Assignment Code: MMPF-001/TMA/2024-25

Course Code: MMPF-001

Assignment Name: Working Capital Management

Year: 2024-2025

Verification Status: Verified by Professor

SECTION A 

Q1) Discuss the Industry Norm Approach and Economic Modelling Approach to the determination of working capital. 

Ans) Industry Norm Approach to Working Capital 

The Industry Norm Approach to determining working capital is based on analyzing the average working capital practices followed by firms within the same industry. This approach assumes that similar companies in an industry operate under similar conditions, such as market demand, production processes, and financial cycles, making their working capital requirements comparable. Firms use the industry norms as a benchmark to determine their own working capital needs, focusing on key metrics such as the average collection period, inventory turnover, and payables turnover. 

A key benefit of this approach is its simplicity and the ease of comparison. Since data on industry norms is often available through financial reports, trade associations, and industry surveys, firms can quickly assess whether their working capital levels are in line with competitors. By adhering to industry standards, companies can ensure that they are neither underinvesting in working capital (leading to operational risks such as stockouts or liquidity problems) nor overinvesting (resulting in idle capital and reduced profitability). 

However, the industry norm approach also has its limitations. It assumes that the average firm’s practices are optimal, which may not always be the case. Firms with unique business models, competitive advantages, or different operational risks may require different working capital strategies. Additionally, industry norms can be slow to adapt to rapid changes in technology, market conditions, or economic disruptions, making this approach less suitable during periods of significant change. 

Economic Modelling Approach to Working Capital 

The Economic Modelling Approach takes a more analytical and data-driven route to determine the optimal level of working capital for a firm. This approach is rooted in economic theory and financial modelling, where firms use a combination of quantitative techniques to model their working capital needs. The objective is to minimize the total cost of maintaining working capital while ensuring smooth operational processes and liquidity.  

The model balances two primary costs: the cost of holding too much working capital (e.g., opportunity cost of idle cash or excess inventory) and the cost of holding too little (e.g., stockouts, inability to meet customer demand, or liquidity crises). 

One common tool within this approach is the cash conversion cycle model, which measures how long it takes for a firm to convert its investments in inventory and other resources into cash from sales. Firms use this model to optimize the time spent in each part of the cycle—inventory holding, receivables collection, and payables. The economic modelling approach may also use regression analysis, sensitivity analysis, or simulation techniques to predict working capital needs under different economic scenarios, helping firms prepare for fluctuations in demand, supply chain disruptions, or changes in financing costs. 

The economic modelling approach is highly flexible and adaptable, as it allows firms to account for their specific operational conditions, risks, and financial goals. It also enables companies to conduct scenario planning, optimizing their working capital strategy based on projected changes in economic conditions, such as interest rates, inflation, or consumer demand. However, this approach requires a significant amount of data, financial expertise, and time, which can be a challenge for smaller firms with fewer resources. Furthermore, the models are only as good as the assumptions and data inputs used, meaning that poor forecasting can lead to suboptimal working capital decisions. 

Comparison of the Two Approaches 

While both approaches aim to determine the appropriate level of working capital, they differ in complexity and adaptability. The industry norm approach is simpler and faster, offering a way for firms to align with their peers, but it may not capture unique firm-specific risks or opportunities. On the other hand, the economic modelling approach is more sophisticated, offering a tailored working capital strategy based on detailed financial modelling, though it requires more resources and expertise. In practice, firms may benefit from using a combination of both approaches, using industry norms as a starting point and fine-tuning their working capital needs through economic modelling techniques. This hybrid approach allows businesses to stay competitive while maintaining financial flexibility. 

Q2) The Profit and Loss Account for the year ended 31st March, 2024 and the Balance Sheet as on that date, for Alpha Ltd. is as follows: 

Balance Sheet as on 31st March, 2024 

The market price of the shares of Alpha Ltd. on 31st March, 2024: Rs. 45 

Reserves 

Calculate the following Ratios – (1) Current ratio (2) Quick ratio (3) Debt- equity ratio (4) Interest coverage (5) Fixed charge coverage (6) Stock turnover (7) Debtors turnover (8) Average collection period (9) Gross profit margin (10) Net profit margin (11) Operating ratio (12) Return on capital employed (ROCE) (13) Earnings per share (14) Return on shareholders’ equity (15) P/E ratio and (16) Earning yield. 

Ans) I will extract the necessary data from the image you uploaded and calculate the required ratios. I will start by calculating each ratio one by one based on the data provided. Here are the formulas for each ratio, and then I will show the computations. 

1. Current Ratio: 

2. Quick Ratio: 

3. Debt-Equity Ratio: 

4. Interest Coverage Ratio:  

5. Fixed Charge Coverage:  

6. Stock Turnover Ratio  

7. Debtors Turnover Ratio: 

8. Average Collection Period: 

9. Gross Profit Margin: 

10. Net Profit Margin:

11. Operating Ratio:

12. Return on Capital Employed (ROCE):  

13. Earnings Per Share (EPS):  

14. Return on Shareholders' Equity:  

15. Price to Earnings (P/E) Ratio:  

16. Earnings Yield:  

Financial Ratios for Alpha Ltd. 

Q3) How does uncertainty affect Inventory Management? Explain any one model of Inventory Management under the condition of uncertainty. 

Ans) Impact of Uncertainty on Inventory Management 

Uncertainty plays a significant role in inventory management, as it directly influences decision-making around how much inventory to hold, when to reorder, and how to balance supply and demand effectively. Uncertainty in inventory management stems from various sources, such as fluctuating customer demand, unpredictable supply chains, changes in production schedules, and external factors like economic conditions, weather disruptions, or geopolitical issues. Managing inventory under uncertainty is a challenge because it increases the risk of stockouts, overstocking, or excessive holding costs, all of which can negatively impact a company's financial performance and customer satisfaction. 

In an uncertain environment, firms need to adopt strategies that allow them to be flexible and responsive to changes. Holding safety stock is one common practice, which involves keeping extra inventory as a buffer against demand fluctuations or delays in supply. However, this approach increases inventory carrying costs, and determining the appropriate amount of safety stock is difficult when demand and supply are unpredictable. Additionally, companies might opt for more frequent reordering or work with suppliers who can offer shorter lead times to minimize the risk of stockouts. 

The key challenge is finding the optimal balance between having enough stock to meet customer demand and not holding so much that it becomes costly or leads to obsolescence. Advanced forecasting techniques, data analytics, and inventory management models are often employed to mitigate the effects of uncertainty and help companies make informed decisions. 

Inventory Management Model: The Newsvendor Model 

One widely used model for inventory management under uncertainty is the Newsvendor Model (also known as the single-period inventory model). This model is particularly useful in situations where companies face uncertain demand for a perishable or time-sensitive product, such as newspapers (hence the name), fashion items, or seasonal products. In these scenarios, firms only have one opportunity to order stock before the selling period begins, and any unsold stock at the end of the period either loses value completely or incurs high discounting costs. 

The newsvendor model helps businesses determine the optimal order quantity that balances the cost of ordering too much (overstock) and the cost of ordering too little (stockout). In other words, it seeks to minimize the expected cost associated with these two opposing risks. The critical decision in this model is finding the point where the marginal cost of overstocking equals the marginal cost of understocking. 

Key Components of the Newsvendor Model: 

1. Demand Uncertainty: In the newsvendor model, demand is uncertain and is typically represented by a probability distribution, often assumed to be normal. The business does not know the exact demand ahead of time but has historical data or estimates to predict its probability. 

2. Order Quantity Decision: The firm must decide how much inventory to order before the selling period begins, knowing that any unsold units will result in a loss, while stockouts may lead to missed sales opportunities. 

   
   

3. Cost Considerations: 

• Cost of Understocking: This is the cost incurred when demand exceeds supply, leading to missed sales. It includes the profit lost from the sale and potential reputational damage if customers turn to competitors. 

• Cost of Overstocking: This is the cost of holding excess stock at the end of the period, which could involve disposal, markdowns, or carrying costs. 

4. Optimal Order Quantity: The newsvendor model uses the critical ratio to find the optimal order quantity. The critical ratio is calculated as: Critical Ratio = Cost of Understocking / Cost of Understocking + Cost of Overstocking  

The critical ratio helps determine the probability of satisfying demand and serves as a guide for setting the order quantity. 

In practice, the model advises the firm to order enough inventory such that it covers a percentage of the demand distribution corresponding to the critical ratio. For example, if the critical ratio is 0.7, the firm will order stock up to the point where it expects to satisfy 70% of potential demand, leaving a 30% chance of understocking. 

Q4) Explain the significance of trade credit. What are the factors that influence the availability of trade credit? 

Ans) Significance of Trade Credit 

Trade credit is an important form of short-term financing used by businesses to manage their cash flows and working capital needs. It refers to the credit extended by suppliers to their customers, allowing the latter to purchase goods or services without immediate payment. Instead of paying upfront, the buyer agrees to pay at a later date, typically within 30, 60, or 90 days, depending on the terms agreed upon. Trade credit acts as an informal loan between businesses and is one of the most commonly used financial tools for managing liquidity. 

The significance of trade credit lies in its ability to help businesses operate smoothly without relying heavily on bank loans or other formal credit mechanisms. For buyers, trade credit provides the flexibility to sell the products they’ve purchased before having to pay for them, thus improving cash flow. It also enables firms to manage unexpected spikes in demand, delays in payments from customers, or temporary cash shortages. For suppliers, extending trade credit can be a competitive advantage that helps build long-term relationships with buyers and fosters customer loyalty. Trade credit can also act as a signal of trust between parties, as it demonstrates the supplier’s confidence in the buyer’s ability to meet future obligations. 

However, trade credit also carries risks, especially for suppliers, who are exposed to the possibility of delayed payments or defaults. Managing these risks is essential, which is why suppliers carefully consider a range of factors before offering trade credit to a buyer. 

Factors Influencing the Availability of Trade Credit 

1. Creditworthiness of the Buyer: One of the most critical factors influencing the availability of trade credit is the buyer’s financial health and creditworthiness. Suppliers typically evaluate a buyer’s ability to meet payment obligations by reviewing credit scores, financial statements, payment history, and overall reputation in the market. A financially strong buyer with a reliable payment record is more likely to receive trade credit than a buyer with a poor credit history or unstable cash flows. Suppliers often use credit agencies or conduct their own risk assessments to determine the level of credit to extend. 

2. Nature of the Industry: The availability of trade credit can vary significantly across industries. Industries with long production or sales cycles, such as manufacturing or construction, tend to offer longer credit periods because the buyer needs more time to generate revenue from the purchased goods. In contrast, industries with faster turnover, like retail or perishable goods sectors, may offer shorter credit periods. Moreover, trade credit norms are often industry-specific, meaning businesses typically follow practices common in their industry when setting payment terms. 

3. Supplier’s Financial Condition: Suppliers need sufficient liquidity to extend trade credit, as they are effectively lending money to their buyers by allowing deferred payments. If the supplier is financially constrained or has limited access to credit themselves, they may be less willing or able to offer generous credit terms. On the other hand, a financially strong supplier may offer more lenient credit terms to encourage more business from buyers, especially in competitive markets. 

4. Competition and Market Conditions: Competitive pressures in a market can significantly influence the availability of trade credit. In highly competitive industries, suppliers may offer more favorable credit terms as a way to attract or retain customers. If a buyer has multiple sourcing options, they may choose the supplier who offers the most favorable payment terms. Additionally, during economic downturns or periods of tight liquidity, buyers may face difficulties obtaining bank loans, increasing their reliance on trade credit. In such situations, suppliers may extend more credit to maintain business relationships but may also become more selective in evaluating creditworthiness to minimize risks. 

5. Relationship between Buyer and Supplier: The length and quality of the relationship between a buyer and supplier can heavily influence trade credit decisions. Long-term relationships based on mutual trust and reliability often lead to more favorable credit terms, as the supplier has a better understanding of the buyer’s payment behavior and business model. A new or untested buyer may face stricter terms or shorter credit periods until the supplier is confident in their ability to meet payment obligations. 

6. Economic Environment: The broader economic climate also affects trade credit availability. In times of economic growth and stability, suppliers may feel more confident in extending credit to buyers. Conversely, during periods of economic uncertainty, inflation, or financial crises, suppliers may tighten their credit policies to reduce the risk of non-payment. Interest rates also play a role—if borrowing costs rise, suppliers may become less willing to finance trade credit, preferring instead to receive immediate payments to meet their own cash flow needs. 

7. Terms of Sale: The specific terms negotiated between a buyer and a supplier can also determine the availability of trade credit. Discounts for early payments (such as 2/10, net 30) encourage buyers to pay early while still allowing flexibility for later payments. The structure of these payment terms often depends on the strategic goals of both parties and the bargaining power of the buyer. 

Q5) Select any Small or Medium Enterprise (SME) of your choice. Discuss with them about why they need to manage working capital and how it is done. What are the various barriers faced by them in optimization of working capital. 

Ans) For this discussion, I chose to speak with the owner of a small manufacturing company that produces eco-friendly packaging materials. The owner emphasized the critical need to manage working capital, as it directly affects the business’s ability to operate smoothly and grow sustainably. Working capital management refers to the process of ensuring that a company has enough cash to meet its short-term obligations while efficiently using its current assets, such as inventory and receivables, to maintain liquidity. 

The owner explained that, in a business like theirs, which relies heavily on raw materials, managing working capital is essential for day-to-day operations. Without proper control of working capital, they risk cash shortages that could hinder production, delay customer deliveries, or result in missed opportunities for bulk purchasing discounts. Effective working capital management allows the company to balance liquidity and profitability by optimizing the use of resources like inventory, receivables, and payables. 

The management of working capital in this SME involves several key practices. First, they maintain a careful balance between inventory levels and demand. Since excess inventory ties up cash, they closely monitor production schedules and customer orders to avoid overstocking. At the same time, they need to ensure they have enough materials on hand to avoid production delays. Secondly, they focus on collecting receivables quickly. The company offers customers a 30-day credit period, but they actively follow up on outstanding payments to prevent cash flow issues. To extend their payment terms with suppliers, they negotiate favorable credit terms, ensuring they pay only after converting inventory into sales, thus reducing pressure on their cash reserves. 

However, the owner highlighted several barriers to optimizing working capital in the SME context. One of the primary challenges is limited access to financing. Unlike large companies that can easily obtain bank loans or lines of credit, small businesses often struggle to secure affordable short-term financing. This means they must rely heavily on internal cash flow for operations, which can be risky during slow sales periods. Additionally, fluctuations in demand and customer payment delays are common problems. As an SME, they cannot always predict demand accurately, leading to either stockouts or excess inventory, both of which strain working capital. When customers delay payments, the company is forced to juggle their own obligations to suppliers and other creditors, which creates cash flow uncertainty. 

Another barrier is limited negotiation power with suppliers and customers. The owner explained that larger suppliers often dictate payment terms, leaving SMEs with little flexibility. Furthermore, large customers sometimes delay payments, knowing the SME depends on their business, further complicating working capital management.