WORKING CAPITAL MANAGEMENT
Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully with out an adequate amount of working capital.
Working capital refers to that part of firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors, and inventories. In other words working capital is the amount of funds necessary to cover the cost of operating the enterprise.
Working capital means the funds (i.e.; capital) available and used for day to day operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a business which are used in or related to its current operations. It refers to funds which are used during an accounting period to generate a current income of a type which is consistent with major purpose of a firm existence.
Objectives of working capital:
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.
Factors that determine working capital:
The working capital requirement of a concern depend upon a large number of factors such as
? Size of business
? Nature of character of business.
? Seasonal variations working capital cycle
? Operating efficiency
? Profit level.
? Other factors.
Sources of working capital:
The working capital requirements should be met both from short term as well as long term sources of funds.
? Financing of working capital through short term sources of funds has the benefits of lower cost and establishing close relationship with banks.
? Financing of working capital through long term sources provides the benefits of reduces risk and increases liquidity
Types of working capital:
Working capital an be divided into two categories-
Permanent working capital:
It refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities.
Temporary working capital:
The amount of such working capital keeps on fluctuating from time to time on the basis of business activities.
Advantages of working capital:
• It helps the business concern in maintaining the goodwill.
• It can arrange loans from banks and others on easy and favorable terms.
• It enables a concern to face business crisis in emergencies such as depression.
• It creates an environment of security, confidence, and over all efficiency in a business.
• It helps in maintaining solvency of the business.
Disadvantages of working capital:
• Rate of return on investments also fall with the shortage of working capital.
• Excess working capital may result into over all inefficiency in organization.
• Excess working capital means idle funds which earn no profits.
• Inadequate working capital can not pay its short term liabilities in time.
Management of working capital:
A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has idle funds which earn no profits for the firm. Inadequate working capital means the firm does not have sufficient funds for running its operations. It will be interesting to understand the relationship between working capital, risk and return. The basic objective of working capital management is to manage firms current assets and current liabilities in such a way that the satisfactory level of working capital is maintained, i.e.; neither inadequate nor excessive. Working capital some times is referred to as “circulating capital”. Operating cycle can be said to be t the heart of the need for working capital. The flow begins with conversion of cash into raw materials which are, in turn transformed into work-in-progress and then to finished goods. With the sale finished goods turn into accounts receivable, presuming goods are sold as credit. Collection of receivables brings back the cycle to cash.
The company has been effective in carrying working capital cycle with low working capital limits. It may also be observed that the PBT in absolute terms has been increasing as a year to year basis as could be seen from the above table although profit percentage turnover may be lower but in absolute terms it is increasing. In order to further increase profit margins, SSL can increase their margins by extending credit to good customers and also by paying the creditors in advance to get better rates.
WORKING CAPITAL AND RATIO ANALYSIS
Ratio Analysis is one of the important techniques that can be used to check the efficiency with which working capital is being managed by a firm. The most important ratios for working capital management are as follows
Net Working Capital:
There are two concepts of working capital namely gross working capital and net working capital. Net working capital is the difference between current assets and current liabilities. An analysis of the net working capital will be very help full for knowing the operational efficiency of the company. The following table provides the data relating to the net working capital of SSL.
NET WORKING CAPITAL = CURRENT ASSETS-CURRENT LIABILITIS
YEAR CURRENT ASSETS CURRENT LIABILITIES NET WORKING CAPITAL
2005 246755108 184541063 62214045
2006 289394416 169342603 120051813
2007 337982290 187602877 150379413
2008 36344554 217973661 145471893
From the above table it can be inferred that the proportion of net working capital had increased from the year 2005 to2007 and decreed in the year 2008 compare with 2007.
Working capital turnover ratio:
This is also known as sales to working capital ratio and usually represented in times. This establishes the relationship of sales to net working capital. This ratio indicates -heather or not working capital has been effectively utilized in making sales. In case if a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company. It is calculated as follows-
YEAR NET SALES(RS) WORKING CAPITAL(RS) RATIO
2005 429128296 62214045 6.89
2006 622181610 120051813 5.2
2007 668215791 150379413 4.4
2008 655229319 145471893 4.5
From the above table we can conclude that working capital ratio is decreasing. In the year 2005 it is 6.89 times it decreased to 4.4 times in the year 2007. And it is increasing 4.5 times in the year 2008.
CURRENT ASSETS TO TOTAL ASSETS RATIO:
Current assets play an important role in day-to-day functioning of an organization. So, every firm should maintain adequate current assets so as to meet the daily requirements of business. If the proportion of current assets in total assets exceeds then the required limit, there will be some idle investments on such assets. At the time, the proportion of current assets in total should not less than requirements. So, every firm should maintain the adequate quantity of current assets. But during the situations of peak demand, should employ more current assets and vice-versa. Particularly in case of production organizations, there is heavy importance to the current assets than fixed assets. This kind of analysis will enable the managers to understand the working capital position of the firm. Data relating to the proportion of working capital in total assets is depicted as follows-
This ratio establishes the relationship between the current assets and total assets.
YEAR CURRENT ASSETS(RS) TOTAL ASSETS(RS) RATIO
2005 217973661 390012770 55.88
2006 187602877 327640705 57.25
2007 169342603 475995664 35.57
2008 184541063 491935181 37.51
From the above table it can be inferred that the proportion of current assets to total assets had decreased 55.88 in the year 2005. In the year 2005 it had increased to 57.25, again in the year 2007 it has decreased 35.57%, again in the year 2008 increase in 37.51
Current assets to sales ratio:
The current assets are used for the purpose of generating sales. A ratio of current assets to sales reveals that how best the assets are applied in business for turnover. As per the above said ratio, a low proportion of current assets in relation to sales indicates better turnover of the company and vice-versa, which will show positive impact on profitability. The data relating to this aspect is provided as follows and it is calculated as follows.
YEAR CURRENT ASSETS(RS) NET SALES(RS) RATIO
2005 246755108 429128296 57.5
2006 289394416 622181610 46.5
2007 337982290 668215791 50.5
2008 363445554 655229319 55.4
From the above table it can be inferred that the proportion of current assets to sales had increased to 57.5% in the year 2005. In the year 2006 it had decreased 46.5%. In the years 2007 it had increased to 50.5% and in the year 2008 had increased 55.4%.
Current assets to fixed assets ratio:
Total assets in any business contain both fixed and current assets. For properly functioning of the organization in terms of production and marketing it is necessary to maintain a properly balance between them. If the proportion of fixed assets increases, it will be a negative impact on the firm’s liquidity and if current assets increase, production increases and which causes impact on the demand for the product. In view of effective management of funds and to invest on both fixed and current assets, it is necessary to take the decision as soon as possible. Data relating to the ratio between current assets to fixed assets is depicted as follows.
YEAR CURRENT ASSETS(RS) FIXED ASSETS(RS) RATIO
2005 246755108 167454219 14.13
2006 289394416 184597059 15.67
2007 337982290 138013376 24.4
2008 363445554 202084725 18.0
From the above table it can be inferred that the proportion of current assets to fixed assets had decreased 14.13% in the year 2005. In the year 2006 it had increased to 15.67%. In the year 2007 it had increased 24.4%it had decrease in year 2008 in 18.0%.
Ratio Analysis is a powerful tool o financial analysis. Alexander Hall first presented it in 1991 in Federal Reserve Bulletin. Ratio Analysis is a process of comparison of one figure against other, which makes a ratio and the appraisal of the ratios of the ratios to make proper analysis about the strengths and weakness of the firm’s operations. The term ratio refers to the numerical or quantitative relationship between two accounting figures. Ratio analysis of financial statements stands for the process of determining and presenting the relationship of items and group of items in the statements.
Ratio analysis can be used both in trend analysis and static analysis. A creditor would like to know the ability of the company, to meet its current obligation and therefore would think of current and liquidity ratio and trend of receivable.
Major tool of financial are thus ratio analysis and Funds Flow analysis.Financial analysis is the process of identifying the financial strength and weakness of the firm by properly establishing relationship between the items of the balance sheet and the profit account
The financial analyst may use ratio in two ways. First he may compare a present ratio with the ratio of the past few years and project ratio of the next year or so. This will indicate the trend in relation that particular financial aspect of the enterprise. Another method of using ratios for financial analysis is to compare a financial ratio for the company with for industry as a whole, or for other, the firm’s ability to meet its current obligation. It measures the firm’s liquidity. The greater the ratio, the greater the firms liquidity and vice-versa.
A ratio can be defined as a numerical relationship between two numbers expressed in terms of (a) proportion (b) rate (c) percentage. It is also define as a financial tool to determine an interpret numerical relationship based on financial statement yardstick that provides a measure of relation ship between two variable or figures.
Meaning and Importance:
Ratio analysis is concerned to be one of the important financial tools for appraisal of financial condition, efficiency and profitability of business. Here ratio analysis id useful from following objects.
1. Short term and long term planning
2. Measurement and evaluation of financial performance
3. Stud of financial trends
4. Decision making for investment and operations
5. Diagnosis of financial ills
6. providing valuable insight into firms financial position or picture
ADVANTAGES& DISADVANTAGES OF RATIO ANALYSIS
The following are the main advantages derived of ratio analysis, which are obtained from the financial statement via Profit & Loss Account and Balance Sheet.
a) The analysis helps to grasp the relationship between various items in the financial statements.
b) They are useful in pointing out the trends in important items and thus help the management to forecast
c) With the help of ratios, inter firm comparison made to evolve future market strategies.
d) Out of ratio analysis standard ratios are computed and comparison of actual with standards reveals the variances. This helps the management to take corrective action.
e) The communication of that has happened between two accounting the dates are revealed effective action.
f) Simple assessments of liquidity, solvency profitability efficiency of the firm are indicted by ratio analysis. Ratios meet comparisons much more valid.
Ratio analysis is to calculate and easy to understand and such statistical calculation stimulation thinking and develop understanding.
But there are certain drawbacks and dangers they are.
i) There is a trendy to use to ratio analysis profusely.
ii) Accumulation of mass data obscured rather than clarifies relationship.
iii) Wrong relationship and calculation can lead to wrong conclusion.
1. In case of inter firm comparison no two firm are similar in size, age and product unit.(For example :one firm may purchase the asset at lower price with a higher return and another firm witch purchase the asset at asset at higher price will have a lower return)
2. Both the inter period and inter firm comparison are affected by price level changes. A change in price level can affect the validity of ratios calculated for different time period.
3. Unless varies terms like group profit, operating profit, net profit, current asset, current liability etc., are properly define, comparison between two variables become meaningless.
4. Ratios are simple to understand and easy to calculate. The analyst should not take decision should not take decision on a single ratio. He has to take several ratios into consideration.
STANDARDS OF COMPARISION:
1. Ratios calculated from the past financial statements of the same firm.
2. Ratio developed using the projected or perform financial statement of the same firm
3. Ratios of some selected firm especially the most progressive and successful, at the same point of time.
4. Ratios of the industry to which the firm belongs.
IMPORTANCE OF RATIO ANALYSIS
In the preceding discussion in the form, we have illustrated the compulsion and implication of important ratios that can be calculated from the Balance Sheet and Profit & Loss account of a firm. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact and enables the drawing of inferences regarding the performance of a firm. Ration analysis is a relevant in assessing the performance of a firm in respect of the following aspect.
CAUSTION IN USING RATIOS:
1. It is difficult to decide on the proper bases of comparison.
2. The comparison rendered difficult because of difference in situation of two companies or of one-company for different years.
3. The price level change make the interpretation of ratios invalid
4. The difference in the definition of items in the balance sheet and Profit & Loss statement make the interpretation of ratios difficult.
5. The ratios calculated at a point of time are less informative and defective as they suffer from sort term changes.
6. The ratios are generally calculated from the past financial statement and thus are no indicators of future.
LIQUTDITY Vs PROFITABILITY
Financial analysis is the process of identifying the financial strengths and weakness of the firm by properly establishing relationship between the items of the balance sheet and profit loss account. Management should particularly interest in knowing financial strengths and weakness of the firm to make their best use and to be able to spot out financial weakness of the firm to take a suitable corrective actions.
Financial analysis is the starting point of making plans, before using any sophisticated forecasting and planning procedures.
Major tools of financial analysis are ratio analysis and funds flow analysis. Financial analysis is the process of identifying the financial strengths and weakness of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.
Meaning and importance
Ratio analysis is concerned to be one of the important financial tools for appraisal of financial condition, efficiency and profitability of business. Here ratio analysis is useful from following objectives.
1. Short term and long term planning.
2. Measurement and evaluation of financial performance.
3. Study of financial trends.
4. Decision making for investment and operations.
5. Diagnosis of financial ills.
6. Providing valuable insight into firm’s financial position or picture.
1. Current Ratio
2. Quick Ratio
3. Absolute Quick Ratio
4. Net Profit Ratio
5. Debtors Turnover Ratio
6. Inventory Turnover Ratio
The current ratio is calculated by dividing current assets by current liabilities.
Current ratio = current assets/current liabilities
The current ratio is a measure of the firm’s short-term solvency. It indicates the availability of current assets in rupees for every one rupee of current liabilities. A ratio of greater than one means that the firm has more current assets than current liabilities claims against them. A standard ratio between them is 2:1. The data relationship the current ratio of ANNAPURNA EARCANAL LIMITED is depicted as follows:
YEAR CURRENT ASSETS CURRENT LIABILITIES Current Ratio (%)
2005 246755108 184541063 1.34
2006 289394416 169342603 1.71
2007 337982290 187602877 1.8
2008 363445554 217973661 1.67
The standard norm for this ratio is 2:1 the empirical analysis of the data relating to the current ratio of Annapurna Ear canal Ltd. Has decreased from 1.71 in the year 2006 to 1.8 in the year 2007
This ratio establishes a relationship between quick of liquid assets and current liabilities. It is an absolute measure of liquidity management of the concern. An asset is liquid if it can be converted in to cash immediately or reasonably soon without a loss of value, if ignores totally the stocks. Because inventories normally require some time for realizing into cash: their value also has a tendency to fluctuate. The standard quick ratio is 1:1.
Quick Ratio = Quick Assets/Current Liabilities
YEAR QUICK ASSETS CURRENT LIABILITIES QUICK RATIO(%)
2005 203744623 184541063 1.1
2006 243039010 169342603 1.4
2007 296815785 187602877 1.58
2008 323437711 217973661 1.48
QUICK RATIO GRAPH
The standard norm for this ratio is 1:1, means for every 1 rupee of current liability, company must have 1 rupee of quick assets.
The quick ratio of Annapurna earcanal ltd.1.1in 2005, 1.4 in 2006 and1.58 in 2007. It have more than 1 rupee of quick assets for all 4years.
Absolute quick ratio:
Since cash is the most liquid assets necessary to examine the ratio of cash and its equivalent to current liabilities. Trade investment or marketable securities are equivalent of cash. Therefore, they may be included in the consumption of absolute quick ratio.
Absolute quick ratio = Absolute Quick Assets/Current Liabilities
YEAR CASH&EQUIVLENT CURRENT LIABILITIES ABSOLUTE QUICK RATIO
2005 4548328 184541063 0.024
2006 9272929 169342603 0.055
2007 16297869 187602877 0.087
2008 24336946 217973661 0.111
Absolute quick ratio graph
The standard norms of absolute quick ratio is 0.5:1.From the above table the firm not maintain the sufficient level of quick assets because of the day-to-day expenses .It is fluctuating between
The standard norm for this ratio is 1:2 means for every 2 rupees of current Liabilities, Company must have 1 rupee of cash and bank balance and marketable securities.
Net Profit Ratio:
As every business is to earn profit, this ratio is very important because it measures the profitability of sales. A business may yield high gross income but low net income because of increasing operating and non-operating expenses. This situation can easily be detected by calculating this ratio.
The profits used for this purpose may be profits after/before tax. To obtain this ratio, the figure of net profits after tax is divided by the figure of net profits after tax is divided by the figure of sales the ratio is also known as sales margin as we can ascertain with its help the margin which the sales leave later deducting all the expenses. The unit of expression is percentage, as is the case with profitability ratios.
YEARS NET PROFIT NET SALES RATIO %
2005 70557286 429128286 1.64
2006 24851266 622181610 3.99
2007 22072724 668215791 3.31
2008 14235566 655229319 2.17
Higher the ratio better is the profitability. From the table the ratio is declining from 2005 to 2006 is increase. Again decrease in the year 2008
Net Profit Ratio is not effective over the period of study. Company has not control over the cost of goods sold, selling, administrative and distribution expenses.
So, effective steps are to be taken to increase the profits.
Cash management is one of the key areas of working capital management. Cash is the liquid current asset. The main duty of the finance manager is to provide adequate cash to all segments of the organization. The important reason for maintaining cash balances is the transaction motive. A firm enters into variety of transactions to accomplish its objectives which have to be paid for in the form of cash.
Meaning of cash:
The term “cash” with reference to cash management used in two senses. In a narrower sense it includes coins, currency notes, cheques, bank drafts held by a firm. n a broader sense it also includes “near-cash assets” such as marketable securities and time deposits with banks.
Objectives of cash management:
There are two basic objectives of cash management. They are-
? To meet the cash disbursement needs as per the payment schedule.
? To minimize the amount locked up as cash balances.
Basic problems in Cash Management:
Cash management involves the following four basic problems.
? Controlling level of cash
? Controlling inflows of cash
? Controlling outflows of cash and
? Optimum investment of surplus cash.
Determining safety level for cash:
The finance manager has to take into account the minimum cash balance that the firm must keep to avoid risk or cost of running out of funds. Such minimum level may be termed as “safety level of cash”. The finance manager determines the safety level of cash separately both for normal periods and peak periods. Under both cases he decides about two basic factors. They are-
Desired days of cash:
It means the number of days for which cash balance should be sufficient to cover payments.
Average daily cash flows:
This means average amount of disbursements which will have to be made daily.
Criteria for investment of surplus cash:
In most of the companies there are usually no formal written instructions for investing the surplus cash. It is left to the discretion and judgment of the finance manager. While exercising such judgment, he usually takes into consideration the following factors-
This can be ensured by investing money in securities whose price remains more or less stable.
This can be ensured by investing money in short term securities including sha\ort term fixed deposits with banks.
Most corporate managers give less emphasis to yield as compared to security and liquidity of investment. So they prefer short term government securities for investing surplus cash.
It will be advisable to select securities according to their maturities so the finance manager can maximize the yield as well as maintain the liquidity of investments.
Cash Management in SSL:
The cash management is carried out in seaways by CTM (Corporate Treasury Management). CTM is a commonly followed procedure in most of the companies.
Ratio Analysis is one of the important techniques that can be used to check the efficiency with which cash management is being managed by a firm. The most important ratios for cash management are as follows-
Cash to current assets ratio:
This ratio establishes the relationship between the cash and the current assets. It is calculated as follows
YEAR CASH (RS) CURRENT ASSETS(RS) RATIO
2005 3460206 246755108 1.4
2006 8184807 289394416 2.82
2007 15209747 337982290 4.5
2008 23476324 363445554 6.45
From the above table it can be inferred that the cash to current assets
Ratio is shown it is 1.4% in the year 2005 and increased till 2008.
CASH TO CURRENT LIABILITIES RATIO:
This ratio establishes the relationship between the cash and current liabilities. It is calculated as follows.
YEAR Cash (Rs) CURRENT LIABILITIES(RS) Ratio
2005 3460206 184541063 1.87
2006 8184807 169342603 4.83
2007 15209747 187602877 8.1
2008 23476324 217973661 10.77
From the above table it can be inferred that the proportion cash to current liabilities ratio is shown decreasing trend. It is 13.40% in the year 2000-01 & decreased to 0.74% in the year 2005-06.
Receivables constitute a significant portion of the total assets of the business. When a firm seller goods or services on credit, the payments are postponed to future dates and receivables are created. If they sell for cash no receivables created.
Receivable are asset accounts representing amounts owed to the firm as a result of sale of goods or services in the ordinary course of business.
Purpose of receivables:
Accounts receivables are created because of credit sales. The purpose of receivables is directly connected with the objectives of making credit sales. The objectives of credit sales are as follows-
? Achieving growth in sales.
? Increasing profits.
? Meeting competition.
Factors affecting the size of Receivables:
The main factors that affect the size of the receivables are-
? Level of sales.
? Credit period.
? Cash discount.
Costs of maintaining receivables:
The costs with respect to maintenance of receivables are as follows-
This is because there is a time lag between the sale of goods to customers and the payment by them. The firm has, therefore to arrange for additional funds to meet its obligations.
Firm incur this cost for manufacturing accounts receivables in the form of salaries to the staff kept for maintaining accounting records relating to customers.
The firm has to incur costs for collecting the payments from its credit customers.
The firm may not able to recover the over dues because of the inability of customers. Such debts treated as bad debts.
Receivables are direct result of credit sale. The main objective of receivables management is to promote sales and profits until that point is reached where the ROI in further funding of receivables is less than the cost of funds raised to finance that additional credit (i.e.; cost of capital). Increase in receivables also increases chances of bad debts. Thus, creation of receivables is beneficial as well as dangerous. Finally management of accounts receivable means as the process of making decisions relating to investment of funds in this asset which result in maximizing the over all return on the investment of the firm.
Receivables management and Ratio Analysis:
Ratio Analysis is one of the important techniques that can be used to check the efficiency with which receivables management is being managed by a firm. The most important ratios for receivables management are as follows-
DEBTORS TURNOVER RATIO: -
Debtors constitute an important constituent of current assets and therefore the quality of the debtors to a great extent determines a firm’s liquidity. It shows how quickly receivables or debtors are converted into cash. In other words, the DTR is a test of the liquidity of the debtors of a firm. The liquidity of firm’s receivables can be examined in two ways they are DTR and Average Collection Period.
YEAR CREDIT SALES (RS) AVG DEBTORS (RS) RATIO
2005 429128286 69433936 6.18
2006 622181610 77624616 8.01
2007 668215791 87464986 7.63
2008 655229319 115088536 5.69
From the above table it can be inferred that the proportion sales to average debtors is showing fluctuating trend in the year 2005 is 6.18. It increased to 1.83 times in 2006 and increases remaining two years decries.
DEBTORS COLLECTION PERIOD:
Data collection period is nothing but the period required to collect the money from the customers after the credit sales. A speed collection reduces the length of operating cycle and vice versa
YEARS AVG Debtors(in Rs) Net credit sales (in Rs) Debtors collection period (in days)
2005 69433936 429128286 59
2006 77624616 622181610 46
2007 87464986 668215791 48
2008 11508856 655229319 64
Source: data compiled from the annual reports of Annapurna earcanal ltd.
From the above table it can be inferred that the debtors turn over ratios showing fluctuating trend. In the year 2005 it is debtors collection period is 59 days and reduced in the year 2006 to 46 days then increased slightly up to 2008.
Inventories are stock of the product a company is manufacturing for sale and components. That makeup the products. The various forms in which inventories exist in a manufacturing company are: Raw-materials, work-in-process, finished goods.
? Raw-Materials: - Are those basic inputs that are converted into finished products through the manufacturing process. Raw-materials inventories are those units, which have been purchased and stored for future production.
? Work-In-Process inventories are semi-manufactured products. The represent products that need more work before they become finished products for sale.
? Finished Goods inventories are those completely manufactured products, which are ready for sale. Stocks of raw-materials and work-in-process facilitate production which stock of finished goods is required for smooth marketing operations. These inventories serve as a link between production and consumption of goods.
? Stores and spares are also maintained by some firms. This includes office and plant cleaning materials like soaps, brooms, oil, fuel, light, bulbs etc. These materials do not directly enter in production. But are necessary for production process.
Need to holding inventory
The question of managing inventories arises only when the company holds inventories. Maintaining inventories involves tying up of the company's funds and incurrence of storage and handling cost. It is expensive to maintain inventories, why does company hold inventories? There are three general motives for holding inventories.
1.Transaction Motive: - Emphasizes the need to maintain inventories to facilitate smooth production and sales operations.
2.Precautionary motive: - Necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors.
3.Speculative motive: - Influences the decision to increase or reduce inventory levels to take advantages of price influences.
A company should maintain adequate stock of materials for a continuous supply to the factory for the uninterrupted production. It is not possible for a company to procure raw materials whenever it is needed. A time lag exists between demand for materials and its supply. Also there exists uncertainty in procuring raw materials in time on many occasions. The procurement of materials may be delayed because of such factors as strike, transport disruption or short supply. Therefore, the firm should maintain sufficient stock of raw materials at a given time to stream line production.
Objective of Inventory Management
In the context of inventory management the firm is faced with the problem of meeting two conflicting needs
? To maintain a large size of inventory for sufficient and smooth production and sales operations.
? To maintain a minimum investment in inventories to maximize profitability.
Both excessive and inadequate inventories are not desirable. These are two dangerous points within which the firm should operate. The objective of inventory management should be to determine and maintain optimum level of inventory investment. The optimum level of inventory will lie between the two danger points of excessive and inadequate inventories.
The firm should always avoid a situation of over investment or under investment in inventories. The major dangerous of over investment are
? Unnecessary tie-up of the firms funds losses of profit
? Excessive carrying cost
? Risk of quality
The aim of inventory management thus should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for smooth production and sales operations. Efforts should be made to place an order at the right time with the right source to acquire the right quantity at the right price and quality. An effective inventory management should
? Ensure a continuous supply of raw materials to facilitate uninterrupted production.
? Maintain sufficient stock of raw materials in periods of short supply and anticipate price changes.
? Maintain sufficient finished goods inventory for smooth sales operations and efficient customer service.
? Minimize the carrying cost and time.
? Control investment in inventories and keep it at an optimum level.
Inventory management techniques
In managing inventories the firm objective should be in consonance with the shareholders' wealth maximization principle. To achieve this firm should determine the optimum level of inventory. Efficiently controlled inventories make the firm flexible. Inefficient inventory control results in unbalanced inventory and inflexibility-the firm ma sometimes run out of stock and sometimes may pileup unnecessary stocks. This increases level of investment and makes the firm unprofitable.
To manage inventories efficiency, answers should be sought to the following two questions.
1)How much should be ordered?
2)When should it be ordered?
The first question how much to order, relates to the problem of determining economic order quantity (EOQ), and is answered with an analysis of costs of manufacturing certain level of inventories. The second question when to order arise because of determining the reorder point.
One of the major inventory problems to be resolved is how many inventories should be added when inventory is replenished. If the firm is buying raw materials it has to decide lots in which it has to be purchased on each replenishment. If the firm is planning a production run, the issue is how much production to schedule or how much to make. These problems are called order quantity problems and the task of the firm is to determine the optimum or economic order quantity (or economic lot size) determining an optimum inventory level involves two types of costs.
2) Carrying cost
The economic order quantity is that inventory level which minimizes the total of ordering and carrying costs.
The term ordering cost is used in case of raw materials (or supplies) and includes the entire cost of acquiring raw materials. The include costs incurred in following activities. Requisitioning purchase ordering, transporting, receiving, inspecting and storing (store placement).
Cost incurred for maintaining a given level of inventory is called carrying cost. They include storage, taxes, insurances, deterioration and obsolescence.
Economic order quantity (EOQ) =v2AC/c
Where A = annual requirement of raw materials
EOQ Graphical Approach
The economic ordering quantity can also be found out graphically. The EOQ figure is as follows:
In the above figure costs-carrying, ordering and total are plotted on vertical axis is used to represent the order size. We note that total carrying costs increases as the order size increases, because, on an average a larger inventory level be maintained, and ordering costs decline with increase in order size because large order size means less number of orders. The behavior of total costs line is noticeable since it is a sum of two types of costs, which behave differently with order size. The total costs decline in their first instance but they start rising when the decreases in an average ordering costs is more than offset by the increases in carrying costs. The economic order quantity occurs at the point Q. Where the total cost is minimum. Thus the firms operating profit is maximized at point.
Reorder Point (ROP)
The problem how much to order is solved determining the economic order quantity yet the answer should the sought to the second problem, when to order this is a problem of determining the reorder point is that inventory level at which an order should be placed to replenished the inventory. To determine the reorder point under certainty, we should know
a) Lead time
b) Average usage
c) Economic order quantity
Lead time is the time normally taken is replenishing inventory after the order has been placed by certainty we mean the usage and lead time do not fluctuate under such a situation ROP is simply that inventory level which will be maintained for consumption during the lead time. i.e,
Reorder point (under certainty) =lead time X Average usage
Re-order Point (under certainty) = Lead time X Average usage.
Inventory management at Annapurna Earcanal Ltd
The Annapurna Ear canal Ltd management all the unit and corporate level every month reviews inventory. All the functional head are called for minutes and the inventory holdings are discussed in detail at the meeting every month .A.E.Ltd purchases the material when the customer places the order, since the product of are tailor-made to customer’s requirements. After purchasing the raw materials, which is mostly, still will be stocked at one place all other procured against production orders are stored. Depending up on the requirement in various production departments the raw material is sent to the respective departments or production shops.
When the order is placed for raw material certain raw material is in transit, such raw material is called as raw material in transit.
Example –Raw material on over seas.
The raw material can be transfer from unit to another unit or from one department to another is called transfer-in –transist.It is nothing but to the transfer of raw material among the inter firm units of Annapurna Earcanal Ltd.
The raw material, which is production process, is called work-in process. The work in process becomes finished goods inventory. The finished should not be kept for a longer time. They should be sold off to clear off the entire inventory. However, finished goods inventory is not there for Annapurna Earcanal Limited, since production is mainly done on customer order and specifications. The raw material is purchased and the whole process is repeated again which we call it as inventory cycle.
Inventory turnover Ratio:-
Inventory turnover ratio indicates the efficiency of the firm in producing and selling its products. It is calculated by dividing the cost of goods sold by the average inventory. The average inventory is the average of open and closing balance of inventory.
Inventory turnover Ratio= Cost of Goods Sold / Average Inventory
Years Cost of goods sold Average inventory ITR( in Times)
2005 307656311 32775024 9.38
2006 606604844 64752367 9.36
2007 399298008 67315972 5.9
2008 390386083 43339215 9
Data compiled from the annual report of Annapurna Earcanal Ltd.
From the above table it can inferred that the proportion cost of good sold to average stock it is increased to 9.38times in the year2005 and again decreased 5.9 times in the year 2007and again increased 9 times in the year 2008.
Inventory holding period:-
Inventory holding period is the reciprocal of inventory turn over ratio.
This can be measure in terms of number of days.
Inventory holding period= Average inventory x365days
Cost of goods of sold
Years AVG INVENTORY CGS (In Rs.) INVENTORY HOLDING PERIOD(In days)
2005 32775024 307656311 39
2006 64752367 606604844 40
2007 67315972 399298008 62
2008 43339215 390386083 41
From the above table it can infer that the proportion of average inventory to cost of goods sold had 39 days in 2005. In the year 2007 it can be increased that is 62 days and again decries.