The main principle of this thesis is to analysis Working Capital Management at Sea Tex Limited. Other objectives are to analyze and apply operating cycle concept of working capital in, Sea Tex Limited and to know how the working capital is being financed. Report also focus on to know the various methods to be followed by Sea Tex Ltd for inventories and accounts receivables and prescribe remedial measures to encounter the problems faced by the firm. Finally examine the effectiveness of working capital management practices of the firm and assess strengths and weaknesses.
Important theoretical developments in finance during the past decade have provided the potential for improved decisions in business organizations. Unfortunately, developments have not been uniform across all areas of financial decision-making within and between business organizations. Working capital appears to have been relatively neglected in spite of the fact that a high proportion of the business failures is due to poor decisions concerning the working capital of the firms (Smith 1980a). Of interest in this book is therefore the area of intra and inter-firm working capital management, which generally encompasses short-term investment and financing decisions of firms. In a perfect world, working capital assets and liabilities would not be necessary because there would be no uncertainty, no transaction costs, and no scheduling costs of production or constraints of technology. The unit costs of producing goods will not change with the amount produced. Firms would borrow and lend at the same interest rate. Capital, labor and product markets would reflect all available information and would be perfectly competitive. In such an ideal business world there would be little need to hold any form of inventory other than a limited amount of goods in process during production. But such an ideal business assumes that demand is exactly known in advance, that suppliers keep to their due dates, production can be smoothed and orders executed directly without costs and delays. There would be no need of holding cash for working capital other than for the initial costs, because it could be possible to make the payment from every receipt of sales. There would also be no need for receivables and payables if customers pay cash immediately and the firm would also make its payments promptly. However, problems of working capital exist because these ideal assumptions are never realistic and therefore working capital levels make a significant part of a firm’s investment in assets and these assets have to be financed implying that investments may have benefits as well as costs. Working capital investments and related short-term finances originate from three main business operations – purchasing, producing and selling. They can be considered as consequences of business operations. However, as much as the operations affect the balances of working capital investments and finances, the later also determine the cost and flexibility with which the operations are performed. Efficient management of working capital investments and related short-term debts can be used to make the purchasing, producing and selling operations cheaper and more flexible. In the latter sense they are used as instruments for the management of business operations, which in the mean time create benefits and costs. Therefore, the relevance of working capital investments and short-term debts originate from these benefits and costs. Beyond doubt efficient management of both items can help the success of firms in generating value. Operations are results of inter-firm transactions. Therefore, managing working capital investments, finances and operations internally within firms and the efficiency with which firms co-operate among themselves determine their end result. Historically, working capital management has passed through different stages, mainly – the control, optimization and value measurement. Working capital management originally started as a systematic approach of controlling the incoming, outgoing and remaining balances of cash, receivables and inventories. At this stage the main objective is that working capital is not misappropriated for personal benefits of those who are entrusted with its management. To this end both researchers and practitioners developed various control measures over the receipts and collections of cash, receipts and issuance of inventories as well as the increase of receivables through credit sales and decrease of receivables through cash collection. Capital is essential for the setting up and smooth running of any business. Investments made on fixed assets will yield excess cash inflows apart from the payback amount and is spread over a longer period of time. Hence the cash inflows (or) benefits associated are not immediate but are expected in the future. Cash inflows & outflows occur on a continuous basis in case of current assets. Credit forms an essential feature in the business (credit given to customers & credit from suppliers). Since there is some time lag from the time of sales & sales realization current assets & current liabilities, which together constitute the net working capital, supports the business in its normal of operations. This calls for an efficient management of working capital. The policies, procedures and measures taken for managing of working capital gain further importance in an organization like Sea Tex Ltd where the working capital requirements runs in cores of takes. Any mismanagement on the part of authority will not just cause loss but may even impair business operations. It is in this context working capital has gained importance. The growth of any organization depends on overall performance of all the departments. A firms financial performance reflects its strength, weaknesses, opportunities and threats of the organization with respect to profits earned, investments, sales realization, turnover, turn on investment, net worth of capital. Efficient management of financial resources and analysis of financial results are prerequisite for success of an enterprise. In that working capital management is one of the major areas of financial management. Managing of working capital implies managing of current assets of the company like cash, inventory, accounts receivable, loans and advances and current liabilities like sundry creditors, interest payment and provision.
The history of the Readymade Garments Sector in Bangladesh is a fairly recent one. Nonetheless it is a rich and varied tale. The recent struggle to realize Workers’ Rights adds an important episode to the story.
The shift from a rural, agrarian economy to an urban, industrial economy is integral to the process of economic development (Kaldor, 1966, 1967). Over a period of 25 years, the garments export sector has grown into a $6 billion industry that employs over a million people. In the process, it has boosted the overall economic growth of the country and raised the viability of other export-oriented sectors.. It also discusses what steps Bangladesh should take in order to deal with the full liberalization of the international garments trade, which occurred in January 2005 and which could potentially threaten the country’s growth prospects. Finally, it details some of the recent developments that have occurred since liberalization took effect
OVERVIEW OF THE BANGLADESHI ECONOMY
Bangladesh is a tropical country in South Asia that is situated in the delta of two major rivers that flow down from the Himalayas (the Ganges and the Jamuna). Bangladesh has an estimated population of 140 million (circa 2005), living in an area of about 55,000 square miles. It thus has the unwanted distinction of being the world’s most densely populated country, and this overpopulation is at the root of many of Bangladesh’s socioeconomic problems. Nevertheless, the economy has proved to be resilient. Since 1990, it has grown at an average rate of 5% per year. The Asian Development Bank projects that real GDP growth will increase to 6% in 2006 and 2007 (ADB, 2005). Bangladesh’s total GDP stood at $275 billion in 2004, and per capita.
PURPOSE OF THE STUDY:
The main aim of any firm is to maximize the wealth of shareholders. This can be achieved only by a steady flow of profits. Which in turn depend on successful sales activity? To generate sales, investment of sufficient funds in current assets is required. The need of current assets should be emphasized, as the sales don’t convert into cash immediately but involved a cycle of operations, namely operating cycle. Sea Tex Ltd is multi product manufacturing unit with varying cycle for each product. The capital requirement for each department in an organization of Sea Tex Ltd is large which (depends on the product target for that particular year) calls for an effective working capital management. Monitoring the operation on cycle duration is an important aspect of working capital.
Some prominent issues that are to be addressed are,
- Duration of raw material stage (depends on regularity of supply, transactions time).
- Duration of work in progress (depends on length of manufacturing cycle, consistency in capacity utilization).
- Duration at the finished goods state (depends on pattern of production & sale).
Thus a detailed study regarding the working capital management in Sea Tex Ltd is to be done to consider the effectiveness of working capital management, identify the shortcoming in management and to suggest for improvement in working capital management.
OBJECTIVES OF THE STUDY
- To study in general the working capital management procedure in, Sea Tex Ltd.
- To analyze and apply operating cycle concept of working capital in, Sea Tex Ltd.
- To know how the working capital is being financed.
- To know the various methods to be followed by Sea Tex Ltd for inventories and accounts receivables.
- To prescribe remedial measures to encounter the problems faced by the firm.
- To assess short-term liquidity and solvency of firm.
- To examine the effectiveness of working capital management practices of the firm.
- To give suggestions, if any, for better working capital management in Sea Tex Ltd.
- To assess strengths and weaknesses.
METHOLODOGY OF THE STUDY
REVIEW OF LITERATURE:
Every manager is involved in working capital management & every organization’s manager is suffered some problems related working capital. In order to take right decisions at right time he should be equipped with sufficient present and past information about the firm and its operations and how it is changing over time.
The word method comes from the Greek words “meta’ and “hodes’ meaning a way (Geddie- 1965). Broadly, a method or methodology is the “underlying principles and rules of organization of a philosophical system or inquiry procedure “(Urdong, 1968. Research methodology used for study includes both primary& secondary sources of data. However most of study is conducted based on secondary sources.
In this study the samples for primary data collection have been selected through random sampling and stratified sampling method. The break down of the samples is given below:
|Sample Type||Numbers of Male & Female|
Secondary sources of data mainly include annual reports of Sea Tex Ltd. Statement of changes in working capital for the past 5 years is done using the data taken from these financial reports. Calculations of ratios are done. Apart from this, the website of Sea Tex Ltd is referred to know the products, product facilities, network etc.
METHOD OF ANALYSIS:
To have a meaningful analysis and interpretation of various data collected, the following methods were made for this study.
- Ratio analysis
- Trend analysis
SEA TEX LTD. Relation with Bangladesh Export Processing Zone Authority
Sea Tex Ltd. is one of the biggest foreign investor in Bangladesh and it have invested its major investments in Bangladesh Export Processing Zones (BEPZ) especially the Chittagong Export Processing (CEPZ) before we move to discuss the relation between Sea Tex Ltd. and BSCIC we may try to illustrate briefly the role of BEPZA in the development of industries in Bangladesh. Bangladesh Export Processing Zone Authority (BEPZA) was established in 1980 under Bangladesh Export Processing Zone Authority act 1980 and foreign private investment (Promotion and Protection 1980). Chittagong Export Processing Zone Authority was formed in 1983 with 630 acres of land located 2.4 km form Chittagong main city. It has 394 plots out of which only 177 plots has been allotted. Total capital invested in this zone is more than 3 (three) billion us dollar. There is deference between the industries under BEPZA and other industries in Bangladesh. There are two type of procedure followed to establish industries in Bangladesh.
1) Establishment of industries in the domestic tariff area:
The industries under Bangladesh Small and Cottage industries Corporation (CEPZ and the industries, which need the approval from the Board investment (2603)
2) The industries under special Zones:
The industries whose does not need any approval of any ministry or any other Government concerns expect the Export Processing Zone Authority is under this category. In these zones the industries have three types those are:
ABOUT WORKING CAPITAL MANAGEMENT
Working capital is the firm’s holdings of current assets such as cash, receivables, inventory & marketable securities. Every firm requires working capital for its day to day transactions such as purchasing raw material, for meeting salaries, wages, rents, rates, advertising etc. The term working capital refers to the amount of capital, which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). Current Assets are resources which are in cash or will soon be converted into cash in “the ordinary course of business”‘. Current Liabilities are commitments, which will soon require cash settlement in “the ordinary course of business”.
ABOUT SEA TEX LTD
SEA TEX LTD. has been in the garment manufacturing business since 1994. Primarily exporting garments to the United Kingdom & other European Union countries. We are a totally vertical operation incorporating knitting, dyeing, finishing & garment making, with the additional capability of yarn dyeing, elastic & embroidery machines. We have established our ethical trading policy in line with local & international law as well as best practice within the industry & place great emphasis on the safety & Well-being of our employees. We have an overriding commitment to quality which permeates through every aspect of our business. Our focus is on ensuring that we deliver to you on time, in full and to the agreed quality. And another focus is on leadership through commitment, quality, better services, environment, and welfare, training, products & processes and Quality relationships with all.
- Be a manufacturer of world class and high quality.
- Readymade garments and achieve the highest quantity exporter and maintain this tend.
- Best use of potentiality of garments industries of Bangladesh.
- Maintaining at least 95% efficiency.
- Use the most modern technology in business field to the best possible extends, which matches with the socio-economic condition of Bangladesh.
- Give opening to the new jobs.
- Developing a set of human resources with the most modern business philosophy, practice and technology.
- SEATEX LTD
- SEA BLUE TEXTILE LTD.
- SEA BLUE ACCESSORIESS LTD
- SEA TEXTILE LTD.
- SEA Blue EMBROIDERY LTD
- B2B EXCELLENCE LTD
- A Company can exist only when it is tune with its customers and it can give faith to its customers through honesty, sincerity and trust.
- The Company is for the customer and operated by the customer, surpassing all their expectations giving higher quality and services with continuous improvement.
- Price does not matter if you make the customer happy by your product quality and effective handling of customer needs and demonstrating unique service to customers.
- Product pricing is always competitive.
- Success alone does not make a great company. What truly matters is its contribution towards making life better for everybody.
- Key success factors lies on the ability of the company to satisfy their customers’ needs, want and demand.
WORKING CAPITAL = CURRENT ASSETS-CURRENT LIABILITIES
Components of working capital are reported under the following headings:
- Cash on Hand
- Cash in Bank
- Unexpended General Revenue Releases
- Other Investments
- Accounts Receivable
- Taxes Receivable
- Interest and Dividends Receivable
- Loans and Notes Receivable
- Contracts and Grants Receivable
- Pension Contributions Receivable
- Allowance for Uncollectible
- Supply Inventory
- Goods Purchased for Resale
- Raw Materials
- Work in Process
- Finished Goods
- Overhead Applied
- Prepaid Items
- Deferred Charges – Current
- Other Current Asset
- Accounts Payable
- Vouchers Payable
- Construction Contracts Payable
- Claims Payable
- Current Insurance Liability
- Accrued Salaries and Wages
- Accrued Prize Liability
- DROP Participants Pension Benefit – Current
- Accrued Insurance Claims
- Accrued Interest Payable
- Deposits Payable
- Matured Bonds Payable
- Matured Certificates of Participation
- Matured Interest Payable
- Current Bonds Payable
Working capital can be classified into two categories i.e,
- Permanent working capital.
- Temporary or variable working capital.
Permanent working capital:
It is the minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. Tandon committee has reserved to this type of working capital as “Core Current Assets”.
Amount of permanent working capital remains in the business in one form or another. It also grows with the size of the business. It is permanently needed for the business, and therefore be financed out of long-term funds.
Variable working capital:
The amount of working capital over permanent working capital is known as variable working capital. The amount of such working capital keeps on fluctuating from time on the business activities. It may further be divided into seasonal working capital and special working capital. Seasonal working capital is required to meet the seasonal demands of busy periods occurring at stated intervals. On the other hand, special working capital is required to meet extraordinary needs for contingencies. Events like strikes, fire, unexpected competition, rising price tendencies or initiating a big advertisement campaign require such capital.
CONSEPT OF WORKING CAPITAL:
To understand working capital better we should have basic knowledge about the various aspects of working capital. To start with, there are two concepts of working capital:
- Gross Working Capital
- Net working Capital
Gross Working Capital:
Gross working capital, which is also simply known as working capital, refers to the firm’s investment in current assets: Another aspect of gross working capital points out the need of arranging funds to finance the current assets. The gross working capital concept focuses attention on two aspects of current assets management, firstly optimum investment in current assets and secondly in financing the current assets. These two aspects will help in remaining away from the two danger points of excessive or inadequate investment in current assets. Whenever a need of working capital funds arises due to increase in level of business activity or for any other reason the arrangement should be made quickly, and similarly if some surpluses are available, they should not be allowed to lie ideal but should be put to some effective use.
Net Working Capital:
The term net working capital refers to the difference between the current assets and current liabilities. Net working capital can be positive as well as negative. Positive working capital refers to the situation where current assets exceed current liabilities and negative working capital refers to the situation where current liabilities exceed current assets. The net working capital helps in comparing the liquidity of the same firm over time. For purposes of the working capital management, therefore Working Capital can be said to measure the liquidity of the firm. In other words, the goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of net working capital is maintained.
Determinants of Working Capital:
There is no specific method to determine working capital requirement for a business. There are a number of factors affecting the working capital requirement. These factors have different importance in different businesses and at different times. So a thorough analysis of all these factors should be made before trying to estimate the amount of working capital needed. Some of the different factors are mentioned here below:-
In order to determine the proper amount of working capital of concern, the following factors should be considered.
- Nature of business.
- Size of the business unit.
- Seasonal variation.
- Time consumed in manufacturing.
- Turnover of circulating capital.
- Need to stockpile raw material and finished goods.
- Growth and expansion.
- Business cycle fluctuations.
- Terms of purchase and sale.
- Pricing level changes.
- Inventory turnover.
- Dividend policy.
Nature of business: Nature of business is an important factor in determining the working capital requirements. There are some businesses, which require a very nominal amount to be invested in fixed assets, but a large chunk of the total investment is in the form of working capital. There businesses, for example, are of the trading and financing type. There are businesses, which require large investment in fixed assets and normal investment in the form of working capital.
Size of business: It is another important factor in determining the working capital requirements of a business. Size is usually measured in terms of scale of operating cycle. The amount of working capital needed is directly proportional to the scale of operating cycle i.e. the larger the scale of operating cycle the large will be the amount working capital and vice versa.
Business Fluctuations: Most business experience cyclical and seasonal fluctuations in demand for their goods and services. These fluctuations affect the business with respect to working capital because during the time of boom, due to an increase in business activity the amount of working capital requirement increases and the reverse is true in the case of recession. Financial arrangement for seasonal working capital requirements is to be made in advance.
Production Policy: As stated above, every business has to cope with different types of fluctuations. Hence it is but obvious that production policy has to be planned well in advance with respect to fluctuation. No two companies can have similar production policy in all respects because it depends upon the circumstances of an individual company.
Firm’s Credit Policy: The credit policy of a firm affects working capital by influencing the level of book debts. The credit term is fairly constant in an industry but individuals also have their role in framing their credit policy. A liberal credit policy will lead to more amount being committed to working capital requirements whereas a stern credit policy may decrease the amount of working capital requirement appreciably but the repercussions of the two are not simple. Hence a firm should always frame a rational credit policy based on the credit worthiness of the customer.
Availability of Credit: The terms on which a company is able to avail credit from its suppliers of goods and devices credit/also affects the working capital requirement. If a company in a position to get credit on liberal terms and in a short span of time then it will be in a position to work with less amount of working capital. Hence the amount of working capital needed will depend upon the terms a firm is granted credit by its creditors.
Growth and Expansion activities: The working capital needs of a firm increase as it grows in term of sale or fixed assets. There is no precise way to determine the relation between the amount of sales and working capital requirement but one thing is sure that an increase in sales never precedes the increase in working capital but it is always the other way round. So in case of growth or expansion the aspect of working capital needs to be planned in advance.
Price Level Changes: Generally increase in price level makes the commodities dearer. Hence with increase in price level the working capital requirements also increases. The companies, which are in a position to alter the price of these commodities in accordance with the price level changes, will face fewer problems as compared to others. The changes in price level may not affect all the firms in same way. The reactions of all firms with regards to price level changes will be different from one other.
Approaches for financing working capital: There are three approaches to financing the working capital:
- Hedging approach
- Conservation approach
- Aggressive approach
Hedging approach: A firm is said to be following Hedging approach if it matches the maturity of the debt with the maturity of assets. For the firm following hedging approach, long term financing will be used to finance fixed assets and permanent current assets and short term financing for temporary or variable current assets. As the level of these assets increases, the long financing level also increases. However, it should be realized that exact matching is not possible because of the uncertainty about the expected lives of assets.
Conservative approach: A firm in practice may adopt a conservative approach in financing its current and fixed assets. The financing policy of the firm is said to be conservative when it depends more on long term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary current assets, the idle long-term funds can be invested in the tradable securities to conserve liquidity. The conservative plan relies heavily on long term financing.
Aggressive approach: A firm may be aggressive in financing its assets. A firm follows aggressive policy when it uses more short-term financing than warranted by the matching plan. Under an aggressive policy, the firm financing a part of its permanent current assets with short term financing. Some extremely aggressive firms may even finance a part of their fixed assets with short-term financing.
The working capital cycle: The working capital cycle starts when stock is purchased on credit from suppliers and is sold for cash and credit. When cash is received from debtors it is used to pay suppliers, wages and any other expenses. In general a business will want to minimize the length of its working capital cycle thereby reducing its exposure to liquidity problems. Obviously, the longer that a business holds its stock and the longer it takes for cash to be collected from credit sales, the greater cash flow difficulties and organization will face.
In managing its working capital a business must therefore consider the following question. ‘If goods are received into stock today, on average how long does it take before those goods are sold and the cash received and profit realized from that sale?’ The answer will depend upon a number of factors that we will consider later in this article. For now we will turn our attention to calculating the length of a business’s working capital cycle.
CIRCULATION SYSTEM OF WORKING CAPITAL
In the beginning the funds are obtained by issuing shares, often supplemented by long-term borrowings. Much of these collected funds are used in purchasing fixed assets and remaining funds are used for day-to-day operation as pay for raw material, wages overhead expenses. After this finished goods are ready for sale and by selling the finished goods either account receivable are created and cash is received. In this process profit is earned. This account of profit is used for paying taxes, dividend and the balance is ploughed in the business.
Working capital is considered to efficiently circulate when it turns over quickly. As circulation increases, the investment in current assets will decrease. Current assets turnover ratio speaks about the efficiency of Sea Tex Ltd in the utilization of current assets. Fast turnover current assets results in a better rate on investment.
Importance of working capital:
A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are harmful. Out of two, inadequacy of working capital is more dangerous for a firm. Excessive working capital results in idle funds on which no profits are earned. Similarly insufficiency of working capital results in interruption of production. This will lead to inefficiencies, increase in costs and reduction in profits. Working capital is like the lifeblood of business. If it becomes weak, the business can hardly prosper and survive. No business can run successfully with out and adequate amount of working capital.
The following are the few advantages of adequate working capital in the business:
- Cash Discount: Adequate working capital enables a firm to avail cash discount facilitates offered to it by the suppliers. The amount of cash discount reduces the cost of purchase.
- Goodwill: Adequate working capital enables a firm to make prompt payment. Making prompt payment is a base to create and maintain goodwill.
- Ability to face crisis: The provision of adequate working capital facilities to meet situations of crisis and emergencies. It enables a business to with stand periods of depression smoothly.
- Credit-worthiness: It enables a firm to operate its business more efficiently because there is not delay in getting loans from banks and others on easy and favorable terms.
- Regular supply of raw materials: It permits the carrying of inventories at a level that would enable a business to serve satisfactory the needs of its customers. That is it ensures regular supply of raw materials and continuous production.
- Expansion of markets: A firm which has adequate working capital can create favorable market condition i.e., purchasing its requirements in bulk when prices are lower and holding its inventories for higher. Thus profits are increased.
Problems of inadequate working capital:
- Firm may not be able to take advantage of profitable business opportunities.
- Production facilities cannot be utilized fully.
- Short-term liabilities cannot be paid because of non-availability of funds.
- Its low liquidity may lead to low profitability. In the same way, low profitability results in low liquidity.
- It may not be able to take advantages of cash discounts.
- Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it may be lose its reputation; thereafter a firm may not be able get credit facilities.
Ratio to measure the efficiency of working capital:
- Current Ratio : Current assets/Current liabilities
- Quick Ratio : (Current assets – Inventories) /Current liabilities
- Sales to cash: Sales during a period / Average cash balance.
- Average collection period: Debtors dividend by annual credit sales and the resulting figure multiplied by 365. This ratio indicates how many days of credit is being obtained from the suppliers.
- Average payment Period: Creditors divided by annual credit purchase and 365 multiply the resultant figure. This ratio indicates how many days of credit are being obtained from the suppliers.
- Inventory turnover ratio: Sales /Average inventory.
Working capital policy:
Working capital management policies have a great effect on firm`s profitability, liquidity and its structural health. A finance manager should therefore, chalk out appropriate working capital policies in respect of each competent of working capital so as to ensure high profitability, proper liquidity and sound structural health of the organization. In order to achieve this objective the financial manager has to perform basically following two functions.
- Estimating the amount of working capital.
- Sources from which these funds have to be raised.
Working capital turnover ratio:
It measures the efficiency of the employment of working capital. Generally higher the turnover, greater is the efficiency and larger the sale of profits. Working capital turnover ratio can be calculating with help of the following formula.
Working capital turnover ratio = Sales/Net working capital
Inventories are the stock of the product made for sale by the company or semi finished goods or raw materials. Inventory of finished goods, which are ready for sale, is required to maintain smooth marketing operation. The inventory of raw material and work in progress is required in order to maintain an unobstructed flow of material in the production line. These inventories serve as a link between the production and consumption of goods. The aspect of management of inventory is especially important in respect to the fact that in country like India, the capital block in terms of inventory is about 70% of the current assets. It is therefore, absolutely imperative to manage efficiently and effectively in order to avoid unnecessary investment in them. Although to maintain low inventories may prove to be profitable but to maintain very low inventories may prove risky on the contrary. This aspect of management if tackled in a proper way may prove to be a boon its effective and efficient management would result in the maintaining of optimum level of inventories. At this level the profitability of the organization will not be jeopardized at the cost of inventory. Now from the above stated facts it is clear that maintaining of optimum level of inventory involves huge cost, so why should keep the inventories at all. Basically there are three main reasons for which inventories are stocked and they are:-
Transaction Motive: This motive lays emphasis on maintaining of inventories in order to maintain a smooth and unobstructed supply of materials for the sales and production operations.
Precautionary Motive: This motive emphasizes on the stocking goods in order to guard against the uncertainties of future i.e. unpredictable changes in the forces of demand, supply and other forces.
Speculative Motive: This motive influences the decisions regarding the increase or decrease in the level of inventory in order to take advantage of price fluctuations.
A company should maintain adequate stock of materials for a continuous supply to the factory for an uninterrupted production. It is not possible for a company to procure raw material instantaneously whenever needed. A time lag exists between demand and supply of material. Also, there exists an uncertainty in procuring raw material in time at many occasions. The procurement of materials may be delayed because of factors beyond company’s control e.g. transport disruption, strike etc. Therefore, the firm should keep a sufficient stock of raw material at a time to have streamline Other factors which may incite us to keep stock of inventories is the quantity discounts, expected rise is price. The work in process inventory builds up because of the production cycle. Production cycle is the time span between the introduction of raw material in to the production and the emergence of finished goods at the completion of production cycle. Till the production cycle completes, the stock of work in process has to be maintained. Efficient firms constantly try to make the production cycle smaller by improving their production techniques. A sufficiently large inventory has to be maintained of finished goods so as to meet the fluctuating demands. If a close link is maintained between the sales and the production department then an organization can do with a small inventory also. In the process, inventory is also necessary because production can not be instantaneous. But it should be seen that the size of production cycle should be small.
Cost of Carrying Inventories:
It costs to carry the inventories. They include the following:
a) Interest Charges,
c) Damages to stock,
d) Thefts, pilferage and other types of shortage and deficits,
e) Storage cost- goes down rent, etc.
f) Risk of price decline.
OBJECTIVES OF INVENTORY MANAGEMENT
In the modern business world there is practically nothing that is done without objective. The objective is also one that would help the organization in reaching its goals in a better way. Hence it can be inferred that the importance given to management of inventory in the business world is not devoid of a concrete reasons behind it. The two main reasons behind all this are, firstly, to maintain a inventory big enough that the production and sales operation are carried on without any hindrance and secondly, to minimize the investment in inventory, in order to maximize the profits. Both, excessive as well as inadequate inventory level is not good. They are the two danger points that a company should try to avoid and should always try to maintain optimum level of inventory. The excessive investment in the inventory has the following drawbacks:
- Unnecessary tie up of firm’s fund and loss of profit.
- Excessive carrying cost.
- The risk of liquidity.
Maintaining inadequate inventory is also dangerous. The consequences of under investment in inventory are
- Production hold ups;
- Failure to meet commitment
If the inventory of finished goods is not adequate than the demand of customer is peak periods may be left unmet and it the under investment is in the area of raw materials that is likely that the production process may be held up frequently.
Pressures for Low Inventories: A manager’s job is to balance the conflicting costs and pressures that argue for both low and high inventories and determine appropriate inventory levels. The primary reason for keeping inventories low is that inventory represents a temporary monetary investment in goods on which a firm must pay (rather than receive) interest. Inventory holding or carrying cost is the variable cost of keeping items on hand, including interest, storage and handling, taxes, insurance, and shrinkage. Thus, the components of holding cost create pressure for low inventories.
Interest or opportunity cost: To finance inventory, a company may obtain a loan or forgo the opportunity of an investment promising an attractive return. Interest or opportunity cost, whichever is greater usually is the largest component of holding cost.
Storage and Handling Costs: Inventory takes up a space and must be moved into and out of storage. Storage and handling costs may be incurred when a firm rents space on either long or short-term basis. There is also an opportunity cost for storage when space productivity in some other way.
Taxes, Insurance and Shrinkage: More taxes are paid if end of year inventories are high, and insurance on assets increase when there is more to insure. Shrinkage takes three forms. Pilferage or theft of inventory by customer or employees is a significant percentage of sales of some businesses. Obsolescence occurs when inventory cannot be used or sold at full value, owing to model changes, engineering modifications, or unexpectedly low demand. A company also faced pressure for large inventories. Let us look briefly at each type of pressure.
Customer Service: Creating inventory can speed delivery and improve on time delivery. Inventory reduces the potentials stock outs and backorders, which are key concerns of wholesalers and retailers.
Ordering cost: Each time a firm place new order, it incurs an ordering cost, or the cost of preparing new purchase order for a supplier or a production order. Managers take decision to order low to minimize the order cost.
Setup Cost: The cost involved in changing over a machine to produce a different component or item is the setup cost. It includes labor and time to make the changeover, cleaning, and new tools or fixtures.
Labor and equipment utilization: By creating more inventories, management can increase workforce productivity and facility utilization by reducing number of setup, changing rescheduling of production and improved resources utilization.
Transportation Cost: Order of low inventory takes high cost for transportation, therefore company face pressure to order high inventory. Sometimes outbound transportation cost can be reduces by increasing inventory levels. Having inventory on hand allows more carload shipment and minimizes the need to expedite shipment by more expensive modes of transportation.
Payments to Suppliers: A firm often can reduce total payments to suppliers if it can tolerate higher inventory level. Suppose that a firm learns that a key supplies is about to increase prices. It might be cheaper for the firm to order a larger quantity than usual-in effect delaying the price increase-even though inventory will be temporarily.
The various techniques or approaches used in the management of inventory by different firms to calculate the economic order quantity are here given below: –
Trial and Error Approach: This is the technique to resolve the economic order quantity problem. In this technique we take the annual requirement, purchasing cost per unit, ordering cost per order and carrying cost per unit for the computation of economic order quantity. We suppose a constant usage and then considering different sizes of orders and calculate the different total costs. The order corresponding to the minimum total cost has the economic order quantity.
EOQ Model: This is quite an easy approach to calculate the economic order quantity than the trial and error approach. Here we find the economic order quantity with the help of the formula
EQ = Sqrt (2AO / C)
Where A -> Total Annual Requirement
O -> Ordering cost order
Graphic Approach: Here the economic order quantity is found out with the help of a graph. We take the order size on horizontal axis and cost incurred on the vertical axis. Now we plot the graph regarding the carrying cost and the ordering costs. Now with the help of these two we draw a graph of minimum total cost. The economic order point is the point at the lowest value of the total minimum costs.
Cash is the important current asset for the operations of the business. Cash is the basic input needed to keep the business running on a continuous basis It is also the ultimate output expected to be realized by selling the service or product manufactured by the firm. The firm should keep sufficient cash, neither more nor less. Cash shortage will disrupt the firm’s operations while excessive cash will simply remain idle, without contributing anything towards the firm’s profitability. Thus a major function of the Financial Manager is to maintain a sound cash position. Cash is the money, which a firm can disburse immediately without any restriction the term cash, includes currency and cheques held by the firm and balances in its bank accounts. Sometimes near cash items, such as marketable securities or bank time deposits are also included in cash. The basic characteristics of near cash assets are that they can readily be converted into cash. Cash management is concerned with managing of:
i) Cash flows in and out of the firm
ii) Cash flows within the firm
iii) Cash balances held by the firm at a point of time by financing deficit or inverting surplus cash.
Sales generate cash which has to be disbursed out. The surplus cash has to be invested while deficit cash has to be borrowed. Cash management seeks to accomplish this cycle at a minimum cost. At the same time it also seeks to achieve liquidity and control. Therefore the aim of Cash Management is to maintain adequate control over cash position to keep firm sufficiently liquid and to use excess cash in some profitable way.
The Cash Management is also important because it is difficult to predict cash flows accurately. Particularly the inflows and that there is no perfect coincidence between the inflows and outflows of the cash. During some periods cash outflows will exceed cash inflows because payments for taxes, dividends or seasonal inventory build up etc. On the other hand cash inflows will be more than cash payment because there may be large cash sales and more debtors’ realization at any point of time. Cash Management is also important because cash constitutes the smallest portion of the current assets, yet management’s considerable time is devoted in managing it. An obvious aim of the firm now-a-days is to manage its cash affairs in such a way as to keep cash balance at a minimum level and to invest the surplus cash funds in profitable opportunities. The ideal Cash Management system will depend on the firm’s products, organization structure, competition, culture and options available. The task is complex and decision taken can affect important areas of the firm.
Functions of Cash Management:
Cash Management functions are intimately, interrelated and intertwined Linkage among different Cash Management functions have led to the adoption of the following methods for efficient Cash Management:
- Use of techniques of cash mobilization to reduce operating requirement of cash
- Major efforts to increase the precision and reliability of cash forecasting.
- Maximum effort to define and quantify the liquidity reserve needs of the firm.
- Development of explicit alternative sources of liquidity
- Aggressive search for relatively more productive uses for surplus money assets.
CASH MANAGEMENT: OBJECTIVES
The Basic objective of cash management is two fold:
(a) To meet the cash disbursement needs (payment schedule);
(b) To minimize funds committed to cash balances. These are conflicting and mutually contradictory and the task of cash management is to reconcile them.
Meeting the payments schedule: – A basic objective of the cash management is to meet the payment schedule, i.e. to have sufficient cash to meet the cash disbursement needs of the firm. The importance of sufficient cash to meet the payment schedule can hardly be over emphasized. The advantages of adequate cash are:
- It prevents insolvency or bankruptcy arising out of the inability of the firm to meet its obligations;
- The relationship with the bank is not strained;
- It helps in fostering good relations with trade creditors and suppliers of raw materials, as prompt payment may also help their cash management;
- It leads to a strong credit rating which enables the firm to purchase goods on favorable terms and to maintain its line of credit with banks and other sources of credit; T
- To take advantage of favorable business opportunities that may be available periodically; and
- Finally the firm can meet unanticipated cash expenditure with a minimum of strain during emergencies, such as strikes, fires or a new marketing campaign by competitors.
Minimizing funds committed to cash balances: – The second objective of cash management is to minimize cash balances. In minimizing cash balances two conflicting aspects have to be reconciled. A high level of cash balance will, ensure prompt payment together with all the advantages, but it also implies that large funds will remain idle ultimately results less to the expected. A low level of cash balances, on the other hand, may mean failure to meet the payment schedule that aim of cash management should be to have an optimal amount of cash balances.
CASH MANAGEMENT TECHNIQUES & PROCESSES
The following are the basic cash management techniques and process which are helpful in better cash management:
Speedy cash collection: In managing cash efficiently the cash in flow process can be accelerated through systematic planning and refined techniques. These are two broad approaches to do this which are narrated as under:
Prompt payment by customer: One way to ensure prompt payment by customer is prompt billing with clearly defined credit policy. Another and more important technique to encourage prompt payment the by customer is the practice of offering trade discount/cash discount.
Early conversion of payment into cash: Once the customer has makes the payment by writing its cheques in favor of the firm, the collection can be expedited by prompt encashment of the cheque. It will be recalled that there is a lack between the time and cheque is prepared and mailed by the customer and the time funds are included in the cash reservoir of the firm.
Concentration Banking: In this system of decentralized collection of accounts receivable, large firms which have a large no. of branches at different places, select some of these which are strategically located as collection centers for receiving payment for customers. Instead of all the payments being collected at the head office of the firm, the cheques for a certain geographical areas are collected at a specified local collection centers. Under this arrangement the customers are required to send their payments at local collection center covering the area in which they live and these are deposited in the local account of concerned collection, after meeting local expenses, if any. Funds beyond a predetermined minimum are transferred daily to a central or disbursing or concentration bank or account. A concentration banking is one with which the firm has a major account usually a disbursement account. Hence this arrangement is referred to as concentration banking.
Lock-Box System: The concentration banking arrangement is instrumental in reducing the time involved in mailing and collection. But with this system of collection of accounts receivable, processing for purposes of internal accounting is involved i.e. sometime in elapses before a cheque is deposited by the local collection center in its account. The lock-box system takes care of this kind of problem, apart from effecting economy in mailing and clearance times. Under this arrangement, firms hire a post office box at important collection centers. The customers are required to remit payments to lock-box.
The local banks of the firm, at respective places, are authorized to open the box and pick up the remittance received from the customers. Usually the authorized bank picks up the cheques several times a day and deposits them in the firm’s account. After crediting the account of the firm the banks send a deposit 4epo slip along with the list of payments and other enclosures, if any, to the firm by way of proof and record of the collection.
Slowing disbursements: A basic strategy of cash management is to delay payments as long as possible without impairing the credit rating/standing of the firm. In fact, slow disbursement represents a source of funds requiring no interest payments. There are several techniques to delay payment of accounts payable namely
1) Avoidance of early payments;
2) Centralized disbursements;
Avoidance of early payments: One way to delay payments is to avoid early payments. According to the terms of credit, a firm is required to make a payment within a stipulated period. It entitles a firm to cash discounts. If however payments are delayed beyond the due date, the credit standing may be adversely affected so that the firms would find it difficult to secure trade credit later. But if the firm pays its accounts payable before the due date it has no special advantage. Thus a firm would be well advised not to make payments early i.e. before the due date.
Centralized disbursements: Another method to slow down disbursements is to have centralized disbursements. The head office should make all the payments from a centralized disbursement account. Such an arrangement would enable a firm to delay payments and conserve cash for several reasons. Firstly it involves increase in the transit time. The remittances from the head office to the customers in distant places would involve more mailing time than a decentralized payment by a local branch. The second reason for reduction in operating cash requirement is that since the firm has a centralized bank account, a relatively smaller total cash balance will be needed. In the case of a decentralized arrangement, a minimum cash balance will have to be maintained at each branch, which will add to a large operating cash balance. Finally, schedules can be tightly controlled and disbursements made exactly on the right day.
Float: A very important technique of slow disbursements is float. The term float refers to amount of money tied up in the cheque that have been written, but have yet to be collected and enchased. Alternatively, float represents the difference between the bank balance and book balance of cash of a firm. The difference between the balance as shown in the firm’s record and the actual bank balance is due to transit and processing delays. There is time lag between the issue of a cheque by the firm and its presentation to its bank by the customer’s bank for payment. The implication is that although a cheque has been issued cash would be required later when the cheque resented for encashment. Therefore, a firm can send remittance although it does not have cash in its bank at the time of issuance of cheque. Meanwhile, funds can be arranged to make payments when the cheque is presented for collection after a few days. Float used in this sense is called cheque kitting.
Accruals: Finally, a potential tool for stretching accounts payable is accruals, which are defined as current liabilities that represent a service or goods received by a firm but not yet paid for. For instance, payroll, i.e. remuneration to employees, who render services in advance and receive payment later. In a way they extend credit to the firm for a period at the end of which they are paid, say, a week or month. The longer the period after which payment is made, the greater the amount of free financing and the smaller the amount of cash balances required. Thus, less frequent payrolls, i.e. monthly as compared to weekly, are important sources of accruals. They can be manipulated to slow down disbursements.
DETERMINING THE OPTIMAL LEVEL OF CASH BALANCE:
Cash balance is maintained for the transaction purposes and additional amount may be maintained as a buffer or safety stock. The Finance manager should determine the appropriate amount of cash balance. Such a decision is influenced by trade-off between risk and return. If the firm maintains small cash balance, its liquidity position becomes week and suffers from a paucity of cash to make payments. But investing released funds in some profitable opportunities can attain a higher profitability. When the firm runs out of cash it may have to sell its marketable securities, if available, or borrow. This involves transaction cost.
On the other hand if the firm maintains a higher level of cash balance, it will have a sound liquidity position but forego the opportunities to earn interests. The potential interest lost on holding large cash balance involves opportunities cost to the firm. Thus the firm should maintain an optimum cash balance, neither a large nor a small cash balance. To find out the optimum cash balance the transaction cost and risk of too small balance should be matched with opportunity costs of too large a balance should be matched with opportunity cost of too large a balance. Figure shows this trade-off graphically. If the firm maintains larger cash balances its transaction cost would decline, but the opportunity cost would increase. At point X the sum of two costs is minimize. This is the point of optimum cash balance. Receipts and disbursement of cash are hardly in perfect synchronization. Despite the absence of synchronization it is not difficult to determine the optimum level of cash balance. If cash flows are predictable it is simply a problem of minimizing the total costs – the transaction cost and the opportunity cost. The determination of optimum working cash balance under certainty can thus be viewed as an inventory problem in which we balance the cost of too little cash ( transaction cost) against the cost of too much cash( opportunity cash) Cash flows, in practice, are not completely predictable. At times they may be completely random. Under such a situation, a different model based on the technique of control theory is needed to solve the problem of appropriate level of working cash balance. With unpredictable variability of cash flows, we need information on transaction costs, opportunity costs and degree of variability of net cash flows to determine the appropriate cash balance. Given such data the minimum and maximum of cash balances should be set. Greater the degree of variability, higher the minimum cash balance. Whenever the cash balance reaches a maximum level, the differences between maximum and minimum levels should be invested in marketable securities. When balance is falls to zero, marketable securities should be sold and proceed should be transferred to the working cash balances.
EVALUATION OF CASH MANAGEMENT PERFORMANCES
To assess the cash management performance this phase is divided as follows:
a) Size of Cash
b) Liquidity and Adequacy of cash
c) Control of cash
Trade credit, the tool that as a bridge for movement of goods through production and distribution stages to customer, is a force in the present day business and a essential device. Trade credit is granted with a motive of protecting the sale from ones, competitors and attaching more of the potential customers. Trade credit is said to be extended to a customer when a firm sell its services or goods and does not receive the payment for them immediately. Thus trade credit creates receivable which refer to the amount, which a firm is expected to collect in near future.
The book debt or receivable which arise a result of trade credit have the following features:
- It involves a element of risk and hence should never to be fiddled with. As credit sale leave a sum to be recovered in future and future can never be the certainty, hence it is risky.
- It is based on economic value, while for the buyer, the economic value in goods passes immediately at the time of purchase, while the seller expects an equivalent value to be received later on
- It represents futurity. The cash payments for the goods or services received by the buyer will be made in future.
The management of receivable gain more importance in the view of the fact that more than one third of the total current assets is blocked in the form of trade debtors. The interval between the date of sale and the date of payment is financed by working capital. Thus a trade debtor represents the investment. As substantial amount are tied up as trade credit hence it requires careful analysis and proper management.
Cost of receivables:
Capital cost: It is the cost associated with the blocking of firm’s resources in the receivables because of the time lag between the sale of goods to customers and realization of sales. The firm therefore has to customers and realization of sales. The firm therefore has to arrange for additional funds to meet its current obligations.
Administrative cost: The firm has to incur additional administration costs for maintaining account receivable in the form of salaries etc.
Collection cost: The firm has to incur costs for collecting the payments.
Defaulting cost : Sometimes after making all serious efforts to collect money from defaulting customers the firm may not able to recover the over debts because of the inability of the customers. Such debts are treated as bad and have to be written off since they cannot be realized.
GOALS OF MANAGEMENT OF RECEIVABLES
As all other aspects of management, this also aims at the maximizations of wealth by a beneficial trade off between liquidity risk and profitability. The main aim of management is not to maximize sales or minimize bad debt risk but in a way it is to expand sale to the extent that the bad debt risk remained within the limits. So in a effort to maximize the wealth, the goals of management of receivable are:
- To obtain optimum value of sales
- To control the cost of credit and keep it to the minimum level.
- To maintain investment in debtors at optimum level.
Sales maximization is not the purpose of credit management but an effective and efficient credit management helps in expanding sales and acts as a marketing tool. A good and well-administered credit means profitable credit accounts. In order to maximize the wealth of the firm, the cost involved in the credit and its management has to be controlled within the acceptable limits. These costs can brought to zero level but that would adversely affect the sales, therefore the objective should be to kept receivable to the minimum level. A dynamic credit policy and its management will help to optimize the sale at a minimum cost. Debtors involve funds, which have an opportunity cost. Therefore the investment in debtors should be never being excessive. Extending liberal credit pushes the sale and results in higher profitability but the increase in level of investment in debtors result in increased cost. Thus we are to bring the investment at a optimum level by doing trade off between the costs and benefits. The level of debtors to a large extent depends on external factors such an industry norms, level of activity, seasonal variations etc. But there is lot of internal factors which affects the firm’ credit policy. These factors include credit terms, standard, limits and collection procedures. The internal factors should be well administered to optimize the investment in debtors.
OPTIMUM CREDIT POLICY
The whole set of decision variables that affects the investment in receivable is termed as credit policy. Generally, we can divide the credit policy into two types
- Lenient Credit Policy
- Stringent Credit Policy
The firms following Lenient Credit Policy tend to sell on credit to its customers very readily, without even knowing the credit worthiness of the customers. The firms with lenient credit policy will have more sales and higher profits. But they can also incur high bad debts losses and face the problem of liquidity. The firm which follows Stringent Credit policy are very selective in extending credit, and credit is extended to those customer only whose credit worthiness is well proven. These firms follow tight credit standards and terms as a result, minimize cost and chances of bad debts. The stringent credit policy never poses the problem of liquidity but restrict the sale and profit margins. Extension of credit increases the sale of the firm. The number of customers purchasing the firm’s goods and services increases as it makes its credit policy liberal. If the costs do not increase at a greater rate, the increased revenue will increase the profit of the firm. As a consequence, the market value of firm’s share will rise. The extent to which the sales will be affected by pursuing a particular credit policy can not be gauged with accuracy. Sales forecast with respect to a particular credit policy can be made with regards to prevailing economic condition. However, cost benefit analysis has to be done in order to anticipate the acceptability of a credit policy.
Credit extension involves cost; the incurred cost can be of many types such as bad debt losses, production and selling costs. Administrative expenses, cash discounts, opportunity cost etc. Bad debt losses are incurred when a firm is unable to collect the book debts. Bad debt losses are more if the credit policy is lenient. This never means that a company should its credit policy, in case the profit generated by additional sales are more than corresponding costs the firm should surely go in for credit policy relaxation.
The additional sales resulting from the relaxed credit policy will increase the production and selling costs. Only the incremental production or selling costs should be estimated. Similarly, the expenses incurred in the administration of credit should be included in the costs of extending credit. The cost of administration generally includes the credit supervision costs and collection costs. Again, these costs will be nil if the credit policy simply utilize the idle capacity of the credit department.
The opportunity cost is the cost of foregone profits of the amount blocked as trade credit to customers in order to sustain or increase sales. As a result of the funds tied up in credit accounts often the firms have to go in for credit from banks in order to sustain their operations.
In order to collect the trade credits at an early date, often cash discounts have to be extended. As a result of these cash discounts firms are not in a position to collect the remuneration for their sales in full. This is essentially a tool to bring the trade credit to a optimum level.
Aspects of Credit Policy:
The important aspects of credit policy should be identified before establishing an optimum credit policy. The important decision variables of the credit policy are:
- Credit Terms: Credit terms are the conditions or stipulations under which the firm extends credit. The terms and conditions can be clubbed according to the period for which they are extended and according to the amount of discount offered thereby there are two important components of trade credit namely cash period and cash discounts. Credit terms can be effectively used as a tool to boost sales. The most desirable credit terms which increases the overall profitability of the firm, should be offered to the customers cost benefit trade off between credits terms should be done to choose the best one. If the action of relaxation of the credit terms is followed by the competitors. Then the firm may have to pay instead of gaining anything.
The time duration for which the credit is extended to the customers is referred to as credit period. Usually the credit period of the firm is governed by the industry norms, but firms can extend credit duration to stimulate its sales. If the firm’ bad debts build up, it may tighten up its credit policy as against the industry norms.
Cash discounts are the offer made by the firm to customer to pay less if the required amount is paid earlier. The cash discount terms indicate the rate of discount and the period for which discount has been offered. If the customer does not avail this offer, he is expected to make the payment by the due date.
- Credit Standards: The credit standards followed by the firm have an impact on sales and receivable. The sales and receivable levels are likely to be high if the credit standards of the firm are relatively loose. In contrast, If the firm has relatively tight credit standards, the sales and receivable are expected to be low. The credit standards are governed by various aspects such as the to willingness of the customer to pay, the ability of the customer to pay in the economic conditions etc.
- Collection Policy: The need to collect the payments early gave rise to a policy regarding it, called as the collection policy. It aims at the speed recovery from slow payers and reduction of bad debts losses. The firm has to very cautious while it goes in for collection from slow payers. The various aspects such as willingness, capabilities, and external conditions should be taken care of before you go in collection procedure. The optimum collection policy will maximize the profitability and will be consistent with the objective of maximizing the value of the firm.
A substantial part of purchase of goods and services in business are on credit terms rather than against cash payment. While the supplier of goods and services tends to perceive credit as a lever for enhancing sales or as a form of non-price instrument of competition, the buyer tends to look upon it as a loaning of goods or inventory. The supplier’s credit is referred to as Accounts payable, Trade Credit, Trade Bill, Trade Acceptance, commercial drafts of bills payable depending on the nature of the credit. The extent to which this ‘buy-now, pay- later’ facility is provided will depend upon a variety of factors such as the nature, quality and volumes of items to be purchased, the prevalent practices in the trade, the degree of competition and the financial status of the parties concerned. Trade credits or Payables constitutes a major segment of current liabilities in many business enterprises. And they primarily finance inventories which form major components of current assets in many cases.
ADVANTAGES OF PAYABLES
Easy to obtain:
Payable or trade credit is readily obtainable, in most cases, without extended procedural formalities. During periods of credit crunch or paucity of working capital, trade credit from large suppliers can be boon to small buyers.
Suppliers assume the risk:
Where the suppliers have the advantage of high gross margins on their products, they would be able to assume greater risk and extend more liberal credit.
In trade credit, there is no rigidity in the matter of repayment of scheduled dates; occasional delays are not frowned upon. It serves as an extendible, convenient source of unsecured credit.
Even as the current dues are paid, fresh credit flows in as further purchases are made. It is continuous source of finance. With a steady credit terms and the expectation of continuous circulation of trade credit backing up repeat purchases, trade credit does, in affect, operate as long term source.
The salient points to be noted on affective management of Payables are:
- Negotiate and obtain the most favorable credit terms consistent with the prevailing commercial practice pertaining to the concerned product line.
- Where cash discount is offered for prompt payment, take advantage of the offer and derive the savings there from.
- Where cash discount is not provided, settle the payment on its date of maturity and not earlier. It pays to avail the full credit terms.
- Do not stretch Payables beyond due dates, except in inescapable situations, as such delays in meeting obligations has adverse affect on buyer’s credibility and may result in more stringent credit terms, denial of credit or higher prices on goods and services procured.
- Sustain healthy financial status and a good track record of past dealings with the supplier such as would maintain his confidence. The quantum and the terms of credit are mainly influenced by suppliers’ assessment of buyer’s financial health and ability to meet maturing obligations promptly.
- Avoid the tendency to divert Payables. Maintain the self liquidating character of Payables and do not use the funds obtained there from for acquiring fixed assets. Payables are meant to flow through current assets and speedily get converted into cash through sales for meeting maturing short terms obligations.
- In highly competitive situations, suppliers may be willing to stretch credit limits and periods. Assess your bargaining strength and get the best possible deal.
- Provide full information to suppliers and concerned credit agency to facilitate a frank and fair assessment of financial status and associated problems. With fuller appreciation of client’s initiatives to honor his obligations and the occasional financial strains which he might be subjected to for a variety of reasons, the supplier will be more considerate and flexible in the matter of credit extension.
- Keep a constant check on incidence of delinquency. Delays in settlement of Payables with references to due dates can be classified into age groups to identify delays exceeding one month, two month, three month, etc. Once overdue Payables are given priority of attention for payment, the delinquency rate can be minimized or eliminated altogether.
CASE STUDY – WORKING CAPITAL MANAGEMENT IN SEA TEX LIMITED.
Management efforts over the few years have been to inculcate cash consciousness through constant emphasis on working capital, mainly inventory and book debtors. In all these, it is to be kept in mind that Sea Tex Limited is a multi product undertaking, were management decisions affecting working capital are taken at managerial level. Managers are taken the necessary steps to solve the working capital related problems by using techniques.
These techniques are as follows:
- Ratio Analysis &
- Trend Analysis
Sources of funds:
Sea Tex Ltd raises its working capital by multiple banking arrangements with 10 Banks. The following are the ten banks, where funds for working capital are raised:
- EASTERN BANK LTD.
- ONE BANK LTD.
- BANK ASIA LTD.
- ISLAMI BANK (BD) LTD.
- PRIME BANK LTD.
- THE CITY BANK LTD.
- BASIC BANK LTD.
- MUTUAL TRUST BANK LTD.
- TRUST BANK LTD.
In Sea Tex Ltd working capital requirement is assessed by
- Fixing the target production
- Preparation of Budget (in Taka)
Working capital requirement are prepared taking into account:
- Actual value of the previous two years working capital.
- Projected value for the next two years
Limits: Sea Tex Ltd is having fund-based limits of Tk.570.65 crores and Non-fund based
limits up to Tk.1231 crores.
Procedure for procurement of funds:
Sea Tex Ltd applies a credit monitoring and appraisal (CMA) report (a 40-page document). The document consists of historical data about the company and profit and loss account, balance sheet, current assets current liabilities, working capital assessment, fund flows etc.EBL subscribes the maximum working capital limit (up to extent of 38%) of the entire working capital assessed. The other banks of the under the multiple banking arrangement above provide the rest of Working capital limits.
INVENTORY MANAGEMENT IS SEA TEX LTD
Sea Tex Ltd has to handle and process of huge quantity of material. Also Sea Tex Ltd being a process industry running 365 days throughout the year 24 hrs a day it material. This calls form efficient inventory management o the part of Sea Tex Ltd. Sea Tex Ltd holds three types of inventory, they are:
- Raw materials
- Stores, spares and scrap
- Semi/finished goods.
Different sections carry out the procurement, storage and control of these inventories.
The raw materials are produced and stored by raw materials department. The basic principle followed by Sea Tex Ltd in holding raw material inventory is to hold indigenous raw material for 10 days.
Stores and spears: the stores and spares are procured and stored by central stores department (a part of purchase department).
Inventory control is major responsibility of stores department in Sea Tex Ltd. It adopts following procedure for inventory control:
- The stores department generates data periodically on the inventory status and conducts analysis of it. The same is circulated to all departments once in a quarter.
- XYZ analysis of all items is carried out and circulated to all departments. Categorization is based on values of item contributing to total value of stock.
- Identification of non-moving and slow moving items on regular basis and intimating it to user departments and there by reducing the indent quantity.
- Identification of absolute and surplus items which are of no use and disposal of the same after receiving clearance from top management.
- Standardization of general store material and spares and reduce the number of items.
- Conduct ABC analysis on consumption pattern o items and submit the same to purchase department for regulation of supplies.
The main reason for such a high quantity of inventory is due to spares and consumables indented irrationally during construction phase. One of the top priorities of Sea Tex Ltd now is to either consume the non-moving items or dispose it at the earliest.
Inventory turnover ratio: Inventory turnover ratio is ratio of sales to average inventory, the turnover ratio of Sea Tex Ltd is between 2 and 8. This is however a low value, indicating huge quantity of funds locked up in stock. As mentioned earlier the reason for low turnover is due to large quantity of nonmoving spares and stores. The inventory turnover ration of Sea Tex Ltd for the past 10accounting periods is shown in the table.
|YEAR||Total Sales||Avg. Inventory||Inv.Turnover ratio|
Inventory turnover ratio
CASH MANAGEMENT IN SEA TEX LTD
Method of cash management:
In Sea Tex Ltd cash requirement is planned and arrived at in the following manner:
- The Managing Director of Sea Tex Ltd in consultation with board of directors decides the production schedule for the following year.
- The production schedule as approved by the directors is then circulated to all departments, after which production target for each month is set.
- The heads of each of 35 budgets, the directors formulate a master budget allocation for each section.
- After receiving all the budgets, the directors formulate master budget for the particular year and the monthly budget allocation for each section.
- At the end of each of month, the actual versus the projected budget is put up to the management and directors discuss the reason for the variances. Any deficit in the cash inflow is adjusted buy pushing the sales in the following month.
Initially cash section of the finance department prepares the cash budget. They forecast monthly and weekly requirements of cash. The forecast of information regarding cash inflows which include the cash from customers, export incentive export credit, etc), cash outflows which include purchase of row materials, spares, excise duty, sales tax, personnel payments customs duty, railway freight etc.
Source of funds: The main source of funds is sales (export & local) realization.
Management of cash credit limit: As the company is maintaining cash credit account with multiple banking arrangements with 10 banks. It does not maintain cash balance except for some petty cash expenses. As regards to information reports the cash section generates daily-
Daily collection at various banks with branch-wise break up. Daily position as regards to utilization of cash credit/packing credit limits with various consortium member banks financing their working capital requirements. Statement showing the details of payments released in the day, Statement showing the details of payments outstanding at the end of the day after taking into account the payments released on the. Monthly cash flow statement showing the actual cash flow in the month with the projected expenditure of the ensuing month. From the above it can be seen that the section interacts with numerous agencies such as the various other departments of the organization, consortium of banks, branch collection centers, suppliers and customers. As many critical decisions are made based on the repots generated at the cash section, accuracy of the same assumes significance.
Cash ratio is ratio of cash held by a firm to current liabilities. Sea Tex Ltd is maintaining almost an average cash of around 0.13 except for the past three accounting periods. This is because as mentioned earlier cash holding is kept at minimum except for some petty cash needs. The increase in cash ratio indicates the significant increase in cash and bank balances in the total current assets.
Cash ratio = cash in hand (or bank)/current liabilities.
Cash ratio for the past few years is as shown.
|Current Liabilities||Cash ratio|
RECEIVEBLES MANAGEMENT IN SEA TEX LTD
Procedure of receivables management: Sea Tex Ltd sells its product directly to its customers. It has 27 marketing officers spread through the country. The marketing and the finance department and top management at the lead quarter formalize the price of different products. The sales and billing are done and the record of the daily transactions is maintained. The cash deposits are done at one of the respective banks and are the entire sum is in turn transferred to the banks at SEA TEX LTD through telegraphic transfer.
Credit policy of Sea Tex Ltd: The credit policy of Sea Tex Ltd is strict in one sense and flexible in other. As Sea Tex Ltd has got a wide network of marketing offices numbering 27 there is always a possibility of increased credit sales by the branch sales offices, resulting in liquidity crunch if proper control is not maintained. Therefore, all regions and branches are given a limit for credit sales beyond which they cannot sell on credit without prior approval of competent authority. At any given point of time credit sales should not exceed the limit given. At the same time branch sales offices are given the freedom to give interest bearing credit which they can decide depending upon the level of finished goods inventory in their stockyard and other aspects of customer.
Receivable turnover ratio: Receivable turnover ration is defined as ratio of total sales to average receivables. This ratio indicates the number of times the management is able to convert the receivables into sales and it indicates the efficiency with which receivable are managed. The receivables turn over ratio of Sea Tex Ltd for past 10 accounting years are given in the table.
Receivables turnover ration= sales/ Average receivables
Receivables turnover ratio:
|YEAR||SALES||AVG. RECEIVABLES||REC.TURNOVER RATO|
Interpretation: The receivables turnover ratio has always been around 21=23 almost every year. The turnover ratio for Sea Tex Ltd is high and this shows that bulk of Sea Tex Ltd’s sales is cash sales through out the last accounting periods. The increase trend earlier was due to cash constraint in Sea Tex Ltd, which necessitated the need for Sea Tex Ltd to go only for cash sales. The decreasing trend in last year is due to sluggish market conditions. This prompted all steel manufacturers to push sales through credit sales and also due to good cash position of Sea Tex Ltd, which allowed it go for credit sales.
PAYBLE MANAGEMENT IN SEA TEX LTD
In Sea Tex Ltd all payments are done through the cash section of finance department. Cash sections monitor the cash position on a daily basis and prioritize the payments. Cash section prepares cash report every morning and checks with the banks for cash balance. Based on the balance available in the banks and prioritized of payments, cheques are issued to the parties. Payments are prioritized so as to optimize the cost. Prioritized is done based on the financial implication of non-payment of the due.
The financial implications considered by Sea Tex Ltd for non-payment of due are:
- interest cost penal and over due
- penalties and fines in case of statuary obligation
- Impact of production and sales in case of payment is for critical item.
Close liaison is maintained between purchase department, bill-passing section of finance department and cash section for efficient management off account payable.
The major payments of the plant are towards:
- Purchase of raw material
- Purchase of stores and spares
- Employee wages
- Freight payments
- Interest on loans including working capital
- Repairs and loans including working capital
- Statutory duties like excise and sales tax.
The company pays:
- Excise duty-2crores/day
- Sales tax-12 crores/month
- Custom duty 12 crores/month
- Employee salary-35 crores/month
- Raw materials-85 crores/month
- Air fright – 50 crores/month
- Ocean fright-15 crores/month
Payable turnover ratio:
Payables turnover ratio is ratio of total purchases to average payable. It indicates the number of times management is able to convert accounts payables into purchase. Payable turn over ratio= purchases/average payable.
|YEAR||Purchases||Avg. Payable||Payable turnover ratio|
The turnover ratio is maintained between 2.0 and 3.0. This was mainly possible due to improved sales cost reduction purchase value reduction and better cash position.
- The total sales of Sea Tex Ltd are showing a positive trend despite cut down in garments prices across the globe. The rise in sales is 32.5% in terms of sales turnover during 2004-2005 compared to 2003-2004 and 22.03% during 2003-2004 compared to 2002-2003. The increase in sales by over 20% indicates the excellence achieved by Sea Tex Ltd in spite of over capacity problem in the market.
- The gross margin of Sea Tex Ltd has increased from Tk. 2073 crores in 2003-20004 to Tk.503.89 crores in 2004-05 (an increase of 57.79%).
- The payable turnover ratio is maintained on an average at 3.0 from 1998 onwards.
- The consumption at raw material stage has increased from Tk. 1394.32 crores in 1999-00 to Tk. 2050.44 crores in 2000-01.
- All units in Sea Tex Ltd have achieved their rated capacity during the year 2000-01 and poised to exceed the same current year. This has resulted in:
- Reduction in cost of production of saleable garments. The cost of production of Sea Tex Ltd following a decreasing trend over the past few years. This is evident from following table given overleaf.
- The reduction is cost of production has increased the leverage to extend cash discount to push sales. This is one of the major reasons for cap to register impressive sales figures in spite of huge dumping from international players.
Sea Tex Ltd has started making net profits from 2002-03. The net profit during 2003-04 was Tk.1547 crores while the net profits touched Tk.2000 crores in 2004-05. The net profit was due to higher cash income than cash expenditure. This is also reflected by net position of Sea Tex Ltd.
|YEAR||COST OF PRODUCTION|
- For the first time Sea Tex Ltd was able to raise working capital funds at an interest rate of less than 4%. It is in the range of 1.8-3.6% in 2003-04 compared to 8-9% in the previous year. This has resulted in the increase in net working capital significantly.
- The current ratio of Sea Tex Ltd is being maintained at 4.2. It shows a very high degree of short-term liquidity position of the firm.
- The dues payment by Sea Tex Ltd is able to pay its dues early. For the past three years Sea Tex Ltd is able to pay its dues early. In 2001-02 parts of old debts were paid. In 2002-03,another part of old debts was also paid ahead before the scheduled time and in 2003-04 cleared all term loans ahead of schedule time.
SUMMARY AND SUGGESTIONS
The concept of working capital is used in two ways i.e., gross and net. Gross working capital refers to the firms investments in current assets. Net working capital means the difference between current assets and current liabilities, and therefore represents the position of current assets, which is financed either from long term funds or banks borrowings. Cash is required to meet a firm’s transactions and precautionary needs. A firm needs cash to make payments for acquisitions of resources and services for normal conduct of business. Cash is also held to meet emergency situations. Some firms hold cash to take advantage of speculative changes in prices of input and out put. Management of cash involves three things.
- managing cash flows in and out of a firm
- managing cash flows within a firm
- financing deficit or investing surplus cash
And thus, controlling cash balance sat any point of time. Firms prepare cash budget to plan and control and cash flows. Cash budget can serve its purpose only when firm can manage its collection and payments with in the allowed limits. A firm should hold optimum amount of cash at any time and invest the temporary excess amount in short term securities.
Trade credit creates book debts accounts receivable. It issued as a marketing tool to expand or maintain the firm’s sales. A firm’s sales. A firm’s investment on account receivable depends on volume of credit sales and collection period through credit policy. Credit policy. Credit policy includes credit terms and collection efforts the firm’s credit policy will be considered optimum at the three methods monitor book debts.
- Average Collection period
- Ageing schedule
- Collection experience matrix
The first two methods are based on the showing payments patterns and hence do not provide meaningful information for collecting book debts. The third approach uses the desegregated data and it is better method than first two methods. The manufacturing companies hold inventories in the form of raw materials work in process and finished goods. They are three motives for holding inventories. They are transaction motive, precautionary motive and speculative motive.
Sea Tex Ltd is a multi product manufacturer unit with varying cycle time for each product. The capital required by each manufacturing unit of Sea Tex Ltd depends on the individuals’ products cycle of each item. The department wise capital whose capital requirement coupled with their production target for a year invites and effective working capital management. In finance, working capital is synonymous with current assets; Sea Tex Ltd is a multi product large organization with huge capital turnover where the working capital requirement depends on the level of operation and the length of operation cycle. Monitoring the duration of the operating cycle is an important aspect of current assets management and control.
- Scope of enhancing: during the year 2004-05 the turnover is Tk.8181 crores and profit is Tk. 2008 crores, during the year 2003-04 turnover is Tk. 6174 crores and profit is Tk.1547 crores. It indicates that the net profit forms nearly 25% of the total sales turnover. During the last financial year average rate is of interest 2-3%. In such situation the company should try to go for expansion, such as production enhancement system, so that the company comes to a position for further increasing its profits.
- During the financial year 2003-04 the company’s average cost of interest is 3-4%, which the company has acquired by forex funds replacing domestic loans and working capital facilities. If the company utilizes the forex replacing domestic loans and working capital facilities. The company utilizes the forex funds where ever it is possible. The company will be in position to take a better advantage to increase the profits.
- Currently the company’s payables towards raw material are replaced with buyer’s credit/suppliers credit in the form of forex funds. The company has tried to nullify the exchange risk by going for forward cover considering India’s dependency on other countries in exchange .Better risk monitoring would be required at the expansion stage when the quantum of import rises.
- The garment industries are having very good time but Sea Tex Ltd could not able to take full of its advantage due to the constraints, primarily raw materials. Unlike any other garment company , Sea Tex Ltd is not having its own sources of raw material yarn & others. These are very basic needs as the company always depends on its supplier for its raw material. Had the company always depends on its supplier for its raw material. Had the company utilized its 2-3 half% of working capital limits for acquisition of mines, purchasing of mines, etc. It could have been a favorable situation.
- The company is getting all its funds i.e. day zero (0) when the rates are compared, the company is investing surplus funds at 8-8.5% and paying at 7-8% to get the funds on zero (0) day. This spread should be maintained during the time of expansion also.
- The company has already accumulated funds in excess of Rs.5500 Crores and can look forward to bigger investment in building up capacities as compared to the proposed 6.1 Million tons.
- Sea Tex Ltd should invest its short investments in short term, low risk and medium return instruments rather than in the fixed deposits which it is presently employing for surplus funds, this would help the company manage its funds better at the time of expansion when the liquidity would be at premium.
1) The interest rate at which Sea Tex Ltd is producing its working capital is about 14-15% against a normal rate of 9-12% in 2000-01, in 2001-02 it was 12%-14%, in 2002-03 it was 8%-9% and in 2003-04, and it was only 1.8%-3.6% because of forex and exchange credit. Also higher profit realization by selling the produces in higher margins will eventually result in higher cash accrual and hence higher credit rating. Higher credit rating results in reduction in interest rates. Hence the company should either try to enhance the production facilities or better investment opportunities other than fixed deposits what the company currently is using for investing surplus funds.
2) The non moving inventory is one of the gray areas in Sea Tex Ltd’s working capital management. They account for 1/3 rd of value total inventory. This is really a critical area where Sea Tex Ltd’s management should focus to bring down the level of non moving inventory. Sea Tex Ltd has to identity areas for using inventory to dispose it. Also identification of such items will help in preventing procurement of such items on future.
3) The other main area where Sea Tex Ltd has tremendous scope for improvement is in manufacturing value an added product. This will result in better sales realization and higher profit.
4) The export sales of Sea Tex Ltd are only 30% of total sales during 2003-04. Present scenario of the industry indicates the need for more garments even with the cause of lower production facilities. The company should now give more importance to exports because it provides good net sales realization but also export benefits.
The following table the contribution of export sales to sales and the justification for the above suggestions.
|% Export sale to total|
Considering the fact that the margins in the export sales are low, but have the potential to raise in the near future, the company can maintain a minimum level of presence in the global market.