1. CAIIB CAIIB- FINANCIAL MANAGEMENT
- MODULE –D – WORKING CAPITAL & TERM LENDING
-Prof. R.S. Ullal
Consultant & Faculty

2. Module D topics Marginal Costing Capital Budgeting Cash Budget
Working Capital

3. COSTING Cost accounting system provides information about cost
Aim : best use of resources and maximization of returns
cost = amount of expenditure incurred( actual+ notional)
Purposes +profit from each job/product, division, segment+pricingdecision+control+profit planning +inter firm comparison

4. Marginal costing
Marginal costing distinguishes between fixed cost and variable cost
Marginal cost is nothing but cost of Producing an additional unit
Marginal cost= variable cost, if such cost does not require creation of additional facilities.
MC= Direct Material + Direct Labour +Direct expenses

5. Marginal costing problems
Sales - variable cost = contribution
Contribution/ (divided by) sales
= C.S. Ratio
Contribution=Fixed cost (at Break even point)
Fixed Cost / (divided by) contribution per unit = break even units

6. Basic formula Sales price (-) variable cost= contribution
SP less VC =
Contribution 10 6 4 9 3 8 2 7 1 5
(1)
(2)

8. Marginal costing problems
SP = Rs.10, VC =Rs.6 Fixed Cost Rs.60000
Find
Break even point (in Rs. & in units)
C/S ratio
Sales to get profit of Rs.20000

9. Marginal costing problems
Sales Rs
Fixed Cost Rs.20000
B.E.Point Rs.80000
What is the profit ?

10. Management decisions- assessing profitability CONTRIBUTION/SALES=C. S
Management decisions- assessing profitability CONTRIBUTION/SALES=C.S.RATIO
Product sp vc
Contribtion
c/s
Ratio %
ranking A 20 10
10/20
50% 1 B 30
10/30
33% 2 C 40
10/40
25% 3

11. DECISION when limiting factorsSP
Rs.14
Rs.11 VC 8 7
Contribution
Per unit 6 4
Labour hr. pu 2 1
Contri.per hr 3

12. DECISIONS Make or buy decisions Close department
Accept or reject order
Conversion cost pricing

13. Marginal costing
cost‑volume‑profit analysis is reliant upon a classification of costs in which fixed and variable costs are separated from one another. Fixed costs are those which are generally time related and are not influenced by the level of activity.
Variable cost on the other hand are directly related to the level of activity; if activity increases, variable costs will increase and vice‑versa if activity decreases.

14. Marginal costing USES OF COST‑VOLUME‑PROFIT ANALYSIS
The ability to analyse and use cost‑volume‑profit relationship is an important management tool. The knowledge of patterns of cost behaviour offers insights valuable in planning and controlling short and long‑run operations. The example of increasing capacity is a good illustrations of the power of the technique in planning.
The implications of changes in the level of activity can be measured by flexing a budget using knowledge of cost behaviour, thereby permitting comparison to be made of actual and budgeted perfor­mance for any level of activity.

15. Marginal costing LIMITATIONS OF COST‑VOLUME-PROFIT ANALYSIS
A major limitation of conventional CVP analysis that we have already identified is the assumption and use of linear relation­ships. Yet another limitation relates to the difficulty of divid­ing fixed costs among many products and/or services. Whilst variable costs can usually be identified with production servic­es, most fixed cost usually can only be divided by allocation and apportionment methods reliant upon a good deal of judgement. However, perhaps the major limitation of the technique relates to the initial separation of fixed and variable costs.

16. Marginal costing ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING
1. More efficient pricing decisions can be made, since their impact on the contribution margin can be measured.
2. Marginal costing can be adapted to all costing system.
3. Profit varies in accordance with sales, and is not distorted by changes in stock level.
4. It eliminates the confusion and misunderstanding that may occur by the presence of over‑or‑under‑absorbed overhead costs in the profit and loss account.

17. Marginal costing
5. The reports based on direct costing are far more effective for management control than those based on absorption costing. First of all, the reports are more directly related to the profit objective or budget for the period. Deviations from standards are more readily apparent and can be corrected more quickly. The variable cost of sales changes in direct proportion with volume. The distorting effect of production on profit is avoided, especially in month following high production when substantial amount of fixed costs are carried in inventory over to next month. A substantial increase in sales in the month after high production under absorption costing will have a significant negative impact on the net operating profit as inventories are liquidated.

18. Marginal costing
6. Marginal costing can help to pinpoint responsibility according to organisational lines: individual performance can be evaluated on reliable and appropriate data based on current period activity. Operating reports can be prepared for all segments of the company, with costs separated into fixed and variable and the nature of any variance clearly shown. The responsibility for costs and variances can then be more readily attributed to specific individuals and functions, from top management to down management

19. Marginal costing DISADVANTAGES OF MARGINAL COSTING
1. Difficulty may be experienced in trying to segregate the fixed and variable elements of overhead costs for the purpose of marginal costing.
2. The misuse of marginal costing approaches to pricing decisions may result in setting selling prices that do not allow the full recovery of overhead costs.
3. Since production cannot be achieved without incurring fixed costs, such costs are related to production, and total absorprtion costing attempts to make an allowance for this relationship. This avoids the danger inherent in marginal costing of creating the illusion that fixed costs have nothing to do with production.

20. CAPITAL BUDGETING
It involves current outlay of funds in the expectation of a stream of benefits extending far into the future
Year
Cash flow
(100000) 1
30000 2
40000 3
50000 4

21. CAPITAL BUDGETING
A capital budgeting decision is one that involves the allocation of funds to projects that will have a life of atleast one year and usually much longer.
Examples would include the development of a major new product, a plant site location, or an equipment replacement decision.
Capital budgeting decision must be approached with great care because of the following reasons:
Long time period: consequences of capital expenditure extends into the future and will have to be endured for a longer period whether the decision is good or bad.

22. CAPITAL BUDGETING
Substantial expenditure: it involves large sums of money and necessitates a careful planning and evaluation.
Irreversibility: the decisions are quite often irreversible, because there is little or no second hand market for may types of capital goods.
Over and under capacity: an erroneous forecast of asset requirements can result in serious consequences. First the equipment must be modern and secondly it has to be of adequate capacity

23. CAPITAL BUDGETING Difficulties
There are three basic reasons why capital expenditure decisions pose difficulties for the decision maker. These are:
Uncertainty: the future business success is today’s investment decision. The future in the real world is never known with certainty.
Difficult to measure in quantitative terms: Even if benefits are certain, some might be difficult to measure in quantitative terms.
Time Element: the problem of phasing properly the availability of capital assets in order to have them come “on stream” at the correct time.

24. CAPITAL BUDGETING Independent Dependent Mutually exclusive
Methods of classifying investments
Independent
Dependent
Mutually exclusive
Economically independent and statistically dependent
Investment may fall into two basic categories, profit-maintaining and profit-adding when viewed from the perspective of a business, or service maintaining and service-adding when viewed from the perspective of a government or agency.

25. CAPITAL BUDGETING
Expansion and new product investment
Expansion of current production to meet increased demand
Expansion of production into fields closely related to current operation – horizontal integration and vertical integration.
Expansion of production into new fields not associated with the current operations.
Research and development of new products.

26. CAPITAL BUDGETING Reasons for using cash flows
Economic value of a proposed investment can be ascertained by use of cash flows.
Use of cash flows avoids accounting ambiguities
Cash flows approach takes into account the time value of money
For any investment project generating either expanded revenues or cost savings for the firm, the appropriate cash flows used in evaluating the project must be incremental cash flow.
The computation of incremental cash flow should follow the “with and without” principle rather than the “before and after” principle

27. Types of capital investments
New unit
Expansion
Diversification
Replacement
Research & Development

28. Significance of capital budgeting
Huge outlay
Long term effects
Irreversibility
Problems in measuring future cash flows

29. Facets of project analysis
Market analysis
Technical analysis
Financial analysis
Economic analysis
Managerial analysis
Ecological analysis

30. Financial analysis Cost of project Means of finance Cost of capital
Projected profitability
Cash flows of the projects
Project appraisal

31. Decision process PLANNING PHASE INVESTMENT OPPORTUNITIES PROPOSALS
REJECTED
Improvement in planning & Evaluation procedure
Improvement in planning & Evaluation procedure
PROPOSALS
NEW INVESTMENT OPPORTUNITIES
EVALUATION PHASE
Rejected
Proposals
PROJECTS
SELECTION PHASE
Rejected
projects
ACCEPTED PROJECTS
IMPLEMENTATION PHASE
ONLINE PROJECTS
CONTROL PHASE
PROJECT TERMINATION
AUDITING PHASE

32. Methods of capital investment appraisal
DISCOUNTING
NON-DISCOUNTING
Net present value (NPV)
Pay back period
Internal rate of return (IRR)
Accounting rate of return
Profitability Index or Benefit cost ratio

33. Present value of cash flow stream- (cash outlay Rs.15000)@ 12%
Year
Cash flow PV PV 1
1000
0.893
893 2
2000
0.799
1594 3
0.712
1424 4
3000
0.636
1908 5
0.567
1701 6
4000
0.507
2028 7
0.452
1808 8
5000
0.404
2020
13376

34. Present value of cash flow stream- (cash outlay Rs.15000 )@10%
Year
Cash flow PV PV 1
2000
0.909
1818 2
0.826
1652 3
0.751
1502 4
3000
0.683
2049 5
0.621
1863 6
4000
0.564
2256 7
0.513
2052 8
5000
0.466
2330
15522

35. CAPITAL BUDGETING The advantages of IRR over NPV are:
1. It gives a percentage return which is easy to understanding at all levels of management.
2. The discount rate/required rate of return does not have to be known to calculate IRR. It does have to be decided upon at sometime because IRR must be compared with something. The discussion as to what is an acceptable rate of return can however be left until much later stage. In a NPV calculation the discount rate must be specified prior to any calculation being performed.

36. The advantages of NPV over IRR are:
1. NPV gives an absolute measure of profitability and hence immediately shows the increase in shareholder’s wealth due to an investment decision.
2. NPV gives a clear answer in an accept/reject decision. IRR gives multiple answers.
3. NPV always gives the correct ranking for mutually exclusive project while IRR may not.
4. NPVs of projects are additive while IRRs are not.
5. Any changes in discount rates over the life of a project can more easily be incorporated into the NPV calculation.
The NPV approach provides as absolute measure that fully represents in value of the company if a particular project is undertaken. The IRR by contrast, provides a percentage figure from which the size of the benefits in terms of wealth creation cannot always be grasped.

42. Future value
Assume that an investor has $1000 and wishes to know its worth after four years if it grows at 10 percent per year. At the end of the first year, he will have $1000 X 1.10 or 1,100. By the end of the year two, the $1,100 will have grown to $1,210 ($1,100 X 1.10). The four-year pattern is indicated below.

43. BUDGET Quantitative expression of management objective
Budgets and standards
Budgetary control
Cash budget

44. PROFIT PLANNING Budget & budgetary control Marginal costing
CVP and break even point
Comparative cost analysis
ROCE

45. PRICING DECISIONS pricing Full cost pricing Conversion cost pricing
Marginal cost pricing
Market based

46. PRICING DECISIONS PRICING AND ITS OBJECTIVES
The objective of pricing in practice will probably be one of the following:
(a) To ‘skim’ the market (in the case of new products) by the use of high prices;
(b) To penetrate deeply into the market (again with new products) at an early stage, before competition produces similar goods;
(c) To earn a particular rate of return on the funds invested via the generating of revenue; and
(d) To make a profit on the product range as a whole, which may involve using certain items in the range as loss leaders, and so forth.

47. PRICING DECISIONS Full cost pricing
The object is to recover all costs incurred plus a percent­age of profit. It is a method best used where the product is clearly differentiated and not in immediate, direct competition. It would not lend itself to situation where price tended to be determined by the market,

48. PRICING DECISIONS Conversion cost pricing
Conversion cost consists of direct labour cost and factory overhead, ignoring the cost of the raw material on the grounds that profit should be made within the factory and not upon materials bought from suppliers.

49. PRICING DECISIONS Marginal cost pricing
Briefly it is that cost which would not be incurred if the production of the product were discontinued. An important advantage of differential cost of pricing is the flexibility it gives to meet special short‑term circumstances, while accepting that full costs must be recovered in the long term. This is by no means always desirable in the short term. For example, there may be surplus productive capacity in a factory, in which case any opportunity to accept an order which covers differential cost and makes a contribution to fixed cost and profit should be accepted. Any contribution is better than none.

50. PRICING DECISIONS Market based pricing
This can be based on the value to a customer of goods or services and involves variable pricing. It also takes account of the price he is able and willing to pay for the goods or services. Businesses using this approach develop special products or services which command premium prices.
The other market‑based approach is to price on the basis of what competitors are charging.

51. Operating leverage Financial leverage
OL= amount of fixed cost in a cost structure. Relationship between sales and op. profit
FL= effect of financing decisions on return to owners. Relationship between operating profit and earning available to equity holders (owners)

52. Working capital
Current assets less current liabilities = net working capital or net current assets
Permanent working capital vs. variable working capital

53. Working capital cycle
cash> Raw material > Work in progress > finished goods > Sales > Debtors > Cash>
Operating cycle – it is a length of time between outlay on RM /wages /others AND inflow of cash from the sale of the goods

54. Matching approach to asset financing
Total Assets
Short-term
Debt $
Fluctuating Current Assets
Long-term
Debt +
Equity
Capital
Permanent Current Assets
Fixed Assets
Time

55. THE WORKING CAPITAL CYCLE (OPERATING CYCLE)
Accounts Payable
Value Addition
Raw
Materials
W I P
THE WORKING CAPITAL CYCLE (OPERATING CYCLE)
Finished
Goods
Cash
Accounts
Receivable
SALES

56. Operating cycle concept
A company’s operating cycle typically consists of three primary activities:
Purchasing resources,
Producing the product and
Distributing (selling) the product.
These activities create funds flows that are both unsynchronized and uncertain.
Unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example collection of receivables).
They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy.
Working capital cycle
Working capital cycle

57. Working capital
FACTORS DETERMINING WORKING CAPITAL 1.     Nature of the Industry 2.     Demand of Industry 3.     Cash requirements 4.     Nature of the Business 5.     Manufacturing time 6.     Volume of Sales 7.     Terms of Purchase and Sales 8.     Inventory Turnover 9.     Business Turnover Business Cycle Current Assets requirements Production Cycle

58. Working capital
Working Capital Determinants (Contd…) 13.     Credit control 14.     Inflation or Price level changes 15.     Profit planning and control 16.     Repayment ability 17.     Cash reserves 18.     Operation efficiency 19.     Change in Technology 20.     Firm’s finance and dividend policy 21.     Attitude towards Risk

59. TYPES OF WORKING CAPITAL
BASIS OF CONCEPT
BASIS OF TIME
Permanent / Fixed WC
Temporary / Variable WC
Gross Working Capital
Net Working Capital
Seasonal WC
Special WC
Regular WC
Reserve WC

60. Working capital Working Capital Levels in Different Industries
A retailing company usually has high levels of finished goods stock and very low levels of debtors. Most of the retailer’s sales will be for cash, and an independent credit card company or a financial subsidiary of the retail business (which on occasions is not consolidated in the group accounts). The retailing company, however, usually has high levels of creditors. It pays its sup­pliers after an agreed period of credit. The levels of working capital required are therefore low:

61. Working capital
Excess of current assets over current liabilities are called the net working capital or net current assets.
Working capital is really what a part of long term finance is locked in and used for supporting current activities.
The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors.
When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources.
In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.

62. Working capital
In contrast, a manufacturing company will require relatively high levels of working capital with investments in raw materials, work-in-pro­gress and finished goods stocks, and with high levels of debtors. The credit terms offered on sales and taken on purchases will be influenced by the normal contractual arrangements in the industry.

63. Working capital Debtors Volume of credit sales Length of credit given
Effective credit control and cash collection
Stocks Lead time & safety level
Variability of demand
Production cycle
No. of product lines
Volume of
   – planned output
   – actual output
  – sales
Payables Volume of purchases
Length of credit allowed
Length of credit taken – Discounts
Short‑term finance All the above
Other payments/receipts
Availability of credit Interest rates

64. Working capital Cash Levels
it is necessary to prepare a cash budget where the minimum balances needed from month to month will be defined.
business is seasonal, cash shortages may arise in certain periods. Generally it is thought better to keep only sufficient cash to satisfy short‑term needs, and to borrow if longer‑term requirements occur
The problem, of course, is to balance the cost of this borrowing against any income that might be obtained from investing the cash balances.
The size of the cash balance that a company might need depends on the availability of other sources of funds at short notice, the credit standing of the company and the control of debtors and creditors

65. Working capital Debtors
The debtors problem again revolves around the choice between profitability and liquidity. It might, for instance, be possible to in­crease sales by allowing customers more time to pay, but since this policy would reduce the company’s liquid resources it would not necessarily result in higher Profits.
historical analysis or the use of established credit ratings to classify groups of customers in terms of credit risk

66. Working capital
Establish clear credit practices as a matter of company policy.
Make sure that these practices are clearly understood by staff, suppliers and customers.
Be professional when accepting new accounts, and especially larger ones.
Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc.
Establish credit limits for each customer... and stick to them.
Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves.

67. Working capital
7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector Keep very close to your larger customers Invoice promptly and clearly Consider charging penalties on overdue accounts Consider accepting credit /debit cards as a payment option Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old.

68. DIMENSIONS OF RECEIVABLES MANAGEMENT
OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES
Profitability
Costs &
Profitability Optimum Level
Liquidity
Stringent Liberal

69. Working capital-FACTORING
Definition:
Factoring is defined as ‘a continuing legal relationship between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the client’s book debts (accounts receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers’.

70. Working capital-FACTORING
It is the outright purchase of credit approved accounts receivables with the factor assuming bad debt losses.
Factoring provides sales accounting service, use of finance and protection against bad debts.
Factoring is a process of invoice discounting by which a capital market agency purchases all trade debts and offers resources against them.

71. Working capital-FACTORING
Debt administration:
The factor manages the sales ledger of the client company. The client will be saved of the administrative cost of book keeping, invoicing, credit control and debt collection. The factor uses his computer system to render the sales ledger administration services.

72. Working capital-FACTORING
Different kinds of factoring services
Credit Information: Factors provide credit intelligence to their client and supply periodic information with various customer-wise analysis.
Credit Protection: Some factors also insure against bad debts and provide without recourse financing.
Invoice Discounting or Financing : Factors advance 75% to 80% against the invoice of their clients. The clients mark a copy of the invoice to the factors as and when they raise the invoice on their customers.

73. Working capital-FACTORING
Services rendered by factor
Factor evaluated creditworthiness of the customer (buyer of goods)
Factor fixes limits for the client (seller) which is an aggregation of the limits fixed for each of the customer (buyer).
Client sells goods/services.
Client assigns the debt in favour of the factor
Client notifies on the invoice a direction to the customer to pay the invoice value of the factor.

74. Working capital-FACTORING
Client forwards invoice/copy to factor along with receipted delivery challans.
Factor provides credit to client to the extent of 80% of the invoice value and also notifies to the customer
Factor periodically follows with the customer
When the customer pays the amount of the invoice the balance of 20% of the invoice value is passed to the client recovering necessary interest and other charges.
If the customer does not pay, the factor takes recourse to the client.

75. Working capital-FACTORING
Benefits of factoring
The client will be relieved of the work relating to sales ledger administration and debt collection
The client can therefore concentrate more on planning production and sales.
The charges paid to a factor which will be marginally high at 1 to 1.5% than the bank charges will be more than compensated by reductions in administrative expenditure.
This will also improve the current ratio of the client and consequently his credit rating.
The subsidiaries of the various banks have been rendering the factoring services.
The factoring service is more comprehensive in nature than the book debt or receivable financing by the bankers.

76. Working capital- INVENTORY MANAGEMENT
Managing inventory is a juggling act.
Excessive stocks can place a heavy burden on the cash resources of a business.
Insufficient stocks can result in lost sales, delays for customers etc.
INVENTORIES INCLUDE
RAW MATERIALS, WIP & FINISHED GOODS

77. FACTORS INFLUENCING INVENTORY MANAGEMENT
Lead Time
Cost of Holding Inventory
Material Costs
Ordering Costs
Carrying Costs
Cost of tying-up of Funds
Cost of Under stocking
Cost of Overstocking

78. Working capital Cost of Working capital
The other aspect of the working capital problem concerns obtaining short‑term funds. Every source of finance, including taking credit from suppliers, has a cost; the point is to keep this cost to the minimum. The cost involved in using trade credit might include forfeiting the discount normally given for prompt payment, or loss of goodwill through relying on this strategy to the point of abuse. Some other sources of short‑term funds are bank credit, overdrafts and loans from other institutions. These can be unsecured or secured, with charges made against inventories, specif­ic assets or general assets.

79. Working capital
Disadvantages of Redundant or Excess Working Capital õ Idle funds, non-profitable for business, poor ROI õ Unnecessary purchasing & accumulation of inventories over required level õ  Excessive debtors and defective credit policy, higher incidence of B/D. õ Overall inefficiency in the organization. õ When there is excessive working capital, Credit worthiness suffers õ  Due to low rate of return on investments, the market value of shares may fall

80. Working capital
Disadvantages or Dangers of Inadequate or Short Working Capital õ Can’t pay off its short-term liabilities in time. õ  Economies of scale are not possible. õ  Difficult for the firm to exploit favourable market situations õ  Day-to-day liquidity worsens õ  Improper utilization the fixed assets and ROA/ROI falls sharply

81. Working capital cycle
Example: X Company plans to attain a sales of Rs 5 crores. It has the following information for production and selling activity. It is assumed that the activities are evenly spread through out the year.
(a) Average time raw materials are kept in store prior to issue for production.2months
(b) Production cycle time or work-in-progress cycle time months
(c) Average time finished stocks are kept in sale in unsold condition /2 months
(d) Average credit available from suppliers /2 months
(e) Average credit allowed to customer /2 months
(f) Analysis of cost plus profit for above sales:
% Rs. In Crores
Raw Materials
Direct Labour
Overheads
Profit
Total

82. Working capital cycle Calculation of Working Capital Requirement:
1. Total months to be financed to Raw Material Months
Time in raw material store
Working progress cycle
Finished goods store /2
Credit given to customer /2 6
Less: Credit available from suppliers ½
Total months to be financed to Raw Materials ½
2. Total months to be financed to Labour
Production cycle
In Finished stock store ½
Credit to customer ½
Total Months to be financed

83. Working capital cycle 3. Total months to be finacned to overhead
Production cycle
In finished goods stores ½
Credit to customer ½ 4
Less: Credit from suppliers ½
Total months to be financed ½
4. Maximum working capital required Rs in crores
Raw Materials 4 ½ / 12 ×
Direct Labour  4 / 12    ×
Overheads 2 ½ ×
Maximum Working Capital

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