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Management of Inventories and Accounts Receivables

By

Prof. Augustin Amaladas

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Aspects of Receivables Management

• 1. credit policy variables

• 2. Credit evaluation

• 3. Credit granting decision

• 4. Control of receivables

• 5. Management of trade credit in India.

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Credit policy variables

• A) Credit standards

• B) Credit period

• C) Cash discount

• D) Collection effort

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A) Credit standards

• Liberal Vs Stiff credit standards

• Optimum Credit policy:

• 1.Trade off between cost of lost contribution and credit administration costs and bad debts losses is minimum.

• 2.The value of firm maximised when the incremental rate of return of an investment is equal to the incremental cost of funds

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• 3. Marginal rate of return should be more than marginal cost of capital

• Important terms:- 3/10 net 30 means customer can pay within 10 days to get discount of 3% otherwise, the customer has to pay within 30 days.

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Steps in evaluation of accounts Receivables

• 1. Estimation of incremental operating profit( Additional contribution or loss of contribution)

• 2.Estimation of incremental investment in Accounts Receivables

• a) total cost =[variable cost+Fixed cost] debtors period/12

[ Calculate with old policy and new policy]

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Calculation• 3.Find the difference between the investment in 3.Find the difference between the investment in

DebtorsDebtors• 4.Calculate incremental costs in receivables4.Calculate incremental costs in receivables• 5. Net increase in operating profit=Incremental

operating profit after tax-interest on incremental investment in A/C receivable.

• See page 422, 434 illustration,-increase in See page 422, 434 illustration,-increase in receivables, and 423-discount to be given or receivables, and 423-discount to be given or not.not.

• See 433-reduction of receivablesSee 433-reduction of receivables

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Example-1

• S. Ltd currently provides 30 days of credit present sales of Rs.50 lakhs. Cost of capital is 10%.Variable cost to sales is 85%.

• New proposal: 1. Extent credit period to 60 days

• 2. Increase in sales by 5 lakhs• 3.Bad debts loss in additional sales is

8%• Whether worth extending credit period?

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Answer

• 1. Incremental benefits=Additional sales*contribution ratio» = 5,00,000*.15» = 75,000»2. Incremental costs:- »A) bad debts loss= .08*5,00,000=40,000»B) incremental existing Accounts receivables» =50,00,000(60-30)/360=4,16,667»New Accounts receivables=.85*60*5,00,000/360» =70,833»Interest on costs involved in Accounts receivables» =4,87,500*10%=48,750»Incremental Benefit- Incremental cost» =75,000-40,000-48,750» =(13,750)

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Similar pattern

• Page-434 prob-2,Page-440 prob.1

• Page-435 prob-3, page-440 prob.3

• Page-433 ill 14.6, page-441 prob.5

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Page-383 prob.1• Current Assets:• Raw material= 8000• Finished goods= 5000• Debtors( inland) 312000*6/52= 36,000• Export 78,000*1.5/52= 2,250• Paid in advance 8,000/4= 2,000• Gross current assets 53,250 ( A)• Current Liabilities:• Delay in wages 2,60,000*1.5/52= 7,500• Stores 48000*1.5/12= 6,000• Rent, royalties 10,000*6/12= 5,000• Staff salary 62400*.5/12 2,604• Manager salary 4800*.5/12 200• Misc.expenses 48,000*1.5/12 6,000• Total 27,304 (B)• Working capital 25946 (A-B)

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Exercise-2

Present Future

sales 40 lakhs 5 lakhs Average collection period 20 days 40 daysVariable cost 0.80

Cost of capital 12%Bad debts ratio 0.05 0.06

Calculate should company relax the collection effort?

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Answer

• Contribution 5,00,000*.2 1,00,000• Interest on additional Capital on B/R

0.12[(40,00,000(40-20)/360 ) -(5,00,000*40*0.80/360)]

= 0.12[2,22,222-44,444]

= 0.12[1,77,777] ( 21,333)

Bad debt loss[0.06*45,00,000-0.05*40,00,000]

=2,70,000-2,00,000 (70,000)

Net Benefit 8,667

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#3.Effective cost if discount is not accepted from creditors

Discount%*360

(1- discount %)(Actual payment period-Discount period)

• A corporation buys its raw material in terms on 3/10, net 60, but it can delay by paying in 90 days if it elects not to avail discounts.

• What is the effective cost of the non free trade credit?• .03*360 = 10.8 =13.91%• (1-.03)(90-10) 77.6

• If 3/10 net 30?

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If 3/10 net 30?

• .03*360/[.97*(30-10)]= 60%

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#4.Working Capital Cycle• The following information is available for M Ltd.• Average stock of raw material and stores 300 lakhs• Average stock of Work in progress 400 lakhs• Average stock of Finished goods 250 lakhs• Average Accounts receivable 400 lakhs• Average Accounts payable 200 lakhs

Average per day cost per unit

Raw Material and stores 12 60

• Work in progress 14• Cost of goods sold 17• Sales 20 100• Processing cost per unit 20• Selling and distribution cost per unit 10• 1.Calculate the duration of operating cycle• 2 Calculate total working capital requirement if cash balance

requirement is 15 lakhs.

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Answer

• 1. Duration: Drm=300/12=25 days• Dwip=400/14=28.6 days• Dfh=250/17=14.7 days• Dar=400/20=20 days• Dap=200/12=17.67 days• Duration of operating

cycle=25+28.6+14.7+20-17.67• =71 days.

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• Working capital requirement=Sales per day*Duration of working capital+ Cash balance

• =20*71+15 lakhs

• =1435 lakhs

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Various committees’ recommendations-page 365

• 1.Dahejis committee

• 2. *Tandon committee

• 3.*Chhore Committee

• 4.Marathe committee

• 5.*Nayak committee

• 6. Vaz committee

• 7. *Kannan committee

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Bank facilities

• Fund Based-Term loans, • Working Capital finance• -Cash credit –Hypothecation, Pledge• Overdrafts –Clean, Secured• Bill finance-Clean-Purchase of drafts, cheques• Documentary-Bill purchase, Bill discount,

Overdrafts against bills sent for collection• Export finance-pre shipment, post shipment• Working capital Demand loan

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Working capital loan criteria by IDBI

• Eligibility criteria-financially sound companies• Net worth:- Not less than Rs.15 Cr.• Debt/Equity ratio:-3:1• Current ratio:1.25:1• Interest Coverage ratio:2:1• Extent of Asistance:Upto 80% of Working capital

gap. Min. Rs.2 Crore or US$ .50mn• Rupee loan Interest-Minimum term lending rate

plus Risk Spread

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Tandons committee

• Method of lending:I. The Borrower should bring 25% of net working

capital from its long term liabilities and its owned funds

II. The borrower should finance 25% of all current assets from owned funds and long term liabilities and the balance be financed by the bank

III. The hard core current assets i.e. the by the current assets which are permanently required by the unit for its functioning must be exclusively financed by the borrower.the borrower should provide 25% of the remaining current assets and only the balance will be financed by the bank.

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Example-1

• Current liabilities

Creditors for purchase 200

Other current liabi-80

Bank borrowing-400

• Current Assets

Raw materials-300

Stock in progress-100

Finished goods-150

Receivables-100

Other current assets-50

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answer

Total current assets 700Less: other current liabilities 280(excluding borrowing)Working capital gap 42025%of working capital margin 105Maximum permissible bank finance(MPBF)-315Excess borrowings-85NO WORKING CAPITAL FINANCE

PERMISSABLE

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METHOD-II

Total current assets 700

Less:25% of above as margin

From long term source 175

Eligible current assets 525

Less:other current liabilities 280

MPBF 155

(Maximum Permissible Bank Finance)

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• II method ensures a minimum current ratio of 1.33:1

• Chore committee recommends the II method of lending.

• Repayment of loan can not be more than 5 years.

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Chore Committee

• Cash credit system

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Maratha committee

• Prior permission required from RBI before availing credit for I crore or more

• Now it is increased to 5 crore.

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Kannan committee

• 1997• Sole discretion of the bank to determine

borrowing limits of corporates• Corporate borrowers are allowed to issue short

term debentures(12-18 months) maturity. Banks may subscribe such debentures

• WC over 20 crores can be granted by way of demand loan.

• Bench markratio of current ratio is 1.33. and D/E ratio is at the discretion of the banker.

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Nayak committee

• 1991• Institutional credit to SSI• Based on projected turn over limited to 20%of

such turn over.• New person it should be based on existing

entrepreneurs• Upto 2 crores-turn over method for other than

SSI• SSI-upto 5 crores• WC above 10 crores- 80% demand-payablein 6

instalments; 20% cash credit

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• END of Debtors’ management

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Thank You

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Inventory Managementunit-15 page-445-476

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Inventory Management-Unit-15

• Techniques of inventory Management

1. Economic Ordering Quantity2. Fixation of inventory levels3. Inventory Turnover4. ABC Analysis5. Bill of Materials6. Perpetual Inventory system

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1.Economic ordering Quantity(448)

• EOQ=Root of (2AO/C)• Where A=annual demand in units• O= Cost of placing order (cost from

the time we order till we receive goods)• C= Carrying cost per unit per year

(measured in terms of percentage on cost per unit)

• Assumptions: normally on an average ½ of the units are in the store all the time.

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EOQ Formula by differentiation

• Total cost=(A*MCPU)+(A/Q)*O+(Q/2)C do/dQ =0+AO/(-1/Q^2)+C/2=0

orQ= (2*A*O)/C

A(MCPU)-Material purchase cost which does not change (Fixed)-almost fixed.

Q= Order quantityA= Annual requirement in unitsO=Cost of placing an orderC=Cost of carrying one unit per year.

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Exercise-1

• Annual demand 600 units

• Ordering cost=Rs.400

• Holding cost=40%

• Cost per unit of raw material=Rs.15

• 1)Calculate EOQ

• 2. If 10% discount on material cost if we buy 500units at a time.

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Answer-Exercise-1

• EOQ=Root of (2AO/C)• = Root of(2*600*400/(40%*15)• = Root of 80000• =282.845 units• Total cost of inventory

annually=(600*15)+(3*400)+(1/2*282*40%*15)=9000+1200+846

• =Rs.11,046.

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• Answer-Exercise-1continues• If 10% discount is given cost per unit=15-(10%of

15)=13.5• Total cost=(600*13.5)+(2*400)+(1/2*500*40%*13.5)• = 8100+800+1350• = Rs.10,250• Advise: Purchase 500 units as annual cost of

inventory is cheaper.

• If safety stock is required at any point of time in order to calculate holding cost we add the safety stock with the ½ of EOQ stock.

• Holding cost includes storage and interest on locked up capital

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If 10% discount is given

• If 10% discount is given cost per unit=15-(10%of 15)=13.5

• Total cost=(600*13.5)+(2*400)+(1/2*500*40%*13.5)• = 8100+800+1350• = Rs.10,250• Advise: Purchase 500 units as annual cost of

inventory is cheaper.• If safety stock is required at any point of time in

order to calculate holding cost we add the safety stock with the ½ of EOQ stock.

• Holding cost includes storage and interest on locked up capital, handling, insurance of godown

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2. Fixation of inventory level(458)

• Re-order level=Maximum leadtime *Maximum usage

• Minimum level= Reorder level-(Normal usage*Normal lead time)

• Maximum level=Re-order level+ Re-order qty-(Minimum usage*Minimum Lead time

• Average level=(Maximum level+ Minimum level)/2

• Danger level=Normal usage*Lead time for emergency purchases

Note: Re-order quantity=EOQ

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• EOQ is calculated in order to find Re- order quantity

• Re-order quantity is different from Re-order level

• Sometimes minimum stock=safety stock

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3. Inventory (Stock) turnover ratio

• It explains operating efficiency of the organisation.

• How quickly raw material are converted into finished goods and also gives number of days of conversion.

• It explains number of times in a year raw material are converted into finished goods

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3.Stock turnover ratio

Value of materials consumed in a year

Average stock

Average stock= (Opening stock+ Closing Stock)/2

Page-461

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ABC analysis

• Classify the various inventories according to their importance(70% of the value)

• A-High cost per unit but less quantity (70% of the value)-large investment-effective control on supply

• B- Moderate price per unit but moderate quantity (20% in value)

• C-less cost per unit but large quantity(10% in value)-control on availability of material

Always Better Control

BetterControl Always

Control Always Better

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5. Bill of materials

• Bill of materials is a list of materials required for a job.. It also indicates quantity required for each item.

• It helps in cost computation, material to be purchased by purchase department, that the order to be executed indicator.

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6.Perpetual inventory control system(page-465)(Unit number 15)• Stocks are recorded as soon as placed in

the godown and also recorded immediately as soon as stock is taken out.

• They are recorded in Bin card and stores ledger.

• It helps if insurance claim initiated and also fixing various level of stock, adjusted for discrepancies and periodical profits are estimated.

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Problems-clarification

• Problem number-03,06,7,8,9 and 10 from exercise-page 474-476-EOQ

• Page-474 and 475- prob.4 and 5 in

unit-15.-Level of stock

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Prob.1-page 473

• EOQ=Root of(2*20,000*100)/(20%*4)

=2225(Approximate)

Number of times=20,000/2225

=8.98 times

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Prob.3-page-474

• Root of (2*2400*4.00)/(12%*2.40)

=818 units

Carrying cost includes interest cost

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Prob.6 –page 475

• 2. Re-order level= Safety stock+ (Normal usage*normal lead time)• =100+(32*10)• =420

1. EOQ= Root of(2*8000*12.5)/(20%*1)

=2,00,000/0.2

=1000units

3.Holding cost=(Safety stock+ order size/2)*Carrying cost per unit per year

= (100+1000/2)(*20%*1)

=Rs.120

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Prob.9-answer

• EOQ=100 units

• Total Ordering cost=Rs8000

• Total storage cost=Rs.8000

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