Financial Management :Working Capital
The Following Factors are consider for availing working capital
Other factors that affect the length of the credit period are the following:
• Buyer's inventory and operating cycle
• Perishability and collateral value
• Consumer demand
• Cost, profitability and standardisation
• Credit risk
• The size of the account
• Customer type
Long credit period may be offered to the customers if this will enable the business to capture a larger share of the available market, or the break into a new market. The initial effect of granting long credit periods may be adverse because of the extra costs involved but profits from increased volumes should more than offset the losses. If it does not there is no use in extending longer credit periods. Even otherwise it is necessary to look to the longer term where, among other possibilities, selling prices may be increased because smaller competitors have been eliminated in the 'credit war'.
Shorter credit may be imposed if demand is inelastic, so that the quantity sold will not be affected simply by changes in credit terms.
Establishing Credit Limits
The fact that the business has a credit policy does not mean that credit terms will be granted to every customer. It is not always easy to decide whether a particular customer is 'credit worthy' in the sense that he has both the ability and the inclination to pay at the due date. Many companies require cash with order from new customers until their creditworthiness have been established.
Five Cs of Credit that a bank looks at are the ones that you should also look at while granting credit:
• Character: Willingness to pay back the credit
• Capacity: Ability to pay back
• Capital: Financial reserves including cash
• Collateral: What assets could be pledged or are pledged to others that hinder payments
• Conditions: Relevant economic conditions
That means that in assessing the creditworthiness of a customer two things are absolutely necessary:
(a) Facts about his business, in particular whether it is profitable, whether it is generating or has access to sufficient cash to met its liabilities, and whether it has suitable assets available to cover the claims of unsecured creditors in the event of winding up. In brief, it is necessary to analyse the accounts of the business. It is helpful also if the customer will supplement these with the sort of information they do not give; e.g., the current order book, any plans for future development, and the condition and market value of the assets owned by his business.
(b) Opinions about the business and the people running it, formed from either personal contacts (director level, or at any reliable and knowlegeable level) or obtained from third parties such as business associates, mutual acquaintances or employees changing jobs.
There are other sources from which we can have information about the company as well as the industry that it is operating in:
(a) Reports from the relevant trade protection association, if one exists;
(b) Trade references from other companies with which the customer does business;
(c) Bank references - these may not give a lot of information but they tend to use a series of standardised replies, and experience of these will indicate the relative credit grading of the customer in question;
(d) Reports published in trade journals or the financial press dealing either with the customer company or with the type of business in which it is engaged.
In assessing the creditworthiness of overseas customers, reports from bankers are an important source of information. It is also necessary to weigh up the risks of the customer being prevented from paying either through political or exchange control restrictions. On all these matters the Export Credits Guarantee Department can usually give guidance.
If the customer's creditworthiness appears to be established, the next stage is to decide the amount of credit to be given.
Theoretically there are three possible ways of doing this:
(a) The income or cash flow method, which requires knowledge of the amounts of cash becoming available to the customer, and how he proposes spending them, thus indicating his ability to pay the supplier's invoices - this method is possible between a bank manager and his client seeking an overdraft or loan, but seldom in business life;
(b) The capital structure method, under which the value of uncharged assets in the customer's last balance sheet is established, and the credit limit will be a percentage of this value. This is a necessary calculation when the proposed value of future transactions will involve a major increase in the customer's total indebtedness, but it is not an indicator of liquidity, and is not particularly relevant to small transactions in the ordinary course of trade;
(c) The requirement method, which is almost always used in practice. If the customer is creditworthy then we should be able to rely on him to pay any amounts arising from the ordinary course of business. The amount of credit granted, therefore, is based on the value of business which the customer expects to place with the supplier each month. The forecast monthly sales to the customer are multiplied by a number of months' credit laid down as company policy to give that customer's credit limit. If, for example, a customer proposed placing orders totalling Rs.1,500 per month with a supplier whose credit terms required payment by the end of the month following the date of invoice (say, two month's credit) the credit limit granted him might be 2xRs.1,500 = Rs.3,000 outstanding on the ledger accounts at any time.
For customers of international repute it may be decided that no limitation of credit is necessary, but the financial difficulties faced by several major companies in recent years must be a warning against the automatic granting of unlimited credit.
Vetting Incoming Orders
The amount appearing on the customer's ledger account at any time will, of course, result from invoicing the orders he has placed, so that if the value of orders in any period were to exceed the original forecast this might not become apparent until after invoicing. At that time the outstanding balance on the ledger would suddenly be found to be in excess of the agreed limit.
To safeguard against this possibility an order register may be kept for each customer, showing the value of orders placed for delivery in particular months. Each incoming order will then be checked against the register to confirm that it will not cause the credit limit to be exceeded. This could be a cumbersome procedure, and normally it would only be used in respect of:
(a) New customers' whose compliance with credit limits has not been established;
(b) Customers who had consistently failed to adhere to their credit limits in the past. (It might be better in such cases to withdraw credit facilities completely).
All incoming orders should be checked to ensure that are placed on the customer's official order form and authorised by somebody purporting to have the power to place that type of order. Computerisation has made this task very easy.
So far as the customer is concerned, the company's credit period does not begin until he receives an invoice. Even then his accounting procedures probably involve a monthly cut off date for the receipt of invoices, so that any invoice received after, say, the 28th day of the month will be treated as belonging to the succeeding month.
It is important, therefore, that delays in invoicing be kept to a minimum. The causes of delay are nearly all within the control of the company, and may include:
(a) An inflexible routine in the sales invoicing department (perhaps invoices are issued only on certain days in the month);
(b) A requirement for approval or signature of sales invoices by members of the sales staff who are often away from the office;
(c) Failure to agree prices for special work; and
(d) For job work, and in other cases where prices are linked with costs, excessively slow procedures for calculating costs.
There must be no slackness in pursuing the collection of debts. In most business purely formal reminders are ineffective, and therefore a waste of money, when an account has passed its due date there should be early personal contact with the customer either by telephone or a salesman's visit or by a letter addressed to a named person in the customer company. If necessary, there may be a follow up at the higher level of authority. And this should be followed by a threat to cut off supplies.
The value of legal action against debtors needs to be assessed. When this stage is reached, the likelihood of the customer's paying is sharply reduced, and additional legal costs may never be recouped. On the other hand, the action may deter potential future defaulters.
From the point of view of the salesman every customer is valuable. From the financial director's standpoint the marginal contribution from goods sold to a late payer will be more profitable without sales to that particular customer.
Overdue debts should be the subject of formal discussion between the sales and financial managers. The reasons for delayed payment should be noted, and decisions should be minuted on the action to be taken in each case and the people responsible for taking it.
Although the salesman's job is not complete until his customer has paid the money due, it is often advantageous for the more rigorous collection procedures to be handled by finance staff, leaving the salesman free to exercise his persuasive influence with the customer's buying department.
Cost of Credit Control
The costs of credit control include the cost of:
• assessing and reviewing creditworthiness;
• checking incoming orders;
• sales ledger keeping, and invoicing
• debt collection.
These costs may occur in various departments of the business, but there should be some means of identifying them and collecting the total cost, which will have to be taken into account in reviewing the benefits of the credit policy.
An alternative or supplement of a formal credit policy is to offer discount for prompt payment. In considering this possibility it is important to bear in mind that:
(a) customers who normally pay promptly will now become entitled to discount, although there will be no improvement in the timing of their payments'.
(b) some late payers will nevertheless deduct discount from their settlements, and there may be some practical difficulty in recovering these incorrect deductions.
There are various other ways in which a business can speed up its collection of cash without requiring the customer to pay any earlier. The most common examples are by using bills discounting or factoring both of which have been mentioned earlier.
An alternative form of protection against bad debts is to take a personal guarantee in support of the customer's account. The value of personal guarantees varies considerably and they are likely to present two problems.
• it may be more difficult to assess the creditworthiness of an individual guarantor than of the trade customer;
• the guarantor does not normally expect to be called upon to pay, and there may be difficulties in obtaining money from him when the need arises.
These problems do not occur to the same extent when the guarantor is another company, often the parent company in the customer's group.
So the objective of the receivables management remains as the most effective way to receive the cash back without sacrificing the sales and future prospects of the company.
When the company gets the trade credit, it would like to pay back as late as possible, because these are the funds that require no interest payments and are free of cost. Right. Wrong, these funds are not free of cost because the sale price of these already includes the cost of the time for which the credit is given.
Cost of Trade Credit
For purposes of measuring the true cost, or the effective annual rate of interest associated with use of trade credit as a discretionary source of short-term business funds, it is necessary to consider the effects of its use both when :
(1) a company fails to take its cash discounts but nevertheless pays within the net period, and
(2) a company fails to take its discounts and allows its payable to become overdue.
These two situations are the only ones that involve an actual cost to the debtor. If no cash discount is offered, then there is no cost for the use of credit during the "net" period, however long it may be. By the same token, if a discount is available and the buyer takes it, there is also no cost for the use of credit during the discount period. However, if a cash discount is offered and is not taken, there is an explicit opportunity cost for the use of third credit.
For example, the Road Company purchases it raw materials on terms of 2/10 net 30. It thus has the option of using the funds for 20 days after the discount period if it "passes" the discount but pays on the final day of the net period. Road Co., however, must pay 2 % of the privilege of using the funds for 20 days. It is given by the equation:
R = C(365 D)
C = the cash discount
D = the number of extra days Road has the use of the
R = the annual interest rate for the use of these funds
In our example, C = 2 percent, D = 20: the effective annual interest rate for the company would be
R = 2 (365) 37.24 per cent
Thus, we see that passed discounts can transform trade credit from a normally easy sources of funds into a very expensive form of short-term financing. Therefore, if other financing is available even though with high interest rates, say 20 or 24%, Road's financial administrator would be well advised to borrow in sufficient time so that it can take advantage of any cash discounts offered by its suppliers.
Sometimes companies that are short of cash and lack reserve borrowing power may be forced to not only pass up cash discounts but also postpone payment beyond the net period. This practice is referred to as "stretching" accounts payable or "riding" trade creditors.
There are two types of costs incurred by a company that stretches its accounts payable
(1) the explicit cost of discounts foregone, as outlined above, and
(2) the implicit cost of permitting its trade credit rating to deteriorate.
If a company rides its creditors excessively, so that its trade payable become noticeably delinquent, its credit rating among all suppliers in the trade will surely suffer. They will view the company as increasingly risky to sell to and may quickly begin to impose rather strict terms of sale, upto and including COD or CBD.
Proper Use of Trade Credit
As compared with other kinds of short-term business credit -- bank loans, for example-trade credit is almost automatic. And because it may be much more readily acquired, business companies must exercise continuing care to avoid falling into the habit of using trade credit to excess.
Because suppliers regard the extension of trade credit as a part of their overall sales promotion programs, they often extend trade credit to many marginally creditworthy companies-small, new companies and old, declining companies-that do not qualify for and consequently cannot obtain credit from other sources of short-term funds. It is also quite easy to get into debt through the use of trade credit.
A company needs only to order additional goods from its suppliers; and if it is occasionally late in making payment, the sales promotion aspect of trade credit extension may prompt suppliers to "look the other way," so that the company's credit reputation may suffer no immediate harm.
Finally, trade credit is exceedingly useful and valuable precisely because business companies can usually obtain it when, as, and to the extent that it is needed. When inventory should be increased to anticipate the seasonal expansion of sales, for example trade credit will automatically finance a part of the increase. Then, as the seasonal sales convert into cash through collections, the company may use the funds to reduce trade payable. For this reason, trade credit is often termed a "spontaneous" source of funds.
Thus, a company's financial officer while assuring that his company benefits from the availability of trade credit in every legitimate way, should always maintain the business liquidity required to pay all his company's bills as they come due. Beyond this, even considering the extremely high cost of passing discounts, he should certainly plan to pay all of his company's trade bills within the discount period. Doing so will have favourable results, not only on the company's credit reputation in the trade but, more important, on its current and long-run profitability as well.
In a negative but equally significant sense, doing so will automatically avoid the possible financial over extension of the company that could result from its succumbing to the temptation to use trade credit excessively "because it is there".
The financial decisions relating to stockholding have certain special features, but looking first at saleable stocks (finished goods) we can postulate that the object of holding stocks is to increase sales, and that the object of increasing sales is to increase profit. We can then create a simple model similar to that for debtors.
The Retail Company Ltd makes cash sales from stock and obtains an average rate of marginal contribution of 25% on sales value. When it holds stocks equivalent to one month’s cost of sales it achieves sales of Rs.10,000 per annum.
It is estimated that by doubling the stock available an increase of 25% in sales value could be achieved; alternatively, if three months’ stocks were held then sales could be increased by 35% from the present level. The effect on profits of these two alternatives, including any relevant changes in costs, is illustrated on the following page.
This somewhat exaggerated example draws attention to three points which are relevant to any further discussion of the financial implications of stockholding policy:
Rs. No credit One month’s Credit Two month’s Credit
Sales 120,000 160,000 240,000
Debtors 13,333 40,000
Stocks (less creditors (Say, 1/12 of sales value) 10,000 13,333 20,000
Total 10,000 26,666 60,000
Increase in working capital through granting credit 16,666 50,000
Marginal contribution 30,000 40,000 60,000
Less: Cost of:
Credit control (6,000) (6,000)
Bad debts (1,600) (4,800)
Relevant comparable profits 30,000 32,400 49,000
Increase in profits 2,400 19,200
But the company requires a return of 15% on the increase in capital employed; i.e. 2,500 7,500
The net advantage (or disadvantage) of the proposed changes in credit policy is therefore (Rs.100) Rs.11,700
There are some points that you need to note here:
• There may be a point beyond which further increase in stock will not give rise to sufficient additional sales and gross profit to justify the additional costs involved.
• Purchase order processing costs per unit or Rs. value of purchases ( and possibly even in total as shown) are likely to diminish as stock holdings are increased, because instead of having to frequent orders for the renewal of stocks, the company is now placing less frequent bulk orders i.e. one negotiation, one order and one progress action cover a large quantity of any particular item;
• Stock holding costs naturally increase with the size of stockholdings because:
1. stocks occupy space which has to be purchased, rented or converted from some other use - that space has to be equipped with racks or containers;
2. people are required to put the stocks into the warehouse, to withdraw them when needed (picking and packing), to record them, check their conditions and ensure they are not lost;
3. stocks lose value if they deteriorate, are wasted in handling, pilfered, destroyed or allowed to become obsolete - it may be desirable to insure against some of these risks;
4. stocks tie up money, involving interest charges or opportunity costs.
Why should increased stocks give rise to increased sales? One reason would be that the business may offer a wider range of goods and it diversifies its range. Another could be that with the existing range the business was offering a better level of service; i.e. it was less frequently out of stock of an item when it was required.
Stock Service Levels
In deciding on an inventory policy it is necessary to define the level of service to be offered to the customer, in the sense of the percentage of order which can be satisfied immediately from stock. This will depend on the nature of the business.
In some cases the company may be the monopoly supplier of certain goods, or may offer particular advantages of quality, reputation., reliability or after-sales services. Where such distinguishing features exist, it is possible that the customers will be prepared to endure occasional delays in meeting their requirements, and it would not be necessary to hold sufficient stocks to ensure immediate delivery.
In other cases quick delivery may be an essential feature of success in achieving sales. This would be the case, for example, if there was strong competition for a limited market, or if the failure to supply a spare part for installed equipment would cause significant loss to the customer while the equipment was out of use.
When the required level of service has been defined, the next problem is to decide how much stock is needed to meet that requirement. This will be the minimum holding, and not the average holding which will be influenced by the stockholding costs illustrated in the previous paragraph.
Pattern of Procurement and Stockholding
Assuming that an item is in constant demand there are no difficulties in obtaining supplies, it would be normal to take a supply into stock and then use it up steadily until it was exhausted, when a new supply would be obtained. Taking the example from the paragraph on control of stock where sales were to be Rs.1,35,000 per annum, assume, that this represents 1,35,000 units of an item of stock at Rs.1 each. If demand is steady, the monthly usage of this item would be 11,250 units.
Now it would be possible to buy all 1,35,000 units at the beginning of the year and to use them progressively as shown in the following diagram:
If this was done then:
• there would be only one purchase, so the related costs in the buying department would be low;
• the average stock holding would be 62,500 units, so there would be 62,500x12 = 7,50,000 unit-months to influence the costs of stock-holding.
An alternative action would be to buy twice during the year, as shown in the next diagram. This would double the procurement costs, but would reduce the average stockholding to 31,250 units so that stockholding costs would be determined by only half the previous number of unit-months.
There is obviously a very large choice of procurement and stockholding patterns; what is needed is to find that pattern which keeps total procurement and holding costs at the lowest possible level.
This means that carrying costs increase with the quantity of inventory on hand and as the inventory go down the carrying costs also go down. But with the declining amount of inventory held restocking costs go up as there are more number of orders and more number of receipts of orders. As total costs are the sum of the carrying and restocking costs we need to find a level where it is minimum. This is depicted graphically in the figure 18.5 above.
Mathematically speaking carrying costs are given by:
Here Q/2 is the average inventory, I the interest rate and P the price per unit.
Similarly Restocking Costs are given by
Here S = total quantity consumed in a year.
As we know that total costs are a sum of these two individual costs. We can say
But this doesn't give us the optimum size of the inventory order. For finding the minimum costs we need to find the 'economic order quantity' for the particular item of stock under review. The effect of the combination of the various items of stock into the total business inventory will be discussed later.
Economic Order Quantity (EOQ)
The economic order quantity is defined as a point where the total costs of restocking and carrying costs are the lowest.
EOQ is usually calculated by a formula based on differential calculus. Though we will not derive the formula we need to understand its working.
There are four assumptions that we make in the EOQ model:
1. Sales can be forecasted perfectly,
2. Sales are evenly distributed throughout the year, and
3. Orders are received as soon as they are placed.
This set of assumptions mean is pretty restrictive and we will relax these assumptions slowly. Before we relax these assumptions there are two important things to note about the EOQ:
1. Although a mathematically precise EOQ can be calculated, in practice there is likely to be a range of order quantities within which total costs remain at a low level. The choice of order quantity within this low-cost range may not significantly affect the overall financial plan.
2. The key factor in the calculations is usually the cost of capital (interest on stockholdings). In times of high interest rates this is likely to outweigh all the other variables. The inventory holding costs will go up very steeply, and one's conclusion will be that stockholdings should be kept to the lowest figure possible having regard to any practical difficulties in obtaining frequent replacement supplies.
Optimum Order Quantity (OOQ)
The last comment above is a reminder that suppliers do not like handling small orders. The purchase price per unit, therefore, may vary with the size of the purchase order, and this will require a modification to our EOQ calculation.
The supplier might, for example, impose a 'minimum order value' so that for quantities below this limit the cost per unit would, in effect, be higher than normal. This would either impose a lower cut-off limit on the size of order placed, or would introduce an upward curve at the lower end of the holding cost line on the EOQ chart, since insurance and interest charges per unit would be relatively high until the small order limit was reached. For larger orders, on the contrary, there might be quantity discounts, and these would cause one or more downward steps at those points on the holding cost line where they began to operate.
This possibility can result in minimum total cost which differs from the position of the EOQ as originally calculated. This point is sometimes distinguished as the 'optimum order quantity'.
Safety Margins in Stockholding
So far we have assumed that a company will he placing purchase orders at regular intervals of time for a fixed quantity (the economic or optimal order quantity) of any particular item. The possibility of doing this depends on demand remaining constant from period to period and on supplies being available as and when required.
Sales demand, however, could show fluctuations around the normal level, so that in a period of high demand the available stock could be used up before fresh supplies are due. Similarly, in some periods deliveries from suppliers could be delayed so that even the normal sales demand could not be satisfied.
Against both these contingencies, it is necessary to hold a safety margin of stock. If it were necessary to hold a safety margin sufficiently large to cover the simultaneous occurrence of a peak in demand and a delay in supplies, then the minimum stockholding would form the greater part of the total stockholding.
Very little can be done to correct for random delays in supply, but it may be possible to anticipate changes in the trend of demand and to modify the purchasing procedure to meet them in one of the following ways:
• to order in economic order quantities but at varying time intervals according to the rate of demand currently being experienced, or anticipated in the near future - this is known as the fixed order quantity or re-order level system (for reasons which will be explained below);
• to order at regular intervals but in varying quantities determined by the current rate of demand - this is the fixed interval, or periodic review
Modified Ordering Systems
The re-order level system involves deciding a level of stockholding at which new purchase orders shall be placed. This will be decided in relation to the normal rate of issues during the normal purchasing lead time. The quantity to be ordered is constant, and an order for that quantity will be placed whenever stock falls to the pre-determined order level. The system thus responds quickly to variations in demand though there is a danger that in doing so it may reflect purely short term or random fluctuations in sales.
The operation of re-order level system include the use of:
• A maximum stock level. This would correspond to the normal peak holding under stable conditions. If the stockholding exceeds the peak level this provides a warning that demand has been running below the rate expected when the EOQ was fixed. The stock controller should then review the correctness of his standard purchase order quantity
• a minimum stock level which, as suggested above, is probably the amount of the safety margin.
The minimum stock level provides a warning of a potential out-of-stock position. When a stockholding falls to that level the stock controller will review his outstanding purchase orders and their due dates, and also the current trend of demand, and can then decide whether additional emergency procurement is necessary.
Under the periodic review system purchase orders are placed at fixed intervals of time but the quantity ordered can be modified to meet the rate of demand indicated by current experience. This gives an opportunity for analysing the trend of demand, and various techniques such as 'exponential smoothing' can be used in forecasting this trend. The system does not respond rapidly to immediate needs, and it may therefore necessitate a larger safety margin than the re-order level system.
It is, in fact, a common experience that the re-order level system gives slightly lower average stock levels, and it is sometimes thought to be the cheaper system to operate because reordering is triggered automatically at the re-order levels, however, requires reviewing in the light of changes in the rate of demand. Any system can appear cheap in the short run if it is operated in a slovenly manner.
Infrequent and Seasonal Demand
In most inventories it will be necessary to carry items which are slow moving in the sense that units of demand are separated by significant intervals of time. These items may have high individual value but because they are demanded infrequently they will probably contribute only a small percentage of the total annual value of sales. The normal distribution of stockholdings would show that about 20% of the line items carried would contribute 80% of the total annual usage, though this relationship will vary between different types of business.
It may be decided not to hold stocks of some slow-moving items, but to procure them as and when they are required. If a stock is needed however the amount held will probably be limited to the quantity most likely to be next demanded, the occurrence of the demand being the signal for further procurement action. The quantity held may, however, be increased if the purchase price per unit is sufficiently lower for large quantities so as to offset any increase in holding costs for a larger stock holding. This could occur for example when the supplier imposed a minimum order value.
There should be a regular review of slow-moving items to identify stocks which have become technically obsolete or for which the demand has diminished to the point where stock holding is no longer justified.
In some businesses (for example, ladies fashion wear), it is necessary to place orders for the full seasonal requirement well in advance of the demand occurring, with a high probability that repeat orders will not be obtainable. In such instances the purchase and sale of each batch will be a separate project or venture dependent heavily on accurate forecasting of demand quantities and selling prices. In this case, the evaluation procedure applicable to stock holding for continuous demand will not apply.
Of a similar nature will be decisions like the following:
• to purchase goods in bulk in advance of demand arising in order to protect the business against anticipated price rises or shortages of supply;
• to purchase commodities forward at a fixed price for future delivery;
• to combine forward purchase options with forward sales options, so as to limit losses arising from price changes (including changes in currency exchange rates);
• to purchase foreign currency forward against specific overseas purchases, so as to minimise the effect of changes in exchange rates.
These are financial decisions quite separate from the routine problems of inventory control, and would be evaluated as investment projects.
The Total Inventory
The techniques described in the foregoing paragraphs all relate to single line items of stock; the assumption has been made that if each item is held at its own economic level then the overall holding of stock will be correctly balanced. This would be true provided that two conditions were satisfied.
• that there was enough space available to hold all the stocks required; and
• that enough money could be found to finance them.
Neither condition is likely to be fulfilled in practice, so some form of mathematical programme might be used to constrain the ideal unit quantities within the limiting factors. There are, however, a number of simple pragmatic approaches to inventory reduction, and these include:
• modifying the service level offered, either generally or in relation to selected items;
• letting the company's suppliers act as stockholders (possibly by placing bulk orders with schedules of call-off dates linked to sales demand);
• discontinuing those items which are the least profitable having regard to their marginal contribution and relevant fixed costs per unit of the limiting factor.
Raw Material Stocks and Work-In-Progress
So far, in considering inventory control we have been discussing saleable stocks, but the same principles apply to stocks of raw materials. The main difference is that demand for raw materials is not direct from the outside customers but indirect through the production plans of the factory using the raw materials.
In considering the scheduling of production the 'Economic Batch Quantity' (EBQ) corresponds to the EOQ for purchased items. Manufacture in small batches will be more costly than in larger batches because there will be greater repetition of planning and progress actions and of the setting up and breaking-down of machine tooling, and also because there will be less opportunity for an efficient momentum of work to be established. However, these batch processing costs (like procurement costs of stocks) will change inversely to the holding costs of the work-in-progress (floor space, insurance, interest on capital, etc.).
A big problem with work-in-progress is that work passes in sequence through a series of operations. What is an economic batch for lathe work may not be economic for drilling, milling or assembly operations. Applying EBQ calculation to one operation in isolation can cause bottlenecks in the flow or production - creating excessive holdings of partly-completed work because it could be produced cheaply in a large batch, even though there will be no demand for that work for some time ahead.
A similar problem is that of keeping skilled work people steadily occupied, since their wages are basically fixed in relation to time, even though outside customer demand may be seasonal or erratic.
Because these problems are concerned with the uneven timing of cash flows they are best solved by the use of discounted cash flow techniques. If, however, there is a capability of a rate of production which is in excess of a steady rate of demand (internal or external) then the problem is to decide what is the economic length of a production run, the facilities then being switched to other work until the next run is required.
As the number of items could be very large in case of raw materials it is necessary to find ways to selectively pay attention to those items that represent the highest value. A categorisation method known as ABC analysis is used for the same purpose. The idea behind ABC analysis is that attention is focussed on the highest value items that are usually small in number categorised as A-category items and the lowest value items are categorised as C and are ordered in more quantities so that less attention is required there.
For example in the figure 18.6 below, the A category items represent only 10 % of total inventory items but represent 57 % of the total value. While C category items represent 50 % of the total items but only 16 % of the value. By concentrating more on the A category items the company is able to manage its raw material inventory better.
Integrated Short Term Funds Planning
Short-term financial planning is concerned with the management of the company's short-term, or current assets and liabilities. The most important current assets are cash, marketable securities, inventories and accounts
receivable. The most important current liabilities are bank loans and accounts payable.
Current assets and liabilities are turned over much more rapidly than the other items on the balance sheet. Short-term financing and investment decisions are more quickly and easily reversed than long term decisions. Consequently, the financial manager does not need to look too far into the future when making them.
The nature of company's short term financial planning problem is determined by the amount of long term capital it raises. A company that issues large amounts of long term debt or equity, or which retains a large part of its earnings, may find that it has permanent excess cash. In such cases there is never any problem paying bills, and short term financial planning consists of managing the company's portfolio of marketable securities. Companies with permanent excess cash should look at the cost of funds and pay them out to the shareholders if they are earning less than the cost of funds.
Other companies raise relatively little long term capital and end up as permanent short term debtors. Most companies attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long term debt. This may even be required by the bank to be so. Such companies may invest cash surpluses during part of the year and borrow during the rest of the year.
The starting point for short term financial planning is an understanding of sources and uses of cash. Companies forecast their net cash requirements by forecasting collections on accounts receivable, adding other cash inflows, and subtracting all forecasted cash outlays.
If the forecasted cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, you will need to find additional finance. It may make sense to raise long term finance if the deficiency is permanent and large. Otherwise you may choose from a variety of sources of short term finance.
In addition to the explicit costs of short term financing, there are often implicit costs. The financial manager must choose the financing package that has lowest total cost (explicit and implicit costs combined) and yet leaves the company with sufficient flexibility to cover contingencies.
Short Term Financial Planning Model
Working out a consistent short term plan requires burdensome calculations. Fortunately much of the arithmetic can be delegated to a computer. Many large companies have built models to do this. Smaller companies do not face so much detail and complexity and find it easier to work with a spreadsheet programme on a personal computer.
In either case the financial manager specifies forecasted cash requirements or surpluses, interest rates, credit limits, etc. and the model grinds out a plan. The computer also produces balance sheets, income statements, and whatever special reports the financial manager may require.
Smaller companies that do not want custom built models can buy general purpose models offered by accounting companies, management consultants or specialised computer software companies.
Most of these models are simulation programmes. They simply work out the consequences of the assumptions and policies specified by the financial manager. Optimisation models for short term financial planning are also available. These models are usually linear programming models. They search for the best plan from a range of alternative policies identified by the financial manager.
Optimisation helps when the company faces complex problems with many interdependent alternatives and restrictions for which trial and error might never identify the best combination of alternatives.
Of course the best plan for one set of assumptions may prove disastrous if the assumptions are wrong. Thus, the financial manager has to explore the implications of alternative assumptions about future cash flows, interest rates and so on. Linear programming can help identify good strategies, but even with an optimisation model the financial plan is still sought by trial and error.
In defining short term finance, we focus on the cash flows connected with the operations of a company. Short term financial management thus encompasses decisions about activities that affect cash inflows, cash outflows, liquidity, backup liquidity, and internal cash flows. Many decisions of a company have a short term financial management aspect.
Components of Working Capital include: Cash, Short term investments, Trade Debtors, Inventory and Trade Creditors. Bank Overdraft or Cash Credit and Short Term Borrowings are tow of the major ways of financing working capital.
Working parameters of a company influence the composition mix of various components of working capital. Whether the company does made to order work or it keeps stock in inventory? Whether it is manufacturing company or a trading company? Single product companies normally operate with a lower quantum of working capital than a multi-product or multi-process companies.
The size of the company’s investment in current assets is determined by its short-term financial policies. A company keeping a flexible working capital policy means that the company is very liberal in its trade terms and has invested a large amount of funds in its operations. This means that the company borrows as the seasonal needs grow to fund its working capital needs. Flexible policy means that company is carrying excess cash and hence bearing higher carrying costs than the other two policies. As the level of working capital increases, shortage costs go down while the carrying costs increases.
There are other factors Influencing Working Capital including: Profit levels, Tax Levels & Planning, Depreciation Policy and Operating Efficiency of the company.
Operating efficiency of an company plays a major role in working capital management. An efficient company will have a shorter manufacturing period, long credit terms available from suppliers and minimal customers credit outstanding.
If we are getting trade credit to fund our needs, we also have to extend trade credit to our customers. This involves various costs including:
1. Cost effects: Extending credit means that the company has to maintain a credit department. This