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Introduction to

Financial Management

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Business

Business is an economic/financial entity &

involves economic/financial activities..

Trading activity

Manufacturing activity

Servicing activities

Buying Selling

Buying Processing Selling

Servicing

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Business Organization/entities - Forms

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Purpose of an economic entity -

Wealth creation

Wealthmanagement, and

Wealthdistribution

Objective To create the best possible values andshare them in the equitable manner among all the

stakeholders.

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Stakeholders in the Business

Investors- Equity holders- Debt holders including banks and financial

institutionsSuppliersDistributors and retailers

EmployeesCustomersCommunity

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Financial Management for a Startup firm

Lets Suppose think you are planning to start your

own business.

No matter what nature of business

What are the questions you think you need toanswer ???

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May be all these..

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Business Finance

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Nature of Financial Management

Financialmanagement ismainly concerned

with the propermanagement of

funds.

It refers to theapplication of

financialmanagementtools and

techniques tocoordinate all the

financialfunctions in the

business

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Financial ManagementDEF

INITIONSAccording to Solomon Financial Management

is concerned with the efficient use of an important

economic resource, namely capital funds

Phillippatus Financial management isconcerned with the managerial decision that result

in the acquisition and financing of short term &

long term credits for the firm.

S.C Kuchhal Financial management deals with

procurement of funds and their effective utilization

in the business.

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Financial management is that managerial activity

which is concerned with the planning and

controlling of the firm's financial resources.

Planning, directing, monitoring, organizing andcontrolling of the monetary resources of an

organization.

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Scope of Financial Management

1. Traditional Approach

It is concerned with raising of funds andadministration of funds

Raising funds from financial institutions

Maintaining proper records and legal activities

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Modern approach

To decide how much amount is required from

where and maintain records.

What type of assets are required In what ways the funds are utilized i.e optimum

utilization

Taking dividend decision

Scope of Financial Management

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Objectives of Financial management

Profit Maximization

Wealth Maximization

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Objectives of Financial management

1.Profit maximizationDecision making in order

to maximize profit.

Profit

Owner oriented conceptamount and share ofnational income paid to the owners of business

Operational conceptvalue created by the use of

resources is more than the total of the input

resources (Profitability)

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Profit maximization

It is Vague

It Ignores the Timing of Returns

It Ignores Quality aspect of benefits

Assumes Perfect Competition

Direct relationship between risk and profit

Timing of benefits cash flow pattern

Narrow concept ignores socialconsideration

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Wealth Maximization

Wealth maximizationMaximizing the value\wealth

of the shareholders, i.e. the market price of the

companys common stock.

ExactnessWealth is based on cash flows and not

on accounting profit.

Quality of benefits-rate ofEPS & capitalizations

rate Time value of moneytiming of benefits

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Wealth Maximization

Maximizes the net present value

Fundamental objective maximize the market

value of the firms shares

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OTHER OBJECTIVES

Anticipatingfinancialneeds

Acquiringfinancial

resources

Allocatingfunds inbusiness

Administratingthe allocation

of funds

Analyzing theperformance

of finance

Accountingand reporting

to themanagement

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FINANCE MANAGER

Initially Financemanager was

handling the rolesof accountant.

His role wasto raise fundsfrom different

sources

Modernchanging

economy haschanged the

role ofFinance

manager.

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CHANGING ROLES OF A FINANCE MANAGER

1.Estimating the requirements of funds

2.Decision regarding capital structure

3.Investment decisions

4.Dividend decision

5.Cash management supply of funds to all parts of the organization

6.Evaluating the financial performance

7.Financial negotiations

8.Keeping touch with stock exchanges

9.Mergers , acquisitions & restructuring

10.Tax planning.

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CHANGING ROLES OF A FINANCE MANAGER

11. Performance Management

12. Risk Management

13.Investor Relations

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ORGANIZATION OF FINANCE FUNCTION

Financial Management in many ways is an integral part of thejobs of managers involved in Planning, resources allocation

and control.

The responsibilities for financial management are dispersed

throughout the organization.

e.g. A Purchase manager influences the level of Investment in

inventories.

A marketing Analyst provides inputs in the process of

forecasting & planning.A sales manager has a say in the determination of the

receivables policy.

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ORGINISATION OF FINANCE FUNCTION

To know, that there are many tasks of financial managementand allied areas( like accounting) which are specialized in

nature and which are attended by specialists.

These tasks are typically distributed between to key financial

officers of the firms, the Treasurer & the Controller.

A Treasurer is mainly responsible forFinancing & Investmentactivities

A Controller is concerned primarily with accounting and

control.

The ChiefFinance Officer, who may be designated asDirector(Finance) or VP(Finance) supervises the work of the

treasurer or controller.

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ORGINISATION OF FINANCE FUNCTION

Treasurer Controller

Obtaining Finance Financial Accounting

Banking Relationship Internal Auditing

Cash Management Taxation

Credit Administration Management Accounting

Capital Budgeting and control

Even though a firm may not have separate financial officers designated as

treasurer and controller, it is helpful to distinguish the functions of treasure &

controller

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Reason for placing the finance functions in thehands of top management

Financial decisions are crucial for the survival of

the firm.

The financial actions determine solvency of the

firm

Centralization of the finance functions can result ina number of economies to the firm.

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CHANGING SCENARIO OFFINANCIAL MANAGEMENT IN

INDIA

Interest

rates havebeen freed

fromregulations

Rupee had

become fullyconvertibleon currentaccount

Optimumdebt-equity

mix ispossible

Free pricingof issues

Liberalizedscenario of

capitalmarkets

Ensuring

managementcontrol with

foreignparticipation

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Financial Management Decisions

Capital budgeting

What long-term investments or projects should thebusiness take on?

Capital structure How should we pay for our assets?

Should we use debt or equity?

Working capital management

How do we manage the day-to-day finances of thefirm?

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Finance Functions

1.Investment decision

Selection of particular projects for investments(based on ROI)

This is also known as Capital budgeting, and itrefers to the decision to invest in long termassets.

The assets are expected to be used over a long

period of time e.g. when a firm acquires plantand equipment or replaces an old equipment orwhen you invest in research and development.

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Importance of Capital Budgeting

It determines the asset mix and hence the

business risk.

It involves heavy initial outlays of the business

resources.

Benefits accrue in future which future is

associated with risk and uncertainty

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Working Capital Decision

This is the decision concerned with the short term

assets/resources an organization uses to meet its

day to day obligations.

Such assets include:

Cash reserves of the organization

Funds collected from debtors of the organization.

Inventories

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Financing decision

Objective is to minimize cost of capital This is the decision concerned with the sourcing

of funds that are utilized under the investment

decision.

Much management time and effort is devoted totrying to ensure the adequacy of the company's

profit flow.

However, it is just as important that a company

has an adequate flow of funds if it is to remain in

business and very much less management time

and effort is devoted to this need.

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Dividend Decision

The Financial Manager has to decide on what to do

with the earnings once they have been realised.

There are three options,

To declare and pay all dividends to shareholders

To retain all the earnings and hence declare and

pay no dividends

To decide on what proportion to be paid and whatto be retained.

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Capital BudgetingDecisions

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Risk Return Trade Off

Financial Decisions involve evaluation of

alternative course of action

To every course of action there is a diffrisk

return implications attached

Financial decision = calculated amt of risk nFinancial decision = calculated amt of risk n

return involved = creating the value for thereturn involved = creating the value for the

firmfirm

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Investment Evaluation Criteria

Three steps are involved in the evaluation of an

investment:

Estimation of cash flows

Estimation of the required rate of return (the opportunitycost of capital)

Application of a decision rule for making the choice

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Determining Cash Flows for

Investment Analysis

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Cash Flows Versus Profit

Cash flow is not the same thing as profit, at least,

for two reasons:

First, profit, as measured by an accountant, is based on

accrual concept. Second, for computing profit, expenditures are arbitrarily

divided into revenue and capital expenditures.

CF (REV EXP DEP) DEP CAPEX

CF Profit DEP CAPEX

!

!

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The Cost of Capital

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Introduction

The projects cost of capital is the minimum

required rate of return on funds committed to the

project, which depends on the riskiness of its

cash flows.

The firms cost of capital will be the overall, or

average, required rate of return on the aggregate

of investment projects.

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Significance of the Cost of Capital

Evaluating investment decisions,

Designing a firms debt policy, and

Appraising the financial performance of topmanagement.

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The Concept of the Opportunity Cost of

Capital The opportunity cost is the rate of return foregone

on the next best alternative investment

opportunity ofcomparable risk.OCC

. Equity shares

Risk

. Preference shares. Corporate bonds.

Government bonds

. Risk-free security

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General Formula for the Opportunity Cost of

Capital Opportunity cost of capital is given by the following

formula:

where Io is the capital supplied by investors in period 0(it

represents a net cash inflow to the firm), Ctare returns

expected by investors (they represent cash outflows to

the firm) andk

is the required rate of return or the costof capital.

1 20 2

(1 ) (1 ) (1 )

n

n

CC CI

k k k

!

L

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The opportunity cost of retained earnings is the

rate of return, which the ordinary shareholders

would have earned on these funds if they had

been distributed as dividends to them.

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Weighted Average Cost of Capital Vs. Specific

Costs of Capital The cost of capital of each source of capital is known as

component, orspecific,cost of capital.

The overall cost is also called the weighted averagecost of capital (WACC).

Relevant cost in the investment decisions is the futurecost or the marginal cost.

Marginal cost is the new or the incremental cost that thefirm incurs if it were to raise capital now, or in the nearfuture.

The historical cost that was incurred in the past inraising capital is not relevant in financial decision-making.

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Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

2. Non-discounted Cash Flow Criteria

Payback Period (PB)

Discounted Payback Period (DPB)

Accounting Rate of Return (ARR)

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Net Present Value Method

Net present value should be found out by subtracting

present value of cash outflows from present value of

cash inflows. The formula for the net present value can

be written as follows:

31 2

02 3

0

1

NPV(1 ) (1 ) (1 ) (1 )

NPV (1 )

n

n

n

t

t

t

k k k k

k!

!

!

L

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Calculating Net Present Value

Assume that Project Xcosts Rs2,500 now and is expected to generate year-

end cash inflows of Rs900, Rs800, Rs700, Rs600 and Rs500 in years 1

through 5. The opportunity cost of the capital may be assumed to be 10 per

cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs500(PVF

!

!

10 )] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

! v v v v

v

!

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Acceptance Rule

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept the project when NPV is zero

NPV = 0

The NPV method can be used to select betweenmutually exclusive projects; the one with the

higher NPV should be selected.

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Calculation of IRR

Uneven Cash Flows: Calculating IRR by Trial

and Error

The approach is to select any discount rate to compute the

present value of cash inflows. If the calculated presentvalue of the expected cash inflow is lower than the present

value of cash outflows, a lower rate should be tried. On the

other hand, a higher value should be tried if the present

value of inflows is higher than the present value of outflows.

This process will be repeated unless the net present valuebecomes zero.

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Calculation of IRR

Even Cash Flows

Let us assume that an investment would cost Rs 20,000 and

provide annual cash inflow of Rs 5,430 for 6 years.

The IRR of the investment can be found out as follows:

6,

6,

6,

PV Rs 20,000 Rs5,430(PVAF ) 0

Rs 20,000 R s5,430(PVAF )

Rs 20,000PVAF 3.683

Rs5,430

r

r

r

!

!

! !

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Acceptance Rule

Accept the project when r> k.

Reject the project when r< k.

May accept the project when r= k.

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Profitability Index

Profitability index is the ratio of the present value

of cash inflows, at the required rate of return, to

the initial cash outflow of the investment.

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Profitability Index

The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow

of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year1 through 4. Assume

a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate

is:

.1235.1

1,00,000Rs

1,12,350RsPI

12,350Rs=100,000Rs112,350RsNPV

0.6820,000Rs+0.75150,000Rs+0.82630,000Rs+0.90940,000Rs=

)20,000(PVFRs+)50,000(PVFRs+)30,000(PVFRs+)40,000(PVFRsPV 0.104,0.103,0.102,0.101,

!!

!

vvvv

!

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Acceptance Rule

The following are the PI acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1

May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater

than one. PI less than 1 means that the projects

NPV is negative.

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Payback Method

Payback is the number of years required to recover the

original cash outlay invested in a project.

If the project generates constant annual cash inflows, the

payback period can be computed by dividing cash outlayby the annual cash inflow. That is:

0InitialI n v e s t m e n tP a y b a c k = =A n n u a lC a s h Infl ow

CC

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Assume that a project requires an outlay of Rs 50,000 and

yields annual cash inflow of Rs 12,500 for 7 years. The

payback period for the project is:

R s 5 0 , 0 0 0P B = = 4 y e a r s

R s 1 2 , 0 0 0

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Payback Method

Unequal cash flows In case of unequal cashinflows, the payback period can be found out byadding up the cash inflows until the total is equal

to the initial cash outlay. Suppose that a project requires a cash outlay of

Rs20,000, and generates cash inflows of Rs8,000;Rs7,000; Rs4,000; and Rs3,000 during the next 4years. What is the projects payback?

3 years + 12 (1,000/3,000) months

3 years + 4 months

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Acceptance Rule

The project would be accepted if its payback period is less

than the maximum or standard payback period set by

management.

As a ranking method, it gives highest ranking to the project,

which has the shortest payback period and lowest ranking to

the project with highest payback period.

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Discounted Payback Period

The discounted payback period is the number

of periods taken in recovering the investment

outlay on the present value basis.

The discounted payback period still fails toconsider the cash flows occurring after the

payback period

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3 DISCOUNTED PAYBACK ILLUSTRATED

Cash Flows

(Rs)C0 C1 C2 C3 C4

SimplePB

DiscountedPB

NPV at10%

P -4,000 3,000 1,000 1,000 1,000 2 yrs

PVof cash flows -4,000 2,727 826 751 683 2.6 yrs 987

Q -4,000 0 4,000 1,000 2,000 2 yrs

PVof cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421

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Accounting Rate of Return Method

The accounting rate of return is the ratio of the average

after-tax profit divided by the average investment. The

average investment would be equal to half of the original

investment if it were depreciated constantly.Averageincome

ARR=Averageinvestment

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Acceptance Rule

This method will accept all those projects whose

ARR is higher than the minimum rate established

by the management and reject those projects

which have ARR less than the minimum rate. This method would rank a project as number one

if it has highest ARR and lowest rank would be

assigned to the project with lowest ARR.

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Capital Structure

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Capital Structure Defined

The term capital structure is used to representthe proportionate relationship between debt andequity.

The various means of financing represent thefinancial structure of an enterprise. The left-handside of the balance sheet (liabilities plus equity)represents the financial structure of a company.Traditionally, short-term borrowings are excludedfrom the list of methods of financing the firmscapital expenditure.

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Meaning of Financial Leverage

The use of the fixed-charges sources of funds, such as

debt and preference capital along with the owners equity

in the capital structure, is described as financial

leverage orgearing ortrading on equity.

The financial leverage employed by a company is

intended to earn more return on the fixed-charge funds

than their costs. The surplus (or deficit) will increase (or

decrease) the return on the owners equity. The rate of

return on the owners equity is levered above or belowthe rate of return on total assets.

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Financial Leverage and the Shareholders

Return The primary motive of a company in using financial leverage

is to magnify the shareholders return under favourable

economic conditions. The role of financial leverage in

magnifying the return of the shareholders is based on the

assumptions that the fixed-charges funds (such as the loanfrom financial institutions and banks or debentures) can be

obtained at a cost lower than the firms rate of return on net

assets (RONA or ROI).

EPS, ROE and ROI are the important figures for analysing the

impact of financial leverage.

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EPS and ROE Calculations

N

)T1)(INTIT(

N

PAT=PS

sharesofNumberaftertaxProfit=shareperEarnings

!

S

)TINT)(1(EBIT=ROE

equityofValue

aftertaxProfit=equityonReturn

For calculating ROE either the book value or the market value equity may beused.

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Effect of Leverage on ROE and EPS

Favourable I > i

nfavourable I < i

eutral I = i

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Plan I: No debtEBIT 25 00 50 00 75 00 120 00 160 00 300 00

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EBIT 25.00 50.00 75.00 120.00 160.00 300.00Less: Interest 0.00 0.00 0.00 0.00 0.00 0.00

BT 25.00 50.00 75.00 120.00 160.00 300.00

Less: tax, 50% 12.50* 25.00 37.50 60.00 80.00 150.00

AT 12.50 25.00 37.50 60.00 80.00 150.00

o. of shares (000) 50.00 50.00 50.00 50.00 50.00 50.00

EPS (Rs) 0.25 0.50 0.75 1.20 1.60 3.0

ROE (%) 2.50 5.00 7.50 12.00 16.00 30.00

Plan II: 25% debtEBIT 25.00 50.00 75.00 120.00 160.00 300.00Less: Interest 18.75 18.75 18.75 18.75 18.75 18.75

BT 43.75 31.25 56.25 101.25 141.25 281.25

Less: tax, 50% 21.88* 15.63 28.13 50.63 70.63 140.63

AT 21.87 15.62 28.12 50.62 70.62 140.62

o. of share (000) 37.50 37.50 37.50 37.50 37.50 37.50

EPS (Rs) 0.58 0.42 0.75 1.35 1.88 3.7ROE (%) 5.80 4.20 7.50 13.50 18.80 37.50

Plan III: 50% debtEBIT 25.00 50.00 75.00 120.00 160.00 300.00

Less: Interest 37.50 37.50 37.50 37.50 37.50 37.50

BT 62.50 12.50 37.50 82.50 122.50 262.50

Less: tax, 50% 31.25* 6.25 18.75 41.25 61.25 131.25

AT 31.25 6.25 18.75 41.25 61.25 131.25

o. of shares (000) 25.00 25.00 25.00 25.00 25.00 25.00

EPS (Rs) 1.25 0.25 0.75 1.65 2.45 5.2

ROE (%) 12.50 2.50 7.50 16.50 24.50 52.50

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Operating Leverage

Operating leverage

affects a firms operating

profit (EBIT).

The degree of operatingleverage (DOL) is defined

as the percentage change

in the earnings before

interest and taxes relative

to a given percentagechange in sales.

%ChangeinEBITDOL%Changein ales

EBIT/EBITDOL

ales/Sales

!

(!

(

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Combining Financial and Operating Leverages

Operating leverage affects a firms operating

profit (EBIT), while financial leverage affects

profit after tax or the earnings per share.

The degrees of operating and financialleverages is combined to see the effect of

total leverage on EPS associated with a given

change in sales.

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Combining Financial and Operating Leverages

The degree of combined leverage (DCL) is given by

the following equation:

another way of expressing the degree of combined

leverage is as follows:

%ChangeinEBIT %ChangeinEPS %ChangeinEPS

%ChangeinSales %ChangeinEBIT %ChangeinSales! v !

( ) ( ) ( )CL( ) ( ) INT ( ) INTQ s v Q s v F Q s v

Q s v F Q s v F Q s v F

! v !

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Financial Leverage and the Shareholders Risk

The variability ofEBIT and EPS distinguish between two

types of riskoperating risk and financial risk.

Operating risk can be defined as the variability ofEBIT

(or return on total assets). The environmentinternaland externalin which a firm operates determines the

variability ofEBIT The variability ofEBIT has two components:

variability of sales

variability of expenses

The variability ofEPS caused by the use of financial

leverage is called financial risk.

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Dividend Decisions

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Dividend Theory

Issues in Dividend Policy

Earnings to be Distributed High Vs. Low

Payout.

Objective Maximize Shareholders Return.

Effects Taxes, Investment and Financing

Decision.

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Relevance Vs. Irrelevance

Walter's Model

Gordon's Model

Modigliani and Miller Hypothesis

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Walters Model

Assumptions

Valuation

Optimum Payout Ratio

Criticism

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Assumptions

Internal Financing (only Retained Earnings)

Constant Return and Cost of Capital

100% Payout or Retention

Constant EPS and DIV

Infinite Time

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Valuation

Market price per share is the sum of the present

value of the infinite stream of constant dividends

and present value of the infinite stream of capital

gains.

( / )( IV / ) (EPS DIV)

r kP k

k!

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Example

0.15, 0.10, 0.08

0.10

EPS R s 10

DPS 40%

(0.15 / 0.1)(4 / 0.1) (10 4) Rs 130

0.1

(0.10 / 0.1)(4 / 0.1) (10 4) Rs 100

0.1

(0.08 / 0.1)(4 / 0.1) (10 4) Rs 88

0.1

r

k

P

P

P

!

!

!

!

! !

! !

! !

( / )(DIV / ) (EPS DIV)r kkk

!

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Growth Firm r>k

Payout Ratio 0%

Div = Rs0

P=[0+(0.15/0.10)(10-0)/0.10

=Rs.1

50

Payout Ratio 100%

Div = Rs10

P=[10+(0.15/0.10)(10-10)/0.10

=Rs.100

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Normal Firm ,r = k

Payout Ratio 0%

Div = Rs0

P=[0+(0.10/0.10)(10-0)/0.10

=Rs.100

Payout Ratio 100%

Div = Rs10

P=[10+(0.10/0.10)(10-10)/0.10

=Rs.100

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Declining Firm , r < k

Payout Ratio 0%

Div = Rs0

P=[0+(0.08/0.10)(10-0)/0.10

=Rs.80

Payout Ratio 100%

Div = Rs10

P=[10+(0.08/0.10)(10-10)/0.10

=Rs.100

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Growth Firms Retain all earnings

Declining Firms Distribute all earnings

Normal Firms No effect

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Criticism

No external Financing

Constant Rate of Return

Constant opportunity cost of capital

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Gordon's Model

Assumptions

Valuation


Criticism

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Assumptions

All Equity Firm

No External Financing

Constant Return and Cost of Capital

Perpetual Earnings

No Taxes

Constant Retention

Cost of Capital greater than Growth Rate

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Valuation

Market value of a share is

equal to the present value

of an infinite stream of

dividends to be received

by shareholders

E P S (1 ) / ( )P b k b r!

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Example

0.15, 0.10, 0.08

0.10

EPS Rs 10

60%

(1 0.6)/ 0.10 (0.15 * 0.6) = Rs400

10(1 6)/ 0.10 (0.10 * 0.6) = Rs 100

10(1 0.6)/ 0.10 (0.08 * 0.6) = Rs 77

r

k

b

P

P

P

!

!

!

!

!

!

!

EPS(1 ) /( )P b k br!

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Growth Firms Retain all earnings

Declining Firms Distribute all earnings

Normal Firms No effect

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Modigliani and Miller

According to M-M, under a perfect market

situation, the dividend policy of a firm is irrelevant

as it does not affect the value of the firm. They

argue that the value of the firm depends on firmearnings which results from its investment policy.

Thus when investment decision of the firm is

given, dividend decision is of no significance.

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Working Capital Management

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S.Niroop, GAT 101

Principles of Working Capital

Management

Concepts of Working Capital

Gross working capital (GWC)

GWC refers to the firms total investment in current

assets.

Current assets are the assets which can be

converted into cash within an accounting year (or

operating cycle) and include cash, short-term

securities, debtors, (accounts receivable or bookdebts) bills receivable and stock (inventory).

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Net working capital (NWC).

NWC refers to the difference between current assets and

current liabilities.

Current liabilities (CL) are those claims of outsiderswhich are expected to mature for payment within an

accounting year and include creditors (accounts

payable), bills payable, and outstanding expenses.

NWC can be positive or negative. Positive NWC = CA > CL

Negative NWC = CA < CL

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Operating Cycle

Operating cycle is the time duration required to

convert sales, after the conversion of resources

into inventories, into cash. The operating cycle of

a manufacturing company involves three phases: Acquisition of resources such as raw material, labour, power and fuel

etc.

Manufacture of the productwhich includes conversion of raw material

into work-in-progress into finished goods.

Sale of the producteither for cash or on credit. Credit sales createaccount receivable for collection.

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The length of the operating cycle of a

manufacturing firm is the sum of:

inventory conversion period (ICP).

Debtors (receivable) conversion period (DCP).

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Inventory conversion period is the total time

needed for producing and selling the product.

Typically, it includes:

raw material conversion period (RMCP)

work-in-process conversion period (WIPCP)

finished goods conversion period (FGCP

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The debtors conversion period is the time

required to collect the outstanding amount from

the customers.

Creditors orpayables deferral period (CDP) isthe length of time the firm is able to defer

payments on various resource purchases.

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Permanent orfixed working capital

A minimum level of current assets, which iscontinuously required by a firm to carry on its

business operations, is referred to as permanentor fixed working capital.

Fluctuating orvariable working capital

The extra working capital needed to support the

changing production and sales activities of thefirm is referred to as fluctuating or variableworking capital.

D i f W ki C i l

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Determinants of Working Capital

Nature of business

Market and demand

Technology and manufacturing policy

Credit policy

Supplies credit

Operating efficiency

Inflation

E i i W ki i l

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Estimating Working capital

Current assets holding period

To estimate working capital requirements on the basis of averageholding period of current assets and relating them to costs based onthe companys experience in the previous years. This method isessentially based on the operating cycle concept.

Ratio of sales To estimate working capital requirements as a ratio of sales on the

assumption that current assets change with sales.

Ratio of fixed investment

To estimate working capital requirements as a percentage of fixedinvestment.

I M

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Inventory Management

Nature of Inventory

Stocks of manufactured products and the

material that make up the product.

Components: raw materials

work-in-process

finished goods

stores and spares (supplies)

N d f I i

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Need for Inventories

Transaction motive

Precautionary motive

Speculative motive

Obj i f I M

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Objectives of Inventory Management

Ensure a continuous supply of raw materials to facilitate

uninterrupted production

Maintain sufficient stock of raw materials in periods of

short supply and anticipate price changes

Maintain sufficient finished goods inventory for smooth

sales operations and efficient customer service

Minimise the inventory costs

Control inventory investment by maintaining optimum

inventory

I M T h i

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Inventory Management Techniques

Economic order quantity (EOQ) ordering costs: requisitioning, order placing, transportation, receiving,

inspecting and storing, administration

carrying costs: warehousing, handling, clerical and staff, insurance,

depreciation and obsolescence

2EOQ =

AO

c

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Reorder point under certainty

lead time

average usage

Reorder point = Lead time x average usage Reorder point under uncertainty

safety stock

Reorder point = (Lead time x average usage) + safety

stock

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Cash Management

F F t f C h M t

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Four Facets of Cash Management

Cash planning

Managing the cash flows

Optimum cash level

Investing surplus cash

M ti f r H ldi C h

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Motives for Holding Cash

The transactions motive

The precautionary motive

The speculative motive

Investing Surplus Cash in Marketable

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Investing Surplus Cash in MarketableSecurities

Selecting Investment Opportunities:

safety,

Maturity, and

Marketability.

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