AG Working Capital Manageme + Net working capital of a business is its current assets less its current liabilities. + The size of this net figure has a direct effect on the liquidity of an organisation. + From financing point of view it represents “the amount of current assets financed using long term sources of finance”.Wh a Working Capital Management =F Working capital management has Twin objectives: EE] * To ensure it maintains sufficient liquidity required to : : a Ee continue in business and + To increase its profitability. These two objectives will often conflict as liquid assets give the lowest returns.BS Oo AAA i Soe | : NN Sie Oats are Working Capital Management As finance manager our responsibility is to determine: * To determine an optimal level of investment (Funds =] Required) in Current Assets and + Arrange finance using short or long term sources.Zs A447 od TA 4 4 ee - Wh * 8 _—~ Level of investment in Working Capital + The nature of the business + Uncertainty in supplier deliveries * The overall level of activity of the business * The company’s credit policy [ix] * The credit policy of suppliers * The length of the operating cycle (will be discussed later).Total] Fluctuating current assets $ assets Short-term finance Permanent current assets Long or short? Long-term finance+ , oo ed tn Be A A A A ld es Nature of Cu Assets 2 3 Permanent Current Assets refers to the minimum level of investment which is required all of the time. It includes = minimum levels of inventories, trade receivables etc. = Fluctuating Current Assets refers to investment which is required at certain times in the trade cycle. For example the levels of fluctuating investment may be higher if companies have seasonal demand.~A AA AANA A ed ed sh Operating Cycle Amongst other factors depends upon length of cash operating cycle Wh The cash operating cycle is the length of period between: + Payments made to raw material suppliers and + Recovery from customers Cash Operating Cycle = Stock days (Raw material days + WIP days + Finished goods) + Debtors days — Creditors days =| + Illustration 1 —_ aAL ALAA i a EA Aled AeA a oe! oz! ish Operating Cycle Amongst other factors depends upon length of cash operating + Payments made to raw material suppliers and + Recovery from customers Cash Operating Cycle = Stock days (Raw material days + WIP days + Finished goods) + Debtors days — Creditors days The cash operating cycle is the length of period between: =. + Illustration 1 eae)Working Capital Turnover Ratios Inventory days (tumover pefod): Measures the average time for which inventory remained with company before tis sald to customer. It can be calculated using below formula we are provided with only one figure of inventory ie. no break-up into raw material, work in process and fished goods avaiable Cet days = Inventory balance X65 nual cost of sales However, where three separate inventory values are provide, inventory days wil be equal tothe sum of Faw material, WIP and fished goods days. These can be calculated as Raw material days = Raw material inventory balance _X ‘Annual raw matenal usage 7 we days = WIP inventory balance __X 365 ‘Anual cost of production {Finished goods days =Laso sect AA A A ed ed A AA Fd dl SO Working Capital Turnover Ratios Debtors’ days (umover period: measures the average time our customer take to pay us from the day of sale. Also known as cred poby of cut company. CBetiors ays = Debtors balance X365 Annual credit sales Creditors’ days (mover perio}: measures the average time out company takes to pay our suppers. Crestors days= Creditors balance X365 “Annual credit purchases For cakulatng tumover ratios in weeks or months instead of days, we should use 52 or 12 respectively, inplace of 365.ceanpoees Bcc Illustration 2: Z Ltd has the following figures from its most recent accounts: Receivables Trade payables Raw material inventory WIP inventory Finished goods inventory Sales (80% on credit) Materials purchases (all on credit) Cost of sales (80% raw material usage) Required: “aan ohh Calculate the relevant working capital ratios and cash operating cycle (COC) of Z Ltd. Round your answers to the nearest day. , sat Illustration 2 ccm rer aot an aoIllustration 4: | ABC Ltd has the following expectations for the next year. Rs. in millions. Sales 100.00 Cost of sales 60.00 Other costs 15.00 Business Finance Decision (BFD) Page 691 Working Capital Management Chapter-11Working Capital Management Chapter-11 Profit 25.00 The following working capital ratios are expected to apply. Inventory days 30 days Receivables days 60 days Payables days 40 days Assume 360 days in a year. Required: Compute the working capital requirement of ABC Ltd for the next year.Means carrying on an excessive volume of trading in relation to the amount of long-term capital invested in the business. Alternatively a company is said to be overtrading when it is relying heavily on short term sources for financing of its current assets.BB eQ A[ AAA 7 i i 2 iF Symptoms may include: [=] + Arapid growth in sales + Increasing debtors’ period + Increasing creditors’ period + Increasing inventory period + Deteriorating current and quick ratios + Increasing sales to net working capital ratio + Declining cash balance/ increasing overdraft balanceOvertrading is very harmful and may lead to forced liquidation of the business. Immediate remedial actions for infected companies may be any one lien of the following 1. Raise long term finance and inject in working capital 2. Improve working capital management to reduce the COC 3. Alast resort could be to lower down the sales activity level to match the available funds. * Question 3 (HA) * Question 4 (HA)a nh y = =|) és a) tA * oo ee) oe oe! Debtors’ Management Acompany must develop a credit policy. This task is assigned to Credit control Department. For accounts receivable, the company's policy will be influenced by: * demand for products * competitors’ terms + risk of irrecoverable debts * financing costs + costs of credit control.} AA A A ed eS iP = soe el AA dd Debtors’ Management Acredit policy has four key aspects: + Assess creditworthiness. * Setting Credit limits. + Invoice promptly and collect overdue debts. * Monitor the credit system. Key calculations in Receivables management Annual cost of financing receivables = Receivables balance X Overdraft interest rate Receivables balance = Annual credit sales _X Receivables days 365 + Illustration 7AAA AL od a AAA A ed dS : evel acest) iscounts Advantages (Benefits) + Early recovery, leading to interest savings + Extra sales, leading to additional contribution + Reduction in bad debts Disadvantages (Costs) + Discountéiscount ‘Annual costo discount = | 4 Bi [asthe Annualized cost of discount (COST) is compared with Overdraft interest rate (BENEFIT) to take decision. However this method is only used when: + All customers are expected to avail discount * Only benefit of discount offer is OD interest saving + Illustration 8Cfe e-Learning 21.ts All customers are expected to avail discount; and Only benefit of discount offer is OD interest saving Illustration 8: A company is offering a cash discount of 2.5% to receivables if they agree to pay debts within one month | The usual credit period taken is three months. Required: What is the effective annualised cost of offering the discount and should it be offered, if the bank would loan the company at 18% pa?Discount Offer However, when above two conditions don’t apply, we follow cost vs benefit (annual basis) approach in absolute terms for evaluating discount offer. + Illustration 9 + Illustration 11Working Capital Management Chapter-11 Alternatively, (when above two conditions don't apply) we follow cost vs benefit approach in absolute terms for evaluating discount offer Illustration 9: Pervez Ltd has sales of Rs. 20 million for the previous year, receivables at the year-end of Rs. 4 million and the cost of financing receivables is covered by an overdraft at the interest rate of 12% pa. It is now considering offering a cash discount of 2% for payment of debts within 10 days. Required: Should Pervez Ltd introduce the offer if 40% of customers are expected to take up the discount? Suggested format for key working: ancing current receivablesacter 11 (WON.DA!* x Should Zubair Ltd introduce the offer if 25% of customers are expected to take up the discount? Illustration 11: In a recently concluded year Yasir Ltd had sales of Rs. 1,200 million and receivables at the year-end were Rs. 175 million. Cost of financing receivables is covered by an overdraft at the interest rate of 15% pa. It is now considering offering a cash discount of 3 % for payment of debts within 10 days. As a result of this offer sales are expected to grow by 10% next year. Company ears a contribution of 20% on its sales. Required: Assuming that 30% of Yasir Ltd’s customers will take up the discount, advise whether the scheme should \Fac' oring Services: Factors are independent organizations, usually subsidiaries of financial institutes’ banks. Factors can provide following services to company: ‘* Debt administration and collection = Financing+ Factors are independent organizations + Usually subsidiaries of financial institutes/ banks. Factors can provide following services to company: 1. Debt administration and collection 2. Financing 3. Credit insurance Factors are very useful to smaller OR fast growing businesses.Mas a) Factoring Services Advantages: o May improve debtors recovery, thus interest saving o Administration cost of managing own department is saved o Top management time is saved Disadvantages: o Outsourcing is more costly o Customers may be lost due to dealing of factors o Loss Of Control over the selection of customer. astat Illustration 12: Axis is a medium sized company producing a range of agriculture products, which it sells to wholesale distributors. Recently, its sales have begun to rise rapidly due to economic recovery. However, it is concerned about its liquidity position and is looking at ways of improving cash flow. Its sales are Rs. 16 million pa, and average receivables are Rs. 3.3 million (representing about 75 days of sales) (One way of speeding up collection from receivables is to use a factor. Required: Determine the relative costs and benefits of using the factor in each of the following scenarios and advise the A best course of action. (a tor “A” will operate on a service only basis, administering and collecting payment from Axis’ customers. This is expected to generate administrative savings of Rs. 100,000 each year The factor has undertaken to pay outstanding debts after 45 days, regardless of whether the customers have actually paid or not. The factor will make a service charge of 1.75% of Axis’ revenue. Axis can borrow at an interest rate of 8% pa. (b) It is now considering a factoring arrangement with Factor “B" where 80% of the book value of invoices is paid immediately, with finance costs charged on the advance at 10% pastat distributors. Recently, its sales have begun to rise rapidly due to economic recovery. However, it is concerned about its liquidity position and is looking at ways of improving cash flow. Its sales are Rs. 16 million pa, and average receivables are Rs. 3.3 million (representing about 75 days of sales), = One way of speeding up collection from receivables is to use a factor. Required: Determine the relative costs and benefits of using the factor in each of the following scenarios and advise the Axis on best course of action. (@)) Factor “A” will operate on a service only basis, administering and collecting payment from Axis customers. This is expected to generate administrative savings of Rs. 100,000 each year. The factor has undertaken to pay outstanding debts after 45 days, regardless of whether the customers have actually paid or not. The factor will make a service charge of 1.75% of Axis’ revenue. Axis can borrow at an interest rate of 8% pa. (b) It is now considering a — with Factor “B" where 80% of the book value of invoices is paid immediately, ance costs charged on the advance at 10% pa. ‘Suppose that this factor will charge sales as their fee for managing the sales ledger, that there will be administrative savings of Rs. 100,000 as before, but that outstanding balances will be paid after 75 days (i.e. there is no change in the typical payment pattern by customers this time).Illustration 14: In looking to reduce the working capital funding requirement, the financial controller of SGS Ltd is considering factoring credit sales. The company's annual turnover is Rs. 2.50 billion of which 90% are credit sales. Bad debts are typically 3% of credit sales. Current receivable period is 2.50 months. The offer from the factor is conditional on the following 1 a The factor will take over the sales ledger of SGS completely. 80% of the value of credit sales will be advanced immediately (as soon as sales are made to the customer) to SGS, the remaining 20% will be paid to the company one month later. The factor charges 15% per annum on credit sales for advancing funds in the manner suggested. The factor is normally able to reduce the receivables’ collection period to one month. The factor offers a ‘no recourse’ facility whereby they take on the responsibility for dealing with bad debts. The factor is normally able to reduce bad debts to 2% of credit sales. A charge for factoring services of 4% of credit sales will be made A one-off payment of Rs. 25 million is payable to the factor. The salary of the Sales Ledger Administrator (Rs. 12.50 milion p.a.) would be saved under the proposals and overhead costs of the credit control department, amounting to Rs. 2.00 milion per annum, would have to be reallocated. SGS' cost of overdraft finance is 12% per annum. SGS pays its sales force on a commission only basis. The cost of this is 5% of credit sales and is payable immediately the sales are a4 us > 64.Working Capital Management Chapter-11 made. There is no intention to aller this arrangement under the factoring proposals. Required: Evaluate the proposal to factor the sales ledger by comparing SGS' existing receivable collection costs with those that woul from using the factor (assuming that the factor can reduce the receivables collection period to of ). Now attempt Question 5: XYZ Ltd. (W-2008, Q4) Creditors Management Creditors are interest free source of finance, but extending creditors too much may create few problems for organization e.g Bad repute Loss of suppliers Refusal of supplies on credit * Increased pricesThe salary of the Sales Ledger Administrator (Rs. 12.50 million p.a.) would be saved under the proposals and overhead costs of the credit control department, amounting to Rs. 2.00 million per annum, would have to be reallocated. SGS' cost of overdraft finance is 12% per annum. SGS pays its sales force on a commission only basis. The cost of this is 5% of credit sales and is payable immediately the sales are Business Finance Decision (BFD) Page 697 Working Capital Management Chapter-14 made. There is no intention to alter this arrangement under the factoring proposals.” ood ed 2 » 8 fe et editors’ Managemen + Creditors are interest free source of finance + Extending creditors much may create problems: o Bad repute. 4 Loss of suppliers o Refusal of supplies on credit ~~ o Increased pricesx owaeD Illustration 15: One supplier has offered a discount to Bakhsh Co of 2% on an invoice for Rs. 750,000, if payment is made within one month, rather than the three months normally taken to pay. Required: If Bakhsh's overdraft rate is 10% pa, is it financially worthwhile for them to accept the discount and pay early? A Illustration 16: Work out the equivalent annual cost of the following credit terms: 1.75% discount for payment within three weeks; alternatively, full payment must be made within eight weeks of the invoice date. Assume there are 50 weeks in a year. Now attempt Question 6: ABC Limited (S-2013, Q1) Inventory Management Objective is to maintain sufficient inventory and yet been able to minimize ANNUAL inventory related following costs: 1. Purchase cost a «(as eosoi dd Inventory Management minimize ANNUAL inventory related following costs: . Purchase cost Ordering cost Holding cost . Stock Out costs fons | Objective is to maintain sufficient inventory and yet been able toBOQ AAA i : a < Set A A A A ed a oes Working Capital Management Annual Ordering Cost = Annual Demand x Cost per order Order Size Annual Holding Cost = (Order Size + Buffer Stock) x Cost of holding one unit p.a 2 * Illustration 17Cfe e-Learning 32.ts Illustration 17: A company requires 1,000 units of material Alpha per month. The cost per order is Rs. 30 regardless of the size of the order. The holding costs are Rs. 2.88 per unit pa. Required: Investigate the total cost of buying the material in quantities of 400, 500, or 600 units at one time. What is the cheapest option? Economic Order Quantity (EOQ)A A co Set A A A dd Dealing with Bulk Discounts If the EOQ is smaller than the order size needed for a discount, should the order size be increased above the EOQ? To work out the answer you should carry out the following steps: 1: Calculate EOQ, ignoring discounts. 2: Calculate annual inventory cost (including purchase cost) for E£0Q and other order sizes qualifying for discount. 3: Compare the costs in Steps 2 and select the order size with minimum annual cost. + Illustration 24apter11 (WON Det * x \ CFAP-4arD Water. Required: Calculate the EOQ ignoring the discount and determine if it would change once the discount is taken into account. Illustration 21: Dawood Co uses component V22 in its construction process. The company has a demand of 45,000 components pa. They cost Rs. 4.50 each. There is no lead time between order and , and ordering costs amount to Rs. 100 per order. The annual cost of holding one component in int is estimated to be Rs. 0.65. | A 0.5% discount is available on orders of at least 3,000 components and a 0.75% discount is available if the order quantity is 6,000 components or above. Required: Calculate the optimal order quantity. Reorder level for avoiding stock out costs In order to avoid stock out costs, reorder level is as under: With Certain Demand and Lead Time:AL AAA i AA TA 4 4 OF ed ed Reorder level Reorder level for avoiding stock out costs With Certain Demand and Lead Time: ROL = Usage x Lead time With uncertain Demand and Lead Time: ROL = Maximum Usage x Maximum Lead time Safety/ Buffer Stock = ROL — (Average usage x Average lead time) + Illustration 22stat acters (WONod* x GAPAaRD Weer? Illustration 22: A company uses material item BZ. The uncertainty about the length of the lead the supplier. There is also some variabil quantity for this material is 12,000 units. There is some een ordering more materials and receiving delivery from ekly demand for the item. Supply lead time (weeks) Average 25 Maximum 3 Minimum 1 Business Finance Decision (BFD) Page 700 Working Capital Management Chapter-11Business Finance Decision (BFD) Page 700 Working Capital Management Chapter-11 Demand per week (units) Average 4,200 Maximum 1,500 Minimum 800 Required: Calculate reorder level and safety stock égditem BZ. dies > pe x4 ioTAN A rd ed od ed Reorder level — Use of Probability + Increasing safety stock to reduce/ avoid stock-out cost increases inventory holding cost. + If a company is prepared to accept the risk of stock-outs, the optimal reorder level might be estimated using probabilities of demand (and probabilities of the supply lead time) to calculate the reorder level that has the lowest expected value of total cost of stock-out and safety stock holding.0 7 v ; He z Pa: 9 Illustration 23: AD Ltd uses item X in its production process. It purchases item X from an external supplier, in batches. For item X, the following information is relevant: Holding cost Rs. 15 per unit per year ‘Stock out cost Rs. 5 for each stock-out/ unit Lead-time 1 week E0Q 270 units AD operates for 48 weeks each year. Weekly demand for unit X for production is variable, as follows: Units demanded Probability during the lead time 70 10% 80 20% 90 30% 100 40% Required: ‘Suggest whether a reorder level its or 100 units would be more appropriate. >» osIllustration 24: BD Lid uses item Y in its production process. It purchases item Y from an extemal supplier, in batches For item Y, the following information is relevant: Holding cost Rs. 25 per unit per year Business Finance Decision (BFD) Page 701 Working Capital Management Chapter-11 ‘Stock out cost LeaStock out cost’ —_Rs. 11 for each stock-out/ unit Lead-time 1 week —0Q 288 units BD operates for 48 weeks each year. Weekly demand for unit Y for production is variable, as follows: Units demanded Probability during the lead time 80 10% 110 20% 150 30% 188 40% Ss Required: Determine optimal reorder level for item Y. Now attempt Question 7: Owais Limited (W-2014, Q1) Now attempt Question 8: Alpha Motors (Private) Ltd. (W-2013. Q1) ad >Alpha Motors (Private) Ltd. (AMPL) manufactures a product X22 at an approximate cost of Rs. 750,000 per unit. Breakup of the cost is as follows: Rupees Component ¥ 600,000 Other raw materials 50,000 Labour 50,000 Variable overheads 50,000 Annual sale of X22 is estimated at 900 units at Rs. 0.8 million per unit. Fixed costs are estimated at Rs. 42 million per annum. Component Y has to be imported from Italy and ideally it takes around 30 days to reach the company after the placement of order. However, the process is sometimes delayed by upto 30 days. The number of days for which the process may be delayed and the probability thereof are given below: Delay (in days) Probability of occurrence 0 90% 10 5% 20 3% 30 2% The ordering costs are Rs. 10,800 per order whereas the inventory is kept in a third party godown which charges Rs. 350 per day per unit of component Y. Incremental cost of financing for AMPL is 15% per annum. During idle time, AMPL pays 50% wages to the labour force. > «3/5Component Y has to be imported from Italy and ideally it takes around 30 days to reach the company after the placement of order. However, the process is sometimes delayed by upto 30 days. The number of days for which the process may be delayed and the probability thereof are given below: Delay (in days) Probability of occurrence 0 90% 10 5% 20 3% 30 2% The ordering costs are Rs. 10,800 per order whereas the inventory is kept in a third party godown which charges Rs. 350 per day per unit of component Y. Incremental cost of financing for AMPL is 15% per annum. During idle time, AMPL pays 50% wages to the labour force. It may be assumed that AMPL works throughout the year and one year has 360 days. Required: Analyse the above data to determine the following (a) Economic order quantity (EOQ) of compoent Y. (04) (b) Safety stock of component Y that should be in hand when the next order is placed, so as to maximize the profit (10) Answer (a)ome Comment FLASon View Form Protect.» Share Connect. «Heb Comment Format ()_ Tel me what you want to do [Fe Efficient Company Limited (ECL) consumes 375 units of a raw material per day. The cost of the raw material is Rs. 20,000 per unit. 5 units of the raw material are used for producing each unit of product ZYX which is sold to a single customer. Deliveries to the customer are made on a daily basis. When ECL is unable to deliver the product due to any reason, the sale is lost and a penalty of Rs. 50,000 per day has to be paid under the agreement with the customer. ECL earns a contribution margin of Rs. 5,000 per unit of product ZYX. The following details are also available: (i) After considering all aspects, the management has worked out the EOQ as 5400 units. (ii) Safety stock of 225 units of Product ZYX and 750 units of the raw material is maintained. (iii) | The minimum and the maximum delivery time is 30 days and 45 days respectively. Note: Assume 360 days in a year Required: (a) | Compute the stock out costs per annum if 8% of all raw material orders are delayed by 12 days and 4% of all orders are delayed by 15 days. (08) (b) | Determine the revised EOQ if consumption increases to 480 units per day, ordering costs increase by 50%, holding costs decrease by 25% and safety stock of raw material is increased by 20%. (03) (c) Discuss the practical limitations of using the EOQ approach for determining the order quantities. (04) Answer 9: Efficient Company Limited (S-2016, Q3) aLEW LY AA ed SN OT OO ee HW bs c st-In-Time (JIT) Stock Management Objective is to minimize stock holding costs by bringing down the inventory to the minimum. Implications: ) Supplier location » Long term contracts with supplier ) Penalty on supply of defective goods ) Minimization of lead time ) Regular visits to supplier warehouse to ensure availability of quality stock Efficient production process by adopting latest technology in production.ZBHPY A\ 4 44 | ed AAA A ed dS = Cash Management Reasons for holding cash: = + Transaction motive + Precautionary motive + Speculative motive Below Models help in deciding: + When to move cash from or to Investment? + How much cash should be moved in 1 transaction?4 4 4 4 ord oe t NALA A A ed dS Miller-Orr Model a Formula | hotmanted F, —— Uso 4 A —— nS \ = 50) a| ie DLN cient) erste Pon sapere 7The formulae (given in € Miller-Orr model are: Return point = Lower limit + (1/3 * spread) so Spr V4 * Transaction cost x Variance of cash flows) + Interest rate] Note: variance and interest rates should be expressed in daily terms. If the question provides you with the standard deviation of daily cash flows, you will need to square this number to obtain the variance. + Illustration 24Cfe e-Learning 42.ts Illustration 24: The minimum cash balance of Rs. 20,000 is required at Miller-Orr Co, and transferring money to or from the bank costs Rs. 50 per transaction. Inspection of daily cash flows over the past year suggests that the standard deviation is Rs. 3,000 per re and hence the variance (standard deviation squared) is Rs. 9 million. The interest rate is 0.03% per Required: Calculate the following for Miller-Orr Co: ji the spread between the upper and lower limits (ii) the upper limit (ii) the return point.Sat In comment ow488 D = demand for cash over the period Ci = cost of holding cash The model suggests that when interest rates are high, the cash balance held in noninterest bearing current accounts should be low. However its weakness is the unrealistic nature of the assumptions on which it is based. Illustration 26: A company generates Rs. 10,000 per month excess cash, which it intends to invest in short term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs associated with each separate investment of funds is constant at Rs. 50. Required: (2) _ Whatis the optimum amount of cash to be invested in each transaction? (b) How many transactions will arise each year? (c) What is the cost of making those transactions pa? (4) What is the opportunity cost of holding cash pa? cece > ps: f Ste wood» -e= ‘Waseem Limited is engaged in manufacture and sale of consumer products. It's management is in the ‘process of developing the sales plan for the next year. ‘The sales director is ofthe view that the main hurdle in increasing the sales is the availabilty of fnance. ‘The summarized statement of financial position as of November 30, 2016 is shown below: Rs. in million ASSETS Fixed assets 950 ‘Current assets 730. 71680" LIABILITIES AND EQUITIES ‘Ordinary share capital 250 Retained earrings 450 700 Long term debts 465 ‘Current tabilties 515, Following additional information is available: () thas been established from the company’s past record that any increase in sales require an investment of 140% of the additional sales amount, in inventories and accounts receivable. Further, the accounts payable of the company also increase by 25% of the additional sales amount. (i) The current sales of the company is Rs. 1,100 million while the net profit after tax is 10% of sales. (iil) Mis the policy of the company to distribute 20% of its profit after tax among the shareholders of the company. ‘company. Required ‘Assuming that you are the Chief Financial Officer of the company, advise the management on the (a) How much additional finance would be required to achieve 20% increase in sales in the next year? (>) What would be the maximum growth in sales that the company can achieve if: + external finances are not avaiable? = the additional financing is limited to an amount which will maintain the existing debt equity ratio? Answer 1: Waseom Limited1. SAUX ZrOK— 8x —D8AOX= BE + 38D 3.09% uestion 2: Puninad Juice Company (S-2011, Punjnad Juice Company is launching a new product. The annual capacity ofthis product is 24,000 units ‘and per unit cost has been estimated as follows: Rupees Material 80 Labour cost 30 Variable overheads 10 Fixed overheads 20 Depreciation 10 750, ‘The soling price would be Rs. 200 per unit. Seling expenses are estimated at Rs. 10 per unit. 80% of the selling expenses are considered variable. Projections related fo the fist two year are as follows: Yeart [Year Production units 715,000__| 20,000. ‘Sales unis 44,000 | 18,000. Other related estimates are given below: = Stock of raw materal months average consumption To be valued at average cost on the basi of i. = Stock of frished goods y Debtors, Cres Yor sup of maton : Cretor Tor varie and fxed overage Bad debts Required: Prepare a statement showing projected working captal equrerens fr Rot fe years related oe new poset (15marks) c ‘Business Finance Decision (BFD) Page 707Mlustration 153: Mazhar Lid produces a range of specialised components, supplying wide range of Pakistani and ‘overseas customers, all on credit terms, 20% of Pakistani turnover is sold to one firm. Having used ‘generous credit policies to encourage past growth, Mazhar now has to finance a substantial overdraft and | concemed about its iquidty. Mazhar borrows from its bank at 13% per annum interest. No further sales ‘growth in volume or valve terms is planned forthe next year In order to speed up collecton from Pakistani customers, Mazhar is considering two aitemative poicies. ‘Option one Factoring on a withoutrecourse basis. the factor administering and collecting payment from Mazhar's Pakistani customers. Ths is expected to generate administrative savings of Rs. 200,000 per annum and to ower the average receivable collection period by 15 days. The factor wil make a service charge of 1% ‘of Mazhar's Pakistani tumover and also provide credit insurance facies for an annual premium of Rs. 80,000. ‘Option two ‘Offering discounts to Pakistani customers who settle their accounts early. The amount of the discount wil depend on speed of payment as folows. Payment within 10 days of dispatch of invoices: 3% Payment within 20 days of dispatch of invoices: 1.5% It's estimated that Pakistani customers representing 20% and 30% of Mazhar’s sales respectively will take up these offers, the remainder continuing to take their present credit period Enxiracts from Mazhar’s most recent accounts are given below, Rs. "000 Rs. "000 20,000 5.000 Ao 25,000 17,000 Operate fT 2.500 4500 “There are ro overseas receivables atthe yea end ‘Note. Taxes end ination can be ignored ints question. Required: Calculate the relative costs and benefits in terms of annua! proft before tax of each of the two proposed methods of reducing domestic receivables, and recommend the most fnancially advantageous policy.Awam Limited (AL) manufactures and sels electrical equipment for the last 20 years. AL is presently experiencing liquidity issues due to low recovery from its debtors. You have been assigned the task to review debtor’ policy. You have gathered the following information: (@ Extracts from AL's lates financial statements: _ Rs. in million Sales (85% credit sales) 41,100 (Cost of goods sold (20% fixed) 34,700 [Debtors (i) Debtors with past due of 100 days are classified as bad debts. Bad debts are currently 69% of credit sales. All such bad debts are referred to a legal firm. The legal proceedings take an average of four months, in which 25% of bad debts are recovered in full and remaining are recovered at an average of 60% only. The legal firm charges a monthly retention fee of Rs. 0.5 million per month plus 15% of the recovered amount (Gi) AL-maimains a recovery department ata monthly cost of Rs. 0.6 milion. (Gv) AL has a running finance facility at an interest rate of 1% per annum, The CEO informs you that following options are under consideration for improving the collection from debtors Option 1 Olfer early payment discount of 2% to all debtors who would make the payment within 30 days. However, if payment is delayed by more than 40 days then surcharge of (0.035% per day would be charged. Under this option, its estimated that credit sales will be reduced by 8%. 30% ofthe customers will avail early payment discount. ‘debtors turnover in days will be reduced to SS days bad debts will be reduced 10 2.5% ofthe credit sles. the services of the legal firm will not be required. Option It Engage Kay Investment (KI) factoring agency, to manage the debtors. Under this option: + KI has offered to take over the administration of debtors with recourse basis on the following tems: Itwould charge a fee of 2% of sales amount. Average collection period would he reduced by 10 days. KI would advance 80% of the trade debts as soon asthe sale is made for which it ‘would charge an interest of 1% per annum. ‘+ Tis estimated that bad debts will be reduced 101.5% of credit sies. Required: (@) Advise whether it would be feasible for AL wo adopt any of he above options as) (®) In case of opting for factoring arrangement with KI, briefly discuss the difficulties ‘which AL may encounter. Also discuss how these difiulties can be resolved, on‘ABC Limited deals in manufacturing of consumer goods. The management is concemed about the ‘company’s operating cash flows and is reviewing the working capita polices Key financial data for the year ended 31 March 2013 i as fotows PROFIT AND LOSS ACCOUNT Rs. In milion ‘Sales 15575 Gost of goods sold (13,770) Gross profit 1,805 ‘Operating expenses (78) Financial charges (483) Other income 126 (1,305) Net proft before tax 500 Income tax @ 35% 175) Net poft ater tax 25 BALANCE SHEET Assets Rs.in milion | Equity and abilities sin milion Non current So 70,560 | Share captal and resones 23510 Curent assets 135% TFCs 71530 Trade debtors 2.500 Current lables Stock in rade 1.530 ‘Shot term loans 3510 Other current assots 615] 4735 Trade creators 41020 ‘Accrued & other labios 765 |__ 5205 525 75,235 In respect of dobtrs, the management proposes to allow an early payment discount of 1% payment is received ‘ays; however, any delay in payment beyond the cred period of 40days wil be subject o a surcharge of &5 paisa per Rs. 1,000 per day of detaul. Credit sales are 80% of the total sales of the company, By ntrodcing the above change, iis expected that: (Creat sales wi decrease by 8% and bad debts would reduce from 4% to 3% of credit sales. (@) 40% of he customers wil aval early payment discount whereas 35% would pay within the credit petod of 40 days (i) Debiors overall tunover wil reduce to 42 days of credit sale ‘The credit period allowed by the suppliers is 60 days. However, in order to avall 1% discount. the payment is made within 40 days. It is nom being proposed thal fil credt period of 60 days should be availed, Other relevant information sas under (Cost of goods sold includes conversion costs wich are approximately 50% of the cost of raw ‘material 20% ofthe conversion costs ae foe (Shortt debt cats ineret @ 15% per onnum, (Income tax rate appicable tothe company is 35% Required: Evaluate the above situations and give your recommendations about the suiabity of the changes ‘rooased bv he mangement (ASSume that One Vear equals 360 davs) a,Illustration 6: ‘The folowing data relate to Musawwar L1d, a manufacturing company, ‘Sales revenue for year: Rs. 1,500,000 Costs as percentage of sales: D Direct materials 30% Direct labour 25% . Variable overheads 10% Fixed overheads 15% 7 ' ‘Seling and distribution 8% Average statistics relating to working capital are as follows: ‘+ receivables take 274 months to pay ‘+ raw materials are in inventory for three months ‘+ raw materials are in inventory for three months, + WIP represents two months’ haif-produced goods ‘+ finished goods represent one month's production ‘+ credit is taken Materials 2 months Direct labour 1 week Variable overheads 1 month Fixed overheads 1 month ‘Seling and distribution ¥4 month, |WIP and finished goods are valued at the cost of material, labour and variable expenses. Required: ‘Compute the working capital requirement of Musawway'Ltd assuming thatthe labour force is paid for 50 working weeks in each year.Q3 Blue Limited (BL) finances its working capital through running finance. Since BI. has already utilized 90% of its existing running finance facility ie. Rs. 800 million, it is ‘negotiating with the banks for enhancement of the facility in order to meet its next year’s 3 requirements. Following information has been gathered to ascertain the working capital requirements for the next year: 2 (Extracts from the lates financial statements: = Last yearsales were Rs. 9,670 million, out of which 30% was cash sales. * Gross profit and profit before tax were maintained at 30% and 22% of the sales respectively. * The ratio of raw material, labour and factory overhead in the total manufacturing cosis was 13:43. Closing inventory of Rs, 1,040 million comprised of raw material (40%) and finished goods (60%). + 40% of factory overheads and 30% of operating expenses comprised of depreciation of fixed assets, depreciation of fixed assets. (i) In order to boost the demand, new credit terms of 3/10 and 2/3) would be introduced which would result in increase in credit sales by 50%. It is estimated that discount bi amount would be Rs. 63 million. The value of sales on which 2% discount would be claimed is expected to be twice the value on which 3% discount would be claimed. The remaining customers would take about 40 days to make the payments. * Bad debts are expected to be 2% of credit sales. Due to introduction of new credit q terms, the next year cash sale price is planned for the next year. expected to reduce by 10%. No change in product (il) BL plans to change the existing practice of maintaining raw wal stock level of one ‘month’s production requirement by adopting the economic order quantity model, This would also require maintenance of safety stock of 1,900 tons. Its estimated that costs of raw material, warehousing costs and ordering costs would 225 per ton and remain the same as last year ie. Rs. 52,000 per ton, Rs. Rs, 387,000 per order respectively. (ix) There would be no closing work in process. , (9) Finished goods inventory would be maintained in direct proportion to the sales , volume. 4 (vi) All expenses would be paid in 15 days’ time except for raw material suppliers which ‘would be paid in 50 days. (vii) All ratios mentioned in (i) above would be maintained unless otherwise specified. Required: Determine the minimum additional running finance amount that II. should seek from the banks. (Assume 360 days ina year) (16) 5 + 40% of" factory overheads and 30% of operating expenses comprised. of p