WCM - Intro

8/6/2019 WCM - Intro

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Working Capital Management

Introduction


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Overview of the course

Pipeline theory of working capital:

Accounts receivable capture major working funds of an enterprise. Hence

the trade credit policy should be such as to increase the value of the

business, without endangering it.

Inventory management has come to major focus in working capital

management of an enterprise. While the risk of being out of stock is very

high in the production floor and the marketing outlets, overstocking eats into

the profitability of an enterprise both in terms of cost of funds and wastage

of materials. Models like MRP shall be dealt with.

Cash flow framework and the day to day management of liquidity models

shall be discussed.

Management of current liabilities shall be discussed.

Financing working capital requirement shall be discussed.


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Definition

Accountants view: Current Assets Current Liabilities. Concerned at the

arithmetical accuracy. Finance Managers view: Current Assets. Concern is to find funds for each

item of CA at such cost and risk that the evolving financial structure remainsbalanced.

Production Controllers View: the fund needed to meet the day to dayworking expenses ie. to pay for materials, wages and other operating

expenses. A more expressive definition: the amount of capital required for the smooth

and uninterrupted functioning of the normal business operations of acompany ranging from the procurement of raw materials, converting thesame into finished products for sale and realizing cash along with profitsfrom the accounts receivables that arises from the sale of finished goods oncredit.

Gross WC: total of CA including loans and advances. Net WC: CA CL including provisions.


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Definition contd

An alternate way of looking at working capital is Non cash working capitaldefined as: Non cash current assets non interest bearing current liabilities.

Why cash is removed from the definition?

Although cash is often held to cover the day to day operations of the firm, it is

also held for other reasons like future investments, safety buffer against adverse

circumstances etc.

Cash earns a market interest rate and hence there is no opportunity cost unlikeinventory and accounts receivables. ( AR)

Only cash that should be considered for the narrower definition of WC is the cash

required for day to day operations. With the advancement of cash management

technologies the cash required for day to day operations has also become

smaller.

The CMS services of banks enables companies to lower interest costs by

reducing the transit time of cheques, improves liquidity, better accounting andreconciliation etc.


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Systems approach operating cycle method

The two sub systems are productive system and the distributive system of a

manufacturing concern.

Productive system is defined as the means by which resource-inputs are

transformed into utility products and services.

A distributive system is defined as the means by which such utility productsare distributed to consumers.

The process by which inputs are transformed into outputs is called

conversion process.

A finance manager has to take an integrated view of the whole system for

proper management of working capital.


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Productive system

Let us assume that the conversion process has 3 sequential stages S1, S2& S3 taking 6 hrs, 4 hrs & 8 hrs.

In order to minimize the idle time the line has to be balanced.

A simple approach to balance the line is taking LCM of 6, 4 & 8 which is 2.

hence S1 will have 3 work places, S2 will have 2 & S3 will have 4.

The balanced conversion will generate 12 units every day with a cycle time

of 2 hrs.

There will be 9 units of inputs always in the pipe line.

6 hrs

6 hrs

6 hrs

4 hrs

8 hrs

8 hrs

8 hrs

8 hrs

4 hrs


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Distributive system

The process is assumed to be

continuous and the flow of finished

goods from the conversion process is

12 units/day.

Assumptions to devise a distribution

system: Also, assume that the sales are on 30

days credit basis.

Hence, pipeline inventory = 228+360

units. ( 30*12) = 588 units. This

includes FG+ debtors.

Adding 9 units of WIP, the total

inventory = 597.

Sequences Averagetime indays

Averagepipelineinventory

Factory storage 1 12

Factory to warehouse 1 12

Processing delay atwarehouse

5 60

Warehouse to distributor 5 60

Processing delay with

distributor

2 24

Distributor to retailer 3 36

Handling and processing atretailer

1 12

Retailer to consumer 1 12

Total 19 228


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In order to enable the system to produce continuously, the pipeline

inventory of 597 units cannot be reduced. Apart from the pipeline, inventories are also built up for:

Optimizing cost and usage of funds, ensuring a reasonable liquidity etc

Two types of inventories that get build up are:

Cycle inventories: the operators in the productive distributive process does notorder for inventory as and when necessary but follows a cyclical replenishment

method based on review of demand and inventory status, transmission time etc. Buffer inventories: besides cycle inventories, a firm is also required to hold

additional inventories to absorb random fluctuations in consumer demand. This iscalled buffer inventory. This can be estimated based on various probabilisticmodels to cushion the effect of greater than expected demand and the averagedemand during the supply lead time.

All these put together forms the minimum possible inventory levels. The

inventories might be higher if the system is not efficient. A small rise or fall in the tail end of the system can create strain on the

firms resources. The strain may be more severe for firms like Bata Indiawhich has to fund the entire system as a whole as it is wholly owned.


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Other discreet assets:

Besides funds blocked in physical inventories, the system may generate other

discrete assets like cash. The liquid cash is necessary as a cushion against

sudden lengthening of the pipeline or a rise in its intensity due to demand.

Other examples includes, security deposit with statutory authorities, suppliers,

advance payments etc. OC theory does not capture the other discreet assets as these are not in the

pipeline.


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Assigning Monetary values

S1 RM 10

OME 2

S2 Value from S1 12

OME 4

S3 Value from S2 16

OME 8

COP 24

Distribution Value from conversion 24

Admin & Distribution 1

CO

GS 25


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Techno financial approach

Core Working Capital: if the pipeline were to stop at the conclusion of the production processie if all goods released by the production cycle were to get sold immediately in cash, the firm

would have required working capital only for the conversion process. This is called CWC.

In our present example:

Annual production is 4320 ( 12*360)

COP Rs 24 * 4320 = 103680

COS = Rs 25*4320 = 108000

Operating expenses are divided undervariable and fixed expenses. The former is proportionalto the volume and the later is a period cost.

Allocation of OH can be made based on the fund cycle of the production process. The amount

ofvariable working expenses and hence the fund engaged in the conversion process is the

value of the WIP.

The conversion fund cycle = aggregate COP / WIP at any point of time.

In the given example = 103680 / 164 = 632.2 times. Ie velocity of conversion fund is 632.2

times a year. Unit velocity of conversion = 1/632.2 = 0.00158179.

Total OH in the example is Rs 4320. Hence, the OH allocated to each cycle of conversion

fund = 0.00158179*4320 = 6.83. Hence, total fund blocked in conversion cycle = 164+6.83 =

170.83.

This is the minimum fund the firm requires under ideal conditions termed as CWC.


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Techno financial approach

Unit velocity of CWC is dependent upon given technology and operatingcondition. Hence it should remain stable for a reasonably long period of time.

A finance manager can do very little on the CWC multipliers of WIP. But there isscope for a finance manager to reduce the multiplier along the distribution line.

Projection of WC

If the volume gets doubled from 4320 to 8640, the variable expenses will also getdoubled to 207360.

Conversion fund cycle = 0.00158179*207360 = 328.

OH per cycle = 0.00158179*4320 = 6.83. ( FOH remain the same)

CWC = 328+6.83 = 334.83.

This is same as COS * Unit velocity.

Both pipeline and discrete assets blocks certain number of CWC cycles. In orderto find out the number of CWC cycles blocked by each asset, divide the amount

blocked by the asset / CWC. Ex: WIP/CWC will give the number of cyclesblocked by WIP.


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Tracing cash

Cash = LTD + Equity+ CL CA other than cash - FA

Sources and uses of cash:

Increasing LT debt & decreasing LT debt

Increasing equity & repurchasing some stock

Increasing CL & paying off a 90 day loan

Decreasing CA other than cash & buying some inventory by cash

Decreasing FA. & buying some property Why did Chrysler offer zero interest loans for low mileage products in 2006

when the gasoline prices soared? What was the impact on the inventory

days of its gas guzzlers?


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Operating & Cash cycles

Day Activity Cash effect

0 Acquire inventory None

30 Pay for inventory (1000)

60 Sell inventory on credit None

105 Collect on sale 1400


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Operating cycle:

The time we acquire inventory to the time we collect cash ie 105 days.

The first part is the time to acquire inventory and sell the same ie 60 days. This is

called the inventory period

The second is the time to collect on sale ie 45 days called the AR period.

Operating cycle = inventory period + AR period.

At each step the asset is moving closer to cash.

Cash cycle:

The cash flows and the other events that occur are not synchronized.

For the AP period we dont pay for the inventory and we dont collect until 105

days.

Hence, 105 -30 = cash cycle. We have to arrange financing for this period.

Cash cycle = operating cycle AP period. The gap in CF can be filled either by ST borrowing or by holding a liquidity

reserve in the form of cash or marketable securities.

This can be shortened by managing the inventory, AP and AR periods.


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Example of managing the cash cycle: Amazon In mid 2006 the market value of Amazon was more than 6 times that of the brick

& mortar bookseller Barnes & Noble even though the sales were only 1.7 times

greater. ST management is one major factor in this.

Amazon turned its inventory about 30 times a year which was 5 times faster than

B&N. Amazon charges its customers CC when it ships and gets paid from the

CC firm in a day. It had a negative cash cycle of 56 days. Similarly Boeing had an inventory period of 59 days and receivables period of 49

days. So its operating cycle was 108 days. But its payables period was 208 days

and hence the cash cycle was (100 days).


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Calculating the operating and cash cycles

Item Beginning Ending Average

Inventory 2000 3000 2500

AR 1600 2000 1800

AP 750 1000 875

Net sales 11500

COGS 8200


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Calculating the operating and cash cycles

Inventory TOR = COGS / Average inventory = 8200/2500 = 3.28 times This means that inventory was bought and sold off 3.28 times during the

year.

Inventory period = 365 days/ ITOR = 111.3 days. Ie inventory sat for 111.3

days before it was sold.

Receivables TO = credit sales / Average AR = 6.4 times

Receivables period = 365/ ARTOR =57 days. Ie the customers took an

average of 57 days to pay.

Operating cycle = 111.3 days+57 days = 168 days. Ie it takes 168 days for

the inventory to get converted to cash.

APTOR = COGS/ average AP = 9.4 times

AP period = 365 days/9.4 = 39 days. Cash cycle = 168 39 = 129 days.


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Interpreting the cash cycle

Cash cycle increases as the inventory and receivables

period gets longer

It becomes shorter if the company can defer the

payment of payables. The longer the cash cycle the more the financing

requirement.

A lengthening of the cash cycle is an early warning

signal that the firm is having trouble moving its inventory

or collecting its receivables. Such problems can be

masked at least partially by an increased payables cycle.

Hence both should be monitored.


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Short term financing policy

The size of the firms investment in CA: a flexible or accommodati

ve policywill maintain a high ratio of CA/ Sales. A restrictive policy would maintain a

low CA/Sales ratio.

The financing of CA: a flexible policy means low ST debt / Long term debt

ratio. A restrictive policy means high ST debt / low LT debt.

Hence a firm with a flexible policy will have relatively large investment in CA

which is financed through LT debt. Flexible policy includes actions like:

Keeping large cash and marketable securities balances

Making large investments in inventory

Granting liberal credit terms which results in large AR.

Restrictive policy actions includes:

Low cash balances

Small in vestments in inventory

Few credit sales.


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Short term financing policy

Managing CA can be thought of as involving a trade off between costs thatrise and costs that fall with the level of investments.

Costs that rise with increases in the level of investments in CA are called

carrying costs. The larger a firm makes investments in CA, the larger the

carrying costs.

Costs that fall with the increases in the level of investments in CA are called

shortage costs.

In general carrying costs are the opportunity costs associated with

investments in CA. the rate of return in CA is very low when compared to

the firms required rate of return.

Shortage costs occur when a firm runs out of cash, runs out of inventory or

when it is unable to extend credit to its customers. A flexible policy is most appropriate when carrying cost is low when

compared to shortage cost.

A restrictive policy is most appropriate when carrying costs are high relative

to shortage costs.

WCM - Intro

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