CONTENTS Chapter No.
Page No. Introduction 1.Objectives
I
2.Scope 3.Limitations
2-5
4.Methodology II
Company profile
6-7
III
Industry Profile
8-14
Scope of the study Limitations of the study IV
Need of the study
15-30
Objectives of the study V
Review of Literature
31-60
VI
Framework for analysis
61-64
VII VIII
Findings, Suggestions and Conclusion Bibliography
1
65-68 69
CHAPTER- I
INTRODUCTION TO WORKING CAPITAL
Working capital OBJECTIVES OF THE STUDY 2
To study the existing working capital management system. To find the liquidity position of the company of current assets and current liabilities. To examine feasibility of present system of managing. To understand how the company finances its working capital. To analyse the financial performance of the company in this regard. To give some suggestions to the management based on the information provided. Every business needs some amount of working capital. It is needed for following purposes For the purchase of raw materials, components and spares.
To pay wages and salaries.
To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc. To provide credit facilities to customers etc.
SCOPE OF THE SUDY
3
Working capital management is one of the key areas of financial decision-making. It is significant because, the management must see that an excessive investment in current- assets should protect the company from the problem of stock-out. Current assets will also determine the liquidity position of the firm. The goal of working capital management is to manage the current assets and current liabilities in such a way that a satisfactory level of working capital is maintained depending upon the status of the firm, if not it is likely to become insolvent and even bankruptsy. Lack of working capital, or cash flow is the main reason why so many good business's, go under it's crucial .advantages, you can pay your suppliers, pay your staff, and pay yourself a wage, and can expand your business. Disadvantages are you can't expand can't pay your staff can't pay yourself and can't pay your suppliers. so in a nutshell, no cashflow or working capital, no viable business. LIMITATIONS Recommendations of the study are only personal opinions. Hence the judgements could not be considered as an ultimate, and standard solutions. Short period of time and the company executives’ preoccupations the study could not be conducted thoroughly on the particular topic.
METHODOLOGY
4
he study of the working capital management is based on the primary and secondary data of the company. The primary data has been gathered through personal interaction with top management of the company. The secondary data has been collected from company’s annual reports and through the data stored in systems.
5
CHAPTER-II COMPANY PROFILE
COMPANY PROFILE M/s. Vinyl Chemicals (P) Ltd., is a small scale private limited company established in the year 1985 for the manufacture of PVC stabilizers, metallic stearates etc.
The unit is located at Kothur Village about 35 kms from
Hyderabad. All infrastructure facilities like buildings, power, water etc., are available in abundance at the factory. The company uses the latest technology in the manufacturing process.
The company has its Registered Office at
123/3RT, Sanjeevareddynagar, Hyderabad.
The company has Authorised
Agents at major areas like Daman, Silvassa, Jaipur, Bangalore and Nagpur. 6
PROMOTERS’ PROFILE Initially Vinyl Chemicals (P) Ltd., has been promoted by Shri. T.V. Hanumantha Rao and Shri. V. Prasada Rao. The company was incorporated on 25th September, 1985. Recently Chairman of the M/s. Motaparti group of Industres ., Shri.M.Prasad tookover 60% of the stake in the company and appointed Shri. M.A. Padmanabha Rao & Shri. V.Shubhas Chandra Bose as Additional Directors. Shri.V.Prasada Rao has resigned due to his old age factor and his son Shri.V.Venkateswara Rao replaced him as a Director. Shri. T.V. Hanumantha Rao is the Managing Director of the Company. Shri. T.V.Hanumantha Rao is a “Chemical Engineering” Graduate. He has vast experience in this line of activity in all faculties. The Additional Director Shri.M.A. Padmanabha Rao is a Chartered Accountant and Financial Controller for Group Companies and he has vast experience in commercial activity in different types of Industries. The day-to-day affairs of the company are managed by both the Managing Director and Additional Director.
7
CHAPTER-III INDUSTRY PROFILE
INDUSTRY PROFILE Polyvinyl Chloride (PVC) is the most important polymer because of its versatile application . PVC resin by itself is not thermally stable when used alone and Plasticizers, Additives like Lead Stabilizers, Lubricants & Filler are incorporated to facilitate process activity for producing PVC Pipes, Cables and Profiles. Lead stabilizers are old-established and are widely used due to their low cost, general effectiveness and simplicity formulation.
They are
particularly popular in Rigid PVC Pipes & Cable compounds. We manufacture complete range of Lead based stabilizer and Stearates for PVC processing. 8
Plastic industry though started in India in the fifties gathered momentum in the late sixties and poised for rapid growth.
The consumption of plastic
materials increased rapidly. In the last two decades, the end use application of plastics have been raising manifold in the fields of construction, tele communications, packaging, transportation , engineering, electricals and electronics, agriculture and irrigation and automobile etc., This is in addition to a host of consumer goods which have contributed to make life more comfortable for the common man. The company is manufacturing the following Products : 1. P.V.C Stabilisers like Tri Basic Lead Sulphate (T.B.L.S) Di Basic Lead Phthalate (D.B.L.Ph) Di Basic Lead Phosphite (D.B.L.P) Di Basic Lead Stearate
(D.B.L.S)
2. Metallic Stearates like Calcium Stearate
(C.S)
Barium Stearate
(B.S)
Lead Stearate
(L.S)
3. One Pack Stabilisers like V.C-031 V.C-033 V.C-034 V.C-035 9
V.C-036 V.C-333 V.C-4617
A. Manufacturing process of P.V.C Stabilisers:-
Required quantity of water will be taken into the reactor then temperature will be raised around 70oC with steam heating ,which is produced from coal fired Boiler. Then depending upon material to make, raw materials like Litharge, Sulphuric acid, Phthalic anhydride, phosphorous acid, Stearic acid will be charged into the reactor. Stirred for about one hour. After completion of the reaction material will be centrifuged (to remove water) in centrifuses, dried in hot air dryers (using steam from coal fired boiler), pulverised then packed.
Flow Chart Equipment
Operation
Reactor
Reaction
¯
¯
Centrifuge
Filtration
¯
¯ 10
Dryer
Drying
¯
¯
Pulverize
Pulverizing ¯
Packing
B. Manufacturing process of Metallic Stearates (C.S and B.S):-
Required quantity of water will be taken into the reactor then temperature will be raised around 60 oC with steam heating, which is produced from coal fired Boiler. Then depending upon material to make raw materials like Stearic acid, Hydrated lime, and Barium hydroxide will be charged into the reactor. Stirred for about 30 minutes.
11
Flow Chart Equipment
Operation
Reactor
Reaction
¯
¯
Centrifuge
Filtration
¯
¯
Dryer
Drying
¯
¯
Pulveriser
Pulverising ¯
Packing
C. Manufacturing process of One Pack Stabilisers and L.S:This is a dry process; no water is required for this process. Depending upon material to make, raw materials like Stearic acid, Litharge, Bisphenol, Wax, Hydrated lime, and Barium hydroxide will be charged into the reactor. Temperature will be maintained around 125 oC. Stirred for about 3 hours. After completion of the reaction material will be flaked, cooled to room temperature, pulverized then packed.
Flow Chart
12
Equipment
Operation
Reactor
Reaction
¯ Flaker
¯ Flaking
®
Packing
¯
¯
Pulveriser
Pulverising ¯ Packing
RAW MATERIALS: The major raw materials required are Litharge, Stearic Acid and other mineral Acids. MAJOR SUPPLIERS OF RAW MATERIALS LEAD METAL SUPPLIERS : 1.
Non Ferrous Metals(Ghana) Pvt. Ltd,Ghana
2.
Bharat Udyog, Jammu
3.
Kedar Metals Pvt. Ltd., Daman
4.
Power Trek Industries., Guntur
5.
Jammu Pigments Pvt. ltd
STEARIC ACID SUPPLIERS : 13
1.
Sudha Agro Oil & Chemical Inds. Ltd., Samalkot
2.
Godrej Soaps Ltd., Malanpur
3.
Sree Rayalaseema Alkalies & Allied Chemicals Ltd., Kurnool
4.
Swastik Olechem Ltd., R.R.District, Hyderabad
5.
Jocil Ltd., Guntur
MARKETING STRATEGY The chemicals we manufacture are used in PVC processing to produce products like PVC pipes, Profiles, Insulated Cables and Coated Fabrics. These chemicals are required as Poly Vinyl Chloride is not thermally stable. These chemicals are used incompounding PVC for different applications as heat stabilizers, light stabilizers and internal lubricants. LIST OF MAJOR CUSTOMERS: 1. 2. 3. 4. 5. 6.
Sudhakar Group of Industries, Suryapet, Andhra Pradesh. Sintex Industries ltd., Kalol. Shankla Industries. Bangalore. Himanshu Extrusions., Silvassa. Kalpana Industries Ltd., Daman. Lalitha Chem Pvt. Ltd., Silvassa & Tarapur
7. 8.
Subray Catal Chem Pvt. Ltd., Silvassa & Tarapur. Radiant Cables Ltd., Hyderabad
14
CHAPTER-IV WORKING CAPITAL
Working Capital Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
Working Capital = Current Assets − Current Liabilities 15
Net Operating Working Capital = Current Assets − Non Interestbearing Current Liabilities Equity Working Capital = Current Assets − Current Liabilities − Longterm Debt A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Calculation Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: • • •
Accounts receivable (current asset) inventory (current assets), and accounts payable (current liability)
Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to: Current Assets – Current Liabilities excluding deferred tax asset/ liabilities, excess cash, surplus assets and/or deposit balances. Cash balance items often attract a one-for-one purchase price adjustment Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short –term assets and its shortterm liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
16
Decision criteria By definition, working capital management entails short term decisions - generally, relating to the next one year period which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. One measure of cash flow is provided by the cash conversion cycle - the net number of
•
days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. •
In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA).
•
Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.
Management of working capital Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
17
•
Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
•
Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity
•
Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
•
Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".
Calculating liquidity For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following: •
the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a nonbanking corporation. However, some current assets are more difficult to sell at full value in a hurry.
•
the quick ratio - calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
•
the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
18
Understanding the ratios For different industries and differing legal systems the use of differing ratios and results would be appropriate. For instance, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio more appropriate than an Internet-based start up corporation.
For example, accounts payable for goods, services or supplies that were purchased for use in the operation of the business and payable within a normal period of time would be current liabilities.
Bonds, mortgages and loans that are payable over a term exceeding one year would be fixed liabilities or long-term liabilities. However, the payments due on the long-term loans in the current fiscal year could be considered current liabilities if the amounts were material. The proper classification of liabilities provides useful information to investors and other users of the financial statements. It may be regarded as essential for allowing outsiders to consider a true picture of an organization's fiscal health.
Definition There are several important profit measures in common use which will be explained in the following. Note that the words earnings, profit and income are used as substitutes in some of these terms (also depending on US vs. UK usage), thus inflating the number of profit measures. Gross profit equals sales revenue minus cost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items. Operating profit equals gross profit minus all operating expenses. This is the surplus generated by operations. It is also known as earnings before interest and taxes (EBIT), operating profit before interest and taxes (OPBIT) or simply profit before interest and taxes (PBIT).
19
(Net) profit before tax (PBT) equals operating profit minus interest expense (but before taxes). It is also known as earnings before taxes (EBT), pre-tax book income (PTBI), net operating income before taxes or simply pre-tax Income. Net profit equals profit after tax (unless some distinction about the treatment of extraordinary expenses is made). In the US the term net income is commonly used. Income before extraordinary expenses represents the same but before adjusting for extraordinary items. Net income minus dividends becomes retained earnings. There are several additional important profit measures, notably EBITDA and NOPAT. To accountants, economic profit, or EP, is a single-period metric to determine the value created by a company in one period - usually a year. It is the net profit after tax less the equity charge, a risk-weighted cost of capital. This is almost identical to the economist's definition of economic profit. There are commentators who see benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as EVA or Economic Value Added. Some economists define further types of profit: •
Abnormal profit (or supernormal profit)
•
Subnormal profit
•
monopoly profit (super profit)
Optimum Profit—This is the "right amount" of profit a business can achieve. In business, this figure takes account of marketing strategy, market position, and other methods of increasing returns above the competitive rate. Accounting profits should include economic profits, which are also called economic rents. For instance, a monopoly can have very high economic profits, and those profits might include a rent on some natural resource that firm owns, where that resource cannot be easily duplicated by other firms.
20
Banking In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a central bank, such as the US Federal Reserve bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally-mandated requirements intended to help banks avoid a liquidity crisis.
Overview Accounts receivable represent money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms. The accounts receivable departments use the sales ledger, this is because a sales ledger normally records: - The sales a business has made. - The amount of money received for goods or services. - The amount of money owed at the end of each month (debtors). The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the accounts receivable department. While the collection's department seeks the debtor, the cashiering team applies the monies received.
21
Payment terms An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date; businesses entities can offer a discount for early payment. Other common payment terms include Net 45, Net 60 and 30 days end of month. Booking a receivable is accomplished by a simple accounting transaction; however, the process of maintaining and collecting payments on the accounts receivable subsidiary account balances can be a full-time proposition. Depending on the industry in practice, accounts receivable payments can be received up to 10 – 15 days after the due date has been reache
Bookkeeping On a company's balance sheet, accounts receivable is the money owed to that company by entities outside of the company. The receivables owed by the company's customers are called trade receivables. Account receivables are classified as current assets assuming that they are due within one year. To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. The ending balance on the trial balance sheet for accounts receivable is usually a debit. Business organizations which have become too large to perform such tasks by hand (or small ones that could but prefer not to do them by hand) will generally use accounting software on a computer to perform this task. Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account. The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision); or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement. 22
The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.
Special uses Companies can use their accounts receivable as collateral when obtaining a loan (asset-based lending). They may also sell them through factoring or on an exchange. Pools or portfolios of accounts receivable can be sold in capital markets through securitization. For tax reporting purposes, a general provision for bad debts is not an allowable deduction from profit - a business can only get relief for specific debtors that have gone bad. However, for financial reporting purposes, companies may choose to have a general provision against bad debts consistent with their past experience of customer payments, in order to avoid overstating debtors in the balance sheet.
Inventory Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English.. In the USA and Canada the term has developed from a list of goods and materials to the goods and materials themselves, especially those held available in stock by a business; and this has become the primary meaning of the term in North American English, equivalent to the term "stock" in British English. In accounting, inventory or stock is considered an asset.
Inventory Management Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to proceed the regular and planned course of production and stock of materials.
23
Business inventory The reasons for keeping stock There are three basic reasons for keeping an inventory: 1. Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this "lead time." 2. Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. 3. Economies of scale - Ideal condition of "one unit at a time at a place where a user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory.
All these stock reasons can apply to any owner or product stage. •
Buffer stock is held in individual workstations against the possibility that the upstream workstation may be a little delayed in long setup or change over time. This stock is then used while that changeover is happening. This stock can be eliminated by tools like SMED.
These classifications apply along the whole Supply chain, not just within a facility or plant. Where these stocks contain the same or similar items, it is often the work practice to hold all these stocks mixed together before or after the sub-process to which they relate,more acute.
Special terms used in dealing with inventory •
Stock Keeping Unit (SKU) is a unique combination of all the components that are assembled into the purchasable item. Therefore, any change in the packaging or product is a new SKU. This level of detailed specification assists in managing inventory.
•
Stockout means running out of the inventory of an SKU.
•
"New old stock" (sometimes abbreviated NOS) is a term used in business to refer to merchandise being offered for sale that was manufactured long ago but that has never been used. Such merchandise may not be produced anymore, and the new old stock may represent the only market source of a particular item at the present time.
24
Typology 1. Buffer/safety stock 2. Cycle stock (Used in batch processes, it is the available inventory, excluding buffer stock) 3. De-coupling (Buffer stock held between the machines in a single process which serves as a buffer for the next one allowing smooth flow of work instead of waiting the previous or next machine in the same process) 4. Anticipation stock (Building up extra stock for periods of increased demand - e.g. ice cream for summer) 5. Pipeline stock (Goods still in transit or in the process of distribution - have left the factory but not arrived at the customer yet)
Principle of inventory proportionality Purpose Inventory proportionality is the goal of demand-driven inventory management. The primary optimal outcome is to have the same number of days' (or hours', etc.) worth of inventory on hand across all products so that the time of run out of all products would be simultaneous. In such a case, there is no "excess inventory," that is, inventory that would be left over of another product when the first product runs out. The secondary goal of inventory proportionality is inventory minimization. By integrating accurate demand forecasting with inventory management, replenishment inventories can be scheduled to arrive just in time to replenish the product destined to run out first, while at the same time balancing out the inventory supply of all products to make their inventories more proportional, and thereby closer to achieving the primary goal. Accurate demand forecasting also allows the desired inventory proportions to be dynamic by determining expected sales out into the future; this allows for inventory to be in proportion to expected short-term sales or consumption rather than to past averages, a much more accurate and optimal outcome. Integrating demand forecasting into inventory management in this way also allows for the prediction of the "can fit" point when inventory storage is limited on a per-product basis.
25
Applications The technique of inventory proportionality is most appropriate for inventories that remain unseen by the consumer. As opposed to "keep full" systems where a retail consumer would like to see full shelves of the product they are buying so as not to think they are buying something old, unwanted or stale; and differentiated from the "trigger point" systems where product is reordered when it hits a certain level; inventory proportionality is used effectively by just-in-time manufacturing processes and retail applications where the product is hidden from view.
Roots The use of inventory proportionality in the United States is thought to have been inspired by Japanese just-in-time parts inventory management made famous by Toyota Motors in the 1980s.
High-level inventory management It seems that around 1880 there was a change in manufacturing practice from companies with relatively homogeneous lines of products to vertically integrated companies with unprecedented diversity in processes and products. Those companies (especially in metalworking) attempted to achieve success through economies of scope - the gains of jointly producing two or more products in one facility. The managers now needed information on the effect of product-mix decisions on overall profits and therefore needed accurate product-cost information. A variety of attempts to achieve this were unsuccessful due to the huge overhead of the information processing of the time. However, the burgeoning need for financial reporting after 1900 created unavoidable pressure for financial accounting of stock and the management need to cost manage products became overshadowed. In particular, it was the need for audited accounts that sealed the fate of managerial cost accounting. The dominance of financial reporting accounting over management accounting remains to this day with few exceptions, and the financial reporting definitions of 'cost' have distorted effective management 'cost' accounting since that time. This is particularly true of inventory. Hence, high-level financial inventory has these two basic formulas, which relate to the accounting period: 26
1. Cost of Beginning Inventory at the start of the period + inventory purchases within the period + cost of production within the period = cost of goods available 2. Cost of goods available − cost of ending inventory at the end of the period = cost of goods sold The benefit of these formulae is that the first absorbs all overheads of production and raw material costs into a value of inventory for reporting. The second formula then creates the new start point for the next period and gives a figure to be subtracted from the sales price to determine some form of sales-margin figure. Manufacturing management is more interested in inventory turnover ratio or average days to sell inventory since it tells them something about relative inventory levels. Inventory turnover ratio (also known as inventory turns) = cost of goods sold / Average Inventory = Cost of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2) and its inverse Average Days to Sell Inventory = Number of Days a Year / Inventory Turnover Ratio = 365 days a year / Inventory Turnover Ratio This ratio estimates how many times the inventory turns over a year. This number tells how much cash/goods are tied up waiting for the process and is a critical measure of process reliability and effectiveness. So a factory with two inventory turns has six months stock on hand, which is generally not a good figure (depending upon the industry), whereas a factory that moves from six turns to twelve turns has probably improved effectiveness by 100%. This improvement will have some negative results in the financial reporting, since the 'value' now stored in the factory as inventory is reduced. While these accounting measures of inventory are very useful because of their simplicity, they are also fraught with the danger of their own assumptions. There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include: •
Specific Identification
•
Weighted Average Cost
•
Moving-Average Cost
•
FIFO and LIFO.
27
Financial accounting An organization's inventory can appear a mixed blessing, since it counts as an asset on the balance sheet, but it also ties up money that could serve for other purposes and requires additional expense for its protection. Inventory may also cause significant tax expenses, depending on particular countries' laws regarding depreciation of inventory, as in Thor Power Tool Company v. Commissioner. Inventory appears as a current asset on an organization's balance sheet because the organization can, in principle, turn it into cash by selling it. Some organizations hold larger inventories than their operations require in order to inflate their apparent asset value and their perceived profitability.In addition to the money tied up by acquiring inventory, inventory also brings associated costs for warehouse space, for utilities, and for insurance to cover staff to handle and protect it from fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such holding costs can mount up: between a third and a half of its acquisition value per year. Businesses that stock too little inventory cannot take advantage of large orders from customers if they cannot deliver. The conflicting objectives of cost control and customer service often pit an organization's financial and operating managers against its sales and marketing departments. Salespeople, in particular, often receive sales-commission payments, so unavailable goods may reduce their potential personal income. This conflict can be minimised by reducing production time to being near or less than customers' expected delivery time. This effort, known as "Lean production" will significantly reduce working capital tied up in inventory and reduce manufacturing costs.
Role of inventory accounting By helping the organization to make better decisions, the accountants can help the public sector to change in a very positive way that delivers increased value for the taxpayer’s investment. It can also help to incentivise progress and to ensure that reforms are sustainable and effective in the long term, by ensuring that success is appropriately recognized in both the formal and informal reward systems of the organization.
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CHAPTER-V REVIEW OF LITERATURE
REVIEW OF LITERATURE
29
FIFO vs. LIFO accounting Main article: FIFO and LIFO accounting When a merchant buys goods from inventory, the value of the inventory account is reduced by the cost of goods sold (COGS). This is simple where the CoG has not varied across those held in stock; but where it has, then an agreed method must be derived to evaluate it. For commodity items that one cannot track individually, accountants must choose a method that fits the nature of the sale. Two popular methods that normally exist are: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory as the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to LIFO's potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting.
Standard cost accounting Standard cost accounting uses ratios called efficiencies that compare the labour and materials actually used to produce a good with those that the same goods would have required under "standard" conditions. As long as similar actual and standard conditions obtain, few problems arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when labor comprised the most important cost in manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of cost in most cases. Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a policy decision to increase inventory can harm a manufacturing manager's performance evaluation. Increasing inventory requires increased production, which means that processes must operate at higher rates. When (not if) something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though s/he has no control over the production requirement or the problem.
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Theory of constraints cost accounting Eliyahu M. Goldratt developed the Theory of Constraints in part to address the costaccounting problems in what he calls the "cost world." He offers a substitute, called throughput accounting, that uses throughput (money for goods sold to customers) in place of output (goods produced that may sell or may boost inventory) and considers labor as a fixed rather than as a variable cost. He defines inventory simply as everything the organization owns that it plans to sell, including buildings, machinery, and many other things in addition to the categories listed here. Throughput accounting recognizes only one class of variable costs: the truly variable costs, like materials and components, which vary directly with the quantity produced.
National accounts Inventories also play an important role in national accounts and the analysis of the business cycle. Some short-term macroeconomic fluctuations are attributed to the inventory cycle.
Distressed inventory Also known as distressed or expired stock, distressed inventory is inventory whose potential to be sold at a normal cost has passed or will soon pass. In certain industries it could also mean that the stock is or will soon be impossible to sell. Examples of distressed inventory include products that have reached their expiry date, or have reached a date in advance of expiry at which the planned market will no longer purchase them (e.g. 3 months left to expiry), clothing that is defective or out of fashion, and old newspapers or magazines. It also includes computer or consumer-electronic equipment that is obsolete or discontinued and whose manufacturer is unable to support it. One current example of distressed inventory is the VHS format In 2001, Cisco wrote off inventory worth US $2.25 billion due to duplicate orders. This is one of the biggest inventory write-offs in business history.
Inventory credit Inventory credit refers to the use of stock, or inventory, as collateral to raise finance. Where banks may be reluctant to accept traditional collateral, for example in developing countries where land title may be lacking, inventory credit is a potentially important way of 31
overcoming financing constraints. This is not a new concept; archaeological evidence suggests that it was practiced in Ancient Rome. Obtaining finance against stocks of a wide range of products held in a bonded warehouse is common in much of the world. It is, for example, used with Parmesan cheese in Italy. Inventory credit on the basis of stored agricultural produce is widely used in Latin American countries and in some Asian countries. A precondition for such credit is that banks must be confident that the stored product will be available if they need to call on the collateral; this implies the existence of a reliable network of certified warehouses. Banks also face problems in valuing the inventory. The possibility of sudden falls in commodity prices means that they are usually reluctant to lend more than about 60% of the value of the inventory at the time of the loan.
Accounts Payable Chart of Accounts Most big and medium size limited and/or Incorporated Companies are using a Chart of Accounts for the Accounts Payable and/or Creditors Book especially when their accounting system is modern for e.g. as in the case of Pastel Evolution. In this Chart of Accounts (that is similar to the General Ledger or the Accounts Receivable Chart of Accounts also known as the Debtors Book) all Suppliers is included in the Approved Suppliers Listing , including those with Zero Account Balances.
Typical features of a Modern Accounting Package such as Pastel Evolution for the Accounts Payable and/or Creditors Book The major parts are 1.Maintenance 2.Transactions 3.Enquiries 4.Reports
1. Maintenance Section : 1. General Maintenance 2. Ageing Records 3. Ageing Periods 4. Areas 5. Delivery Address 6. Groups 7. People 8. Settlement Terms 9. Suppliers 10. Transaction Types 11. Allocation Utilities 12. Balance Relink 13. Defaults 14. Purge Transactions 15. Rename Account 2. Transaction Section : 1. Accounts Payable Transactions 2. Automatic Payment and Remittances 3. Automatic Payment Batches 4. EFTS Export 5. Standard 32
3. Enquiries Section : 1. Transactions Enquiry 2. Account Enquiry 3. Balances Enquiry 4. Orders Enquiry 5. Annuity Billing Enquiry 6. People Enquiry 7. Incident History Enquiry 8. Inventory Items Enquiry 4. Reports : 1. Reports Summary List 2. Age Analysis Report(s) 3. Allocations Report(s) 4. Delivery Address Report(s) 5. Labels Report(s) 6. Remittance Advice Report(s) 7. Supplier Listing Report(s) 8. Transactions Report(s) 9. Unrealised Profit and/or Loss Report(s) .
Matching of the internal Accounts Payable Book with the external Accounts Receivable Book First tick off all Matching items to get only the Net Outstanding Non Matching Items in both sets of Books (the internal Accounts Payable and/or Creditors Book with the external Accounts Receivable and/or Debtors Book) (The external Accounts Receivable and/or Debtors Book should at least in theory , provided it is correctly drawn up be similar to the correct net outstanding debits and credits send out as per the balance reflected on the statement irrespected of whether or not this is Management Driven or Information Technology Departments' Driven or Consultants' Driven) Such a RECORD would normally consist of the opening Balance (and for successful Reconciliations to be done you would need to start with US $ 0.00 (and or the applicable currency value) in both sets of Books and take it from there) Plus Debits for invoices in the Accounts Receivable Book of the Supplier /Contractor and Credit
in
the
Accounts
Payable
Books
of
the
receiver
of
Goods/Products/Services/Values/Benefits Plus Debits for additional charges such as interest or Not Specifically Claimed in Contract Charges in the Accounts Receivable Book of the Supplier/Contractor and Credits in the Accounts Payable Books of the receiver of Goods/Products/Services/Values/Benefits Plus Debits in the Accounts Receivable Book for Payment Reversals and Credits in the Accounts Payable Books Plus Debits in the Accounts Receivable Book for Subcontract Work charged directly to the Main supplier Of the Contract and credits in the Accounts Payable Book Plus Credit notes Reversals that is either an Invoice with a new number or the reissue of an invoice Or a cancelled Credit note entry or a 33
specific issued with reference number Official Credit Note Reversal Plus Any additional charges such as agreed upon legal costs (Debits in the Accounts Receivable Book and Credits in the Accounts Payable Books) Plus Unique situations such as Rebates Reversals (Debits in the Accounts Receivable Book and Credits and the Accounts Payable Book)
Audits of accounts payable Auditors often focus on the existence of approved invoices, expense reports, and other supporting documentation to support checks that were cut. The presence of a confirmation or statement from the supplier is reasonable proof of the existence of the account. It is not uncommon for some of this documentation to be lost or misfiled by the time the audit rolls around. An auditor may decide to expand the sample size in such situations. Auditors typically prepare an ageing structure of accounts payable for a better understanding of outstanding debts over certain periods (30, 60, 90 days, etc.). Such structures are helpful in the correct presentation of the balance sheet as of year end.
. Project Financing: Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure where project debt and equity are used to finance the project, rather than the balance sheets of project sponsors. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks that provide loans to the operation.
Non Fund Base Letter of Credit: The LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all 34
letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any
Securitization Main article: Securitization Securitization occurs when a company groups together assets or receivables and sells them in units to the market through a trust. Any asset with a cashflow can be securitized. The cash flows from these receivables are used to pay the holders of these units. Companies often do this in order to remove these assets from their balance sheets and monetize an asset. Although these assets are "removed" from the balance sheet and are supposed to be the responsibility of the trust that does not end the company's involvement. Often the company maintains a special interest in the trust which is called an "interest only strip" or "first loss piece".
Debt, inflation and the exchange rate As noted below, debt is normally denominated in a particular monetary currency, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to inflation or deflation, so it can happen even though the borrower and the lender are using the same currency. Thus it is important to agree on standards of deferred payment in advance, so that a degree of fluctuation will also be agreed as acceptable.
Inflation indexed debt Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and are used in some countries. For example, the US government issues two types of inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS) and I-bonds. These are one of the safest forms of investment available, since the only major source of risk — that of inflation — is eliminated. A number of other governments issue similar bonds, and some did so for many years before the US government. In countries with consistently high inflation, ordinary borrowings at banks may also be
Current asset In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include
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cash, cash equivalents, short-term investments, accounts receivable, inventory and the portion of prepaid liabilities which will be paid within a year. On a balance sheet, assets will typically be classified into current assets and long-term assets. The current ratio is calculated by dividing total current assets by total current liabilities. It is frequently used as an indicator of a company's liquidity, its ability to meet short-term obligations.
Fixed assets Main article: Fixed asset Also referred to as PPE (property, plant, and equipment), these are purchased for continued and long-term use in earning profit in a business. This group includes as an asset land, buildings, machinery, furniture, tools, and certain wasting resources e.g., timberland and minerals. They are written off against profits over their anticipated life by charging depreciation expenses (with exception of land assets). Accumulated depreciation is shown in the face of the balance sheet or in the notes.
These are also called capital assets in management accounting.
Intangible assets Main article: Intangible asset Intangible assets lack of physical substance and usually are very hard to evaluate. They include patents, copyrights, franchises, goodwill, trademarks, trade names, etc. These assets are (according to US GAAP) amortized to expense over 5 to 40 years with the exception of goodwill. Websites are treated differently in different countries and may fall under either tangible or intangible assets.
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Tangible assets Tangible assets are those that have a physical substance and can be touched, such as currencies, buildings, real estate, vehicles, inventories, equipment, and precious metals.
Other related meanings Information asset Main article: asset (computer security) In Information technology, chiefly in Information security, data needed to conduct the organization business and the technical equipment to manage (input, store, display, print) are called information asset. They can represent a large portion of intangible and tangible asset of an organization. If these assets become unavailable, business operations can be disrupted. Confidential information disclosure can represent a huge liability. While evaluating the potential loss tied to an asset or a group of assets, the value tied to the largest sum between the related asset and their value should be considered
Cash conversion cycle In management accounting, the Cash Conversion Cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, 37
shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.
Definition CCC = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations. =
Inventory
conversion + Receivables
period Avg. Inventory
= COGS / 365
conversion – Payables
period
conversion
period
Avg.
Accounts
+ Receivable Credit Sales / 365
Avg.
Accounts
– Payable COGS / 365
Derivation Cashflows insufficient. The term "cash conversion cycle" refers to the timespan between a firm's disbursing and collecting cash. However, the CCC cannot be directly observed in cashflows, because these are also influenced by investment and financing activities; it must be derived from Statement of Financial Position data associated with the firm's operations. Equation describes retailer. Although the term "cash conversion cycle" technically applies to a firm in any industry, the equation is generically formulated to apply specifically to a retailer. Since a retailer's operations consist in buying and selling inventory, the equation models the time between (1) disbursing cash to satisfy the accounts payable created by sale of a unit of inventory, and (2) collecting cash to satisfy the accounts receivable generated by that sale.
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Accounting (use different accounting vehicles if
Label Transaction
the transactions occur in a different order)
Suppliers (agree to) deliver inventory A
•
→Firm cash
owes
$X
(debt)
to
suppliers Customers (agree
to)
acquire that inventory B
→Create accounting vehicle (increasing accounts payable by $X)
•
"COGS" expense of $X; accruing revenue
cash (credit) from
C
suppliers
and increasing accounts receivable of $Y) •
accounts payable by $X)
debts to its suppliers Firm collects $Y cash from D
Cashflows (decreasing cash by $X) →Remove accounting vehicle (decreasing
→Firm removes its
customers
Operations (decreasing inventory by $X) →Create accounting vehicles (booking
→Firm is owed $Y customers Firm disburses $X cash to
Operations (increasing inventory by $X)
•
Cashflows (increasing cash by $Y)
→Firm removes its
→Remove accounting vehicle (decreasing
credit
accounts receivable by $Y.)
from
its
customers.
Taking these four transactions in pairs, analysts draw attention to five important intervals, referred to as conversion cycles (or conversion periods): •
the Cash Conversion Cycle emerges as interval C→D (i.e. disbursing cash→collecting cash).
•
the payables conversion period (or "Days payables outstanding") emerges as interval A→C (i.e. owing cash→disbursing cash)
•
the operating cycle emerges as interval A→D (i.e. owing cash→collecting cash)
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the inventory conversion period or "Days inventory outstanding"
•
emerges as interval A→B (i.e. owing cash→being owed cash) the receivables conversion period (or "Days sales outstanding")
•
emerges as interval B→D (i.e.being owed cash→collecting cash Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.) Hence, interval {C → D} CCC
(in
days)
= interval {A → B} +
interval {B → D}
Inventory = conversion
Receivables
+
conversion period
period
–
interval {A → C} Payables
–
conversion period
In calculating each of these three constituent Conversion Cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE). •
We estimate its LEVEL "during the period in question" as the average of its levels in the two balance-sheets that surround the period: (Lt1+Lt2)/2.
•
To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it). •
Payables conversion period: Rate = [inventory increase + COGS],
since these are the items for the period that can increase "trade accounts payables," i.e. the ones that grew its inventory. NOTICE that we make an exception when calculating this interval: although we use a period average for the LEVEL of inventory, we also consider any increase in inventory as contributing to its RATE of change. This is because the purpose of the CCC is to measure the effects of inventory growth on cash outlays. If inventory grew during the period, we want to know about it. •
Inventory conversion period: Rate = COGS, since this is the item
that (eventually) shrinks inventory. 40
•
Receivables conversion period: Rate = revenue, since this is the item
that can grow receivables (sales).
Material Material is anything made of matter, constituted of one or more substances. Wood, cement, hydrogen, air and water are all examples of materials. Sometimes the term "material" is used more narrowly to refer to substances or components with certain physical properties that are used as inputs to production or manufacturing. In this sense, materials are the parts required to make something else, from buildings and art to stars and computers.
Raw materials and processing A material can be anything: a finished product in its own right or an unprocessed raw material. Raw materials are first extracted or harvested from the earth and divided into a form that can be easily transported and stored, then processed to produce semi-finished materials. These can be input into a new cycle of production and finishing processes to create finished materials, ready for distribution, construction, and consumption.
Some Examples of Materials Cotton An example of a raw material is cotton, which is harvested from plants. Cotton can be processed into thread (also considered a raw material), which can then be woven into cloth, a semi-finished material. Cutting and sewing the fabric turns it into a garment, which is a finished product. Steel Steelmaking is another example – raw materials in the form of ore are mined, refined and processed into steel, a semi-finished material. Steel is then used as an input in many other industries to make finished products. 41
Chemistry In chemistry materials can be divided into different typologies in relation to their composition, for example: •
metals and alloys
•
ceramics
•
plastics
•
semiconductors
•
composite materials.
•
glasses
Return on capital Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the after-tax operating income (NOPAT) by the book value of invested capital.
Formula
•
This differs from ROIC. Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as net operating profit less adjusted taxes divided by invested capital and is usually expressed as a percentage. In this calculation, capital invested includes all monetary capital invested: long-term debt, common and preferred shares. When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed.
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ROIC formula
•
Note that the numerator in the ROIC fraction does not subtract interest expense, because denominator includes debt capital.
Capital employed Capital employed has many definitions. In general, it represents the capital investment necessary for a business to function. Consequently, it is not a measure of assets, but of capital investment: stock or shares and long-term liabilities.
Definitions Capital employed is usually presented as total assets less current liabilities, or non-current assets plus working capital:
Capital Employed = Total Assets − Current Liabilities Capital Employed is equal to Non-Current Debt and Equity provide obvious sources of longterm funding, but a further source is provided by the short-term debt that remains on the balance sheet at the year end. The sum of these sources of long-term funds is termed capital employed. Capital employed can be defined as equity plus loans which are subject to interest or one can say that it is total assets less non bearing interest liabilities. Capital employed can be defined as shareholders funds (ie. Share capital and reserves) plus creditors > 1 year (long-term liabilities) plus provisions for liabilities and charges. NB. This MUST equal Total assets less current liabilities. More clearly capital employed means total of long term liabilities, ie equity share capital+ pre share capita+ debenture capital+ long term loan from financial institutions. Capital employed is the value of the assets that contribute to a company's ability to generate revenues, ie. their liquidity.
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Return on equity Return on equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are considered desirable.
The formula
ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. As with many financial ratios, ROE is best used to compare companies in the same industry. High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate. The benefit can also come as a dividend on common shares or as a combination of dividends and reinvestment in the company. ROE is presumably irrelevant if the earnings are not reinvested. •
The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
•
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
The DuPont formula The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal the net margin 44
multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt.
Cost of capital The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Cost of debt The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default 45
premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate. The yield to maturity can be used as cost of capital.
Cost of equity Cost
of
equity
=
Risk
free
rate
of
return
+
Premium
expected
for
risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the relevant market:
Where: Es The expected return for a security Rf The expected risk-free return in that market (government bond yield) βs The sensitivity to market risk for the security RM The historical return of the stock market/ equity market (RM-Rf) The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
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Expected return The expected return (or required rate of return for investors) can be calculated with the "dividend
capitalization
model",
which
is
Comments The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium. The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. The dividends have increased the total "real" return on average equity to the double, about 3.2%. The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.
Cost of retained earnings/cost of internal equity Note that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
Weighted average cost of capital Main article: Weighted average cost of capital The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt 47
(the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity Capital. Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
Capital structure Main article: Capital structure Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firm's value can be maximized. The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.weighted average cost of capital
Cash In common language cash refers to money in the physical form of currency, such as banknotes and coins. In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately (as in the case of money market accounts). Cash is seen either as a reserve for payments, in case of a structural or incidental negative cash flow or as a way to avoid a downturn on financial markets. 48
Cash and cash equivalents Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months. Another important condition a cash equivalent needs to satisfy is that the investment should have insignificant risk of change in value; thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.
Payments "Cash and cash equivalents", when used in the contexts of payments and payments transactions refer to currency, coins, money orders, paper checks, and stored value products such as gift certificates and gift cards.If in adjustment of cash flow it is written that investment is short term you should not consider that investment as a part of cash and cash equivalent,
Debtor A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterparts of this debt arrangement is a bank, the debtor is more often referred to as a borrower.
Default Main article: Default (finance) Default occurs when the debtor has not met its legal obligations according to the debt contract, e.g.- it has not made a scheduled payment, or has violated a covenant in the debt contract. Default may occur if the debtor is either unwilling or unable to pay its debt. This can occur with all debt obligations including bonds, mortgages, loans, and promissory notes. 49
If the debt owed becomes beyond the possibility of repayment, the debtor faces insolvency or bankruptcy; in the United Kingdom and some states of the United States until the mid-19th century, debtors could be imprisoned in debtor's prisons, while in some countries such as Greece the practice of imprisoning debtors is still practiced.
Debtor in Bankruptcy and Individual Voluntary Arrangements An Individual Voluntary Arrangement is a legally binding arrangement supervised by a licensed Insolvency Practitioner, the purpose of which is to enable an individual, sole trader or Partner ("the Debtor") to reach a compromise with his creditors and avoid the consequences of bankruptcy. The compromise should offer a larger repayment towards the creditor's debt than could otherwise be expected were the Debtor to be made bankrupt. This is often facilitated by the Debtor making contributions to the arrangement from his income over a designated period or from a third party contribution or other source that would not ordinarily be available to a Trustee in Bankruptcy
Cash management In United States banking, cash management, or treasury management, is a marketing term for certain services offered primarily to larger business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it is more often used to describe specific services such as cash concentration, zero balance accounting, and automated clearing house facilities. Sometimes, private banking customers are •
than a telephone call.
•
Controlled Disbursement: This is another product offered by banks under Cash Management Services. The bank provides a daily report, typically early in the day, that provides the amount of disbursements that will be charged to the customer's account. This early knowledge of daily funds requirement allows the customer to invest any surplus in intraday investment opportunities, typically money market investments. This is different from delayed disbursements, where payments are issued
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through a remote branch of a bank and customer is able to delay the payment due to increased float time.
Work in progress Work in progress or work-in-progress is a work that has been started but not yet completed (acronym: WIP), it may also refer to: Film •
A Work in Progress, a documentary film of the recording of Rush's Test for Echo album.
•
Work in Progress, a 2000 computer animated short film.
Music •
Work in Progress, an album by the punk rock band Man Alive.
•
"Work in Progress", a song by melodic hardcore band Set Your Goals.
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"Work in Progress", a solo album by Edgar Meyer.
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"Work in Progress", a song by rapper/producer Kev Brown.
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"Work in Progress", a song by the country singer Alan Jackson
Finished good Finished goods are goods that have completed the manufacturing process but have not yet been sold or distributed to the end user.
Manufacturing Main article: Manufacturing Manufacturing has three classes of inventory: 1. Raw material 2. Work in process 3. Finished goods A good purchased as a "raw material" goes into the manufacture of a product. A good only partially completed during the manufacturing process is called "work in process". When the good is completed as to manufacturing but not yet sold or distributed to the end-user, it is called a "finished good". 51
Finished goods is a relative term. In a Supply chain management flow, the finished goods of a supplier can constitute the raw material of a buyer.
Credit (finance) Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately (thereby generating a debt), but instead arranges either to repay or return those resources (or other materials of equal value) at a later date. The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred payment.Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower. Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services . However, in modern societies credit is usually denominated by a unit of account. Unlike money, credit itself cannot act as a unit of account. Movements of financial capital are normally dependent on either credit or equity transfers. Credit is in turn dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also traded in financial markets. The purest form is the credit default swap market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this risk – the protection "seller" takes the risk of default of the credit in return for a payment, commonly denoted in basis points (one basis point is 1/100 of a percent) of the notional amount to be referenced, while the protection "buyer" pays this premium and in the case of default of the underlying (a loan, bond or other receivable), delivers this receivable to the protection seller and receives from the seller the par amount (that is, is made whole).
Loan A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower.
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Demand Demand loans are short term loans (typically no more than 180 days) that are atypical in that they do not have fixed dates for repayment and carry a floating interest rate which varies according to the prime rate. They can be "called" for repayment by the lending institution at any time. Demand loans may be unsecured or secured.
Target markets Personal or commercial Loans can also be subcategorized according to whether the debtor is an individual person (consumer) or a business. Common personal loans include mortgage loans, car loans, home equity lines of credit, credit cards, installment loans and payday loans. The credit score of the borrower is a major component in and underwriting and interest rates (APR) of these loans. The monthly payments of personal loans can be decreased by selecting longer payment terms, but overall interest paid increases as well. For car loans in the U.S., the average term was about 60 months in 2009.
Loan payment The most typical loan payment type is the fully amortizing payment in which each monthly rate has the same value overtime. The fixed monthly payment P for a loan of L for n months and a monthly interest rate c is:
Abuses in lending Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over him or her. Where the moneylender is not authorized, they could be considered a loan shark. Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by
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consumer organisations of lending at usurious interest rates and making money out of frivolous "extra charges". Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.
United States taxes Most of the basic rules governing how loans are handled for tax purposes in the United States are codified by both Congress (the Internal Revenue Code) and the Treasury Department (Treasury Regulations — another set of rules that interpret the Internal Revenue Code). Yet such rules are universally accepted. 1. A loan is not gross income to the borrower. Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth. 2. The lender may not deduct the amount of the loan. The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment). Deductions are not typically available when an outlay serves to create a new or different asset. 3. The amount paid to satisfy the loan obligation is not deductible by the borrower. 4. Repayment of the loan is not gross income to the lender. In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender. 5. Interest paid to the lender is included in the lender’s gross income. Interest paid represents compensation for the use of the lender’s money or property and thus represents profit or an accession to wealth to the lender. Interest income can be attributed to lenders even if the lender doesn’t charge a minimum amount of interest. 6. Interest paid to the lender may be deductible by the borrower. In general, interest paid in connection with the borrower’s business activity is deductible, while interest paid on personal loans are not deductible. The major exception here is interest paid on a home mortgage.
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CHAPTER-VI FRAME WORK FOR ANALYSIS
Vinyl Chemicals Pvt. Ltd. (from 1-Apr-2008-09) as at 31-Mar-2009 Sources of Funds : Capital Account Loans (Liability) Current Liabilities Profit &
Loss 55
65575702.00
82.16
34793803.00
% 43.60
17073394.78
% 21.39
-
% 47.15
A/c Opening
37473976.67
Balance Current Period Less:
-221713.95 -379775.00
Transferred Total Application
37632037.72
%
79810862.06
100 %
20641736.00
25.86
59169126.06
% 74.14
79810862.06
% 100 %
of
Funds : Fixed Assets Current Assets Total
Vinyl Chemicals Pvt. Ltd. (from 1-Apr-2009-10) as at 31-Mar-2010 Sources of Funds : Capital Account
64580602.00
76.63
43698327.00
% 51.85
Current Liabilities
7571593.63
% 8.98 %
Profit & Loss A/c
-31573113.41
37.46
Loans (Liability)
%
56
Opening Balance
37632037.72
Current Period
-6265158.31
Less: Transferred
-206234.00
Total
84277409.22
100 %
25448439.00
30.20
58828970.22
% 69.80
100 %
% 100 %
Application of Funds : Fixed Assets Current Assets 100 %
100 %
Vinyl Chemicals Pvt. Ltd. (from 1-Apr-2010-11) as at 31-Mar-2011 Sources of Funds : Capital Account
64580602.00
63.28
64978777.00
% 63.67
Current Liabilities
1761254.63
% 1.73 %
Profit & Loss A/c
-29272265.32
28.68
Loans (Liability)
% Opening Balance
31573113.41
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Current Period
-2452650.09
Less: Transferred
-151802.00
Total
102048368.31
100 %
27120897.00
26.58
74927471.31
% 73.42
102048368.31
% 100 %
Application of Funds : Fixed Assets Current Assets Total
CHAPTER-VII FINDINGS, SUGGESTIONS&CONCLUSIONS
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Findings and Suggestions on working capital:
2007-08 According to the statement of funds flow of the company for the Financial Year 2007-08, it shows a net loss of Rs.1,09,784/- out of the sources of funds for that period after considering net profit and deferred tax asset, minus provision for fringe benefit tax and prior period expenses. 2008-09 As per the statement of funds flow of the company for the Financial Year 2008-09, it shows a net loss of Rs. 1,58,061/- out of the sources of funds for that period after considering net profit and deferred tax asset, minus provision for fringe benefit tax and
prior period
expenses. 2009-10 In the Financial Year 2009-10, the company’s financial position was improved a lot better compare to the earlier financial years of 2007-08 & 2008-09 by earning good profits of Rs.60,58,924/- after adding deferred tax asset and deducting the prior period expenses.
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2010-11 In the Financial Year 2010-11, the company’s financial position was decreased a bit compare to the profits earned in the financial year 2009-10 and could earn very marginal profits of Rs. 23,00,865/- after deducting prior period expenses despite the increase in turnover.
Suggestions
1. For the Financial Year 2007-08, the company needed to sell their products at a higher rates compare to the high input costs of raw- materials, etc. and production costs to earn more returns of profits. 2. For the Financial Year 2008-09, the company needed to sell their products at a higher rates compare to the high input cost of raw- materials, etc. and production costs to earn more returns of profits. 3. In the Financial Year2009-10, the company could earn good profits compare to the earlier financial years. Hence no suggestions are required. 4. In the Financial Year 2010-11, the company was needed to increase the selling prices of all products to gain more profits compare to the financial year 2009-10.
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Conclusion 1. The company has to increase their selling prices compare to the input costs and other overheads from time to time to run the business more efficiently. 2. The company has to purchase the raw- materials on credit basis from the regular Suppliers. 3. The company has to reduce the credit limit to maximum 30 days to all debtors. 4. Cost cu down mechanics can be employed. 5. Turnover can be increased for better returns against the short margins on selling prices.
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Bibliography : Referred Publications:
1. Name of the book: Financial Management Author : Brighan Houston Edition : 12th edition Publications : South western college publications 2. Name of the book: Financial Management Author : I.M.Pandey, Edition : 9th edition, Publications : Vikas Publishing House,
3. Name of the book: Financial Management Author: Prasanna chandra 62
Edition: 5th edition, Publications : Tata Mc Graw Hill,
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