan or that credit sales will turn into the bad debts. So, if the factoring is
without recourse then it is a factors loss, factor cannot not return the uncollected bills they cannot
return it back to the selling firm.
But if it is with recourse then on the due date the factor would like to receive the payment from
the buyer who has to make the payment after the end of the credit period. But if the buyer is
delaying the payment or trying to default the payment then factor makes some efforts but if the
factor is not successful in receiving the payment then these invoice they are sent again back to
the selling firm.
And selling firm has to receive from the buyer and anyway they have to settle the selling firm
make the responsibility of the selling firm to settle the factor’s bills. So, in India factoring
without recourse is not allowed only factoring with recourse is allowed. So, that interest of the
factor is also safe and the interest of the selling firm is also safe and the buyer or the buying firm
is also under pressure that if he not pay to the factor then we will have to pay to the selling firm.
Otherwise we will have to spoil the relationship with the selling firm forever, no maintenance of
the bills collection department. Once we are taking this services of the factor selling firm is not
required to maintain the bills collection department because everything is taken care of by the
factor itself they collect the credit sale bills they issue the necessary notices they receive the
payment and finally after deducting their interest or commission if any.
They transfer the funds to the selling firms accounts, interest slightly higher than interest charge
on the credit line by the banks. Factors charge the interest little higher as compare to the bank but
if it is say foldable by the selling firm to borrow money from the factors. Then I think is a very
good source, factoring is not as same as advance against bills when we get the bills discounted
from the banks is not like that.
Because though the factoring is with recourse in India but factor goes beyond the level the banks
cannot go on the due date. Normally it remains the responsibility of the selling firms if they have
got the bills discounted from the banks. Then it is a responsibility of the say selling firm to
collect the funds from the buyers and then to pay back to the banks. But in the factoring case,
factor collects the funds from the buyer and then after deducting their commission and
administrative charges plus interest.
They if any balance is left then they send it back to the seller, commission at the rate of 1 to 2%
of the face value of the bill, factor will charge the commission of the face value of the bill that is
1 to 2%. And it is very useful for the small scale industries especially for those firms who do not
have a say desired credit rating and who are little say you can call it as not having a very good
financial position in the market whom the banks sometime are reluctant to lend the funds.
Apart from the say this discounting or the credit sale bills there are certain other services which
is the factors gave.
So, I have lay down and noted down other things which is the factors do for the firms, for the
manufacturing sector firms which you can go through here they are self explanatory. Other
services they take care of the credit sale ledger apart from discounting of the credit sale bills they
help the firms to have the credit information and other advisory services.
To whom to sell on credit and to whom to not to sell on credit, factors do this kind of service
also. And regarding the cost of factoring as I told you it involves the 3 important components 1 is
the commission the factor charge for giving the services, second the factor administrative
charges and third is the interest which they charge if they lend the funds, discount the credit sale
bills and lend the funds to the selling firms.
Factors in India these are some of the companies and if you see largely these are the factoring
companies largely sponsored by the commercial banks in India. There are some in the private
sector also but in the beginning the lead has been taken by the commercial banks and they have
say establish the factoring services. So, bank finance is easily available in India, so factoring has
not become a very popular source because of the easy availability of the bank finance.
Then we talk about the next source is a forfaiting, forfaiting is as same as factoring but only the
difference is that factoring can be with or without recourse. But forfaiting is always without
recourse and forfeiting will act in case of the import, export process. If any firm in India who is
manufacturing any particular product and their entire production they are exporting outside or
maybe part of the production they are exporting outside.
And when they are exporting on the credit they do not know the financial creditability of the
buyer in the other country. So, in this case to make sure that whatever the sales they are making
on credit their bills will be paid back by the buyer they can take the help of forfaiters, forfaiters
after the sales made by the exporter in India to importer in the other country they will get the
sales bill discounter from the forfaiter.
And it is a forfaiter’s responsibility to collect the bills from the buyer in his own country. So,
forfaiting is almost as same as with the say comparable with the factoring but it is only
applicable in case of the export import process whereas factoring is available for the in-house
trade or in-house vigilance. All these conditions I have put here you can read them and then you
try to understand what the forfaiting is that if you want to know it in detail.
There is a detailed procedure involved I have given that what procedure is involved how we can
take the help of the forfaiters and how exporters can make use of them what kind of the charges
can be paid.
So, the charges to be say charged by the forfaiter from the exporters or in say 3 components, first
component is the financial charge, second component is the commitment charge and third
component is the exim bank fees. So, financial charge ranges between 50 to 400 basis points
above the libor, so it means if the libor is 6% then it maybe 10% the forfaiter charges maybe
6.5% to 10%, commitment charges there for example if any firm exporter has enter into an
agreement with the forfaiter that I will sell to X importer in your country.
And later on I will get the bill discounter from you and because of any reason after the agreement
this transaction does not match your exporter does not export to the importer even then the
exporting firm has to pay the commitment charges to the forfeiter and that charge is ranges
between 13 to 15 basis point and third thing is exim bank is also involved in this process to
safeguard the interest of the exporter.
So, exim bank in India also charges some fees from the selling firm right, then like factors
forfaiters also give the many other services.
And these services are almost the same credit information help to locate the customers advise on
the economic trends, implications of the physical policy on industry, global scenario, work load
analysis, machinery replacement, technology identification and import. So, all these things these
services apart from discounting the credit sale bills forfaiters provide to the exporters. Now we
talk about quickly about the public deposits, public deposits is another importance source which
the firms can say arrange the funds from.
And they can invite the deposits from the general public for a short-period of time maximum for
a period of 1 year and people who are interested investors who are in interested to buy or make
investment into the short-term deposits with the manufacturing sector firms. They can make
deposits, earn interest and after that say 1 year period of time these deposits have to be redeemed
by the borrowing firms back to the depositors.
But here the again the point here is that here also depositor cannot ask any kind of the collateral
any kind of the security from the borrowing company. So, they are unsecured deposits and the
period in India ranges from 6 months that is a minimum to 3 years maximum, after 3 years
maximum it has to be redeemed by the borrowing company back to the depositors and how much
public deposits can be arranged that is maximum equal to the 25% of the share capital plus free
reserves of the borrowing company or the manufacturing company maybe you should for 3
months.
But up to 10% of the share capital plus free reserves, rate of interest as per the prevailing market
rates and arrangement of amount for the annual redemption. So, it means every year some
deposits are becoming due to be redeemed by the borrowing company back to the depositors. So,
they have to make the provisions in their budgetary balance sheet for the next year that they will
make the payment back to the depositors of those deposits which are becoming due to be paid in
the next year.
Then is the true and fair disclosure by the firm, when they are inviting the public deposits from
the general public, then they have to give a detailed picture of the firm and depositors must be
knowing about the firm in detail before depositing here money or their funds with the
manufacturing sector firms.
And then one more sources is inter corporate deposits, sometime what happens manufacturing
sector companies when they have surplus funds with them and they do not require these funds,
they can invest into the other manufacturing sector companies and then the need arises they can
ask these funds back from the other manufacturing sector companies and this is again important
source of working capital finance.
These days in India we have call deposits, so any time we can deposit and give to the other
company and ask it back from them it can be 3 months deposits also, it can be 6 months deposits
also. So, inter corporate deposits are the very important source and sometimes firm is make use
of these funds if they are of the surplus funds, one manufacturing firm lends it to the other. If
there is a shortage of the firm then the same firm may borrow it from the other firms who have
the surplus funds available with them.
So, apart from these sources I have listed here back some sources like say here we have the list in
the beginning we have seen and say inter corporate deposits Apart from that we have a
commercial paper. Commercial paper is another say source which can provide the working
capital finance and the commercial paper is again a 1 instrument which is little different from the
loan or borrowing, commercial paper is sold by the borrowing company the market with the help
of 1 commercial bank.
And that is sold on discount but redeemed at par, so the difference of the selling price and
redeeming price is the return available to the investor. So, detailed procedure is available for that
but this is a 1 important instrument which the firm can make use of for generating the say short-
term finance. And apart from these 7 sources then we have one more that is the financial
derivatives.
Financial derivatives are normally of 2 categories one is the interest rate swap another is the
forward rate agreement. Interest rate swaps is like something that when 2 firms in the 1 country
or maybe 2 firms in the 2 different countries when they come closer and help each other in
reducing the financial cost. If it is within 1 country here might be 2 firms and there we brought
together by bank which is a common bank to both the firms.
For example there is a firm who want to borrow the short-term finance for meeting their working
capital requirements on the fixed rate of interest but to that firm bank wont to give the loan but at
the variable rate of interest. There is another firm who want to borrow the funds at the variable
rate of interest but the bank is ready to give to that from the funds at the fixed rate of interest.
So, it means there is a problem to both the firms, so what will happen bank knows both the firms.
So, bank will bring them closer and bank will advise them that you want to borrow at the fixed
we want to give you at the variable. So, you borrow from I have said the variable rate of interest
and the other one is you want to borrow at the variable we want to give you at the fixed rate of
interest.
If you borrow from us as at the fixed rate of interest and then both of you swap the interest right,
you pay that the interest back to us on our terms and conditions and whatever the interest
differentials are you swap with each other. So, that means the firm who want to borrow the funds
at the variable rate of interest that firm got the funds at the variable rate of interest and the firm
who want to borrow at the fixed rate of interest.
That firm got the funds at the fixed rate of interest, so bank’s need is also fulfilled, borrower’s
need is also fulfilled and funds are also same. So, these are called as the interest rate swaps, then
is the forward rate agreement FRA’s commonly known as FRA’s these are basically OTC
arrangements and OTC means over the commuter. FRA’s are sold by the banks, commercial
banks to the borrowers.
And there basically to protect the interest rates for the borrower also and for the bank also. For
example the market is volatile interest rates are expected to go up, come down. So, in that case in
some cases banks are also in trouble and borrowers are also in trouble. So, what happens that to
safeguard the interest of the bank as well as the borrower bank may offer a forward rate
agreement to the borrower that okay.
We are say lending you the funds but to safeguard the interest variables or maybe the interest
changes. For example because of the interest is variable and over the period of time interest rates
go down and in the borrower has borrowed and the fix rate of interest which is very high. So, it
means what will happen that the borrower has to pay the high rate of interest and reverse may
also happen that interest rates are going up.
And bankers lend the funds to borrower at the low rate of interest. So, bank will earn the low rate
of interest. So, in this case what will happen they will lend the firm the funds today and they will
sell the FRA also and in case of the FRA for which they will charge some amounts, some
nominal amount and FRA normally makes the interest rates fixed. For example if the bank has
given any particular loan at a particular rate of interest and tomorrow for example the interest
rate goes up.
So, what will happen the firm will pay the bank, the increased rate of interest but the bank will
return back the increased part because interest rate is variable it is not fixed. So, if the interest
rate is moving upward. So, what will happen, the firm borrowed are the 8% but today the rate of
interest has become 12%, so bank will charge 12%. So, bank would receive 12% from the firm
but because the firm is purchased FRA, so bank would return 4% back to the firm later on.
But firm has to deposit the total 12%, reverse may happen that the bank has lend at 12% but the
rate of interest is gone down to say 8% now. So, what will happen because variable rate of
interest, so borrower will pay back to the bank 8%. So, there loss to the bank by 4%, so what will
happen that the borrower will pay to the bank only 8% and they will compensate for the loss of
4% to the bank by paying additional amount of the 4%.
So, in a way that interest rates are locked for the borrower also and for the bank also, so this can
be done or can be possible with the help of the forward rate agreements and these forward rate
agreements protect the interest of each other. So, these are some of the sources which are
available other than the bank finance, so in total we have seen there are 9 sources and any of the
9 sources or some of the 9 sources together maybe use by the firm to fund their short-term
requirements, working capital requirements.
And they can run their business smoothly, so for the detailed consultation and if you want to
learn about these sources and some detailed discussion if you want to have, detailed say
explanation of these you want to have again I would request you to refer to the book that is
working capital management by hrishikesh bhattacharya its prentice publication, you read the
book, buy the book read it.
And you will find the explanation, clarification on all these sources including bank finance in
that book. So, with this I close the discussion on this subject and I hope that say after going
through all the 60 lectures you will be means enjoying that what we have learned in the working
capital finance that is really enriching, useful and really valuable for you, I stop here, thank you
very much.
Dr. Anil K. Sharma
Lecture - 07
Trade-off between Profitability and Risk - II
Welcome students. So in the previous class we were talking about the a company Hypothetical
Limited. The company’s financial requirement was given to us and we had to work out that how
they should manage the funds. What are the different sources they should manage the funds from
so that the cost of funds becomes minimum. The total cost of the funds goes down and in that
case we have seen that we have different approaches as we have been talking about.
We have different approaches like say your conservative, aggressive, and the hedging or
matching approach. So we assumed in the previous class that say in the normal circumstance it is
not possible to use the aggressive approach. It is not the ball game of every firm or every
organization. So largely the firms use either the conservative approach or the matching approach
or the hedging approach.
Even using the hedging approach is also requiring a lot of disciple, financial discipline,
punctuality, regularity and they have to be very careful that any payment when becoming due to
be made that should be made on time as I have told you in some say previous classes that
financial discipline as well as the short term funds management is concerned demands that if any
payment is due to be made to any supplier maybe tomorrow say till 10 o’clock or 10 am the
cheque should reach him it is better to send the payment by today evening rather than delaying it
by tomorrow evening.
That is not considered as a good thing because what happens. There is a symbiosis. A kind of a
proper arrangements, maybe our supplier is depending upon us or the supplier of any firm is
depending upon that firm that by tomorrow say today say if it is 6 December and tomorrow 7
December he is expecting a cheque of 3 lakh rupees from the company xyz limited that I have
supplied to them and tomorrow is the due date and they will make me the payment and if the
company delays the payment right.
So he is expecting that the payment will arrive at or the cheque will arrive at 10 am tomorrow
and that same cheque he will deposit in the bank and against that cheque he will write another
cheque to his supplier or to anybody to whom he has to make the payment or he has to make the
payment to his workers or maybe to somebody else and he has made the arrangements like that I
will receive the payment in the one hand and immediately after that I will make the payment to
my supplier or to somebody to whom I have to make the payment.
So if you delay the payment by tomorrow, if the firm xyz limited delays the payment, if they take
it lightly that not tomorrow morning 10 am it may be sent by 5 or 6 pm in the evening or maybe
next day, we can delay it by 1 day. So what is happening? The cost of the say financial
indiscipline of the xyz limited the say total arrangement of the xyz suppliers are disturbed and
like that it is disturbing the total symbiosis.
His supplier’s arrangements will also be disturbed. His employees’ arrangements will also be
disturbed. Everybody will be disturbed. So it is not considered as a good practice. So we have to
be sure that anytime if any payment is due to be made to any of the suppliers or any of the
stakeholders, that should be made, it is better to make the payment before time but never delay
the payment beyond the due date or the due time.
So for that reason we assume that it is not possible to follow the aggressive approach. It is better
to follow the say not conservative I would say because that will increase the financial cost
beyond a level. So if it is possible to follow the hedging approach or matching approach then it is
fine. Otherwise, what we can do is we can have a trade-off. So we saw in the previous class that
how we can work out a trade-off.
We have seen that total requirement of the company, there is a minimum and the maximum
requirement was 6900 was the minimum requirement and say 9000 was the maximum
requirement over the period of 12 months and when we calculated it by following a conservative
approach our cost went up. That was somewhere 720 million rupees or 1000 Rs or whatever it is.
So I think that was too high.
And when we worked it out by using a say your the matching approach or the hedging approach
the cost came down to 581 million rupees. So means here also you can say that we have 2
extremes say. Because under the matching approach you have zero net working capital. There is
no cushion that if any of the current assets are not convertible into cash due to any reason
because how do we move to use the cash in the firm.
First of all we use the cash which is in hand then cash at bank. Then we say sell the marketable
securities which are there with the firm as a very short term investments. We sell the marketable
securities. Once these 2 cash and the marketable securities are fully exhausted then we try to
generate funds from the sundry debtors and sundry debtors because they will not make the
payment to the firm before the due date normally.
So the firm can say offer them discount. They can resort to a strategy that okay a payment from
some supplier is due after 15 days. So if can make the payment tomorrow then I think it will
serve the purpose. So how we can induce him so that he can prepone the payment date by 15
days. So for that he would like to have something that some incentive should be given to him. So
firm can decide that okay let us give him some discount.
Maybe we can give him 1 or 2% discount of the total payment, cash discount especially so that
he can prepone the, he should have the reason to prepone the payment. So if we give him the
discount so we can say okay after giving discount for 2% or by 2% or up to 2% he is going to
make the payment to us. So that can be tried. So that will serve the purpose and if we need more
funds then the other debtors also can be induced by giving the discount.
And if it is not possible then there is a way that we can take the help of the bank. Whatever the
credit sales bills firm has whatever the credit sale bills the firm has normally those debtors are
going to pay on the due date and that if the due date is after say a month or maybe after 2 months
or 45 days I think giving the discount may not be a right proposition because they would expect a
big amount of discount say large amount of discount maybe 2, 3, 4%.
That may not be in the interest of the firm. So what the firm can do? Those credit sale bills can
be got discounted from the banks. Banks easily give the money by keeping those bills as a
security because banks know it that this firm has sold on credit to the different people in the
market and those people bank should be knowing or normally banks know the credit rating of the
buyers.
If the credit rating or the financial reputation of those buyers is good in that case banks normally
do not mind in buying the bills. So banks purchase the credit sale bills and then they release the
funds up to 80% of the credit sale bill and 20% they release it on the settlement of the amount
which is paid by the debtor either to the bank or to the company and finally on the due date or on
the settlement date.
So it means in that way we can generate the funds and if if anything is means not working or
maybe all the avenues have been fully exhausted then you have to go for the selling of inventory
in the market. But that is as you can call it as the least liquid asset. You cannot convert the
inventory into cash as and when you want it because if we want to sell the inventory in the
market even either we have to give the huge discount or we have to sell it on the credit in the
market so that is not going to provide any liquidity to the firm.
So we should be careful that when you are following a matching approach or hedging approach
in that case what is happening you have no cushion means there is a zero amount of the funds
coming from the long term sources. We are or what we had a created a watertight compartment.
The short term, all short term needs or current assets fully will be financed from the short term
sources only. No funding will come from the long term sources only.
So it means on the on the say say pretext of saving the financial cost we are creating the liquidity
problem so we can say that as we saw in the previous class that we have see that yes cost is
coming down to 580 million rupees from 720 million rupees but the risk is also going up. Net
working capital is 0. Liquidity position is quite tight. So we can say that what to talk of
aggressive even to some extent your hedging approach is also one extreme.
So we try to find out our trade-off and then we saw that we can have a trade-off so we changed
the situation that okay what is the maximum requirement that is 9000 and what is the minimum
requirement 6900. So you divide this maximum plus minimum divided by 2 and when we
worked out this requirements we saw that that requirement has changed, went up little up means
average amount when we worked out that amount went up that is from 6900 minimum to the
7950.
So we can say that we have taken the average amount that is 7950 and when we worked out that
average amount of 7950 we saw that this amount, not 6900 but 7950 will come from the long
term sources. And the remaining amount we worked out for every month which was the seasonal
requirement and when we worked out the seasonal requirement so that seasonal requirement we
could find out that the total of the seasonal requirement was that is somewhere 2700 Rs.
Then we worked out the requirement, we could see that 7950 will come from the long term
sources and the remaining will come from the short term sources. So we worked out the seasonal
requirement and when we worked out the seasonal requirement the total was say total as
compared to the say previous case which was 11600 for the whole of the year divided by 12 we
could find out that whole of the year now the requirement is 2700 from the which is the seasonal
fluctuating requirement.
When we divided it by 12 so monthly requirement worked out as 225. Then we calculated the
financial cost by applying the interest rate of 3% on the short term finance and 8% on the long
term finance and then we worked out the cost and the cost came out as that is total cost came
down and that cost worked out was 642.75 or you can say 643 which is quite less from 720 but
little more from 580. It is in between.
So what we have done here is that we have increased the liquidity so by increasing the liquidity
you are reducing the risk and we are increasing the finance cost little bit which will impact the
profitability but profitability is not everything for the firms along with the profitability you have
the reputation of the firm, financial reputation of the firm also and that should also be not at
stake.
So in that case rather than means saving only upon the cost and taking huge risk it is better for
the firms that you increase the financial cost little bit and you minimize the risk to the extent it is
possible by increasing the net working capital and by increasing the liquidity right.
So because it was very totally done in the previous class so I thought of say just having a
discussion on this case that while we followed the trade-off approach which was the in between
approach of conservative as well as the hedging approach and we assumed that in the normal
circumstance following the aggressive approach or the negative working capital may not be
possible for all the firms.
So it is better to go for the trade-off between the hedging and the hedging and the conservative
approach right. So now we will see certain other important aspects with regard to managing the
working capital. We have been talking that the level of current assets should be as low as
possible. We have seen in the say previous discussion also and a case also the balance sheet
when we saw that total assets were 14000 where 6000 or 5400 were from the say current assets
and 8600 are the say your fixed assets or the long term assets.
So then we calculated the cost. Then we calculated the profits.

Then we calculated the liquidity, net working capital when we jacked up the level of current
assets from 5400 to 6000 by 600 Rs or million or whatever it is. You have seen that as the
amount of the current asset increases being current asset being least productive our cost has
increased, profitability has declined though the liquidity has improved. Then we reduced the
level of current assets then we saw that liquidity has gone down.
Risk has increased but the profitability has gone down. So means that the conclusion is that
current assets are least productive assets. We have seen in the beginning classes also that neither
inventory has any return nor credit sales has any return nor cash has any return. Only marketable
securities are giving us some return. So in that case ultimately means we are bound to keep the
current assets in the balance sheet of the firm but that should be as low as possible.
So we have seen we have made a small analysis for your say help that you feel convinced that
yes level of current asset is impacting the profitability. So if you see the this these 3 situations we
have created. You can say that these are the say 3 different approaches right. One approach is
like you can say the first approach is the conservative approach which we are saying in the
column A. Column B is the hedging approach or matching approach.
And column C is the here we are following the aggressive approach right. So if you see these so
look at the last column. That column is that is the ratio of current asset to fixed asset and the ratio
of the current asset to fixed asset here is say you can say that is 1:1 that out of the total assets or
the 1 million rupees that is 10 lakh rupees half of the assets are fixed asset and half of the assets
are the current assets.
So if you do like this look at the ROI. ROI is just 15%. Return on investment is just 15%. Then
you move to the next level. We increase the we reduce the level of current assets somewhat not
much but we reduce the level of current assets. We reduce the level of total assets also and we
reduce the level of say current assets.
So it means we are now doing the business not by having total assets of the 1 million or 10 lakh
rupees but by having only the say total assets of 9 lakh rupees out of which fixed asset level is
same that is 5 lakh rupees but we have been able to reduce the current assets. As I told that the
current assets level should be as low as possible. So we reduced the level of current assets. So
you see that the ratio has also changed.
The ratio now is that is the 0.8:1 and if you see the column B the last column in the column B the
last row that the ratio has now changed come down from the 1:1 to 0.8:1 and when you have
reduced the level of current assets your ROI has say gone up that is from 15% to 16.67% and
then you see we are moving to the next level by keeping the lowest level of current assets. Now
we have reduced the level of current assets not 5 lakhs not 4 lakhs but we have come down to 3
lakhs.
And now we are running the show with the total amount of the assets that is of 8 lakhs; 5 lakhs
are the fixed assets and 3 lakhs are the current assets. So we are not disturbing the fixed assets by
keeping the same amount of fixed assets. If you are reducing the level of current assets ratio has
also changed. Ratio is now 0.6:1. So it means as against 100% of the current assets in the first
policy or in the first column you have reduced it to 60% as compared to the fixed assets.
And you can see the impact of this that your ROI has seriously gone up that is almost by say 3%
that is 2.75% it has gone up it has increased which was 15% in the say when the policy A was
being followed and the level of current asset was equal to the level of fixed asset. So it came
down in the column B and when you changed the policy it became aggressive.
Means you can say this is the kind of a situation of the negative working capital that we have
60% of current assets against the 100% of the current liabilities. So it means we have the
negative working capital and we are more aggressive in this case. Ratio has also come down and
the impact of that is the on the ROI so it means we can prove it we are convinced now that the
level of current assets in any firm should be as low as possible because they are the least
productive assets.
Only we should try to maximize the fixed assets and minimize the current assets right. Now we
move to the next level and we look it from the other perspective, sources of financing. Sources of
financing the assets of the firm, total assets of the firm if you look at.
And here also I tell you that say your short term finance is cheaper as compared to the long term
finance because of the term structure of interest rates. So we should try to have larger amount of
the funds. I would not say the maximum funds from the short term sources but the larger
component or amount of the funds coming from the short term sources rather than from the long
term sources.
Now we will move to the next part that is say next thing that is the means it is one more
important concept that till now we have seen that say how the current asset impact the
profitability or level of the current assets impact the profitability. Now let us see from the other
perspective that is from the financing. So I have been talking to you that short term sources of
the funds are lesser expensive as compared to the long term sources of the funds.
And in this case we have to see we have to verify that whether it happens or not. Now for
example you see that we have again the situation like the total fixed assets are for 3 lakh rupees
and the current assets are for 2 lakh rupees so total assets are 5 lakh rupees right. Now total
assets of the 5 lakh rupees how they will be funded. They will be funded we have seen in the first
case that is the first approach, conservative approach.
Under the conservative approach we are say providing say out of say 3 lakh rupees which is
coming from the debt that is the borrowed capital total is of the 5 lakhs. So 3 lakhs we are
showing here that 3 lakh is coming from the borrowed sources as a debt or as a long term loan or
as debentures or anything and remaining is coming from the share capital. So that 3 lakh rupees
which is a borrowed capital that is coming in the form of short term debt as well as the long term
debt.
And we have assumed here that the cost of the short term debt is 12% and the cost of the long
term debt is 14%. So look at the conservative policy the column one, first column or the second
column in this case under the financing plans. First is the conservative policy. Under the
conservative policy how we are financing the total asset requirement that is from the borrowed
sources 240000 Rs are coming from the long term sources.
And only 16000 is coming from the say short term sources which is just 12% which is just 12%
and it is coming from the short term sources as you call it as the ratio of the total finance I am
talking about. It is not the ratio of the say long term to short term debt. Total finance that is the 5
lakhs, out of that 5 lakh rupees 16000 that is just 12% is coming from the short term sources and
remaining amount is coming from the long term sources including share capital.
So look at the total cost. Profit before interest and taxes 90000 Rs, Interest component is 40800
Rs. Earning before taxes 49200. Tax at the rate of 35% it is 17220 and if you calculate the ROE
that is return on equity so it is 16%, it is just 16% because we are only arranging 12% of the total
requirement of 5 lakhs from short term sources. Now you move to the moderate plan or the say
you can call it as hedging plan.
We have increased the component proportion of the short term finance as against the total
requirement and now it is not 60000 it is 150000 Rs. So from the borrowed capital which is a
debt component half is coming 50% is coming from the short term sources and 50% is coming
from the long term sources.
And if you have seen this change then the impact of this change we have we can easily find out
is number one is the ratio of the short term funds to the total funds has gone up by say a
sufficient amount that is 18% from 12% to 30% and as a result of that we can see here that your
profit before interest and taxes say 19000. Interest component has gone down seriously that is
39000 and then earning before tax is that is 51000.
Tax is the same amount we are taking tax as 17850 and your return on equity has improved from
16% to 16.58% and in the third approach which is aggressive approach more amount of the
funds is coming from the short term sources as against the long term sources and we are so
aggressive that you see that the ratio is that that the proportion of short term funds as compared
to the total funds, 60% of the funds are coming from the short term sources.
And if you talk about the borrowed capital, borrowed capital in the borrowed capital nothing is
coming from the long term sources. Entire amount is coming from the short term sources that is
3 lakh rupees from the short term borrowings and remaining 2 lakhs is coming as a share capital
as it was coming under the previous 2 approaches. So borrowed capital is 100% from the short
term sources. It being a cheaper source look at your PBTs again.
Profit before interest and tax is again 90000 but look at the interest component which has come
down from the 40800 under the first approach which came down to 39000 under the second and
it has come down to 36000 under the third approach and as a result of that your net income has
improved and net income which was say you can say 31000 around it has it became 33000 and
now it has become 35100.
And ROE if you calculate which has gone up by almost 1.55% or no ya 1.55% which was 16%
in the first approach rose up to 16.58% and now it is 17.55%. So it means you can easily find
out, you can easily verify the impact of the say composition of the funds. If the more funds are
coming from the short term sources as compared to the long term sources as far as the borrowed
capital is concerned in that case your cost of funds total financial cost is going to seriously go
down.
And impact of that is the increased profitability, increased income, and the increased return on
the equity because ultimately it is the benefit of the equity share holders for the firm that after
servicing the borrowed capital or after providing the debt or paying the interest on the debt on
the borrowed capital remaining amount of the profit or income goes to the equity share holders.
So equity share holders are at the benefit.
So they should try to generate maximum funds from short term sources. I would not say
maximum but yes as much as possible funds from the short term sources so that the financial
cost can be managed but you see the problem of the short term funds is that when you are
arranging the funds from the short term sources your financial cost is going to go down but your
risk is also increasing.
Because making the payment to the short term sources becomes quickly due so we have to have
the sufficient liquidity in the firm so that we can service the short term debt as and when it
becomes due to be paid and the interest to be paid on that and finally we can maximize the
profitability. That much caution we have to keep. If we are able to keep the caution and to
maintain the liquidity in the firm it is always better to have the funds from the short term sources,
more funds from the short term sources as compared to the long term sources right.
Now we talk about the certain say cases of certain companies that how they have been managing
their working capital. We have the situation of the 3 companies here and these 3 companies
belong to the same sector that is the steel sector. In the steel sector you see I told you in the
previous classes also sometimes little bit not more that in the steel sector we have number of
companies working now in India after 1991.
The steel sector is opened up for the say private participation and many companies have entered
in this sector. So if you talk about the companies now means if you compare the say steel sector
or the position of the players business players in the steel sector before 1991 SAIL was having
the largest market share some part was with the TISCO but SAIL was the steel maker to the
nation right.
But after that we have seen that some companies have come in the western part of the country
like ESSAR, Lloyd Steels. They have come in the western part. They are serving the western
market. In the southern part of the country Jindal’s created a very high tech Asia’s first high tech
plant that is JVSL that is Jindal Vijayanagar Steel Plant which is now called as is now it has
become the part of the Jindal Steel Works JSW.
So it means now the SAIL has to say lose market. SAILs overall financial performance has been
affected.
And if you see the liquidity how they are managing the liquidity of the firm or how they are
managing the working capital here you can see that the current ratio of the SAIL from the, ratios
are somewhere from 2001 to 2012 for the past 10 years you can say. So the ratio is very high.
Standard norm of the current ratio which was earlier I would say that the norms of the say
current ratios have changed.
If you talk about the norms of current ratio earlier before 1991 the norms of current ratio was
current ratio is that is the norm was 2:1. Then we have the quick ratio or you call it this ratio is
the asset ratio also this was 1.5. You can say it was 1.5:1. This now was 1.5:1 and for the cash or
the super quick ratio this is the super quick ratio, this is the old norm which was 1:1. This was
the these are the old norms.
But now the new norms are like that if you see the norms currently prevailing in the market the
proper say you can call it acceptable level of current ratio is 1.33:1. This ratio you consider good
is 1:1 and this ratio is considered good as 0.5:1. So these are the new norms of the current ratios.
We have reduced the level of say current assets. Now for example when it was 2:1 so what was
the situation that we had to keep current assets 100% more than the current liabilities.
Means if you have say current assets if your current liabilities are of the 5000 Rs then you have
to have the current assets of the 10000 Rs. So means 100% more than the current liabilities you
have to keep the current assets. And I told you that after the term structure of interest rates when
you see that this is the current ratio. So current ratio is here. When we are having a current ratio
of 2:1 it means net working capital is how much that is 1.
So it means and this net working capital will come from where from the long term sources LTS
and long term sources are highly expensive. So if you are increasing the proportion of the long
term sources to finance your short term requirements and that proportion is 100% of your current
liabilities then how much funds are coming from the short term spontaneous and short term
sources same amount of the funds is coming from the long term sources.
So in that case you can understand how much is going to be the financial cost of the firm. How
much expenses are going to increase and how much the financial cost is going to increase. So in
that case it was very very difficult for the firms to survive in a changed economic scenario where
they have to face the competition from the best players in the market.
And their financial cost is so high because now if you are calculating the total cost of the product
if you are calculating the total cost of the product, we have the raw material cost. We have the
other say overheads cost. We have labour cost. We have some indirect expenses like office
expenses, electricity, power, water. All these costs are there. We calculate and add it up and then
we have the financial cost.
Till 1991 in India the scenario was that financial cost was not considered as a very important
cost. It was not for 1 company, all the companies were following the same norm. Largely, most
of the companies were or most of the business sectors in India were controlled by the public
sector companies and in the public sector companies something means on the name of financial
discipline almost there was nothing.
Easy capital was available from the government. Government was providing the easy capital.
Huge country was the market available to them. So whatever is going to be the cost of the
production if there is only single player in the market manufacturing the product in the market
you have no option to buy the product from any source. In that case whatever the price they want
to charge, whatever the cost is there and whatever the price they want to charge you have to pay
the price.
No option because the basis of deciding the price is the cost. So if the cost is high so it means the
price will also be high keeping their margin intact. So it means everybody was paying the same
price. So that was the case with the SAIL also. SAIL you see the entire steel sector of this
country, we were almost 100 crore people 1 billion people at that time or maybe more than that.
And this market of the 1 billion people was being served, steel market for the 1 billion people
was being served by only one single company largely. TISCO was also there but large market
share was with the SAIL and if you have only 1 company you have no other option. Whatever
the garbage they are manufacturing and selling to us and the cost rather the price they are selling
it to us we are bound to have it. There is no comparison.
Same was the case with other sectors also. If you talk about the other sectors that was the same
case. Say even petroleum sector is even today marketing of the petroleum product is even today
dominated by the public sector companies. Now some private sector companies have started
coming in the market like ESSAR, Reliance. But it will take time. So thus we are buying the
petroleum products at a very high price in the Indian market.
And we are paying for the inefficiencies of these public sector companies. So that was the
situation at that time. And because of this we were running the show with this very high current
ratio of 2:1 where we are keeping 100% of the funds from the long term sources as a safeguard.
This was basically cushion that this cushion should be there that if all the current liabilities if are
paid to be paid at one point of time so we will start from the assets current assets.
First we will use the cash. Then we will use the marketable securities. Then we will use the
sundry debtors and then we use the inventory and if any of the current assets are not convertible
into cash that is the sundry debtors and inventory then the funds will be roped in from the long
term sources because we have already kept the current ratio too high that is 2:1. So it means
there is no problem and liquidity is always there.
And at the cost of liquidity we are losing something that is the profit because your financial cost
is very high. So were having the very high current ratio and since nobody bothers about the cost
in this country, bothered at that time so it means there is no question on the cost of the product
that at what cost the product is being manufactured and at what price it is being sold to the
people because there was no comparison.
Similarly, the case was with the quick ratio 1.5:1 and so per quick ratio it means you had to keep
the cash or almost near cash, liquidity, pure liquidity, and backup liquidity, cash and marketable
securities that should be equal to 100% of your current liabilities. So look at the financial
indiscipline I would say at that time. So these were the rules of thumbs of the ratios.
And now we have brought down these rules of thumbs to the ratio of these ratios that is from say
2:1 to 1.33:1, 1.5:1 to 1:1 and from 1:1 to 0.5:1. So we have brought down these rules of the
thumbs of the liquidity or the liquidity ratios. Why we have done that and what is the benefit we
are going to reap out of it that we will discuss in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 08
Working Capital Management in Indian Business
Welcome students. So in previous class we were talking about the say norms of liquidity ratios.
In other way around we call them the rules of thumb also. So rules of thumb we were talking
about and we saw that say we have 3 important liquidity ratios.
So I told you that earlier if you talk about the rules of thumbs till 1991 or a little after 1991 even
so we were following these 3 rules and the reason I say explained in the previous class because
say if nobody is bothered about the cost because only there is a single player in the market of
manufacturing one product and now you think of most of the products in the market.
Steel was dominated by the SAIL, Steel Authority of India Limited, public sector company.
Petroleum as I told you in the previous class also even today is dominated by the public sector
companies. You talk about say other even the public sector companies are manufacturing the say
bread, butter, biscuits the modern foods. Even the hotel industry we had many 5 star hotels
which were owned by the government and many other sectors if you talk about.
Even the electronics, many public sector companies like Electronics Corporation of India and
other they were manufacturing the colour TVs. So that sector was there. So it means and most of
the say public sector companies they were in the very bad financial position despite exploiting
the market fully huge market of the 1 billion people and whatever the products they were
manufacturing, whatever the price they were charging from us we were paying a huge price.
And after that also they were the say loss making companies and they had to be closed down
after the this liberalization of Indian economy. So that is a different story. I will not go into that
but as far as the working capital management is concerned it was very poor at that time and if
you see that even the because the total business of this country was dominated with the public
sector companies.
They never bothered about the cost and financial cost was just nothing for them, nothing to be
considered as the part of the total cost of production. So they were enjoying the liquidity like
anything and they were keeping this high level of the current ratios. Now the level of current
ratios this norms have been revised. One reason was of having the high level of current ratios
was the inefficiency of the firms.
Because they are not able to maintain and manage the liquidity and second reason was the
requirement of the banks, second reason was the requirement of the banks. I have told you
sometime in the past that in India the major most prominent and the most important source of
working capital finance if you call it as the short term source of working capital finance it is the
means the source is the bank finance.
Bank, the banks are bound to give the say funds for meeting the short term requirements of the
Indian manufacturing sector whether it is a public sector or it is a private sector. Is the most
preferred, most convenient, and most easily available source of the fund. So everybody resorts to
the bank finance and banks because there is a requirement or there is a you can call it as a
stipulation.
There is a condition from the government also that as far as the working capital finance is
concerned banks cannot ask for any kind of the security or any kind of the collateral normally
from the borrowers because their total assets, their fixed assets, their long term assets are already
hypothecated against the long term loans. So they do not have anything to give as a security, as a
say pledge or anything. You can call it as a collateral. There is nothing to be given.
So if the banks are asking for the collateral or security for providing the working capital finance
so firm will be at the say means in a very difficult state other than inventory they do not have any
security to be given. So if the amount of the working capital is very large so banks sometime
take control of the inventory of the firms but if other than inventory there is no security no
collateral.
So since no collateral was possible to be taken for providing the working capital finance to the
businesses or to the firms or to the companies so banks always use to say that the total your
current assets, the level of the current assets should be double of the current liabilities so that any
time when our funds become due to be paid by you or by the firm to be returned by the firm to
the bank so in any case for example your cash is not sufficient.
Your marketable securities are not sufficient, your sundry debtors are not convertible into cash,
your inventory is not convertible into cash so at least you have long term sources of the funds
and if they are 100% of your current liabilities it means half of the funds are coming from the
bank finance and half of the funds are coming from the your own other sources, long term
sources.
So bank’s funds are safe so that any time when the bank’s funds are becoming due to be repaid
by the firm back maybe the interest of the total amount so the bank has no problem in collecting
the funds back or getting the funds back. So it was their condition that you have to keep the
current ratio 2:1, quick ratio this much, and super quick ratio this much but after liberalization
because of say many reasons.
First reason was that many sectors were opened up for the private sector participation and when
the private sector participation was allowed and many companies private sector efficient best
companies came into the different sectors earlier reserved for the public sector then competition
increased. When the competition increased then naturally the inefficient public sector players
had to go out of the market or if not to go out of the market they were bound to lose a sizeable
amount of the market.
And when they had to lose a sizeable amount of the market in that case there is a means there is a
you can call it as the threat of sustenance. There is a risk of sustenance means if they are losing
the market quickly in favour of the private sector players in the same sector so it means there are
say so many stake holders and the first and the foremost stakeholders was the employees. If the
company is closed if the business concern is closed then most of the people will come on the
roads and unemployment will increase.
So they have to run the show somehow. So in some cases they try to compete with the private
sector companies and when there is a question of competition, question of competition comes in
terms of the 2 things. One thing is the quality of the product had to be improved and second thing
is that the cost of production has to go down and so that the price is competitive because cost is
the basis of price.
So if the price has to be kept low in the market of the finished product or the final product you
have to first reduce the cost. So for reducing the cost, for reducing the cost everything is
important, the financial cost, which was totally ignored earlier by the public sector companies.
That is why they were having the luxury of keeping this much current ratios now they cannot
afford to have the very high financial cost.
They have to bring the financial cost down and they realized that in the total cost financial cost
plays very important role. In the total cost financial cost plays a very important role and when
they realized this thing so they requested the banks. They requested the banks. They as well as
all the borrowers including private sectors they requested the banks that now in the changed
competitive scenario of the country, in the changed competitive scenario of the country it is not
possible to have say huge current ratio that is 2:1.
So that means you have to have say level of current assets that is double of the current liabilities
is not possible if the level should be brought down. We should be able to or we should be
allowed to lower down the ratio if you want to have some cushion, if you want to have some
security we are ready to keep it more than one. We do not want that the current ratio should be
1:1. We are ready to keep it more than 1 but not 2:1.
So banks agreed that okay you reduce the ratio but at least your current ratio, the satisfactory
current ratio will be considered which is 1.33:1. So in today’s scenario 33% of the current assets
should be financed from the long term sources and remaining funds can come from the short
term sources including bank finance. So now this is the reason that why the norm of the current
ratio has been revised and now the new norm of the current ratio is 1.33:1.
This is the minimum threshold level. This is the minimum norm. Current ratio can be more than
this. But if it is to be reduced from this level if you reduce from it goes down below 1.3 or 1.33 if
it goes below this level firm cannot expect the bank finance. Firm cannot expect the bank
finance. They if they depend upon the bank finance then it is up to them. They can have the
current ratio that is 0.7:1 or 0.8:1 or 0.6:1. That is their wish. Then there is no problem.
This ratio is normally required by the banks. When we go the banks for seeking the working
capital finance as the working capital say loans say limit or something then this ratio is a
requirement of the banks that your current ratio should be this your quick ratio should be this and
your super quick or the cash ratio should be this. So why banks want this 0.33 because it is a
cushion.
Any time if the banks funds become due to be paid by the firm which they have borrowed for
meeting the working capital requirements if they become due to be paid so maybe again the same
situation can come that first they will use the cash, then the marketable securities, and then the
sundry debtors and then the inventory. So after exhausting the cash and marketable securities if
sundry debtors are not convertible into cash or the inventory is not convertible into cash at least
they have a cushion of 33%.
The funds which have come from the long term sources they would always be available with the
firm. So firm will not have the liquidity problem. That is why banks want because they do not
have any collateral, they do not have any security. If the firm defaults in making the payment
what the bank can do? They have this never taken any security. They cannot sell the security in
the market and recover the funds.
When we borrow for the long term funds, for the long term say for the fixed assets even we
borrow for buying a house. The house is pledged with the bank. We borrow money from the
bank for buying a car. The car is pledged with the bank. When the moment you default repaying
the loan back to the bank they would immediately take the control of your house. They will take
the control of your car.
They will control take the control of the asset, any other asset which we have purchased by
borrowing money from the bank. So in this case the working capital there is no security as such.
There is no security so banks want to ensure the liquidity at least. Because if the firm is liquid if
your firm is having sufficient liquidity then they would not default normally in making the
payment.
So that is why this cushion is there that yes not 2:1 but 1.33 1 has to be there all the times. Now I
will discuss with you one thing that say how the banks provide the working capital finance in
India or what are the modes of providing the working capital finance because we are discussing
this topic so in relation to this liquidity and the liquidity ratios let us know about that how the
banks provide the working capital finance.
So it is because of the requirement of the banks the current ratios, norms were fixed at this level
and now on the request of the industry because the financial cost is also now the important cost.
So the banks have agreed that yes these norms can be revised and can be brought down but still
the current ratio has to be positive ratio. It has to be more than 1 and the level is 1.33:1 but this is
the minimum level, not maximum level.
You have to maintain minimum the level of current ratio that is 1.33:1. Then the quick ratio 1:1
and the super quick ratio or cash ratio that is 0.5:1. Now because we are discussing this topic and
we are talking about the norms or the rules of thumb of the liquidity ratios so now I will discuss
with you that how the bank finance is provided in India to fulfill the working capital requirement
of the firms.
And I would again tell you that even today 80-90% of the working capital requirements of the
Indian business or the business organizations is are fulfilled by the banks. It is the bank finance
which is most popular for providing the working capital or fulfilling the short term financial
requirements of the firms. So which is not the case in the other countries, which is not the case in
the other countries.
So let us see first discuss that how the working capital finance is provided by the banks in India.
So there are 3 ways.
One is the CC limit which is means cash credit limit. In short we call this limit as the CC limit,
cash credit limit. This is the one norm. This is one way of providing the working capital finance.
Second is the working capital, second way is the working capital loans. And third is, this is 1,
this is 2, and this is third is discounting of credit sales bills, discounting of the credit sales bills.
These are the 3 norms how the working capital finance is provided by the banks to the industry.
CC limit, this is a very interesting concept. Under the CC limit how this limit works. First of all a
company who needs the working capital finance from the banks they request, they send a
proposal to the bank that we are a manufacturing organization and our total annual turnover is
this much and our working capital requirements are this much.
So this out of the 100% requirements, maybe 10, 20% will come from our internal sources and
remaining they apply to the bank that they should be provided the working capital finance by
sanctioning a cash credit limit or the CC limit. Bank will analyze their financial position for the
minimum for the past 3 years for which the companies are required to submit the their balance
sheet, profit and loss account, and cash flow statement for the period of past 3 years to the bank.
Bank will analyze it and then both will mutually means arrive at some figure that yes this much
of the working capital finance can be provided to the firm. Firm will demand more, bank would
then analyze it. Bank will apply some cut and then they would say if the firm is asking for 100
Rs bank would say no we will be able to give you 80 Rs not 100 Rs. So finally mutually a figure
is agreed upon that yes the total requirement of the firm is say 1 or 10 lakh rupees, 1 million
rupees for a period of whole of the year.
That is 1 million rupees or 2 million rupees or 3 million rupees or 1 billion rupees depending
upon the size of the firm. So once the it is mutually agreed then bank would say yes we can
provide you the working capital finance. Now the question arises what mode will be followed by
the bank for providing this finance. Firm’s approach remains that total funds should come under
the first mode that is the CC limit.
But banks want the firms that okay partly we can give you the under the CC limit, partly we can
give you say as the working capital loan and partly you have to use the bill discounting facility.
But firms say tend to use the first mode to the extent possible that is under the cash credit limit.
Now how the cash credit limit works? Cash credit limit and what is the benefit to the firm and
what is the loss to the bank.
So cash credit limit how it works say for example 1million rupees limit is sanctioned by the bank
to the firm. So in that case any time when the firm needs funds say for example they received a
truck full load of raw material. After say 3, 4, 5 days they have to make the payment of say 2
lakh rupees to the supplier. So they will write a cheque against that CC limit account. That
cheque will be sent to supplier and supplier will present it to the bank and the bank will clear the
bill.
Condition here is that whenever the firm needs the funds they can withdraw the funds from the
CC limit account and if the firm receives the funds on account of sales from the say on account
of the cash sales or on account of the credit sales then those funds should also be deposited in the
same account. It is not the case that for withdraw borrowing the money you use this account and
for depositing your say proceeds you use another account, no.
This is the condition by the banks that withdrawal will also be from this account and deposit will
also be in this account. Total operations of the firm that is the borrowing as well as deposit will
be through this account only. Firm will not maintain any other account in any other bank or any
other branch of the same bank. So here the in the first case firm borrowed 2 lakh rupees to make
the payment to the supplier.
And that 2 lakh rupees the firm has used for a period of say 15 days. After 15 days firm received
some 2 lakh rupees from some credit buyer or maybe on account of the cash sales and those 2
lakh rupees were deposited in the bank and that 2 lakh rupees which were withdrawn by the firm
15 days back these are returned back to the bank so it means now again the account will come
back to 1 million or 10 lakh rupees.
Because when they withdrew 2 lakhs account balance has gone down to 8 lakhs but when they
received cash from some source, from sale, cash or credit then they deposited that 2 lakh rupees
in the bank and now again the account balance has become 1 million rupees or the 10 lakh
rupees. Now the question arises for how much period bank will charge the interest and for on
how much amount.
Here the beauty of the CC limit is that the firm has used only 2 lakh rupees out of 10 lakh rupees.
Firm has not withdrawn the remaining 8 lakh rupees. And that 2 lakh rupees have also been
withdrawn or used only for a period of 15 days. So bank will charge interest only on 2 lakh
rupees for a period of 15 days and on the remaining 8 lakh rupees and for the remaining period
no interest will be charged from the firm, from the business.
So this is why the businesses prefer the working capital more and more working capital under the
CC limit rather than the working capital loan. Because if it is a working capital loan it is the
second mode, working capital loan then what will happen. Then what will happen? Bank has
sanctioned 10 lakh rupees, 1 million rupees loan for the whole of the year.
Whether the firm uses entire 10 lakh rupees, whether the firm uses 1 lakh rupees, whether the
firm does not use even a single penny of that, firm has to pay the interest on the entire amount of
1 million rupees and for a period of the whole of the year. So that is very difficult for the firms to
manage and maintain the loan accounts, working capital loan accounts so they prefer the CC
limits. Because under CC limit there is a flexibility.
Anytime you need the funds you withdraw it. For the period you are using the funds you use it
and when you deposit the funds back the bank will calculate that this much amount was
withdrawn and for this much period of time this much amount was used. So it means you have to
pay the interest to us for this much period of time. So this is a big pressure on the banks.
This is a big pressure on the banks that their funds sometime large chunk of their funds remain
unused. If that firm for example their actual requirement is half a million, 5 lakh rupees for the
whole of the year they got a limit of 1 million that is 10 lakh rupees. It means half of the loan or
half of the CC limit was unused by the firms. They have not used it at all and banks cost is
increasing but there is no return available and finally bank has to pay the price.
So firms insist for the CC limits and banks insist for the loan but somewhere they have to have
some common agreement that yes some proportion we will give you the CC limit. Some
proportion we will give you the working capital loan and third is the bill discounting facility. Bill
discounting facility I told you in the previous class also that when the firms sell on credit so they
can use those credit sales as a because credit sales are also an asset.
Those credit sales will be recovered after the expiry of the credit period and in India say for
example the credit period normally ranges from 45 days to 2 months, 60 days. So some firm is
given a credit of 2 months, 60 days and if the firm who has given the credit they require the
funds. So first they will use the cash available with them in the hand or in the bank. Then they
will resort to the marketable security. They will convert the securities into cash.
Then they see that inventory is also not convertible into cash because that is not saleable as and
when we want it. So it means now we have only the sundry debtors that is the credit sales. So if
firm urgently need the funds and there is no other source of getting the funds in that case what
will happen. In that case what will happen. The firm will go with those credit sale bills to the
bank that we have this much say we our bank will firm will work out that their financial
requirement is how much, 2 lakh rupees right for a period of how many days, 1 month right.
They want 2 lakh rupees for a period of 1 month. Their CC limit is exhausted. There is no money
left in the working capital loan. So only they have the credit sale bills. With these bills they will
go to the bank and they would say that look we have the bills of say 3 lakh rupees. We are sold
on credit. This money is coming to us after 2 months. But we need money now for a period of 30
days.
So you please keep the bills and give us amount maybe 3 lakhs or 2 lakhs or somewhere in
between how much the bank can give as per the banks rules and regulations. Then bank may
think about it. Bank may look at those credit sale bills and normally what happens. Banks divide
those credit sale bills into 3 categories.
These 3 categories are A, B, and C. A category creditors, B category creditors sorry not creditors
but debtors; A category debtors because of credit sales. A category, B category, and C category.
Who are the A category or the debtors who have bought on credit, who have a very good
financial reputation in the market. For example there is some supplier who is manufacturing say
say some part of a car and he is a regular supplier to the Maruti Suzuki.
Suzuki Motors has a very good reputation in the market and if some supplier he is supplying to
Suzuki also. He is supplying to say Hyundai also and he is supplying to some other company
which is not that much creditworthy, for example General Motors. Now, total bills some sales to
Suzuki, some sales to Hyundai Motors, some sales to the General Motors. So those bills will be
or maybe he is not supplying to General Motors maybe some other company which is less
creditworthy.
Now, those total bills will be divided into 3 categories by the banks. Bank would say for this A
category of bills bank has no problem. Because bank knows that these are fully secured. On the
due date after 2 months Suzuki can never afford to default because of their financial reputation
and position in the market. So if we discount these which we buy these bills our investment or
our loan is secured. Even in case of the B it is also secured.
Because this company is also very good company but there is some doubt in the C category of
the bills. But here what happens? A category of the bills companies also do not want to discount
because they are fully secured. C category of the bills banks do not want to buy. So finally the X
lies on the B category of the bills. B category of the bills which are moderately secured banks
buy.
And if there is still there is a requirement for the company funds are not sufficient under the B
category of the bills then they would like to sell the A category of the bills also. But C category
of the bills bank will never discount. So in this case under the bill discounting facility bank will
purchase this B category and part of the A category of the credit sale bills. They will keep these
bills as the security.
And up to 80% of the total amount of this B and A category of the bills bank will immediately
give to the firm. 20% is kept by the bank and that will be settled on the due date when that credit
buyer or the sundry debtor will make the payment to the company. In that case either the
company will receive the payment and then they will make the payment to the bank.
Or sometime company informs the debtor that to directly make the payment to the bank we have
already got the bill discounted so when the bank gets the payment from the debtor then bank will
settle the account. Bank would say now the total seats are 100%. Say that bank had given for
example 2 lakh rupees. So 2 lakh rupees is just the 80%. So they will get the bills for 100%. So
out of the 100% bank would say 80% is already given to the firm.
Now out of the 20% bank would say deduct its first interest charges, commission and
administrative charges and if any amount is left then that will be transferred to the main firm the
seller. Otherwise that 20% will be used by the bank to recover their interest, their commission
and their administrative charges. If some amount is left then still the firm will get so for example
the 10% works out as the total interest, administrative charges and commission.
So it means the remaining 10% will be given by the bank to the firm. So in this case firm
immediately could get 90% of the credit sales they could immediately get from the bank under
this facility. So it means they have to lose 10% but they could get the funds. They could save
their reputation in the market and they could maintain the liquidity also.
So under this system under the discounting of the bills credit sale bills facility this is the third
source of the working capital finance and first is the most preferred for the firms is this. Next one
this and in between then they arrive at some common figure and these days now what is
happening that partly the bank provide the CC limit. Partly bank provide the working capital loan
and partly banks provide the bill discounting facility to the firms who need the working capital
finance.
There is a instruction from the RBI to the banks that loans of 10 crores means working capital
requirement of 10 crores and above. If the working capital requirement of any firm is of 10
crores and above then in that case 80% should be given as the working capital loan and bill
discounting facility. Only 20% should be given as the CC limit. So it means 2 crores can be
given as the CC limit.
8 crores worth of rupees or above if the total requirement is more has to be given by way of
working capital loan or by as a bill discounting facility. But what is happening? If the firms if the
banks start imposing this kind of the discipline on the on the business firms then what happens?
They are say they expect to lose the good customers from their say account or means the good
customers who have a good credit rating in the market.
They will shift from current bank to the new bank. So banks are not able to implement this
threshold level of the 10 crores and above and this is not the 10 crore and above only. RBI says
that over a period of time this threshold level of 10 crores should come down. It should be
somewhere 7 crore. Then 6 crore, 5 crore, 2, 3. Slowly and steadily the approach of the RBI is
the policy of the RBI is that total working capital finance from the banks going to the industry
should be in the form of loan and the working capital loan and the bills discounting facility.
CC limit should be totally abolished because in most of the countries this CC limit is not there.
This is largely in India. This is the most prevalent source of the working capital finance, most
popular source of working capital finance only in India not in the other countries. In other
country for example I tell you the story of US. In US CC limit is not there. Working capital loan
is there.
But under the working capital loan also if you want to borrow working capital loan from the
bank there in US then what they say, what they do, what are the conditions that if we the total
requirement, working capital requirement of the firm is say 1 million dollars. Then bank would
say half of the amount. It means half a million 5 lakh rupees you deposit in the other account and
that 5 lakh dollars will be kept as a collateral or as a security by the bank and no interest will be
paid on that 5 lakh dollars.
Once you have deposited that 5 lakh rupees then bank would give the loan of the 1 million
dollars. It means in fact what is that loan. In fact the bank has given only half a million loan not
of the 1 million loan because half a million the firm has already given as a security to the bank.
And as far as the interest is concerned the firm is not getting any interest on their 5 lakhs but
bank is charging the interest on the total 1 million dollars.
So how expensive the working capital finance is in US. How expensive the working capital
finance is in US? Hardly the firms resort to this source of the working capital finance in US.
Businesses never use bank finance as the work source of the working capital finance in US. They
use other sources. They use say financial other financial institutions they use the public deposits.
They use the inter-corporate borrowings. They use the factoring.
Factoring is very popular source in US. They use the say forfeiting. They use the say nowadays
we are talking about the derivative finance which is very popular. So they use the derivative
finance. So different other sources firms use. That is why the other sources are very popular in
US or in the other countries, not the bank finance. It is in India only the bank finance is the most
popular source of working capital because it is the cheapest, safest, most secure, easily available
source of the finance for fulfilling the working capital or the short term requirements of the
firms.
In other countries normally the working capital comes in the form of the working capital loans,
not under the CC limits. So here I would like to remind you that look at the efficiency of those
companies. In India we never bother about the financial cost till 1991 even some years after that
till 2000 even. Those companies who are paying very heavy financial cost they are say paying a
very heavy labour cost and other kind of the cost also.
Taxes also are again high in those economies despite that they are the best say firms
manufacturing the best products in their own country and they are distributing that product to the
not to their own country’s market but to the world markets. For example you talk about say
General Motors. General Motors is not supplying cars to US only. They are in India. They are in
the many countries of the world.
After means facing so much of the problems their financial cost is high, their labour cost is high,
their other input costs are high. Despite that they are so competitive, they are so efficient that
they are able to say sell the cars in the Indian market also and in the Indian scenario look at the
business situation where finance is so easily available, labour is so cheap, raw material to a larger
extent is easily available but still we are not able to compete in these markets.
So because of this reason, because of this problem the Indian business has not been able to come
out of its shell. Could not grow, could not face the competition and because of that say we are
still dependent upon the multinational companies for most of our day to day requirements. Our
cars are coming from multinational companies, our electronics products are coming from the
multinational companies. Our even steel is coming from multinational companies.
Our cement is coming from the multinational companies. So we have not been able to do much
because of some defective business models which we followed in the past. But we expect that in
future we will be able to improve the situation and many Indian companies would become the
world players. So I will stop here in this class and remaining discussion on the different liquidity
ratios of the steel sector companies like SAIL, like JSW, or JVSL or TISCO all their liquidity
position, their current ratios I will discuss with you in the next class. Thank you very much.
Dr. Anil K. Sharma
Lecture - 09
Working Capital Management in Indian Business - II
Welcome students. So in the previous class we were talking about the Indian business scenario
and how the working capital finance is provided by the banks to the industry. So now let us see
the different liquidity ratios of the different companies which are working in the steel sector.
And if you look at the liquidity ratios of SAIL Steel Authority Of India Limited you see that
right from 2000-2001 till 2011-12 their liquidity ratio is say if you talk about the current ratio
though it is now touching the threshold level that is of the 1.33 in the later years but in the
beginning or you say in the previous years the ratio was very high which was 1.58:1 in 2000-
2001 and in the years like 2007-08 it had become 2.19 and 2.07.
Which is much higher as even compared to the threshold level of for the rule of thumb of the 2:1.
So it means how the SAIL is managing their working capital. How the SAIL is managing their
working capital it means how much financial cost they are paying by keeping say large or huge
amount of the current assets. Similarly, you talk about the say acid test ratio if you talk about the
acid test ratio is the liquidity ratio for which the rule of thumb now is 1:1.
And if you look at it say they have the acid test ratio which is quite manageable but in the current
ratio which is very high so they have the level of current assets which is again very high. So it
means you can you have to think about that how they are managing their liquidity position. Now
why their current ratio is very high as compared to their acid test ratio? I will take you to this.
But before that let us see the other companies that how their say these 2 ratios are like.
If you talk about the again in the SAIL the level of the current asset to the total assets, so current
assets to the total assets are say sometime in the beginning year it was half of the say you can call
it as the ratio of the current asset to total asset means 50% assets are current assets and 50% even
some cases the 60% the level is 60% as compared to the total asset 60% are the current assets
and 40% are the fixed assets.
And percentage wise also we have seen that it is in one year it had gone up to 60% also and in
half of the years it is 50% though it is coming down over the years. So average if you work out
we have seen the average also, average percentage which is 48% which is very alarming
percentage, not good for the health of the SAIL and this is the indication why SAIL has become
a sick company because of a very large amount of the current assets.
If they are keeping such amount of the current assets, very large amount of the current assets it
means they are not able to manage the liquidity or you can call it as their working capital
properly but liquidity is there. Technical insolvency may not be there but if you look at the
profitability of the firm if you look at the overall say financial health of the organization that is
not in the interest of the company.
That is not at all up to the acceptable level because of the very high level of the current assets
which is say indicated by the current ratio and maybe the percentage of the current asset to the
total assets. Let us see now how it is the situation in the other companies like say we talk about
the short term liquidity position in the other companies and we are comparing SAIL with the say
other 2 companies like TISCO and JVSL and this comparison is only for the past 3 years 2009-
10, 10-11, and 11-12 and we have calculated the average also.
So you see that average current ratio for SAIL was 1.35:1 which is nearer to the rule of thumb,
but you see TISCO. TISCO is having a negative working capital and JVSL. Look at the JVSL
means look at the approach they are following. That is even their current ratio is current assets
are not even half of the current liabilities. Not even half of the current liabilities so both the
companies, both the private sector companies they are facing so many problems.
Even if you talk about the raw material, most of the raw material of these 2 companies is coming
from the imported sources and because total say captive mines of the iron ore they are in the
control of SAIL. So if they have to buy the iron ore they have to buy it from SAIL or if they are
not to buy it from SAIL then they have to import from the other countries. JVSL that is now
which is called as JSW Jindal Steel Works that largely depending upon the imported raw
material.
So after having the imported raw material and then paying the total taxes and other costs they are
maintaining a negative working capital. They are running the show by following a aggressive
approach and if you even see the TISCO also is a properly means a well-managed company is a
highly financially disciplined company and they are also running the show with a negative
working capital where their current ratio is less than 1.
And they are means average if you see it is 0.9:1. As compared to SAIL these 2 companies
which are recent means TISCO is a old player in the market but Jindal is a recent player in the
market. They have means come in to the market especially after the liberalization of the Indian
economy after 90s and look at the performance and the Jindals this Asia’s this JVSL Jindal
Vijayanagar Steel Plant was ranked as Asia’s first high tech plant manufacturing steel.
So the quality of the steel and the price, the people were paying for the steel of these 2
companies is much less as compared to the SAIL product. So it is the reason that the company
SAIL which enjoyed the huge market of this country for a period of you can say more than 50
years being sole player in the market having 90% or 80-90% of the market. They are means
performing so bad as far as the working capital management is concerned and if you talk about
these private sector companies they are far ahead.
So this is the difference in the public and the private sector and how the working capital is
managed in the public sector companies or in the private sector companies. Similarly, if you talk
about the percentage of the current asset to the total assets here in the 3 companies the
percentage of the current asset to total assets. Current assets which was very high level in SAIL
in the say early years. Over the later years it has come down to 34%. Average works out as 34%.
Look at the level of TISCO which is 23% and in JVSL the current asset as compared to the total
assets are only one fifth that is the just 20%. They are keeping current assets only 20% because
they know it that current assets are least productive so they are only keeping 20% not more. So it
means they are ought to be efficient companies. Both the companies they are nearer to the mark
of 20% whereas in SAIL recently it has come down to 34%.
Earlier years we have seen it was about 60% also. So it means if you compare these public and
private sector companies we are seeing the difference and ultimately people have been paying
the price for their mismanagement for the their say lack of efficiency on all the fronts. You talk
about the quality of the product. You talk about the cost of the production. The price people are
paying for that inefficient and the raw production in the market.
That was all against the expected norms from these companies and we can say that public sector
model has miserably failed. I would tell you that even if you are curious to learn about the more
about the working capital position you make a comparison, you collect the data from different
data sources like say we have prowess of the Center for Monitoring Indian Economy CMIE. It
has a database of say more than I think 11000 companies.
You can pick up the balance sheets of this public sector companies in same sector. Public sector
company and private sector companies and then you can see what is their working capital
position means you will see that huge amount of cash is lying and public sector companies huge
amount of the inventory is lying in the public sector companies and nobody cares for that. They
do not know that this all current assets level the level they are maintaining it has a cost.
They should minimize this. If they are able to do it. They should minimize it. But if you compare
the private sector companies in the same sector you would find that the level of current assets is
very low and if they have they will have some amount of cash and credit sales, level of inventory
will be very low. They will try to minimize the level of current assets. So this is the difference in
the culture between the public and the private sectors.
So here I would like to take you little back say just telling you the background of the SAIL why
the SAIL has this kind of the luxury or they have the say current ratio so high. If you look at the
difference in the 2 ratios, current ratio and the quick ratio or the say acid test ratio. The current
ratio is very high and the acid test ratio is you can say it is manageable. Still manageable it is less
than 1. So why there is a huge gap in the current ratio and the say your quick ratio acid test ratio.
You see that when you calculate the current ratio, the current ratio is the you can say it is the
current assets divided by the current liabilities right. We take all the current assets maybe it is
inventory, it is the credit sales, it is the prepaid expenses. It is the cash in hand, it is the cash at
bank or there is the marketable securities everything we are taking into account and total of the
current assets make the current assets as the numerator for calculating the current ratio.
But and current liabilities are the same as we have the short term that is the spontaneous finance
as well as the short term finance both including bank finance that make the current liabilities of
the denominator. But when you calculate the acid test ratio or quick ratio when you calculate this
so this is calculated like current asset minus inventory, minus inventory divided by current
liabilities.
So it means when you are seeing this current ratio like say current ratio is very high and the
quick ratio or the acid test ratio is at the manageable or at the acceptable level it means if you are
subtracting inventory from the current assets then what happens. These assets become quick
assets. These assets not remain current assets they are called as quick assets. So the ratio
becomes now quick assets divided by the current liabilities.
So quick assets are one which are say quick assets are current assets minus inventory divided by
the current liabilities. So denominator remains the same. Only numerator changes. In this case
we are finding out that for calculating the acid test ratio we are taking the quick assets and quick
assets are current assets minus inventory. So when you are subtracting inventory from the current
assets the ratio becomes manageable, at the acceptable level.
Acceptable level is 1:1 so it is less than 1. So it is acceptable. It means the large chunk in their
current assets is the inventory. Large chunk in their current assets is inventory and why they have
huge amount of inventory the reason is clear. Why have they have the huge of amount of
inventory the reason is very clear because till 1991 steel sector was reserved for the public sector
only and SAIL was enjoying 90% market share.
If you see the old advertisements of the SAIL they were showing so many things and at the end
they were writing one the punch line of the SAIL was that steel maker to the nation. So they
were the steel maker to the nation at that time. They had no challenge. Whatever the garbage
they were manufacturing, at whatever the cost they were manufacturing, what were the price
they were charging from the people, people were bound to this huge market of, one billion plus
people they were bound to buy the steel from SAIL only.
There is no other company. There are no other company can manufacture and sell steel in India.
TISCO was there but TISCO’s market share was very nominal. So there was no pressure, no
competition, no control, and finally they were the having the might and because of their might
because of their existence in the market they were running the show. But now when the sector
was opened up for the private sector participation in 1991 immediately SAIL has to face the
music.
When the, in the western part 2 steel sector, 2 private sector companies Lloyd and Essar Steel
when they came up in the western part of the country they snatched the western market of steel
from SAIL. Similarly, in the southern market of the company JVSL Jindal Vijayanagar Steel
Plant when this came up this totally snatched the market from SAIL so it means out of the 100%
or 90% market of India SAIL was reduced to only to the just you can 50 or 60% market.
50 or 60% market. They lost the western market. They lost the southern market. They lost the
part of the central market of India. These companies are selling their product up to the central
part. And then some part was, some central part was served by TISCO. It means now the sale is
left in the north, eastern part of the country and some part of the central India. So it means out of
the total market maybe they were enjoying 90, 95% market.
They lost half of the market. It means their production is continuously going on because all the 6
plants they are continuously the production is going on that cannot be stopped. So if the
production cannot be stopped but the market is lost so ultimately where the product will go? The
product, finished product, finished steel is going to the inventory and inventory is mounting.
Because you cannot stop the product. It is a public sector company.
Public sector company means people have the permanent jobs. They cannot be thrown out. When
the labour cannot be thrown out plant cannot be shut because ultimately have to pay the salaries
to the people. So once you have to pay the salaries to the people the plant cannot be shut, the
people cannot be thrown out. So ultimately you have to go for the production. So you are
producing at the same pace as you were producing in the past.
But you have lost half of the market it means your inventory will mount. This is the same reason
we are finding here when you see the gap between the current ratio and the acid test ratio you see
here that inventory level is very high because SAIL has lost half of its market. So SAIL tried to
recoup the market but they failed as far as the Indian market was concerned, Indian territory was
concerned.
Because the steel which is coming from the this private sector companies they are manufacturing
the steel by having a latest new technology which is very efficient giving the very efficient
quality product as well as when you are using the new technology, latest technology, efficient
technology naturally your price will also be very low or at the acceptable or at the manageable
level.
So you have the price of the manageable level and you have the quality of the steel which is far
more better as compared to the quality of the steel of the SAIL. So it means people will shift to
the private sector companies rather than buying the garbage from SAIL. So they lost the market
and they could not throw the people out. They could not reduce the labour. They could not
reduce the manpower and at that time in the 90s the manpower of the SAIL was 1.47 lakh people
which was far more than the actual requirement of this company.
So if you have say huge labour which is employed on not on the say rational basis but on some
other considerations you cannot remove the people. They are permanent employees. It is a public
sector company. Your production is continuous but your sales have come down. So income is
becoming half. Income has gone down to half and your say expenditure is 100%. Output is there
but there is no sales in the market so what will happen? You will become a sick company.
So then what happens? Steel this SAIL tried for many years to recoup the market or to say regain
the lost market share but they could not do it. So finally, the case of the SAIL was referred to one
consulting organization McKinsey International. McKinsey is a consultancy firm and they were
asked by the company that you please study our overall say position and performance and
suggest us that how we can come out of the present situation and how to deal with the situation
of sickness.
Even the government also tried to disinvest this company and to sell it to the private sector and to
sell it to the private sector even the global tenders were given by the government by the Ministry
of Steel. But they could not find any buyer of this company because of the huge manpower. No
world company could think of that because of the very stiff Indian labour laws when you cannot
remove the people who are not required in the company if somebody had to take over the
company they have to face the music with this kind of the labour, huge manpower.
So nobody came forward to buy this company. When nobody came forward to buy this
company. So government ultimately thought of reviving it within the public sector. Because
there is a question of saving the employment. Otherwise if you close down the company so 1.47
lakh people will come on the road. So they have to save the employment so because of that
reason then government thought of reviving it.
And when they thought of reviving it the company was referred to McKinsey and McKinsey
studied the entire say position of the SAIL and the internal say situation of the SAIL and they
finally say made some observations. They made some observations like that see you have lost the
Indian market. You would not be able to regain it because your competition is with the people or
with the players who are very efficient in this market.
So you cannot think of competing with them. You have lost the market. You have lost the
market. So to make this lost market good you have to go out of this country in search of new
markets. So search for the new markets and think of exporting your product rather than selling it
in India as you have been doing it in the past. So then McKinsey suggested that Middle East
countries Iran, Iraq, Saudi Arabia.
These middle east countries, Kuwait, can be the markets for you. If you think about selling your
steel to them to those countries maybe you can negotiate the price and the supply chain
arrangement with them and then you can think of say to some extent recouping or making the
lost market good by which you have lost in India by say gaining some market out of India. So
that suggestion was well taken by the company.
A long term contract channelizing agency was opened up in Dubai. Office was opened up in
Dubai and that agency now procures a long term steel supplying contracts from the Middle East
to SAIL and then SAIL supplies steel to them. So now this is the one factor which has
contributed to improve the performance of the company. This is one part of the story. Second
part of the story which McKinsey suggested to the SAIL that over a period of time you have
reduced you have to reduce your manpower. You have to reduce your manpower.
McKinsey was of the view that normally the total manpower of any company should not be more
than the 15% of the total turnover of the company. If the turnover the company is 100 Rs then
your this labour expense your human resource expense can be maximum 15%. At that time when
McKinsey studied SAIL, the actual cost, human resource cost of the company was more than
22%. 1.47 lakh people were not required in this company.
They were hired on terms other than say the rational terms and they were surplus people. So
McKinsey said as a second measure you have to reduce the manpower over a period of time.
Either you offer then the voluntary retirements or you say throw some people out by say
negotiating with them giving some lump sum amount or something like that but anyhow do
whatever you want to do but reduce the manpower.
So over a period of time SAIL also has done that and I think till the least recent past the
manpower of the SAIL was reduced to 1.17 lakh people. So significant decrease by 30000
people in a phased manner. Third suggestion which was given by the McKinsey to SAIL was
that since your plants are very old your technology is very old so immediately you need to inject
50000 crores of the rupees to modernize your 3 plants at Bokaro, Rourkela, and Bhilai. So 3
plants require 50000 crores of rupees. You have to arrange this money.
If you can arrange this money you can modernize your technology. You can modernize your
plants. Then you can think of that the product coming out of that technology and at that cost will
be acceptable to the people not in the world markets but in the Indian markets also and you
would be able to compete with the rival sector companies. So that money was not easily
available 50000 crores.
Because this company tried hard with the government, with the Ministry of Steel, with many
other sources but they could not generate this money but somehow in a phased manner now they
are replacing the old plants with the new ones and they are improving the technology also. So
now the SAIL is it seems to be that it is back on the wheels that we are seeing here from the
current ratios that the current ratio is declining.
It is coming to the close to the standard rule of thumb and your quick ratio was already managed
ratio you can see it was at the acceptable level. So over a period of time if you calculate the
recent ratios for 2017 or 16 or 15 I think you would see that remarkable change in the
performance of SAIL so it has improved because not they have changed the technology also so
they are say improving their position in the domestic market also.
They are exporting it to the world markets also and better technology, better products at a very
competitive price if they are selling in the market they are improving. So this is the story of the
SAIL. So why this indication given to us by these ratios or the working capital management or
the working capital position in SAIL we could easily make out that because there is a huge
difference in the current ratio and the quick ratio.
So the difference is because of this inventory and why the inventory was too high I told you the
story that how the SAIL has or the phases the SAIL has passed through over the past you can say
10, 15 years. Still it is a sick company. Still it is a sick company. It cannot be considered that it
has come out of the red but its position has improved.
Now they are hiring say efficient young people, technical people who are technically sound who
are financial sound who are say knowledgeable people and they are replacing the old staff with
the new people and now they are thinking of competing in the say world markets also and they
are running the show with that. When you talk about the other 2 companies, other 2 companies
like we have seen the TISCO and we have seen the JVSL. You will see the TISCO.
TISCO is a very stable company. It is a it is small in size but a very stable company for the past
say since its inception and since the beginning it has a sustainable growth and existence in the
market. So that is the reason they are able to maintain their negative working capital also and to
run the show with the negative working capital also. JVSL, JSW they are following the
aggressive approach.
Here I would like to share with you that following the aggressive approach is not very easily
possible for all the companies. If you join any company tomorrow and if you happen to work in
the finance department of any company and for example with God grace if you become the CFO
of a company even you cannot think of say following the aggressive approach as far as the say
short term funds management is concerned.
But JVSL is very efficiently doing. If you look at this, this ratio, this is say the current ratio is in
this company is the short term liquidity position if you see the current ratio in this company is
say less than you can call it as less than 0.5. And the extent of the current assets is only 20%. So
do you not think that this company is always under the threat, under the constant threat of
becoming technically insolvent of or defaulting while making the payment to their suppliers. So
this company has never defaulted because there is a secret behind it.
What is the secret that most of the steel, most of the raw material of the JSW or JVSL comes
from other countries. The raw material comes as a imported steel say raw steel they imported
from the other countries and largely they imported from the Middle East countries. In the Middle
East countries these countries have been into the state of war, Iraq and Iran for many years.
So they have so much used missiles and say that much type of the you can call it as the shells of
the missiles now they have collected and they have means these companies maybe companies
from India and different parts they are collecting that material and then they are supplying it to
convert that into the finished steel. So Jindal Steel Group is a this JVSL or Jindal Steel Work is
also a group company which manufactures the finished steel at this Vijayanagar Steel Plant.
But their raw material comes from their own group company which is in the Middle East. So
their supplier is also not an outsider. Their supplier is also within the group. That supplier or
subsidiary of the Jindal Steel Works that is operating in say Middle East they collect they arrange
the raw material from there use the missiles and their shells and their so many other say other
sources also.
So used steel as well as the raw steel iron ore they arrange from the other countries and then they
supply it to the Jindal Steel Works in India and that is how they finally manufacture the finished
product and sell it in the Indian as well as in the other country’s markets. So now see the supplier
when it is within the group, supplier when it is within the group so even if Jindal Steel Works is
not able to make the payment to the supplier on the due date and they default.
So that news does not go out of the group. One company, one group company is making the
payment to the other group company and if that group company is defaulting by not making the
payment on time to the supplier so it means the supplier would not mind it because the top
management is same. Top management is same so the reputation there is no question of spoiling
the reputation. There is no question of say losing the financial credibility in the market.
There is no question of say losing any goodwill in the market. They are both are the group
companies. So yes if the supplier is also within the group and final user is also within the group
then you can easily think of adopting the say aggressive approach and maintaining the level of
current assets that is just 20%.
But otherwise if you are independent company and independently operating in the market and
depending upon the say number of suppliers in the market who are independent free suppliers in
the market we are expecting the supplies from them then I think following the aggressive
approach will be very difficult and maybe you can call it as risky also. Because anytime the
company because their current asset level is very low.
So it means you can make out that in this 20% they must have the cash also. They must have the
marketable securities also. They must have the credit sales also. They must have the inventory
also. And their liabilities are 80% more than the current assets. So if any liability which is
becoming due to be paid if sufficient cash is not available from the current assets so what will
they do. It means they will default in making the payment.
And when any company defaults in making the payment, maybe it is otherwise a good company.
If that company is not able to make the payment on due date or on the due time as and when it is
due then the company is called as technically insolvent. So that insolvency is quite possible if
you follow the aggressive approach so we should try to avoid it but if it is possible we can do
that. Real story is with TISCO.
TISCO is running the show with just 23% of the current assets whose supplies are also coming
from outside say place. Most of the time they are buying the iron ore and other inputs from SAIL
because SAIL is the owner of the captive mines in this country. So they are buying their raw
steel from SAIL and from some other say suppliers but still they are managing the show with just
23% of the current assets or very low current ratio.
So here it is a very very important say you can call it as we can learn many things from the
management of TISCO. There is many thing to learn from say JSW also but nothing from SAIL.
SAIL only we can learn that how this current high level of current assets impact the working
capital overall and the overall financial position of the firms negatively but if you see the story of
TISCO as well as Jindal Steel Works then we can learn many things.
That if we are financially disciplined and if we are vigilant organization then even by keeping a
very low level of the current assets you can run the show and can say have the liquidity also,
sufficient liquidity. You can be technically solvent also. Make all the payments on time and save
upon significantly save upon the financial cost also and then you can maximize the profits of the
company.
So working capital is such a say useful and important subject to learn that if we are able to
manage our lower part of balance sheet efficiently and say more usefully then I think to a larger
extent we can save and manage our financial cost and if you are able to manage the financial cost
successfully automatically the other cost will also have to be managed but ultimately the cost,
total cost of production will be under control.
And the profitability can be enhanced by having a competitive position in the market. So this is
just introductory part of the working capital management, foundation of the working capital
management till now, up to the classes till now. And from now onwards we will build up the say
the total structure of this subject and next concept I will be talking to you is that how to assess
the working capital requirements of a company.
That the different techniques, tools, that how to assess the working capital requirements of
different companies or of a single company. What are the tools, techniques, and processes
available that all and many other things I will discuss with you in the next class. Thank you very
much.

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INDEX

S.No. Topic Page No.

13 Working Capital Requirement Assessment - II 59

31 Motives of Credit Sale-I 161

37 Valuation of Receivables at Cost or Sales Value 196

43 Credit Risk Analysis-II 239

49 Certainly Model by Baumol Contd… 279

57 Other Accruals and Overtrading 317

So there is a concept of calculating weighted operating cycle. There is a concept of calculating

Statement of, statement of working capital requirement. Statement of working capital

So it is a comprehensive problem, interesting but comprehensive problem where you have to do

High inventory maybe it is a inventory of raw material. It is a inventory of work in process or it

So it means sometime inefficient management sometime some unavoidable circumstances as I

So if we keep inventory and sometime if there is a unprecedented demand in the market if we

We have different methods of valuing inventory 5, 6 method or 6, 7 methods of valuing

Achievement of ultimate goals of sustainable competitive advantage because we have to stay in

So it means the inventory strategy is to acquire maximum, manufacture maximum, sell

Largely it is assemble to order or make to order or engineer to order. Sometime we have to

So ultimately everything is interlinked. So we have to be very careful while managing inventory

Welcome students. So in the process of learning management of inventory as a important current

Because we call is as accounts receivable we call is as sundry debtors we call is as advance

I am again reading that working capital management is a significant part of financial

If it is saturated technology be careful do not supply to such companies for manufacturing

(Refer Slide Time: 09:41)

Because every lender wants it whether he is a lender of funds or he is a lender of material or a

(Refer Slide Time: 13:02)

So if we have this situation should we follow conservative approach, should we follow

So then we calculated the cost. Then we calculated the profits.

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