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Management of Working Capital by Square Textile Ltd.
Cash forecasting is extremely important to most firms. It enables them to anticipate periods of surplus cash and periods where financing will be necessary. This anticipation is the reason for which cash forecasting is necessary. Anticipation enables the firm to plan much more effectively for investment and financing, and via these planning, produce superior returns. The Square Textiles Ltd. uses the Tally software specially customized for the company for preparing cash budgets and making forecasts.
1.1. Cash Budget:
The types of cash forecasts generated by the firms can be differentiated along two dimensions: the length of periods included with the cash forecast and the approach to cash flows used in the cash forecast.
1.1.1 The length of periods:
It refers to the units of time into which the cash forecast is divided. The Square Textiles Ltd. forecasts their cash needs on monthly basis. They forecast their cash inflows and outflows for single period.
1.1.2 Approaches to cash flow:
The Square Textiles Ltd. applies the receipts and disbursements approach to cash flow in generating the cash forecast. The receipts and disbursement approach uses the amounts of cash expected to be received and disbursed by the firm over the periods chosen for the forecast. This approach uses the amounts of cash expected to be received and disbursed by the firm over the periods chosen for the forecast. This method minutely traces the movement of cash and preferred by firms that exercise very close cash control. The firms that made forecasts for relatively short time horizons use it.
1.1.3 Items to be forecasted:
In the receipts and disbursements cash forecasting method, estimates need to be made of the numerous major and minor items that the firm collects and that it pays. The more individual categories of items the firm includes in its forecast procedure, the more accurate the forecast may be.
A list of some inflows forecasted by Square Textiles Ltd. is provided as follow:
Some possible types of cash disbursements:
1.1.4 Estimating uncertainty in cash forecasts:
As the Square Textiles Ltd. forecasts their cash need for relatively short time horizon they consider the following three uncertainties mainly:
It refers to the risk regarding the firm’s future levels of sales. Most firms try to forecast accurately enough to hold errors in short run sales forecasts to less than 10% and for Square Textiles Ltd. the level of acceptable errors for monthly sales data is 5%.
Collection rate uncertainty:
This is the uncertainty regarding the firm’s future collection patterns of receivables. The firm may historically have collected an average of a certain percent of its outstanding receivables from a particular period in another particular period, but this average contains considerable variability. Further, changing market ad economic conditions may make chancy extrapolations of past historic data into future periods. The firm first supplies its products to dealers at credit and receives cash after dealers sell the products in the market, and this is the main source of uncertainty faced by Square Textiles Ltd. in case of accounts receivable.
Production cost uncertainty:
This is the risk with the actual labor and material costs that go into the making of a product or service. Labor productivity may be more or less than expected, which makes labor costs uncertain. The costs of materials used may vary due to unexpected changes in price or in amount of materials necessary to produce products and services. As Square Textiles Ltd. imports most of its raw materials from abroad, changes in exchange rate of dollars also affects the cost of production.
1.1.5 Estimating uncertainties:
Square Textiles Ltd. assesses the individual sources of uncertainty on important individual outcome variables. This requires sensitivity analysis. This kind of analysis provides very useful information about the amounts of possible surpluses and deficits in the future.
1.2. Balance Policy:
At the end of the each period of cash forecast, the firm expects to be in either a surplus or deficit position. Without some kind of hedge against the uncertainties of future cash flows, the firm incurs costs that could be avoided by the use of hedging strategy. There is a trade off between the cost of the hedge and the expected costs that it avoids.
1.2.1 Extra borrowing capacity:
The Square Textiles Ltd. maintains Current Accounts with Standard Chartered and HSBC, secured by hypothecation of stock and trade debtors.. When the firm faces ay difficulty for financing its disbursements by internal income it can overdraft from these accounts.
1.3. Investment Policy:
The Square Textiles Ltd. has investment in the stocks of Square Yarns Ltd. one of its subsidiaries. However this investment is for long term thus it does not work as balancing of excess cash available to the firm.
1.4. Bank Loan:
For financing the production activities Square Textiles Ltd. uses short-term bank loans. The firm has Revolving Credit Account Standard Chartered Bank and the firm uses funds from these accounts to meet its short term fund need. The firm also maintains Trust Receipt (secured by hypothecation of stock and trade debtors) with HSBC and LPO with Bank Al Falah. The firm mainly uses this loan for purchasing raw materials, to carry on the costs of production, to pay its accounts payable and to carry the factory overhead cost and some other short-term costs.
Inventory Management Policy.
2.1 Inventory Procurement Policy:
Inventory of the firm mainly consists of raw materials of the products and packing materials.
Square Textile Ltd. mainly concentrates on inventory of raw materials and packing materials. But its inventory stocks consists of raw materials, packing materials, raw materials in transit, work-in-process, finished goods, waste cotton, spares& spares in transit.. Inventories are bought from foreign market as well as from local market. All packing materials are purchased from local market.
2.1.1 Reasons for holding different kinds of inventory:
Reasons for holding raw materials inventory:
• It makes production scheduling easier
• It helps to avoid price changes for these goods.
• The firm may keep extra raw materials inventory to hedge against supply shortages
• The firm may order and keep additional inventories of raw materials to take advantage of quality discount.
Reasons for holding work in process inventory:
• A major reason that firm keeps work in process inventory beyond the minimum level is to buffer production.
Reasons for holding finished goods inventory:
• One reason to keep finished goods inventory is to provide immediate service to the customers.
• A second reason to keep finished goods inventory is to stabilize production.
2.1.2 Costs that are considered in inventory procurement policy:
Different types of costs are discussed in the following paragraphs:
• Cost directly proportional to amount of inventory held:
Carrying cost of inventory or holding cost of inventory. The formula for this type of costs are Cost = (a) (amount of inventory)
Where, a is a coefficient representing the sum of all costs that are directly proportional to the level of inventory.
• Cost not directly proportional to the amount of inventory held:
There are group of costs that varies with inventory size but not in direct proportionality. The formula for these costs is:
Cost = f (inventory level)
Where, f (inventory level) means that cost is a function of inventory level, with the particular mathematical relationship depending upon the type of cost being considered.
• Cost directly proportional to the number of orders:
There are costs to the ordering, delivering and payment processes. these costs depend directly on the number of times the orders are placed and received. Cost of this sort include set o[ costs on machines to produce inventory, costs of generating a purchase order for the inventory, costs of writing a cheque and mailing it in payment for the order, fixed costs of unloading the order and so forth. The formula for this type of cost is:
Cost = © (number of orders)
Where, c is a coefficient representing the sum of all the costs in this type.
• The price per unit of inventory obtained:
Due to quantity discounts and economics of scale in production, the price per unit of goods purchased or produced for inventory may vary with the amount ordered. The formula for the total cost of the inventory is:
Cost = Pa S
Where Pa is the unit price for the quantity ordered by the firm and S is the yearly usage of the good.
• Stockout cost:
Another cost that is dependent on the firm’s inventory strategy is stockout cost. Stockout cost occurs when immediate service is required but inventory is unavailable.
Usually a minimum amount of spoilage occurs for holding inventory. But ordering cost and carrying cost of inventory is considerable in case of materials purchased from foreign market. Materials that are purchased from local market incur less amount of both direct and indirect cost of holding inventory.
Stock out cost is a common problem for the firm. This happens because of low predictions about market demand. A good prediction about market demand and safety stock position can alleviate the problem. But the firm does not have a good policy for maintaining adequate safety stock. Another problem for not meeting up the market demand is a long lead time, which helps to fail the fulfillment of demand.
2.2 Inventory Store Management:
The management of inventory is one of the oldest concerns of management science. Like all other assets inventory represents a costly investment to the firm. There are some reasons why a firm may want to carry inventory. Square Textiles Ltd. follows the periodic inventory system for managing the inventory records. The problem that they face with stocks is somewhat related to dynamic inventory problem where the goods have value beyond the initial period; they do not lose their value completely over time. The process of followed by Square textiles Ltd for managing inventory is as follows:
Where the cost of merchandise purchased during the year is debited to a Purchases account, rather than to the inventory account. When merchandise is sold to a customer, an entry is made recognizing the sales revenue, but no entry is made to reduce the inventory account or to recognize the cost of goods sold. The inventory on hand and the cost of goods sold for the year are not determined until year end. At the end of the year, all goods on hand are counted and priced at cost. The cost assigned to this ending inventory is then used to compute the cost of goods sold. The only computation that is kept up to date in the accounting records is the purchases account. The amounts of inventory at the beginning and end of the year are determined by annual physical observation.
2.3 Inventory Valuation Method:
The break up of Inventory Stock of Square Textile ltd for the year 2004 is as follows:
The break up is under:
Raw materials 336456255
Raw material in transit 2442980
Packing Materials 2898296
Work in Process 6570867
Finished Goods 20740646
Spares at Store 32539232
Spares in Transit 698685
Waste Cotton 3102848
The basis of inventory valuation is as follows:
Inventory stocks comprise of raw materials, packing materials, raw materials in transit, work-in-process, finished goods, waste cotton, spares& spares in transit. Stocks are valued at the lower of cost and net realizable value. Value of stock other than stock of finished goods represents weighted average cost. Finished goods are valued at lower of cost or net realizable value and include allocation of production overheads while works in process are valued at material cost.
Asset that arise from credit sale. Granting credit is an investment to a customer
Receivable management starts where the management of inventory ends and ends where the management of cash starts. Accounts receivables or more familiar credit management is concerned with two questions:
What terms of sale should the firm use?
To whom should the firm grant credit?
3.1.1Terms of sale decision:
terms of sale refers to the period for which credit is granted cash discount and the type of credit instrument. This decision differs from industry to industry. In generally much liberal for goods of high value than perishable goods. Terms of sale decision has a big impact on firms’ sale cash collection and price. For taking decision about credit period firms consider
• Size of the account
• Perish ability of goods and may use the following approaches;
In addition to that firm also consider the following issues:
Market demand and Competitors
Collection policy refers to payment of past due account. Collection policy is closely related to the terms of sale decision. If the preceding decision is very conservative then it may results to bad debt experience. Firm can take various attempts to make the collection smooth:
• Factoring receivables
• Appointing collection agency
• Monitoring regularly the account receivables
• Discounting bills
3.3Credit granting decision:
Decision about to which the credit should be granted.
The policies necessary for the proper management of credit granting decisions are extremely important and nee to be carefully formulated as the questions involved in credit granting are complex and their impact is substantial.
3.4Factors considered in case of credit granting decisions:
Five C’s approach:
Capital: the evaluation of the applicant’s financial position.
Character: this is the willingness of the buyer which is analyzed using all related information of the buyer.
Collateral: information is gathered in case of secured credit
Capacity: this dimension has two aspects; management’s capacity to run the business and the applicant firm’s plant capacity.
Condition: these are the economic condition in the applicant’s firm and in the economy in general.
One period net present value model with nonzero recoveries:
This net present value model coordinates the shareholders value maximization by considering the cash flow and the possibility of default
3.5Receivable management and Square Textile:
Marketing process of Square Textile:
Square Textile sale its products to foreign buyers mainly. There are also some local sales too. No distributors or dealer is appointed in marketing operation. The dealing process with foreign buyers is as follows:
• Buyers submit orders.
• Square Textile agree to ship goods with the importers
• Buyers open letter of credit and send other related papers to the seller for shipment.
• Shipment is made with shipping document.
• Buyer open L/C and got the shipment .that is the shipment is done or the sale is made on credit and L/C gives guarantee in case of buyers default. So receivables arise and it is secured too by the buyers’ bank.
• For the local buyers sale is made in maximum time in cash. In this case open account is opened with the buyers.
Terms of sale decision:
What will be the terms of sale –this decision is influenced mainly by the
–the market condition and
— Size of the account
Minimum credit period Square Textile is 180 days.
They do their aging of receivables in the following way:
Above 180 days———amount
Below 180 days———amount
Foreign buyers: credit against export selling is already secured for the company. Foreign buyers mainly use the electronic mail system to transmit remittance. Square Textile does not appoint any collection agency. Factoring is not used but sometimes they use discounting. Buyers bank transmits the remittance to the f0irm bank.
Credit granting decision: To whom the credit will be granted that is the selection of buyer in case of credit sale is also very important for Square Textile like other firms in textile industry where maximum sale is made on credit.
Factors considered in case of credit granting decision:
Like many other firms Square Textile also use the traditional five C’s approach. They do not use other method such as one period net present value model with nonzero recoveries.
But the reality is firm does not have enough flexibility in case of choosing buyers because
?The power of buyer is higher in this industry
?Lack of necessary expertise in case of importers.
?Information about international buyers is hard to obtain.
Firms use short term financing as a means to operate their operation smoothly. In our quires of the reputed textile company Square Textiles Ltd (STL)’s short term financing management, we find that they use shot term financing as a major source of financing. We will discuss in this section, the management of short term financing of square textile Ltd with the context of our text book.
4.1 Why use short term financing:
In considering this issue, it is useful to think of current debt as composed of two:
i) temporary short term financing and ii) permanent short term financing.
i) Temporary short term financing:
Temporary short term financing is used to provide funds for transient cash flow shortages, such as those caused by seasonality in sales. When it is cheaper to borrow funds to cover such deficits than to keep a reserve of funds against them, temporary borrowings are attractive to the firm. Square uses temporary short time financing depending upon the market, demand and nature of the product. For example- in winter they need to supply more textiles in the foreign market. So in this case they use temporary financing to ensure they continue supply of this cold product in the market that is demanded by the customer for seasonality.
ii) Permanent short term financing:
Permanent short term borrowings are another matter. They are used by firms on a continuing basis and are refinanced with new short term debt as they mature. Square uses it for its smooth and proper business operation and distribution keeping peace with the industry norm.
4.2 Sources of short term financing:
In attempting to obtain an advantageous structure of short term liabilities, Square consider alternatives sources of short term debt. Depending upon availability, cost, maturity and other characteristics, Square follows the following short term financing:
4.2.1 Bankers’ acceptance:
Bankers acceptances are negotiable discounted short term instruments. For bankers’ acceptances the default risk never rests solely with the issuing entity. A bankers’ acceptance is always backed by both a bank and a firm. This dual responsibility makes bankers’ acceptances very safe, and consequently their interest cost is quiet low. Most bankers’ acceptance are generated in connection with international trade. They exist because of two problems faced by exporting firms. First, terms of sale in international commerce are much longer than terms of sale for domestic transactions. Second, many firms that sell to buyers in other countries do not have the necessary expertise in the non domestic accounting conventions, business practices, and so forth necessary to make reliable credit granting decisions on export customers. Further, even if the exporting firm has the necessary expertise, credit information on international customer hard to obtain.
Consequently, selling firms need a method of obtaining guaranteed payment for goods and of receiving this payment in a reasonable amount of time. The bankers’ acceptance is a response to this need.
Square textile Ltd. exports their goods in abroad in huge amount. They export manily in European union countries and USA. In 2005, STL’s export was Tk 2358346242 and local sale was Tk 32632279. They uses bankers’ acceptance in their export of goods. The cost of production has varied during the past years primarily due to wide fluctuation in the price of raw cotton, packing materials, fuel & power and spare parts which were beyond the control of the management.
4.2.2 Sundry creditors:
The trade credit granted from one firm to another for the purchase of goods provides more financing to business than all the other sources of short term financing put together, including bank borrowing. The ready availability of trade credit relative to bank credit stems partly from the different margins experienced by selling firms and by banks in granting credit. The margin of banks is the difference between the interest cost of funds raised and the interest income from the loans. This difference is often averages about 3 percentage. For firms, however, the margin is the difference between the selling price and the cash cost of the goods sold which may be 20 percent or more. Consequently, firms often find it quit profitable to grant credit to buyers whose profitability of default is sufficiently large that banks would deny credit. Further, even if buyers preferred to purchase goods for cash, imperfect knowledge by buyer of the quality of seller’s goods and the convenience of handling cash make the use of a minimum amount of trade credit almost mandatory. The ready availability of trade credit, along with the minimum mandatory use of this debt, account for its prevalence in providing short term financing. Strategies for the use of trade credit as a financing vehicle revolve around the payment dates of invoices. The later the firm pays, the more financing will be granted. Three typical policies for the payment of invoices are:
i) Pay on the discount date of the invoice if the supplier offers a cash discount as part of its terms of sale.
ii) Pay on the due date on the invoice
iii) Pay after the due date on the invoice
Square textile Ltd. Uses accounts payable in their operation with suppliers. They have some good acquainted suppliers for that they can easily use a/c payables without any condition. As a good company they use pay on the due date of the invoice. But depending upon the business condition they sometimes follow pay after the due date of the invoice. Trade debtors are stated at their nominal value and consider good. No provision for doubtful debt and no amount was written off as bad debt. In 2005, the amount of sundry creditors represents amount payable to regular suppliers of raw materials, deferred L/Cs, packing materials, utilities and other services rendered to the company. All suppliers were paid on a regular basis.
4.2.3 Provision for income tax:
Provision for income tax presents accrual to a firm. Firms incur accruals for which immediate payment is not required. For example-
• The firm may obtain the labor of executives and hourly employees,
• incur liabilities for future tax payments
• Accumulate interest expense on borrowed funds without paying cash for these items.
Any such accrual involves a delay in payment, and thus it is a potential source of financing. As with account payable, it would be uneconomical for the firm to avoid minimum level of many accrual liabilities. Moreover, these minimum levels of accrual liabilities reduce the amount of other short term financing that must be obtained to achieve a specific level of total short term debt.
Square textile Ltd incurs accruals in tax. We did not find any other provision for accrual in their balance sheet. Provision for income tax is made at effective rate on net income as per income statement. Net income and taxable income may differ due to temporary and permanent differences. A provision is made for accumulated taxable temporary differences for the years foregone and tax difference due to permanent difference may be adjusted in the following year.
4.2.4 Secured borrowings with stock & trade debtor as collateral:
As with any secured financing system, the advantage for the lender of having the security determines how much will be lent and the interest rate that will be charged. Since the advantage to the lender revolves around the liquidation value of the asset, the type of inventory that the firm holds will be a major determinant of the availability and cost of financing when using inventory as collateral. The more salable the inventory, the more worth as security. Work-in-process inventory rarely has any resale value, and therefore is useless as collateral. However, firms with substantial raw materials and finished goods inventories may find this financing of use. The more fungible these inventories, the more advantageous the financing that will result. Besides its liquidity, another characteristic of the firm’s inventory that will have a major impact on its value as collateral is the ease with which the inventory can be monitored and controlled by the lender. To make inventory worthwhile as security, the lender must be able to claim and liquidate the inventory if the borrower defaults.
In the case of the accounts receivables value of the assets depends on the numbers and type of customers to which the firm grants credit. The more credit worthy the buyers of the borrower’s product, the more that can be lent against receivables from those buyers.
Square textile Ltd uses secured borrowings with inventory as collateral as short term financing. In our queries, we find that they consider the following items as stocks: raw materials, raw materials in transit, finished goods, packing materials, work- in –process, comber noil, spared in store, spares in transit. But it is for very short period for overdraft and trust receipts from HSBC and Standard Chartered Bank.
4.2.5 Liability for other finance:
Square textile ltd. incurs other short term liability from the followings:
4.2.6 Short Term Loan:
Square textile ltd. Incurs short term loan by the following categories: