Format for working capital management

For Estimation of Working Capital. Three things are very important these are

(1) Production – Unit

(2) Price – Cost

(3) Period – Time lag

FORMAT

COST STRUCTURE

PARTICULER	AMT(P.U)
Raw material	XX
+wages	XX
+overheads	XX
=Cost of production	XX
+selling expenses	XX
+Administration expenses	XX
=Total cost	XX
+profit	XX
Selling price	XX

Statement showing estimation of working capital

Particular	Calculation	Amt	Amt
(a)Current assets
STOCK
Raw material	Production*rawmaterial price*period 12month/365days/52weeks	Xx
W.I.P	Production*W.I.P price*period 12month/365days/52weeks	XX
Finished goods	Production*COP price*period 12month/365days/52weeks	Xx
			XX
DEBTORS	Production*selling price*period 12month/365days/52weeks		Xx
CASH			XX
	GROSS WORKING CAPITAL (A)		XX
(B)Current liabilities
CREDITORS	Production*rawmaterial price*period 12month/365days/52weeks		XX
OUTSTANDING EXPENSES	Production*respective expenses price*period 12month/365days/52weeks		Xx
BANK OVERDRAFT			XX
	TOTAL CURRENT LIABILITIES		XX
	NET WORKING CAPITAL (A)-(B)		XX
	+ SAFTY MARGIN		XX
	WORKING CAPITAL		XX

Financial Break-even point :

It is that point where company is having sufficient earning to pay of its external liability i.e. it is that earning where EPS is zero. No profit, No loss to equity shareholder, it is that point where EBIT or earning is cover just interest burden as well as preference burden.

In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then such level of EBIT is known as financial break-even level. For example, in the above case, the financial break-even level for firm Y & Co. is Rs. 6,000 and for Z & Co. the financial break-even level is Rs. 9,000 (i.e. just equal to their interest charges respectively) Thus, the financial break-even level is such a level of EBIT at which only the fixed financial charges of the firm are covered and  consequently the EPS is zero. If the EBIT reduces below this financial break-even level, the EPS will be negative. The financial break-even level of EBIT may be calculated as follows :

If the firm has employed debt only (and no preference shares, the financial break-even EBIT level is :

If the firm has employed debt as well as preference share capital, then its financial break even EBIT will be determined not only by the interest charge but also by the fixed preference dividend. It may be noted that the preference dividend is payable only out of profit after tax, whereas the financial break-even level is before tax. The financial break-even level in such a case may be determined as follows:

For example, a firm is having interest liability of Rs. 20,000 and preference dividend of Rs. 36,000. Given the tax rate of 40% find out the financial break-even level and verify the result. The financial break-even level for the firm may be ascertained as follows:

Financial break-even EBIT = Interest Charge + Pref. Div. (1-t)

= Rs. 20,000 + Rs. 36,000 (1– 4)

= Rs. 80,000.

Verification : If the firm has EBIT of Rs. 80,000 out of this EBIT interest of Rs. 20,000 will be paid and the remaining profit of Rs. 60,000 will be subject to tax at 40%. So the profit after tax would be Rs. 36,000 which is just sufficient to pay the preference dividend no profit will be available for the equity shareholder and the EPS would be zero. So the financial break-even level may be defined as that level of EBIT at which the EPS would be zero.

Indifference point/level :

The indifference level of EBIT is one at which the EPS remains same irrespective of the debt-equity mix. While designing a capital structure, a firm may evaluate the effect of different financial plans on the level of EPS, for a given level of EBIT. Out of several available financial plans, the firm may have two or more financial plans which result in the same level of EPS for a given EBIT. Such a level of EBIT at which the firm has two or more financial plans resulting in same level of EPS, is known as indifference level of EBIT.

The use of financial break-even level and the return from alternative capital structures called the indifference point analysis. The EBIT is used as a dependent variable and the EPS from two alternative financial plans is used as independent variable, and the exercise is known as indifference point analysis. The indifference level of EBIT is a point at which the after tax cost of debt is just equal to the ROI. At this point the firm would be indifferent whether the funds are raised by the issue of debt securities or by the issue of share capital.

It is that point where company get same EPS in two different options. If a company get same EPS in two different options of capital structure then company will be indifferent to select any one of these options. Means company can select any option, the EPS is same in both the options.

Capital Structure :

  Capital Structure :

Let us take an example Mr. A manage garage the Automobile workshop along with the servicemen B. Mr. B observed so many time that Mr. A allows discount and if customer is not satisfied he allow him to go without making payments. One day Mr. B asked Mr. A ‘‘How do you manage? and why do you keep loosing every day’’. Mr. A replied, ‘‘I do this for continuing business and to survive in the market. Few years passed Mr. B resigned from job. Mr. A asked why you resigned. Mr. B replied as my uncle died and he transferred his millions of property to me so no need of working. I will lend money and live peacefully. Mr. A sensed good opportunity to grow. He asked Mr. B why don’t you lend money to me? With your Money I will added more facilities and increase the business and which lead to expansion and diversification of business.

Mr. B agress but he started interfering in Mr. A’s business as he is worried about his interest and his return of principal amount balance if Mr. A is going to continue the practices of allowing discount and let customer go without payment will lead to loss of business and his interest and principal  will be lost. Mr. A started thinking did I had taken right decision to borrow money from Mr. B. He got mixed thinking in his mind, positive as well as negative. Positive as he got money he expanded, got more facilities and he grew at the same time negative was that Mr. B started interfering in his business.

From the above example, it is clear that Mr. A is in dilemina. (1) Whether to continue to borrow from B as it gives fund which is required to expand or to (2) Stop or restrict to some extent interfering in business. (3) Or to have balance structure and strategies so that he can borrow and give Mr. B good return so that he will not interfere in business as he received his money.

This type of situation is faced by almost all the organizations and this decision is known as capital structure of the company.

Capital structure means financial structure of the organization Financial structure include debt as well as equity. Capital structure decision refers to the proportion of debt and equity and find out whether there is a capital structure that can be said to be optimum for the shareholder of the firm.

Proforma                        Formulae

EBIT X

Less: INT (X) (1) Value of firm =  or

EBT X Or value of Debt + value of equity

Less: Tax (X) (2) Value of Debt =

EAT X (3) Value of equity =  

Less: Pref. dividend (X)

Earning to Equity Share (i) X or =

No. of shares (ii) X

EPS (1/11) X

PE rate X X

Mkt price EPS × PE

                                                                            (4)ROCE =  × 100

There are 3 approaches to capital structure

(1) Net income approach (value of firm depend on C.S.)

Net income approach is based on the following Assumptions.

There is a relationship between CS and value of firm i.e. company can affects its value by increasing or decreasing debt proportion in overall finance mixed.

● Cost of Debt and cost of equity remain constant in all different debt equity mix. It implies that the supplier of debt and equity capital are not concerned with level of debt the firm has instead they are concerned with their desired returns respectively.

● Cost of debt is less than cost of equity

Kd < Ke

As per this assumption cost of debt is consider cheaper capital and cost of equity is considered as expensive capital. Means whenever equity proportion (Expensive Capital) in overall capital employed is replaced by debt fund (cheaper fud) then over all cost of capital will reduce.

(3) When debt is 0 then K0 = Ke means high cost of capital accordingly to this theory debt is a cheaper capital and should be given first preference i.e. optimum capital structure is that structure where the firm can borrow at maximum of its  capacity.

(4) When Kd increase Ko come down as Debt proportion income then expensive propostion leads to Reduction in overall cost of capital i.e. Ko

(2) Net operating income approach – (Value of firm depend on Operating profit Not on capital structure)

Ko – remain constant

This approach is exactly to opposite NI approach. It indicates that capital structure has nothing to do with value of firm. The value of firm depend on earning available to shareholders. They assume that Kd remain constant and Ko remain constant.

As company borrowing more and more of Debt fund which is considered as cheaper fund the external liability also increases as a result equity shareholder feels that their risk of getting return is also increasing (because outside liability is more) which company need to make payment first.) risk increase leads to increase in cost i.e. equity shareholder also expect more rather in the form of dividend Ke)

This approach says that in Ko whenever equity proportion is replaced by Debt proportion i.e. expensive capital replaced by cheaper capital. Ko will be reduced because of low cost Debt but increase in Debt lead to increase Risk to equity leads to rise in equity cost which will set off this low cost benefit therefore overall cost of capital will come back to its old rate. (i.e. constant)

As per this approach there is no specific capital structure which we call as optimum C.S.

Ko = Ke

Ke  and value of firm remain constant

MM Approach

MM approach is practical application of NOI approach by arbitrage process.

MM says that value of firm remain same as determined its assets, no matter how they are acquired. It has nothing to do with capital structure. It state that value of firm remain same, only the nature of claims on the earning change with change in Debt ratio. Just as the slice of bread does not change no matter how many slices are cut into and who shares those slice, the value of firm remain constant no matter how the earning are shared between debt holder and equity holder

• Distinguish between:

1. Revenue Receipt VS. Capital Receipt

	Revenue Receipt	Capital Receipt
1	RR relates to business activity	CR relates to financing activity.
2	Amt. received need not be returned / refunded	Amt. received may be returned back
3	It is recurring in nature.	It is non-recurring in nature.
4	RR of current year is shown as income in P & L A/c & RR of future period is treated as Liability	It is shown as Liability in Balance Sheet.
5	Ex.: Sale of goods, fees, interest, dividend, royalty reced.	Ex. : Capital from owner, loans from Bank etc.

2: Capital Expenditure VS. Revenue Expenditure

	Capital Expenditure	Revenue Expenditure
1.	It pertains to investing activity	It pertains to business activity
2.	It helps to set up and develop a business	It helps to run a business
3.	It helps to acquire new asset.	It helps to maintain an asset.