Ratio Analysis

FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION
Direct Materials:

These represent materials used directly in production. Direct materials may be of two types:

1. raw materials which are converted into finished products by processing, machining, etc.,
and
2. purchased items bought directly from vendors for assembly or direct sale.

If the bought-in items are composed largely of finished goods purchased from the market for
direct sales without much further processing, then it should be brought out separately to
evaluate the real strength of the manufacturing function.

Why Do We Need This Segregation Of Materials Between Direct And Bought-Out?

This segregation often reveals interesting facts:

1. Some times it may so happen that the company has lost a sizable part of the market share
for its own products as a result it is trying to cancel by clubbing the finished goods
purchased with its own direct materials.

2. It may be also that certain items previously manufactured and marketed by the company
under its popular brand names have ceased to be cost effective vis-avis that of the new
entrants in the same field. However, since the company continues to enjoy the brand
popularity of the products, it may decide to get these manufactured elsewhere,
particularly in small establishments, at less cost and market them under the same brand
names.

Seasonality:

Storage of materials and the volume of their use may often depend upon seasonality.

For example:

1. The manufacturer of sports goods will find his sales picking up during a particular sports
season but raw materials for manufacturing sports goods are generally available almost
uniform throughout the year.

2. Similarly, in case of sugar industry, procurement and consumption of raw material
(sugarcane) will be high during the peak harvesting season and stock of sugar will be very
high during this period and will be sold gradually over the year.

Imported Materials:

Raw materials may be indigenously procured or imported from abroad. This information is
available as a note to all published annual reports. A company using a bulk of imported raw
materials may be the subject to the vagaries:

1. international prices and exchange rate movements and
2. changes in customs duties and governments general import policy which may affect the
cost and the availability of materials and high lead time which may force that company to
carry huge inventories.

Valuation Methods:

The issue price at which materials are charged to production and the valuation of period end
inventory may affect cost and profit of an organization significantly.

1. Under FIFO it is presumed that materials are issued to production in order of their
receipts in stocks.
2. At the time of stable prices, cost of production is correctly valued, as well as the period
end inventories.
3. When the prices are falling, however, the FIFO method over value the production while
inventories are valued close to market rate and there will be reverse if prices are rising
also.

1. In case of LIFO method the materials are charged to production in the reverse order of
FIFO i.e., the latest receipt is the first issue.
2. Here the production is charged close to market prices of materials but inventories are
valued at historical cost, which may be over valued or under valued depending upon
whether prices are falling or rising.

Some companies follow either simple averages, weighted averages or moving averages also.

Manufacturing Labour Cost:

- In terms of cost accounting methodology, labour costs associated with manufacturing and
assembling the product are treated as direct labour costs such as machine operators and
assembly workers. The new concept of manufacturing labour costs include all wages and
salaries paid for manufacturing (including those of all administrative heads responsible
directly for the manufacturing function whether sitting within the factory premises or at
the head quarters) should be treated as labour spent on manufacturing. This has resulted
in changing in the behaviour of this cost from variable to semi-variable.
Power and Fuel:

- This is direct conversion cost and includes consumption of electricity, coal, water,
minerals and other fuels used during the process of manufacturing. If a company has an
alternative power generating installation, expenses under this lead would include diesel an
other costs of running the generating set, and not the electricity consumed by units as in
case of electricity. The nature of costs under this head suggests that it will be dominantly
variable.

Maintenance and Repairs:

- Unlike the small companies, large companies have separate maintenance departments,
treated as a distinct cost centre, responsible for the maintenance and repairs of the entire
plant and machinery. All expenses like salaries and wages; stores and spares; and other
costs of use of capital in the department are pooled together and charged to various
product departments as maintenance overheads at predetermined rate, e.g., per hour of
engagement. In such a situation, the total cost of the maintenance department may feature
as such in the annual accounts of the company without any further cost classifications
under different heads, e.g. salaries and wages, stores and spares etc.

- However, some firms may choose to use maintenance overhead rates for internal control
purposes and desegregate the expenses of the maintenance department under different
heads for reporting in published accounts. In this case it is desirable for an analyst to pool
together all such cost of maintenance and repairs with respect to plant and its impact on
the manufacturing function of the company. Maintenance and repairs costs are
predominantly semi-variable in nature.

Depreciation:

- The expired cost fixed assets is known as depreciation and is a non cash expenses (except
when a depreciation fund is invested in sinking fund investments for future replacement
of assets) and is charged to the profit and loss account and retained in the business like
any other reserves for the purpose of future expansion.

- Generally, companies use either straight line and/or written down method in charging
depreciation and are bound to disclose the methods of depreciation in their annual reports.
An analyst must be careful while dealing with the depreciation because this may affect
the profit and assets also.

Mandatory Provisions:

- Making provisions for depreciation is governed by two Acts, namely, the Companies Act
and the Income Tax Act. Companies Act prescribes the minimum rate to be charged on
various classes of assets before a company is eligible for declaring dividend, while the
Income Tax Act prescribes the maximum rates allowable as deductions from profit for tax
purposes. It is likely, therefore, that the accounts published by the company in its annual
report will vary from the one submitted to the Income Tax authority.

Revaluation of Assets:

- During recent years it has been observed that many companies are evaluating their assets
to bring them closer to market values as a result this will increase the amount of
depreciation that can be charged on the revalued assets. Although the book value of an
asset is increased because of its revaluation, there is, in effect, no increase in the
productive capacity of such an asset.
- It is, therefore, logical that the manufacturing or other operating functions of the
enterprise cannot be asked to bear the additional burden of depreciation for which no
additional benefit has been received.
- A sound accounting policy demands that the additional depreciation on the revalued
portion of the assets should not be charged to operations but adjust against the revaluation
reserve created on the liability side of the balance sheet consequent upon revaluation of
assets*.
- The profit and loss account of an enterprise will reveal the annual depreciation (net of
revaluation adjustment) as a charge against profit while the balance sheet will show
accumulation of all such annual depreciation as deduction from gross fixed assets.
- It may so happen that the annual depreciation figures available from the profit and loss
account may not tally with the difference between the accumulated depreciation of the
last two years. This is possible because of the reason mentioned in * and it may found that
some the fixed assets might have been sold during a year and consequently, the
accumulated depreciation on such assets has also been written off. This point has an
important bearing on the funds flow analysis of an enterprise. Depreciation is generally
treated as a fixed overhead.

Other Manufacturing Expenses or Production Overheads:

- Such costs are insurance paid for pant and machinery; factory premises; manufacturing
inventories like raw materials, stores and spares; work-in-process, heat, light, gas (besides
power and fuel), stationery, royalty, and other service charges. Some of these expenses
like stationery because of small amounts clubbed together from different functions and
charged to administration.
Excise Duty:

- Although excise duty is a real cash expense which is claimed by the exchequer at the time
of dispatch of finished products from the factory gate, it may not be included as a part of
cost of sales. This is because excise duty is beyond the control of the manufacturing
function or for that matter beyond the purview of the enterprise function itself, as it is
imposed by the government from outside. Besides, at the enterprise level, it is difficult to
see how this expenditure is adding any further value to the product. If we want to judge
the efficiency of any function we cannot make responsible for an enterprise for an
expenditure over which it has no control.
- It is desirable to deduct the excise duty (and also sales tax for the same reasons) from the
gross sales and then compare it with cost of goods sold to arrive at the manufacturing
gross profit.
- Now, when we add up all the costs mentioned above, we obtain the figure of the total
manufacturing expenses of a given year.

Work-In-Process Inventory:

- Like material inventory, an enterprise is presumed to carry forward its process inventory
on the opening day of the new financial year, which it consumes in the next year. At the
end of the year, it is left with a new work-in-process inventory which ahs consumed a part
of the manufacturing expenses but has not produced any output.
- Therefore, in order to arrive at the true cost of production of the finished goods, we have
to first add the opening inventory of the work-in-process to the total manufacturing
expenses but has not produced any output.
- Some companies do not report the work-in-progress inventory in their published accounts
considering it to be small. They club it with raw materials inventory. An analysts will
definitely dig out this important item of manufacturing operation because, it reveals
important information about the technological state of an enterprise.

Finished Goods Inventory:

An enterprise may carry forward unsold goods of the last year and be left with some unsold
stock at the end of the current year. Then we have to make the similar adjustment to arrive at
the figure of cost of goods sold.
Manufacturing Gross Profit:

- Cost of goods sold is thus derived by making adjustments to the opening and closing
inventories as mentioned above. This figure is then compared with the sales net of excise
duty to arrive at the manufacturing gross profit.
- However, it is not always possible from the published accounts to know how much of
direct purchase of finished goods (bought-out items) remain in inventory of finished
goods to arrive at the correct figure of manufacturing gross profit. It is desirable that such
information is obtained from internal sources.
- In the absence of that, the impact of such purchases for direct sale on total sales of the
enterprise may have to be captured by different ratio.

Plant And Machinery:

- This is the principal asset of the manufacturing function, the rotation of which
generates output for sales. Making provisions for depreciation is more important in the
case of plant and machinery than any other asset because it wears out faster than any
other assets due to use, or even non-use.
- If a company has not charged depreciation in a particular year for want of profit, or due to
other reasons, the fact will be noted in the auditors report annexed to the published profit
and loss account and balance sheet along with the quantum of depreciation not so
charged.
- In such a case, the unprovided for depreciation should be duly provided for in the profit
and loss account and deducted from the assets.

FINANCIAL ACCOUNTING RATIOS

Plant Turnover Ratio:

Year 1994-95 1995-96 1996-97 1997-98
(1) Cost of Production 24926 28776 34576 39832
(2) Plant & Machinery* 2833 4589 4866 5054
Ratio (1/2) 8.80 6.27 7.11 7.88

Depreciated i.e. net Bock Value after depreciation provided for.

- Although it is preferable to calculate this ratio by using the actual number of units
produced in a given period, for a multiple unit like UFL, where usage of plant or
production facilities may be common for more than one product, may have to calculate it
by cost of production.
- This ratio measures the total plant utilization capacity.

Nature of the Ratio:

- During the initial years when all plant parameters have not been fully synchronized the
system may suffer from production instability, which will be reflected by an erratic
movement of this ratio.

- When plants are synchronized, capacity utilization of the plant increases gradually and as
a consequence this ratio will show a gradual improvement and it reaches a plateau where
it should remain more or less stable for quite some time or even starts declining inspite of
all repairs and maintenance (Bhattachararya, 1992).

- The effect of this decline is captured by taking the depreciated value of the assets as the
denominator and then matched against a corresponding decline in the volume of the
product in the numerator which gives rise to a stable ratio over the life of the plant.

- A company is, however, not expected to wait till the plant finally dies out at the cost of a
faster increase in the cost of production and consequent loss market competition,
particularly when an advanced machine has already arrived. It will have a programme for
gradual replacement of equipment in order to stay in the market and as a result it will
have an effect of a constant improvement of the ratio.

- Therefore, if this ratio is suffering from a declining trend, then the business is falling to
make use of its plant capacity which may be due to a bottleneck in its productive system
or a fall in the demand for its product, compelling a decease in production.

Determining The Trend:

- In case of UEL, this ratio was high during 1994-95, immediately falling very low during
1995-96 and made some improvement during the following two years but still way
behind the 1994-95 figure.
- In order to determined a trend, we need more of years data, but a quick estimate of the
trend can be made by using the following formula:

X1 + 2X2 + 3X3 + 4X4 nXn
N + 1
_____________________________ > _________
X1 + X2 + X3 + X4 . Xn < 2

Where X1, X2, .. Xn are values of the ratio for year 1,2 .n and N is the total
number of year for which the ratio is calculated.

The trend may be regarded as rising if RHS>LHS

The trend may be regarded as flat or declining if RHS < LHS
In case of UEL the trend is appears to be flat revealed by the following calculation:

8.80 + 2 x 6.27 + 3 x 7.11 + 4 x 7.88 74.19
LHS = ----------------------------------------------- = ----------- = 2.49
8.80 + 6.27 + 7.11 + 7.88 30.06

4 + 1
RHS =------- = 2.50
2

Case of UEF:

- The analyst now has to enquire why the ratio was so high during 1994-95 and fell so low
in 1995-96, because if we ignore the year 1994-95 then the ratio shows a rising trend.
- It might be that 1994-95 was an extraordinary year or that in 1995-96 there was addition
of new plant and capacity of which is yet to be fully utilized.
- The data given in the balance sheet under Net Block (P&M) shows that there has been
substantial addition to the plant in 1995-96 which pulled down the ratio in that year (and
had the effect of making the overall trend almost flat).
- Subsequently, there has been a constant improvement in plant utilization as revealed by
the rising trend of this ratio since 1995-96.

Material Consumption Ratio:

Year 1994-95 1995-96 1996-97 1997-98
(1) Direct Material Consumption* 19489 22047 28353 31973
(2) Net Sales excluding scrap income 45748 55107 63794 69972
Ratio (%) (1/2) 42.60 40.00 44.44 45.69
Trend Upward

Consumption including stores and consumables.


- This ratio indicates materials consumption as percentage of sales (i.e. material efficiency
of the manufacturing system), which is expected to be constant over a period of time
because direct materials are predominantly of variable nature during a given technology
period and production level i.e. volume of sales.

- During the initial steaming off period of the plant, the ratio may be high but it should
soon settle down to a normal level and continue at that level during the given technology
period and production level i.e. volume of sales.

- In fact this ratio should decrease if there is increase in volume of sales within a given
technology period because of volume discount on huge raw materials purchased and to
some extent the economies of scale also.

- An upward movement of this ratio generally indicates increasing wastage or rise in the
cost of raw materials without corresponding rise in prices of output i.e. it is not possible
for the company to pass over the rise in the cost of materials to the consumer because of
competition in the market.

- If the company is of a monopolistic type, the failure to pass over the rise in cost may be
due to high price elasticity of the product and / or a rise in the availability / demand for
substitute goods in the market.

- If the company is a price taker (opposite of price leader) in a competitive market, then
failure in terms of high percentage of materials consumption to total sales could be
attributed only to its internal inefficiencies because other competitors are able to hold on
to the price line inspite of a rise in materials cost. This may indicate that the companys
plant and machinery has become obsolete by arrival of new machines in the market which
save on materials consumption per unit of output produced.*

Case of UEL:

- In the case of UEL, the latter conclusion * may not be true because in 1995-96 there has
been massive investment in additional plant and machinery that should have lowered the
ratio.

- The ratio really did go down by more than 2% in 1995-96 as compared to 1994-95 but
immediately thereafter, the ratio shot up by about 5% and even crossed the ratio obtained
in 1994-95, i.e. the year prior to investment in new machines.

- Thus, it reveals that even with the renewal of plant and machinery the company has not
been able to make any savings on its materials consumption which may be due to the
wrong choice of machines and as a price taker it has not been possible for the company to
pass on the cost increase to the market.

Treatment Of Scrap Sales:

- It may be seen that while calculating this ratio we have taken Net Sales as the
denominator and not the Total Income from operations, because the latter includes
income derived from the sale of scrap.

- Materials are consumed for the production of output. Scrap is nothing but waste having a
market value. For some products, using different technology, some amount of scrap may
be normal but for that reason one cannot take it out from the list of wastages and include
it in the list of outputs i.e. Net Sales.

- Materials are consumed for producing sales inspite of the scrap. Hence, gross materials
consumption should be related to Net Sales to estimate the material efficiency of the
manufacturing system.

- Some companies are found in deducting scrap from the materials consumption in their
published accounts which gives a wrong value of materials consumption and to an extent,
suppresses a fall in material efficiencies. Besides, this approach may distorts the figure of
operating inflow of the firm.

Material Import Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Imported Materials 4063 5224 5853 5860
Direct Material Consumption 19059 21631 27700 31373
Ratio (%) 21.32 24.15 21.13 18.68
Trend Downward

Note: The figures are taken from the profit and loss account which exclude materials
consumption for capitalised items.

- A manufacturing company like UEL, which has to depend on imports for about 20% of
its materials consumption, suffers from vagaries in international commodity markets,
exchange rate movements and volatile government policy towards imports.

- Criticality of imported materials is a dominant factor in this aspect because the entire
manufacturing function of an enterprise may come to a halt due to non-availability of
critical items. As a result it makes difficult for an enterprise to quote a stable price for its
product if the import content of materials is very high.

- Firms like UEL are therefore required to move towards developing indigenous source of
materials. The downward trend of the materials import ratio for UEL suggest that the
company is moving in the right direction.
Spares Import Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Imported Spares 9 63 47 127
Consumption of Spares 41 100 134 248
Ratio (%) 21.95 63.00 35.07 51.21
Trend Upward

Case of UEL:

- For the UEL, the spares import ratio was 22% in 1994-95 which shot upto 63% in 1995-
96, when the company went in for the large scale investment in plant and machinery, then
dipped down to 35% but again shot upto 51%.

- It is likely that the company purchased mostly imported or high import content machines.
Apparently, this is not a very alarming situation, even if the company has also assured
itself of a regular supply of spares.

- The manufacturing system, however, remains under threat all the time because sources of
spares may dry up owing to the closure of the supplier of spare parts, change in design or
even temporary disturbances in international transport and communication systems.

- Due to these uncertainties in the supply of both imported materials and spares parts many
companies are found to hold large inventories for these items, which often are beyond
reasonable levels even considering the risk of stock non-availability.

Manufacturing Labour Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Manufacturing Wages & Salaries 4127 5132 5932 6523
Net Sales (cost of production) 45748
(24926)
55107
(28776)
63794
(34576)
69972
(39832)
Ratio (%) 9.02
(16.56)
9.31
(17.83)
9.30
(17.16)
9.32
(16.38)
Trend (ignoring 1994-95) Flat

Note: Figures in brackets represent cost of production and ratio based on it.


- Since the largest component of this cost is factory wages, it should be dominantly
variable with sales.
- The reasons for the constancy that the cost is dominantly variable, a part of it,
representing wages of skilled workers and salaries of supervisory and managerial staff, is
fixed in nature which will have the effect of pulling down the ratio as sales increases. The
reverse will be true when sales fall.
- In a highly capital intensive and automated industrial units this phenomenon is frequently
observed.

Case of UEL:

- In case of UEL this ratio has been calculated on Net Sales which remains almost constant
since 1995-96, when company made large investment in plant.

- The post 1995-96 ratio is however, higher than the ratio obtained in 1994-95. Apparently,
for a 100 percent manufacturing company (which UEL is not) this manner of movement
of the ratio would be disturbing, because with the renewal/modernization of the plant
labour cost is expected to go down similar to material cost.

- It is true that there had been a substantial increase in sales in 1995-96, compared to 1994-
95, and this trend continued during the next three years but there should be no reason why
the labour ratio should also increase and in fact there is every chance for its decline if
UEL were a fully manufacturing concern.

- Apparently, there is no reason why the equilibrium should be reached at a higher level,
unless, the company has deliberately installed labour intensive technology, which it often
does to absorb surplus labour who cannot be disposed of except at the cost of tremendous
social unrest.

Trading Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Purchased of finished goods 11237 15046 16097 15183
Net Sales 45748 55107 63794 69972
Ratio (%) 24.56 27.30 25.23 21.70
Trend Flat


- A company whose purchase of finished goods for direct sales comprises a sizable part of
net sales, should separate this component from the materials consumption figure
otherwise it may give distorted materials consumption ratio for the manufacturing
function.

- As these purchases are purely for trading purposes, not forming a part of manufacturing,
the ratio is called Trading Ratio.

- When Trading Ratio of manufacturing company is high, the one conclusion that can be
safely reached is that the internal economy of manufacturing these products within the
plant is no longer available but a brand goodwill still exists in the market which the
company intends to cash on.

- If these products were among the ones previously manufactured by the company then it is
likely that the company is an old enterprise and it can no longer carry large overheads for
manufacturing these products due to stiff competition from new companies, particularly
in the small sector, with low overheads.

Case of UEL:

- The ratio indicates that the purchase of finished goods for direct sale comprises more than
one fifth of its net sales which is quite substantial. In fact. The ratio would have been
larger if we had known the sale value of these purchased products.

- Generally it is not possible to know from the published accounts that how much of these
products purchased, sold and balance left as inventory.

High Overheads:

- A high trading ratio for a manufacturing company cannot sustain the enterprise for long.
Ultimately, the enterprise has to regain its manufacturing strength if it desires to stay in
the market by reducing costs.

- Because a high trading ratio in a manufacturing company indicates the existence of high
overhead costs. It signals a warning that if these overheads are not reduced and controlled
by proper restructuring of manufacturing and administrative function, then other products
soon be affected, resulting in a movement of more items from the manufacturing list to
the trading list.

- The uncontrolled overheads would soon start eating into the margins on the products in
the trading list itself.

- However, the situation would not be so disturbing if is found that the company had made
a new wage agreement simultaneously with the renewal of the plant. Here too the
manufacturing labour ratio would once again stabilize, though now at a higher level,
unless there is a fall in labour productivity.

Purchase of Finished Goods:

- In case of UEL, purchase of finished goods for direct sales constitute more than one fifth
of net sales. It means that the manufacturing labour would not have been associated with
these purchase or sales.

- In this case it is preferable to calculate this ratio on cost of production instead of net sales.
It is revealed that this ratio (Manufacturing Wages & Salaries / Cost of Production) is
suddenly moving upwards in 1995-96 and declining since then, surpassed even the
achievement of 1994-95 in 1997-98, which indicates that there is improvement in labour
absorption by the manufacturing function.

Spares Consumption Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Consumption of Spares 41 100 134 248
Net Sales (Cost of Production) 45748
(24926)
55107
(28776)
63794
(34576)
69972
(39832)
Ratio (%) 0.09
(0.16)
0.18
(0.35)
0.21
(0.39)
0.35
(0.62)
Trend (Ignoring 1994-95) Upward


- Consumption of spares, though representing a small percentage of net sales or cost of
production, reveals many important things about the state of the manufacturing function
of an enterprise.

- Spares are consumed mostly for the maintenance and repairs and in machine set up. In the
case of former, it is often clubbed together with other maintenance costs but it is
preferable to separate it out for closer examination, as has been done in the case of UEL.

- It is semi-variable expense which is expected to rise with the decrease in the life of the
plant. The rise should however, be low.

Case of UEL:

- In the case of UEL we find that this ratio calculated as a percentage of net sales or as a
percentage of cost of production is showing a rather steep rise through out the period.
This is inspite of the renewal of the plant in 1995-96, when ordinarily should have fallen.

- This may signal a loosening of control in the manufacturing function. Most of the spares
are probably being consumed not so much for value addition but because of wastage.

- A step rise in the spares consumption ratio indicates that a culture of wastage is engulfing
the organisation, though it may not be visible immediately.

Power and Fuel Consumption Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Consumption of Power and Fuel 329 559 479 640
Net Sales (Cost of Production) 45748
(24926)
55107
(28776)
63794
(34576)
69972
(39832)
Ratio (%) 0.72
(1.32)
1.01
(1.94)
0.75
(1.39)
0.91
(1.61)
Trend (Ignoring 1994-95) Upward


- Consumption of power and fuel, like materials, being highly interlinked with level of
production should be dominantly variable in nature.

- Hence, this ratio should be constant over a given technology period, after the production
parameters settle down to normalcy.

Case of UEL:

- In case of UEL this ratio is upward. A rise trend would either indicate simple wastage or
worn out state of machines which demand more power per unit of rotation than before.

- The first speaks of slackening of manufacturing controls while the latter indicates the
time for replacing worn out machines.

- This latter may not be the case of UEL because in 1995-96 substantial investment in plant
had been made, which should have been lowered down this ratio.

- It appears that some of the cost parameters of UEL, though small in magnitude, are
settling down at a higher level after of the plant in 1995-96.

Maintenance Ratio:

Year 1994-95 1995-96 1996-97 1997-98
(A) Maintenance & Repairs (Plant) 129 168 208 246
Net Sales 45748
(24926)
55107
(28776)
63794
(34576)
69972
(39832)
Ratio (%) 0.28
(0.52)
0.30
(0.58)
0.33
(0.60)
0.35
(0.62)
Trend Moderately Upward

Year 1994-95 1995-96 1996-97 1997-98
(B) Maintenance & Repairs (Plant) 129 168 208 246
Net Sales 2833 4589 4866 5054
Ratio (%) 4.55 3.66 4.27 4.87
Trend Moderately Upward


- It is general rule that cost of maintenance and repairs rise with the age of the machines.
This is however, must be gradual, as has been the case with UEL. If there is a sharp
increase in this cost it may indicate that maintenance is not being done in an organised
manner it is treated more as a fire fighting exercise.

- In most of the Indian Companies what exists really is repair-maintenance,
Maintenance people get together around the machines only when the smoke comes out.
This is costly both in terms of cost of maintenance and resultant loss in production.

- On the other hand, the high and sharply rising cost of maintenance and repairs may
indicate that the machine are also wearing out fast and signaling for their replacement.

- Low or declining maintenance cost, within a given technology period, may not always
mean good manufacturing health of the plant. It may in fact be just opposite. When a
company is not doing well financially, repairs and maintenance is often the first sacrifice.
This small decision has a tremendous snow-balling effect upon the manufacturing system
itself.

Materials Inventory Turnover Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Materials Consumption
(Including Stores)
19489 22047 28353 31973
Materials Inventory 2523 3103 3905 3969
Ratio (%) 7.72 (47) 7.11 (51) 7.26 (50) 8.06 (45)
Trend Almost Flat

This ratio is also called velocity of Materials Inventory.

Components of Materials and Their Valuation:

- UEL does not maintain a separate inventory for stores, though consumption is shown
separately. Either the entire stores are consumed (written off) within the year of their
purchase or whatever stock remain at the end of the year are clubbed together with
materials inventory.

- Since the methods of inventory valuation may affect the profitability and liquidity
position of the company, it is necessary therefore, to find out from the annual reports
whether there has been any change in the methods of valuation and, if so, necessary
adjustments should be made to the reported inventory and profit before embarking on any
analysis. However, in the case of UEL there has not been any such change during the
period under review.


- It should be remember that each piece of materials carried to inventory contributes
negatively to the profitability of the business in term of
1. the cost of physically carrying the inventory and
2. the interest (opportunity) cost of the funds blocked it.

- Efforts are being made by large corporations to synchronize materials supply with the
productive system through proper vendor development that there would be no need to
hold my inventory of materials i.e. by reducing the production cycle of the company as
well as of the suppliers.

Case of UEL:

- The message is loud and clear. The company must move towards reducing the level of
inventory, if not making it zero. As long as that is not possible, it is essential that the
inventory turnover ratio is held at constant level.

- It may be noted that companys PBT is Ra. 1.530 lakh, the interest cost alone for carrying
the present level of inventory is more than Rs. 700 lakh.

The Problem of Dead Stock:

- If the materials inventory turnover ratio is worsening for quite some time then is likely
that the company is carrying increasing amount of dead stock in its inventory, which it
unable to write off for fear of registering a substantial fall in the profit or even making a
loss because of liquidity crunch or cash crunch.

- Instead of taking a hard, though prudent, decision (i.e. writing off dead stock of
inventory) at this juncture to prevent eating up capital, many companies decides to
postpone the decision to a latter date, waiting for good times and in process delay the
arrival of that good time.

A simple calculation will make it clear
Total dead stock of inventory = Rs. 100
Company has to pay income tax = Rs. 35 (because profit has been inflated to that extent)
Proposed dividend (for example) = Rs. 15
Net cash out flow = Rs. 65 against which no matching assets asset now exists
(ignoring the opportunity cost of carrying that dead inventory)

- This cash out flow will recur year after year as long as the company carries this dead
stock in its books of account which will result in continuous deterioration of its each
position.

- A low materials inventory turnover ratio may be due to the high content of materials
consumption. As we have seen in case of UEL that materials import ratio is high at
around 20%.

Imported Raw Materials Inventory Turnover Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Materials Consumption (Imported) 4063 5224 5853 5860
Materials Inventory (Imported) 538 749 825 741
Ratio (%) 7.55 (48) 6.97 (52) 7.09 (51) 7.91 (46)
Trend Almost Flat

Case of UEL:

- It appears that for UEL movement of both the total materials inventory turnover ratio and
imported materials turnover ratio are almost the same. The trend is flat at around 48 days.

- This is good considering the uncertainties in the imported materials market. It may be that
the company has been able to locate stable sources of supply of imported materials, which
it has to, because about 20% of its materials consumption is imported.

Work-In-Process Inventory Turnover Ratio:

Year 1994-95 1995-96 1996-97 1997-98
Cost of Production 24926 28776 34576 39832
Work-In-Process Inventory 2543 2972 4610 5484
Ratio (%) 9.80 (37) 9.68 (38) 7.50 (49) 7.26 (50)
Trend Down Ward

Note: Figures in the brackets indicate number of days holding.

This is also called Velocity of Work-In-Process inventory.


- While materials inventory is primarily market driven, work-in-process inventory is
dominantly technology driven.

- When an enterprise buys a technology, it essential buys a process of manufacture. All
manufacturing process are continuous, though apparently some of them may look
disjointed. WIP is therefore, central to the manufacturing system of an enterprise and it is
also here that the first dose of working capital (asset) is generated.

- Raw materials gain value as these are absorbed in the conversion cycle and this value
addition is done by wages and other non-material operating expenses engaged in the
cycle. When the value addition is complete the raw material is converted into an output.

- The conversion cycle may be few minutes, hour, days, months or even years. If we could
stop the line at any point of time, we would find values being held at different stages of
the process, which are yet to be converted fully into outputs.

- The aggregate of all these values what we call WIP is composed mainly of costs which
are proportional to the level of production, and hence the turnover of WIP or its Velocity
should be constant during a particular technology period.

Case of UEL:

- It appears that the velocity of work-in-process inventory (WIP turnover ratio) of UEL has
fallen (increase in number of days of holding WIP inventory).

- It should be recalled that in 1994-95 the company made considerable investment for
renewal of its plant and machinery.

- It may be that the company is yet to gain full control of its production parameters, which
has given rise to the higher than normal holding in WIP or that the new technology itself
demands higher holding.

- The latter is likely to be true because it appears that the WIP inventory is settling down at
around 50 days of holding as the ratio for the next two years is more or less constant. The
actual take-off with the new technology might have begun in 1995-96.

Bottlenecks in Production:

- For companies where this is not the case, a fall in this turnover ratio indicates that serious
bottlenecks have cropped up in the manufacturing process which is causing wastage of
materials and other operating resources.

- More serious than this is the loss of management control over manufacturing expenses,
resulting in a break down of their proportionality / variability with the volume of
production, i.e. more and more expenses are now becoming fixed in nature against falling
productivity.

- But in case of UEL this is not true because we have already seen that the materials
consumption ratio and the manufacturing labour ratio are more or less constant (even
though there is increase in materials consumption and labour in absolute amount),
indicating their variable nature it means company is not able encash the economies of
scale. Moreover, we will see in latter that this situation will be justified by the gross profit
ratio.

The product chart shows that the operator A, H and I should be questioned and operator C,
E,G,K and L should be rewarded.

Difficulty In Setting Up Standards

- Remember that there is some element of subjectivity in fixing up any standard of
performance. Although the technical standard of output of a machine can be divided from
the technical parameters of a machine, this is subject to the working facilities available in
a particular manufacturing organization, the work culture prevalent in the enterprise as a
whole, and also on negotiations with the unions.
- Above all, the maximum that standard should not be too high to be perceived by the
operators as unachievable or too low also. A mechanism must be developed by which
standard are made flexible, so as to accommodate any change in the performance variable
mentioned above, as well as made rigid, so as to undermine the competitive advantage of
the manufacturing function.

Case Of UEL :

- A look at performance control chart of the product section may suggest an upward
revision of the standard, ( Only if this is found to be the pattern for quite some time)
because, except for operators A, H and I, most low performers are within 5 per cent of the
standard and 50 per cent of the operators have either met or exceed the standard.
MANUFACTURING PRODUCTIVITY RATIOS

Manufacturing productivity itself is a ratio or the product of two ratios as will be revealed
from the following definition:

Manufacturing productivity is a finite measurement that encompasses the performance level
of operators of production machinery as well the utilization of that machinery.

The operational aspect of the above definition can be broken down into the following
objectives of the manufacturing management:

1. Machine operator(s) must meet established performance standards of machine output.
2. Plant management must see that the machine are being manned and operated with a
minimum amount of down time to ensure their maximum utilization.

For purpose of management control and monitoring, the first objective can be reduced to a
performance ratio while for the second objective an utilization ratio can be constructed. The
combination of these two ratio gives rise to productivity.

Nation Ratio :

- Is ratio measures the capacity utilization of the plant at the floor level.

- Terms of manufacturing management the term utilization can be expanded to in a
measure of the number of hours a machine is actually being operated spared to the
number of hours the machine is available for production.

Actual Man-Machine Hours
Nation Ratio = ---------------------------------------------
Available Man Machine Hours

- Intinue with the earlier example:

Number of operators are = 4 working at a time it means there are 4 machines.

No.of machines x Hours per shift x Shift per day x Day per work
(4) (8) (3) (7)

Machine crew size = Available Man-Machine Hours
(1) (672)

type for a week under investigation it has been found that all the four machines taken may
have worked for 610 man-machine hours.
610
Machine Utilization ratio = -------- = 0.908
672

Performance Ratio x Utilization Ratio = Productivity
0.970 (97%) x 0.908 (90.8 %) = 0.88 (88 %)

- It is observed that the 97 per cent performance ratio is reduced to a productivity of 88 per
cent due to a lower utilization ratio of 90.8 per cent. Any increase in productivity ratio
will have a corresponding effect on productivity.

- For example, if utilization ratio is increased by 5 per cent, i.e., if it were possible to work
30.6 man-machine hours more, then the productivity would also have increased from 88
to 93 per cent. The contrary will happen when the utilization ratio decreased by the same
percentage points.

- If productivity of the manufacturing function is failing, it is likely that the cause is a
failing utilization ratio, which not only pulls down the productivity but also leaves an
increasing amount of capacity costs ( fixed overheads) unabsorbed.

- However, utilization is also related to performance to a certain extent. For Example, if
performance is controlled ( improved), then downtime will be minimized simply
because production supervisors will now be correcting their production problems faster
than before.

- One should, however, remember that utilization is generally more affected by production
planning and control than by downtime. A low utilization ratio is indicative of
inefficient production planning and control, which may eat into the high performance
ratio of operators and thereby reduce the overall productivity of manufacturing function.
Downtime Ratio :

Nature Of Ratio :

- This ratio talks about the aspects of the manufacturing function that is value added and
non-value added functions.

- Downtime mainly consists of setup, machine adjustments, rework, materials arrival time,
repairs, tooling, training, etc. It is often found that all these downtime factors
(components) absorb approximately one-fourth to one-half of all direct labor hours
available.

This ratio attempts to relate time on production with the time on non-productionin the
following manner.

Direct Labour Hours On Downtime
Downtime : =-------------------------------------------------------------
Total Direct Labour Hours Worked In The Plant

Case Of UEL:

In one of the plant of UEL the year and analysis of direct labour hours reveals the following
figures:

Total direct labour hours worked : 8,556
Direct labour hours in production : 6,454
Direct labour hours on downtime : 2,102

The Downtime Ratio of the plant will be :2102/8556=0.25 (25%)

- It is preferable to take this ratio plant-wise to make inter-plant comparisons possible, and
monthly or quarterly to enable the plant management to take corrective steps in time.

- Alnog with the calculation of downtime ratio detailed analysis of the components of
downtime as mentioned earlier should be made, to locate the major reason for taking
timely actions.
Lead Time Ratio :

Nature Of The Ratio :

- Lead time is all the time spent in a plant or a product section. This is also called total
process time or through put time, which includes in-process time where actual input
conversion takes place and also idle time which includes the following:

1. Set up time.
2. Queue time( material waiting to be worked),
3. Delay time ( machine problems etc),
4. Wait time (finished operation waiting to be moved to be next operation) and
5. Transit time

Then lead time can be summarized in the following equation:

Lead Time = In-Process time + Idle time

- In-Process Time is Value Added time where as Idle Time Non-Value Added Time which
is often as high as 60 per cent of the total process or through time of a manufacturing
organization.

In-Process Time 9
Value Flow ratio :---------------------------------------------- = ------- = 37.5%
Total Process Time (lead time) 24

Idle time 15
Nan Value Flow ratio :-------------------------------------------- = ------- = 62.5%
Total Process Time (lead time) 24

Case Of UEL :

- It appears that the flow ratio of this product section is quite low.. Efforts are needed to
increase this ratio. Since In-Process Time is generally technology driven, it is very
difficult to improve upon the value flow ratio bt reducing this time.

- Thus, attention should be directed towards the non-value flow ratio, because any fall in
this ratio will automatically increase the value flow ratio, because any fall in this ratio
essentially means a reduction of total process time, which, in effect, implies a reduction
of Idle Time.

- The above tow ratios i.e Down Time and Lead Time ratio should be calculated on
component-wise also.
Cost Of Quality (COQ) Ratio :

- The COQ, a management accounting ratio, is now receiving increasing attention of
operational managers, as it has turned out to be one of the important variables of
operational control to enable firm to stay in the market competition.

Components Of Quality Costs :

1. Warranty Costs : Whenever this cost is incurred it indicates that the product
has failed to perform its intended functions The cost chain
progress with the customers complaint followed by
investigation of returned goods and ends with their sorting,
testing,etc.,

2. Scrap Costs : These cost are the result of systems failure internal to the
manufacturing function of the enterprise, whereby materials and
parts have become totally useless for the purpose for which these
have been brought. Besides materials and parts, scrap cost also
include labour spent and overhead unabsorbed.

3. Rework Costs : These costs are also due to internal systems failure and
include materials, labour, and overheads incurred when a defective
product is shorted, inspected, tested, and finally reworked, to recover
the parts of materials for further use.

4. Appraisal Costs :These costs also called monitoring or inspection costs and
include costs associated with inspecting the product to assure
compliance with the company or customer specifications for
materials, parts, and other brought-in components. Appraisal costs
also includes costs to inspect the manufacturing process and costs
associated with determining vendor quality.

5. Engineering Costs: These cost include costs related to the change design.

These are so many hidden quality costs which are not available in accounting record can be
calculated using Taguchis Quality Loss Function that uses a Quadratic Model.
Cost of quality
Cost Of Quality ( COQ) Ratio : ----------------------- x 2 *
Sales

- is factor for the hidden cost of quality ( cost loosing market share and other opportunity
costs)
- First of all the cost of quality with respect to the available mentioned above should be
calculated(cost of quality with respect to warranty, scrap, rework, etc) and then the total
of quality should be calculated.

+ The COQ ratio beyound 6 per cent is of great concern for the manufacturing
management because a company may not even an operating profit of 10 per cent on
sales.

Vendor Quality Ratio :


One of the major source of quality costs is a poor supplier base, both in terms of quality of
materials and timelines of delivery.

Number of lots accepted
Vendor Quality Ratio (%0 =-----------------------------------
Number of lots inspected.

FINANCIAL ACCOUNTING RATIOS

Sales Assets Turnover Ratio:

Components Of The Ratio :

- Trade debtors should not only include export receivable but also sellers bills and
suppliers bills discounted with the bank which is generally available in the annual report
under the head contingent liabilities which has not been proved for.

- Gross sales should include excise duties because debtors are raised not in net sales but in
full value. It is preferable to exclude scrap sales because sales of scrap is normally made
from the factory, marketing department is hardly called upon to make these sales.

- The primary asset of the marketing department is the finished goods inventory that it
receives from the manufacturing function and secondary assets are debtors, which arise
out of its own activities.
- Efficiency of the marketing function resets primarily upon how fast it is turning over
these assets, that is, what the velocity of sales assets is. Separately the individual velocity
of each of these assets will be discussed under working capital management ratios.
- This ratio is used to measure the performance of the marketing department.

Table 20 :

Year 1994-95 1995-96 1996-97 1997-98
Gross Sales 51037 61658 72091 78004
Trade Debtors+FGI 19515 22548 29442 33532
Ratio(%) (1/2) 2.62 2.73 2.45 2.33
Trend Downward

Case Of UEL :
- It appears that the trend of the velocity of sales assets in UEL is downward.
- If an enterprise is adding variety ti its product line, velocity of sales assets may fall owing
a broadening of its stocking base and larger credits granted for market presentation.
However, this should be for a short period only and ratio should stabilize soon.

However, in case of UEL it has not happened. It indicates that the company the company,
having perhaps been pushed out from a sellrs market into a buyers market is losing its
competitive advantage.

Table 21: Direct Marketing Expense Ratio :

- Like manufacturing , the marketing function receives finished goods as raw materials,
which it converts into sales through a marketing and sales process. The conversion cost
of the marketing function may be called as Direct Marketing Expense.

- Direct Marketing Expense includes salaries and allowances for marketing and sales
people, forwarding expense, sales commission, travelling, bad debts, and advertisements.

- It excludes unusual items such as large investments in big promotional/publicity
campaigns (which are generally amortized over a period as part of miscellaneous
expenditure) or bad debts, which are not trading nature, like Rs. 403 lakh written off by
the BFIR (see table 3.3)


- Direct marketing expense are semi-variable in nature. The ratio should, therefore, be
moving slowly downward as sales increase ( which is happening in case of UEL except
1995-96)

- This is because the marketing department is established with a particular sales capacity,
which is gradually realized ( or capacity or cost absorbed) over a period of time just like
the plant in the manufacturing department.

- In fact, manufacturing and marketing companies this synchronized that once a certain
realisable capacity of production (sales) is installed in the factory, a similar capacity
should also be build up in the marketing, so the factory, a similar capacity should also be
built up in the marketing department, so that when production picks up, the marketing
and sales function is ready to convert production into sales quickly.

- Unfortunately in large and medium companies this synchronization does not take place to
avoid unnecessary overheads when there are no sales. As a result, the marketing and
sales department gets stretched beyond capacity, causing a downturn in its efficiency.

- It is observed that capacity addition to the marketing and sales function is often a slower
process than capacity addition in the manufacturing function.

Table 22:
Year 1994-95 1995-96 1996-97 1997-98
Marketing Expenses 2798 3645 4101 4281
Sales 45748 55107 63794 69972
Ratio(%)(1/2) 6.12 6.61 6.43 6.12
Total (ignoring 1994095) Flat Downward

Case Of UEL :
- Kedentally , it appears from the movement of the direct expense ratio in UEL that both
the manufacturing and marketing dunctions of the company have received in tandem.
The rise of the ratio during 1995-96 indicates that the company moght have invested in
capacity expansion of the marketing and sales department --------- it increased its plant
capacity. The subsequent fall in the ratio indicates that it is analyzing this capacity.

Return Of Marketing Assets (ROMA)

- Like manufacturing the market function receives finished goods as raw materials,
which it converts into sales through a marketing and sales process. The conversion cost
of the marketing function may be called as Direct Marketing Expense.

- Then the total cost of marketing and sales department will, therefore, be cost of sales(
representing finished goods) plus direct marketing expense and contribution can be
calculated by deducting the total cost of marketing and sales from the net sales also.

Table 23 :

Year 1994-95 1995-96 1996-97 1997-98
A Net Sales 45748 55107 63794 69972
B Cost Of Sales 36551 43472 49894 54879
C Direct marketing expense 2798 3645 4104 4281
D Total cost in marketing and sales
department (B+C)
39349 47117 53998 59160
E Marketing contribution (A-D) 6399 7990 9796 10812
F Marketing contribution as % of
net sales
13.99 14.50 15.36 15.45

- Marketing assets comprises sales assets i.e. the finished goods inventory reeived from the
manufacturing function and debtors which arise out of its own activities plus other fixed
assets belonging to the marketing and sales department, namely, furniture, fixtures and
office equipment.

Table 24 :

Year 1994-95 1995-96 1996-97 1997-98
Sales Assets (A) 19515 22548 29442 33532
Furniture, Fixtures & Equipments(B) 320 454 568 615
Marketing Assets (A+B) 19835 23002 30010 34147

Table 25 :

Year 1994-95 1995-96 1996-97 1997-98
Marketing contribution 6399 7990 10812 33532
Marketing assets 19835 23002 30010 34147
Ratio (%) 32.74 34.74 32.64 31.66
Trend Downward

Case Of UEL:

+ The ROMA (Table 25) of UEL is showing a somewhat downward trend. This
is inspite of the fact that the direct marketing expense ratio (Table 22) has shown
consistent improvement since 1995-96; as is the case with marketing contribution as a
percentage of sales (Table 23).

+ However, it is seen that the turnover of sales assets (Table 20) is showing
downwars, as is the ROAM. While the contribution as a percentage of sales (Table 23) is
improving, the trend of the direct marketing expense ratio (Table 22) is good except
during 1995-96 for UEL.

+ Therefore, the major villain of the piece is the turnover of sales assets (Table
20). It means the marketing and sales function of UEL is doing well in terms of expenses
(Table 22) and margin on sales (Table 23) but failing to make good use of the sales
assets in terms of generating enough sales ( Table 20) which result in a fall of ROMA
(Table 25)
MARKETING AND SALES MANAGEMENT-
MANAGEMENT ACCOUNTING RATIOS.

Velocity Of Distribution Channel Ratio :


- This ratio tries to capture the existence of bottlenecks in the distribution channel of an
enterprise.

- There are normally three lock gates in a distribution channel through which products pass
to a customer. These are warehouse, wholesaler or distributor and retailer. If there is no
bottleneck in any of these lock gates then turnover of inventory at every stage will be the
same.

Sales(dispatch) at warehouse/
Wholesaler / Retailer
Velocity Of Distribution Channel Ratio :-------------------------------------------------
Stock warehouse/ Wholesaler/
Retailer

- This ratio should be calculated at least quarterly to locate the bottlenecks and take
corrective actions quickly.

Example :
Turnover Of Stock At Different Stages :

Stage Period-I Period-II Period-III Period-IV
(Target)
Turnover of stock at warehouse 15 29 14 24
Turnover of stock at wholesales 20 20 14 24
Turnover of stock at retailer 20 24 16 24

- It appears that all three stages of distribution channel are not synchronized.

- In period I there is a lower ratio at warehouse stage as compared to the wholesaler and
retailer stages, indicating over production, resulting from wrong demand projection,
giving rise to overstocking at the warehouse.

- In period II turnover of stock at both the warehouse and wholesaler / distributor stages
has matched but the retailer stage has picked up faster, depleting the stock at that end
without proper replenishment.

- Once a bottleneck is located along the distribution channel, further investigation is called
for to find out the reason for such a bottleneck.

- The cause may be external to the business. There may be other competitors trying to eat
into the market share of the business. There may be other competitor trying to eat into the
market share of the enterprise or cinsumer resistance is building up at the retail out lets.

- Both call for urgent steps to gear up the marketing function to arrest the progress of the
competitors and neutralize consumer resistance.

- It is desirable to calculate and monitor these ratios for every product. Market segment of
the company.

Average Age Of Debtors Ratio :

- For the purpose of control and monitoring of debtors, this is one of the most widely used
ratio.

Debtors at the end of the period
Average Age Of Debtors Ratio :------------------------------------------ x Number of
Credit Sales during the period. Days in the
Financial period.

- We can depict the movement of this ratio by taking data from a prduct segment of UEL
namely, the fan the year 1997-98.

Month End Credit Sales Debtors Average Age Of Debtors (Days)
February 700 500 20
March 500 350 22
April 400 370 28
May 600 520 27
June 900 780 26
July 1300 1130 27

- It appears that the average age of debtors has after March and remained almost constant at
around 27 days from April to July.

- As the product division is fan, it is expected that sales will pick up during the summer
season. Average age of debtors during a busy season may also rise, but only marginally

- In case of UELs fan division it has increased by about one week (7 days) which may not
be the marginal considering the fact that a weeks debtors on July sales block as much as
Rs. 350 lakh at an interest cost of approximately 18 percent annum.

- It may be that vigour of the sales people during the peak season was not quite matched
by the vigour of the collection staff.

- A rise in the average age of debtors indicates either a failure of the credit policy of the
firm or the collection department or the both.

Margin Variance Ratio :


- Margin is the market pronoum for discount allowed to dealers/ retailers on the price of
the products sold. The list price is equal to list price for the customers (selling price)
minus selling price for the dealers by the company. For example, the selling price for the
customers is R.120 and the selling price for the company is R.100 then the list price
margin for the dealers is Rs.20.

- However, due to various promotional practices like rewards, gifts, renting of self-space,
reimbursement of transport cost, and partial reimbursement of cost of sales staff, the
actual margin for the dealer may vary widely from the list price margin provided by the
company to the dealers.

Actual Margin (list price margin + other margin due to
Promotional practices).
Margin Variance = ------------------------------------------------------------------------------
List Price Margin.

- The ideal ratio should be close to one. But, at times, it rise when an enterprise makes a
deliberate attempt to penetrate into a market or to increase its existing market share
substantially by a large promotional campaign.

- However, in a competitive economy, it is likely that competitors will suit quickly, as a
result of which the industry as a whole will suffer. The market force will equalize the
ratio for all players, through at a higher level, It would be difficult then to bring the ratio
down close to one because the dealers expectation may have increased by then.

Replacement Sales ratio :

- This ratio is calculated primarily for consumer durables that enjoy a replacement
advantage after the lapse of a certain period of time, which may not be very long, as in
case of industrial machinery and equipments.

- Suppose of example, when a refrigerator is sold by a firm for the first time, it expects that
the refrigerator will be replaced by the customer in the sixth year. If the customer does
replace the refrigerator from the same firm in designated replacement year, then total
sales of that year will comprise new sales for that year plus replacement sales.

- When sales of an enterprise are growing at a particular rate and replacement sales are
being captured by the firm duly, then in the first replacement year the rate of sales
growth is expected to shoot up, following which the firm will experience a new but
higher rate of sales growth.

Sales of the replacement year
Replacement Ratio :----------------------------------------------
Replacement sales.

- Suppose Godrej has sold refrigerator worth Rs.2 crore during 1990 which are expected to
generate replacement sales after 6
th
year i.e. 1996. Suppose during 1996 the replacement
sales is Rs. 1.5 crore and the new sales is Rs. 3 crore.

Rs.4.5 crore(Rs. 3 crore + Rs. 1.5 crore).
Then the Replacement Ratio : --------------------------------------------------------
Rs. 1.5 crore.

- For a growing company this ratio should be reasonably above one.

- If it is equal to or less than 1 then the company may not be getting all its replacement
sales.

- A downward movement of this ratio is a sure indication that the company is losing out to
competition may be because there has not been any product development since the
product was first caunched or no attempt was made to certain customer goodwill by
proper after sales service and maintenance publicity.

CORPORATE RATIO FOR
OPERATIONAL MANAGEMENT :

- After discussing ratios for two functional division of the operating management of an
enterprise, now we will look into certain special ratios in order to enable the corporate
management to take a total view of the operating management of the business.

Fixed Assets Turnover Ratio :

- This ratio is also named as velocity of the fixed assets. Deviation and movement of this
ratio for UEL are given, both before and after revaluation of fixed assets.

Components Of Fixed Assets :

- Operating fixed assets excludes capital work-in-progress as these are yet to enter into
production.

- Depreciated value of fixed assets(net block) are taken because sales(production)
generation capacity of fixed assets fall as they age, and hence net sales of a given year can
be compared only with the present state of the fixed assets of the company.

Revaluation Of Fixed Assets :

- While discussing the plant utilization ratio, the revalued fixed assets should not be
considered because the revaluation of fixed assets is merely a book adjustment. There is
neither ant cash inflow nor any fresh addition to existing capacity. Hence, real velocity of
fixed assets would remain unaffected by any revaluation while calculating the turnover
ratio of fixed assets, in order to understand correctly how efficiently the fixed assets of
the firm are being utilized.
- However, there is one strong argument is favour of calculating this ratio on revalued
assets. It enables the analyst to understand the sales capacity of assets at their current
value and compare it with that of the new entrants in the market, who would have brought
these assets at current prices. That is why Fixed Assets Turnover ratio has been calculated
both after revaluation and before revaluation.
- When fixed assets are revalued, the fixed assets turnover ratio will obviously fall, as is
evident from the calculation of this ratio before and after revaluation, but trend of the
ratio will not normally be affected.

Table 26

Year 1994-95 1995-96 1996-97 1997-98
Net Sales 45748 55107 63794 69972
Operating fixed assets (before
revaluation)
5286 8143 8822 9398
Ratio (%) 8.65 6.77 7.23 7.45
Trend (ignoring 1994-95) Upward

Table 27

Year 1994-95 1995-96 1996-97 1997-98
Net Sales 45748 55107 63794 69972
Operating fixed assets (after
revaluation)
8067 10863 11482 12003
Ratio (%) 5.67 5.07 5.56 5.83
Trend (ignoring 1994-95) Upward


- Of this ratio is failing, one can immediately draw the conclusion that its commercial
viability is being eroded i.e. commercial profitability (ROS). The reason may be both
internal and external.
- Internally, the technical capacity of the assets might have fallen due to age of there may
be production bottlenecks due to faulty line balancing r there are labour problems which
remain unresolved or it may simply be a failure of the marketing function or time taken
by the fixed assets to be fully exploited ir huge amount of investments in supportive fixed
like SAP, canteen, etc,.
- Externally, the company may be losing its competition due to both technological and
product obsolescence or there may be general recession in the economy and company
could not foresee and plan well in advance in order to diversify into different product line.
- It is often argued that the interpretation of this ratio may get contaminated during a period
of inflationary price rise, in the sense that it may hide an actual fall in sales. The best way
to overcome this problem is to take sales by quantity rather than by value. However, for a
company manufacturing multiple product in various sizes and dimensions, calculating
this ratio become difficult also but however, the other option is to make an inflationary
adjustment to sales by a chosen index.
- But for the inter firm comparison, it is not necessary to make any such adjustment
because inflationary price rise will be common to all the firms in given industry.

Case Of UEL :

- In the case of UEL the ratio trend is upward since 1995-96 but it is yet to reach the level
of the ratio during 1994-95 (Table 26). This is because the substantial investment in
fixed assets made in 1995-96 is yet to fully exploited.
- Normally, for a manufacturing organization with high capital intensive , a fixed assets
turnover beyond 5 (before revaluation) is considered to good. UELs ratio is much more
that that. However, remember at the same time, that about 25 per cent of its net sales are
derived not from its manufacturing operation but from trading activity, which demands
much lower outlays of fixed assets. Hence, trading components of the total turnover
should be excluded while calculating this ratio.
Total Assets Turnover Ratio :

- It is also called velocity of total assets For UEL this is calculated both before and after
revaluation of fixed assets.

Components Of Operating Assets :

- Total operating assets should exclude investments, capital work-in-progress and any other
asssets which do not contribute to generation of sales.
- Now the question arises as to the treatment of amortized expenditure clubbed together
under the head miscellaneous expenditure such as prelimnary expense, share issue
expenses, patent, copyrights, technical know-how, expenditure on large advertisement,
goodwill etc. For UEL we have ignored miscellaneous expenditure altogether from the
calculation of operating assets because it comprises mainly of expenses items.

Operating Assets Of UEL

Table 28

Year 1994-95 1995-96 1996-97 1997-98
Fixed Assets (excluding capital WIP) 8067 10863 11482 12003
Operating current assets 28389 32805 42330 48993
Total 36456 43668 53812 60996
Other Non-Current But Operating
Asset

Security Deposits. 70 190 250 300
Staff Loans And Advances. 404 655 739 812
Technical Know-How. 251 252 607 588
Total Operating Assets (after
revaluation)
37181 44765 55408 62696
Less: revaluation Reserves 2781 2720 2660 2605
TotalOperating Assets(before
revaluation)

Xerox : Table 4.1, analusis of Current Assets and Current Liabilities of UEL., Page
No.156 for the Operating Current Assets.

- When a firm experiencing an upward trend in the velocity of operating fixed assets but
downward trend in the velocity of the total operating assets, a reasonable conclusion
would be the while the firm is gaining in its manufacturing strength it is losing in the area
of both marketing and working capital management.
- The situation, however, is better that what would have been had the country been true
because, as we have mentioned earlier, it is difficult to arrest the downfall of a firm if it
is losing on its manufacturing viability.

Case Of UEL:

- The turnover ratio of the total operating assets in UEL is not only low but it is falling too
while the fixed assets turnover ration is rising.
- This means that the current assets of the company are not being turned over as fast as
fixed assets. Current assets comprise more than 75 per cent of the total operating assets
of UEL.
- The largest items in the current assets constitutes debtors which is more than 60 per cent
of total current assets and about 50 per cent of toal operating assets. The major cause is
therefore debtors, which turnover ratio must be falling, as we will see later.
Operating Profit Margin Ratio :

Table 29

Year 1994-95 1995-96 1996-97 1997-98
Operating Profit (PBIT) 3542 4641 5418 5320
Net Sales 45748 55107 63794 69972
Ratio (%) 7.74 8.42 8.49 7.60
Trend Flat

Nature And Components of Operating Profit Ratio And Operating Profits :

- Operating profit is the profit before interest and taxes. It is argued that as the operating
managers are not responsible for financing the business, they cannot be burdened with
interest cost especially interest cost of long-term finance where operating managers are
not involved but not for working capital loans which interest cost depends on operating
function only.
- Hence operating profit margin ratio which measures the performance of the operating
function, should ignored the interest cost of long-term finance and taxes which are not
within the control of the operating managers. Some times the depreciation should not be
deducted while calculating operating profit especially while company-wise comparison is
made as different companies follow different depreciation is made as different companies
follow different depreciation methods and rates also.

Case Of UEL:

- In case of UEL this ratio trend is flat through it has fallen during 1997-98. As sales and
operating profit are highly related, the normal tendency of this ratio is to remain constant
over a given technology period, through with the increase in sales some small
improvement may be noticed as fixed costs get distributed over large volumes.
- The reason behind fall in this ratio in case of UEL during 1997-98 can be ascribed to
general rise in cost, as various expense ratios described earlier have revealed, and also in
general and administration expenses, as we shall see later.
General And Administration Expenses Ratio :

- General and administration expense being semi-variable in nature should register a
downward trend with rise in sales, because the fixed component of this cost group gets
spread over a large amount of sales.
- If this trend is upward at a time when sales are also rising, an obvious conclusion is that
the semi-variable character of this expense group is lost, at least during the period under
investigation.
- This loss may be either because the variable components expense group have lost their
proportionality and are rising more than proportionality with sales ot the fixed
components have lost or both also.

Table 30

Year 1994-95 1995-96 1996-97 1997-98
General and Administration Expense 3341 4052 5164 6198
Net Sales 45748 55107 63794 69972
Ratio (%) 7.30 7.35 8.09 8.86
Trend Upward

Case Of UEL :

- This ratio has begun to rise since 1994-95 when there was considerable addition/renewal
of capacity. The administrative structure of the company may have had to be expanded
to cope with the expansion is sales, resulting in disproportionate rise in administration
expense.
- It is expected that the situation soon be brought under control when the expense would
reach a stable state, through at a higher level then before. This ratio would start falling
slowly as the sales increase.
- If the trend continues to be upward even after a reasonable period of time, then serious
attention has to be given to the administrative structure of the business, which might have
become heavy and hence, is doing an injustice to the operating function of the business
by eating into its operating profit.
Value Coverage Ratio :

Table 31 value Addition In UEL (Rs. In Lakhs)

Year 1994-95 1995-96 1996-97 1997-98
Net Sales 45748 55107 63794 69972
Inventory Adjustment: 45748 55107 63794 69972
WIP 31 429 1638 874
Finished Goods (388) 356 779 136
Value Of Production (A) 45391 55892 66211 70982
Raw Materials. 19059 21631 27700 31373
Stores, Spares and Consumables 471 516 787 848
Power and Fuel 329 559 479 640
Purchase Of Finished Goods 11237 15046 46097 15183
All Materials (B) 31096 37752 45063 48044
Value Added (A-B) 14295 18140 21148 22938

Value Coverage Ratio:

Table 32

Year 1994-95 1995-96 1996-97 1997-98
Consumption of all Materials (B) 31096 37752 45063 48044
Value Added (A-B) 14295 18140 21148 22938
Ratio (%) 2.18 2.08 2.13 2.09
Trend Flat

Definition Of Value Added :

- The Bureau of Public Enterprises of India in its Annual Report on Public Sector
Companies defines value added as value of production less cost of direct materials
consumed.
- Direct material includes all converter inputs like stores, spares, power, fuel, and water.
- Value of production is further defines as sales and services rendered plus/minus accretion
in the value of WIP and finished goods. Value added is the ultimate source of profit.

- Value coverage ratio indicates the extent of value added coverage of materials. It is
measure of the net output of a firm in relation to the alue of the throughput which it
process.
- Lower the ratio greater the net output produced in relation to the throughput. If this ratio
is less than it may be concluded that the
Conversion process done by the firm in its material is of high degree or product is not
material intensive or
Technological progress at the operational level like automated production process and
value engineering directed towards reducing wastage and economising on the cost of
materials of a product by locating alternative materials.

- All these call for large investment in plant and machinery. Generally, a low intensive of
labour and material demands high intensity of capital. These tow inversely related.
- However, the low intensity of labour in advanced technological conditions means high
value addition per unit of labour employed.
- The value coverage ratio implicitly captures the technological environment of an
enterprise. Lower the ratio higher is the capital intensity.
- A downward trend in the value coverage ratio suggest an increasing level of value
addition by economising on cost and use of materials and maximizing the value of labour
with the modern instruments of production
- On the other hand, and upward trend of the ratio suggests wastage or uneconomic use of
materials, less skilled workforce, and technological obsolescence.

Case Of UEL:

- The trend in the value coverage ratio of UEL is, however, flat-indicating virtually a
status quo in technology. This might have emanated from a deliberate policy decision
of the management not to go for in for a high capital intensive productive system for high
value added products.
- Being an old organization it gradually acquired a large workforce which it does not want
to replace now by capital intensive technology.
- The investment in plant and machinery made during 1994-95 might have gone largely
towards labour intensive technology and hence, there could nor be any improvement in
the coverage ratio of the company.
Return On Investment (ROI) This ratio is also called Return On Assets (ROA)

Table 33

Year 1994-95 1995-96 1996-97 1997-98
Total Operating Assets(before
revaluation)
34400 42045 52748 60091
Ratio (%) 10.30 11.04 10.27 8.85
Trend Down Ward +

Table 34

Year 1994-95 1995-96 1996-97 1997-98
Total Operating Assets(after
revaluation)
37181 44765 55408 2696
Ratio (%) 9.53 10.37 9.78 8.49
Trend Down Ward +

Nature And Components Of The Ratio:

- This is the most comprehensive ratio for operating management, as it translates the
financial objective of a firm into such terms as selling prices, profit margins, sales
turnover, production costs, and capital equipments.
- In thus integrates the major functional sub-systems to the overall objectives of the
enterprise. This ratio captures two important ratio such as Total Assets Turnover
(Velocity of functional groups of assets) and Operating Profit Margin Ratio (expense
group).

Sales Operating Profit Operating Profit
------------------ x ---------------------------- = --------------------------- = ROI (ROA)
Total Assets Sales Total Assets

Case Of UEL:

- Comparative analysis of the ratios (Table-33 & 34) reveals that the ROI is falling which
is primarily due to worsening of expense group ratios; turnover of total assets has
worsened only marginally.
- The manufacturing function has done a somewhat better job in generating sales
(production) indicated by an improvement in fixed assets turnover of total assets has
worsened only marginally.
- The manufacturing function has done a somewhat better job generating sales (production)
indicated by an improvement in fixed assets turnover ratio, but this improvement has been
eaten up by the marketing and finance function (working capital management) whose
turnover ratios have fallen.
How to Improve ROI:

- Though in the case of UEL operating profit ratio can be improved to some extent by
making concerted efforts towards reduction of expenses, it is generally not possible to
make much improvement in this ratio because of high correlation between the two
variables that make this ratio. The ratio will be more or less constant during a given
technology period. We have already seen earlier that the trend of this ratio in UEL is flat.

- Therefore the attention of the management should be given more towards the total assets
turnover ratio whose numerator and denominator are not so related with each other; there
is a scope for manipulation of either of these tow variables without affecting the other.

- The total assets turnover can be improved by increasing capacity utilization of say, fixed
assets, but the same improvement can be achieved.
by pruning down the asset base of the firm by say, discarding slow or non-moving
current assets,
by squeezing flabby inventories, and
by increasing realization of debtors.

Precaution Of analyzing ROI:

- Revaluation of fixed assets i.e. market value of fixed assets should be considered
otherwise asset base is understand because of inflation whereas profit is will be overstated
as it is presented at market price.

- At the same time the total assets are contaminated because of inventory valuation that is
when it is valued on the basis of especially LIFO method.

WORKING CAPITAL MANAGEMENT RATIOS

- Once a firm has installed plant and machinery, it requires working capital fund current
assets generated by the operating functions of the business. The manufacturing function
generates raw materials inventory and work-in-progress inventory, while the marketing
and sales function holds finished goods inventory and generates debtors. Other current
assets like cash, advance payments, and prepaid expenses are hold for the operating
function.

Nature Of Current Assets:

- Current assets are a burden on the business. These exist because of imperfections in the
manufacturing system and markets for materials and finished products. If the
manufacturing system could be properly synchronized with the market at both ends, then
a company would be able to operate virtually on the basis of a stockless production i.e. at
JIT level.
- If the product market has always been a cash market, then the enterprise would not
require funds for holding debtors. Every up of current assets along his productive
distribute chain.
- Every piece of current asset demands funds. Providing for funds has got a cost. Therefore,
objective of working capital management is to reduce current assets to their minimum
level that is to maximize the velocity of current assets.
STRATEGY OF WORKING CAPITAL MANAGEMENT

- If current assets are to exist as necessary evils, the objective of a funding operation will
be least- cost financing, with minimum risk to the business.
- Major source of working capital finance are supply creditors, advance payments from
customers, overdrafts from banks and finance institutions, and net worth.
- Supply creditors and customers credits are the least costly almost free of cost-among all
sources of working capital finance but, they are also risk prone. Default in paying a
creditors has an adverse effect on the credit worthiness and standing of the firm, as it
sends nervous signals to other creditors, who suddenly descend upon the firm demands all
payments and stopping all supplies.
- As all firm can pay up all its creditors at one time, except by selling off its assets, the
consequences of a default in payment may be as disastrous assets the winding up of the
business altogether. In order to safeguard against this eventualities, the concept of net
working capital management has been evolved.
- Net Working Capital is the positive difference between current assets and current
liabilities. As it comes from long-term sources (net worth + termloans), it provides a
stable cushion against the occasional maturity gap between current assets and current
liabilities.
Replacement Sales Ratio:

- This ratio is calculated primarily for consumer durables that enjoy a replacement
advantage after the lapse of a certain period of time, which may not be very long, as in
case of individual machinery and equipments.
- Suppose for example, when a refrigerator is sold by a firm for the first time, it expects
that the refrigerator will be replaced by the customer in the sixth year. If the customer
does replace the refrigerator from the same firm in designated replacement year, then total
sales of that year will comprise new sales for that year plus replacement sales.
- When sales of an enterprise are growing at a particular rate and replacement sales are
being captured by the firm duly, then in the first replacement year the rate of sales growth
is expected to shoot up, following which the firm will experience a new but higher rate of
sales growth.

Sales of the replacement year.
Replacement Ratio : -------------------------------------------
Replacement sales.

- Suppose Godrej has sold refrigerator worth Rs 2 crore during 1990 which are
expected to generate replacement sales after 6
th
year i.e. 1996. Suppose during 1996
the replacement sales is Rs. 1.5 crore and the new sales is Rs.3crore.

Rs. 4.5 crore ( Rs. 3crore +Rs. 1.5 crore)
Then the Replacement Ratio = ---------------------------------------------------------
Rs. 1.5 crore.

- For a growing company this ratio should be reasonably above one.
- If it is equal to or less than 1 then the company may not be getting all its replacement
sales.
- A downward movement of this ratio is a sure indication that the company is losing out
to competition, may be because there has not been any product development since the
product was first launched to no attempt was made to retain customer goodwill by
proper after sales service and maintenance publicity.

Debtors Turnover Ratio :

Components of the Ratio :

Gross sales are inclusive of duty and scrap sales, as both of them have entered into debtors by
way of credit sales. Trade debtors should include bills discounting also.

Increasing volume of debtors without a matching increase in sales, reflected by a fall in
debtors turnover ratio is an indication of the slowing down of the collection machinery or an
extended line of credit allowed or forced upon the enterprise.

This may be due to several reasons

BASIC CONCEPT OF WORKING CAPITAL

Meaning and Significance Of Working Capital

The requirement of finance for a company arises mainly out of two factors :
acquisition of fixed assets and provision for working funds or working capital ( also called
circulating capital )
The fixed assets are meant for use in the business to earn profit through recurring production
and sales. The working funds are necessary, on the other hand, to meet the day-to-day
revenue expenses, like raw material purchase, wage payment, meeting overhead expenses,
etc. Working capital actually keeps the business going since physical assets like plant and
machinery cannot effect any production or generate any sales unless these are adequately and
regularly fed with materials and varied services. The finance required to buy such materials
and pay for such services is really the working capital.

The significance of working capital lies in the fact that it enables an industrial unit to convert
into actuality the potential of its fixed assets in terms of level of production and sales.
Without working capital, fixed assets cannot be activated or made to generate business
activities. Thus there should be an optimum level of working capital and anything higher or
lower than this would either mean loss of resources or loss of opportunities because of
unexploited potential of the fixed assets.

From the accounting point of view, working capital is the money locked up in inventory,
debtors and other current assets minus others money locked up with the business in the form
of sundry creditors, bills payable, etc. By definition, working capital is current assets minus
current liabilities.

Gross Versus Net Working Capital

Gross Working Capital = Total Current Assets
Net Working Capital = Total Current Assets - Total Current Liabilities

Fixed Versus Variable Working Capital

The hard core element in working capital commensurate with the broad activity range within
which the business operates is known as fixed working capital. On the contrary, changes in
working capital position resulting from changes in actual activity from time to time is called
as variable working capital.

Chief Determinants Of Quantum Of Working Capital :

1. Some of the factors which generally affect the quantum and composition of working
capital required by a business unit are as follows.
2. Technology - capital intensity, balancing of productive equipments, etc.
3. Size or scale - availability of economies of scale.
4. Marketing conditions - credit conditions, demand pattern including seasonality, etc.
5. Broad socio-economic condition.
6. Management attitude towards risk taking. This affects the quantum of inventory to be
held.
7. Optimal relationship between the sequence of production and sales.
8. External constraints - import restrictions, credit squeeze, money market, etc.

Working Capital Requirement Forecasting :

The methods of forecasting working capital range from the crudest to the sophisticated. The
crude methods of forecasting working capital requirement comprise mainly of establishing
some broad percentage relationship between working capital and various parameters that
would influence it. Some such bases commonly adopted are as follows:

1. Working capital as percentage of sales - This is simple and most commonly used. It can
give some broad indication only if selling price is fixed and cost structure is stable.

2. Working capital as percentage of cost of production - This is ordinarily a good method
particularly when the cost relationship, if not the amount, remains unchanged.

3. Working capital as percentage of cost of sales - The results may not be reliable because of
the inclusion in cost of sales of selling and distribution costs which, besides including
some policy costs, might vary widely and abruptly.

4. Working capital as percentage of marginal cost of sales - This is perhaps the best among
all these short-cut methods. Its strength lies in the fact that marginal cost, comprising only
the variable elements in all costs, seldom changes except over a relatively long period and
under extraordinary situations.

Refined Approach For Working Capital Forecasting :

For a manufacturing-cum-marketing organisation the following factors should be considered:

i. How many weeks / months raw materials should on an average be kept in stores, always
ready to be used in production.
ii. How many weeks / months sales requirement of work-in-progress should be kept on an
average in stores.
iii. How many weeks / months sales requirement of finished goods should be kept on an
average in stores.
iv. The average credit period to be allowed to debtors or customers.
v. The average credit period expected from suppliers.
vi. The average production time.

FACTORS INFLUENCING WORKING CAPITAL

1. Nature Of Business
2. Nature Of Raw Material Used
3. Process Technology Used
4. Nature Of Finished Goods ( Composite Order )
5. Seasonality Of Operations
6. Degree Of Competition
7. Paying Habits Of Customers
8. Synchronization Of Cash Inflows And Outflows

WORKING CAPITAL POLICY

1. CONSERVATIVE AGGRESSIVE

2. FOCUS ON LIQUIDITY FOCUS ON PROFITABILITY

3. LOW TURNOVER OF CURRENT HIGH TURNOVER OF CURRENT ASSETS
ASSETS

4. LOWER RISK HIGHER RISK

5. LONG TERM PATTERN OF FINANCING THROUGH BANK
FINANCING BORROWINGS

6. COST OF FINANCING HIGH COST OF FINANCING LOW

7. LOW RISK OF TECHNICAL HIGH RISK OF TECHNICAL
INSOLVENCY INSOLVENCY

Duration of the Operating Cycle (O) = Duration of Raw Material Stage (R) +
Duration of the Work-In-Progress Stage (W) + Duration of the Finished Goods Stage
(F) + Duration of the Accounts Receivable Stage (D) Duration of the Accounts
Payable Stage (C).

O = R + W + F + D C

R = Average Stock of RM and Stores / Average Daily Consumption of RM & Stores.

W = Average Stock of WIP Inventory / Average Daily Cost of Production

F = Average Daily FG Inventory / Average Cost of Goods Sold.

D = Average Receivables / Average Daily Credit Sales.

C = Average Creditors / Average Daily Credit Purchases.

WEIGHTED OPERATING CYCLE :

Shows differential magnitudes of investment at different stages of Operating Cycle.

Weighted Operating Cycle ( WO) = R * W
rm
+ W W
wip
+ F W
fg
+ D W
ar
C W
ap

W
rm
= RM and Store Cost Per Unit / Sales Price Per Unit.
W
wip
= RM and Stores Cost Per Unit + 0.5 Process Cost Per Unit (Mfg. OH) / Sales Price
Per Unit.
W
fg
= Cost of Goods Sold Per Unit / Sales Price Per Unit.
W
ar
= Sales price Per Unit / Sales Price Per Unit. ( One )
W
ap
= RM and Stores Cost Per Unit/ Sales Price Per Unit.

APPLICATION OF WEIGHTED OPERATING CYCLE :

It can be used for calculating the working capital requirement :

Working Capital Requirement = Sales Per Day * Weighted Operating Cycle + Cash Balance
Requirement.

WORKING CAPITAL LEVERAGE :

Working Capital Leverage reflects the sensitivity of return on investment to changes in the
level of current assets.

WCL = Percentage Change in ROI / Percentage Change in CA
Percentage Change in ROI ( A ROI ) = A ROI / ROI
Let us consider the case where current assets reduce by ACA without in any way impairing
the earning capacity of the company. The percentage increase in ROI in this case is equal to :
|EBIT / (TA- A CA)| - EBIT / TA
= -----------------------------------------------------
EBIT / TA
= ACA / (TA-ACA)

The percentage decrease in current asset is equal to = ACA / CA

Hence WCL = | ACA / (TA-ACA) | / | ACA / CA |
= | ACA / (TA-ACA) | * ( CA / ACA )
= CA / (TA - ACA)

BOX Ltd. COX Ltd.
Current Asset (CA)
(Rs. In Mill.)
150 50
Net Fixed Assets (FA)
(Rs. In Mill.)
50 150
Total Assets (TA)
(Rs. In Mill.)
200 200
EBIT
(Rs. In Mill.)
30 30
ROI ( % )

15 15
WCL for 20% reduction
in CA
.88 .26

Looking at the WCL values it is evident that the sensitivity of ROI to changes in the
level of CA is far greater for BOX Ltd. than COX Ltd.

DEFINITION OF CREDIT MANAGEMENT

RECOVERIES

POOR RECOVERIES LEADS TO :

1. Difficult To Meet Statutory Requirement.

2. Unable To Provide Funds In Time To Purchase Dept

- Force to Purchase some mat. on credit at a higher cost.
- Unable to pay suppliers in time No reliability
- Overdue interest
- Purchase dept. is not able to bring the materials in time.
- Execution of order in time is possible.

3. Interest On Blocked Inventory Waiting For Rest But Not Possible Due To Shortage Of
Funds.

4. When Purchase Is Affected , It Is Difficult To Know Whether Machines Capacity Is
Fully Utilised Or Not ? The Machine Man May Not Have Adequate Work I.E. Idle.

5. Delays In Deliveries To Customers
Dissatisfied Custmers
6. Additional Cost Of Financing
7. Lower Profits
8. Cash Flow Problems
9. Late Payments To Suppliers Higher Prices No Reliability
10. Production Bottlenecks

BETTER RECOVERIES LEADS TO :

1. Better Cash Flow
2. Improved Liquidity Batter Bargaining Power With the Suppliers
3. Production Can Meet Your Demands
4. Reduced Interest Costs
5. Better Profits

WHAT ARE YOU DOING TO IMPROVE IT ?

1. Better Monitoring & Follow Up
2. Good Information System About Customers.
3. Get Better Terms .
4. Be Selective In Extending Credit.
5. Accept Orders Where Recoveries Will Be Faster
6. Anticipate Problems

RESPONSIVENESS TO CUSTOMERS :

1. Importance Of Customer Retention
2. Cost Of Getting A New Customer Is 5 To 6 Times The Cost Of Retaining An Existing
Customer

WHAT ARE YOU DOING TO IMPROVE CUSTOMER RETAINTION ?

- Improved Communication
- How Do You Rate Your Communication With The Customers ?
- Do You Keep Your Customers Properly Informed ?
- Do You Answer Their Queries Promptly And Satisfactorily ?
- If You Have A Genuine Problem , It Is Better To Inform Them Rather Than Trying To
Avoide Talking To Them.

PROJECTION OF REQUIREMENTS:

- Need For More Systematic Information Gathering And Objectivity In Giving Feedback
To Manufacturing And Projecting Requirements
- Proper Study Should Be Conducted Before Drawing Conclusion
- Should Not Resort To Generalisation Based On One Or Two Cases

WRONG PROJECTION OF REQUIREMENTS:

1. Unnecessary Investments
2. Non-Moving Inventories
3. Delay In Introduction Of Products
4. Higher Costs Leading To Higher Prices Or Lower Salaries

- PRACTICE OF ORDERING WHAT IS NOT AVAILABLE AND CALCELING THE
REQUIREMENTS WHEN THESE ARE AVAILABLE

- STRONG BELIEF AT PRODUCTION CENTRES - MARKETING WANTS WHAT IS NOT
AVAILABLE FAST - IF NOT GIVEN A BIG NOISE IS MADE WHEN MADE AVAILABLE NOT
WANTED - NO DEMAND

WHAT IS YOUR CONTRIBUTION TO CREATING AND IMPROVING PROFITS ?

1. Reaching Turnover Targets
2. Better Utilisation Of Assets
3. Remunerative Price
4. Collection On Time
5. Negotiation Of Better Terms
6. Collection Of Advances
7. Avoid Penalties & Ld
8. Avoid Bad Debt Losses By Control On Extending Credit
9. Maintain Optimum Stock Levels
10. Control Overhead Expenditure Within Your Reach
11. Improve Productivity
12. Improve Quality Of Orders
13. Focus On Profit

ENHANCE YOUR CAPABILITY TO CONTRIBUTE TOWARDS THIS AND CREATE CONDITIONS
TO GENERATE BEST PROFITS FOR THE COMPANY

PURPOSE OF RECEIVABLES

1. Increasing Sales
2. Increasing Profits With Increased Sales Volume. Higher Margin Of Profit On Credit
Sales.
3. Increasing Competition Compels To Offer Better Credit Facilities Than Offered By
Competitors.
COST OF MAINTAINING RECEIVABLES

1. Additional Fund Requirement Due To Blocking Of Funds.
2. Administrative Costs
3. Collection Costs
4. Defaulting Costs ( Increased Collection Effort / Bad Debts )
5. Size Of Receivables Or Investment In Receivables

CREDIT POLICY

1. IS A TRADE-OFF BETWEEN ADDITIONAL PROFITS AND COSTS
2. INFLUENCED BY INDUSTRY PRACTICE

ESTABLISH OPTIMUM CREDIT POLICY:

1. CREDIT STANDARDS
2. CREDIT TERMS

1. CREDIT STANDARDS

- Stiff Standards May Result In Lower Sales, Lower Receivables, Little Bad Debts And
Less Collection Expenses. Liberal Standards Work In The Other Way.

- Look At Credit Rating By Professional Agencies.
- Rating Customers Into Various Categories Ranging From High, Good, Fair, Limited, Etc.

- Compare Incremental Benefits Of A Liberalised Policy And Associated Incremental
Costs. Decide For A Liberal Policy When Net Incremental Benefit Are Positive. And
Decide Against When Nib Is Negative.

ASSUMPTIONS:

1. The Company Can Meet The Increase In Sales Demand Without Incurring Additional
Fixed Costs.

Existing Customers Will Not Alter Their Paying Habit Even After Liberalisation Of Credit
Policy.

- SETTING CREDIT STANDARD
AP = AS ( 1V ) k AI bn AS
Where AP = change in profit
AS = increase in sales
V = ratio of variable costs to sales
k = cost of capital
AI = increase in receivables investment
| AS / 365 * ACP * ( V ) |
bn = bad debt loss ratio on new sales

Example : The impact of credit relaxation on gross profit.

1 The Company PCs net sales for the year 1997-987 = Rs.100 lakhs.
2 Company has classified its customer into four categories such as A, B, C and D on the
basis of the their credit ratings.
3 At present PC extends unlimited credit to the A and B category customers, limited to the
C category customers and no credit to the D category customers. As a result company is
foregoing sales to the extent of Rs.10 lakhs to the customers in the category of C and
Rs.10 lakhs to the customer in the category of D.
4 Company want to adopt a liberal credit policy under which customers in the category C
would be extended unlimited credit and customers in the category of D would be
extended limited credit.
5 Such relaxation would increase the sales by Rs.15 lakhs on which bad debt loss would be
10 percent.
6 The contribution margin ratio(1-V) for the firm is 15 percent,
7 The average collection period is 40 days and the cost of capital (K) is 10 percent.

Find out the effect of relaxing the credit policy on gross profit ?

AP = AS ( 1V ) k AI bn AS

= |15,00,000 (0.15) | | 0.10 (15,00,000 * 40 / 365) 0.85 | - | 0.10 ( 15,00,000 ) |
= Rs.60,833
Since the impact of change in credit standards on gross profit is positive, the proposed
change is desirable.

SELECTING CREDIT PERIOD ( Not more than 60 % of APP)

AP = AS ( 1 V ) k AI bnAS
AI ( Increase in investment in receivable ) =
( ACPn ACPo )(So / 360 ) + V ( ACPn ) AS / 360
ACPn = New Average Collection Period ( after lengthening the credit period )
ACPo = Old Average Collection Period
V = Vatio of Variable Cost to Sales
AS = Increase in Sales
Example :
1. Zenith Corporation currently provides 30 days of credit to its customers. Its present level
of sales is Rs.50 lakhs.
2. Cost of capital = 10 percent.
3. Ratio of variable costs to sales = 85 percent.
4. Zenith wants to extend its credit period to 60 days which will result in increase in sales by
Rs.5 lakhs.
Find out the effect of lengthening the credit period on the grogg profit of Zenith ?
Solution :
AP = AS ( 1 V ) k AI bnAS
AI ( Increase in investment in receivable ) =
|( ACPn ACPo )(So / 365 )| + |V ( ACPn ) ( AS / 365)|

AI = | ( 60 30 ) (50,00,000 / 365) | + |( 0.85 ) ( 60 ) ( 5,00,000 /365 ) |

AP = 5,00,000 ( 0.15 ) 0.10 | | ( 60 30 ) (50,00,000 / 365) | + |( 0.85 ) ( 60 ) (
5,00,000 /365 ) | | - | 0.08 ( 5,00,000 ) |
= - Rs.13750

CASH DISCOUNT

AP = AS ( 1 V ) + kAI A DIS

Where AS = Increase in Sales
V = Ratio of Variable Cost to Sales
k = Cost of Capital
AI = Savings in Receivables Investment*
A DIS = Increase in Discount Cost**

ORDER PROCESSING

Base systems and procedures (and have as few rules as possible) on customer requirement

Accuracy - Get it right the first time you might not get a second chance.

React Quickly - Do not the phones keep ringing

CASH COLLECTION : BILLING

Keep your customers minds concentrated on paying your invoices

- Continuous follow up

TERMS OF PAYMENTS

Usually agreed by the board consulting with credit manager as a result CM feels part of the
decision - making process and becomes more confortable in administrating the term.

Give them the very best information to help them. Keep it simple clear and
friendly.

- Please pay within 30 days of the invoice date

- Please pay by 25th of the month following the month of invoice.

- Please ensure that your payment reaches this office by 24th August,
1996.

Most comps follow credit term in accordance with industry average

Some companies may deliberately decide to give extended credit as part of their
marketing strategy to win more customer.

Disadvantages :

- increases the chances of something nasty happening to it

- allowing extra time - allowing customers to become lazier, more relaxed
and less financially efficient

- CM will be seen as the least effective

- Longer taxes to collect debts, loonier takes to react to the manuetplace

Cash settlement discount is most preferable than trade discount

The essential skill required in cash collection is the skill to communicate effectively.

Good communication is not just about impacting information, it is about listening.

Infact the best communication is the one who listens first which enables him (credit
personnel) to establish a sound understanding of customer needs so as to take appropriate
action by the first level staff which will effect the future of the company business relationship
with the customers.

- Credit personnel must be explained properly what is expected from them and how to
achieve those expectations.

CMS Main Task

To collect companys debts within the terms of payments for which CM must have access to
adequate information late payment reasons from other company departments.

Solution: Call the customers up to a week before the a/c is due for payment week on more or
less can be determined after consulting with purchase ledger system regarding the length of
time if to process supplies invoice.

Calling customers before the accounts are due for payment achieves two objectives:

1. Confirm the payment position and also whether the cash flow forecast is on schedule.

2. Confirm whether the customers are happy with your products and service.

Emphasis on the cash Collection effort will depend on company culture.

- A customer - oriented culture would put the emphasis up front.

- A middle of the road culture, with no particular emphasis, might start the collection

process with ten days to go before the due payment date.

- Crisis driven culture where everything is always done in a hurry at the last minute.

ISSUES IN THE MANAGEMENT OF CASH

CONCEPT:

CASH VS PROFIT

LIQUIDITY VS PROFITABILITY

LIQUIDITY MOTIVES

PLANNING:

CASH FORECAST & BUDGET

COMPUTATIONS

CONTROL:

CASH REPORTS

COLLECTION

DISBURSEMENTS

INVESTMENT OF SURPLUS CASH

REASONS FOR HOLDING CASH:

TRANSACTION MOTIVE

PRECAUTIONARY MOTIVE

SPECULATIVE MOTIVE

UNSYNCHRONISED INFLOWS & OUTFLOWS

ASYMMETRIC CONSEQUENCES OF
SHORTAGES & SURPLUSES

CASH MANAGEMENT

SHORT TERM CASH - FORECAST
+

SURPLUS OR DEFICIT ?
+

INVESTMENT SURPLUS / FINANCE DEFICIT
+

MINIMIZE IDLE CASH BALANCES
&
MINIMIZE PROBABILITY OF CASH-OUT

CASH BUDGETING

CASH BUDGET USEFUL IN :

1. ESTIMATING CASH REQUIREMENT

2. PLANNING SHORT TERM FINANCING

3. SCHEDULING CAPITAL EXPENDITURE
DISBURSEMENTS

4. PLANNING PURCHASES

5. DEVELOPING CREDIT POLICIES

6. CHECKING ACCURACY OF LONG
TERM FORECASTS

FORMAT OF CASH BUDGET

RECEIPTS & PAYMENTS FORMAT

ADJUSTED NET INCOME FORMAT

CONTROL OVER RECEIPTS & PAYMENTS

- RECEIPTS ( INFLOWS )

- PROMPT BILLING & MAILING

- PROMPT CHEQUE COLLECTION & REMITTANCE

- PAYMENTS ( OUTFLOWS )

- CENTRALISED PURCHASES & PAYMENTS

- PLAYING THE FLOAT

INVESTING SURPLUS CASH AVERAGE APPROACH

TWO ASPECTS :

AMOUNT OF SURPLUS CASH

CHANNELS OF INVESTMENT

AMOUNT OF SURPLUS CASH

IDENTIFY NORMAL & PEAK PERIODS

DECIDE NUMBER OF DAYS CASH TO BE HELD

CHANNELS OF INVESTMENT

CRITERIA : SECURITY ,LIQUIDITY, YIELD AND MATURITY

MOTIVE FOR HOLDING SURPLUS CASH :

PRECAUTIONARY LIQUIDITY OVERRULES YIELD

TRANSACTIONARY MATURITY IMPORTANT

SPECULATIVE YIELDS IMPORTANT

CASH FLOWS PROFITABILITY

A KEY PARAMETER TO JUDGE YOUR PERFORMANCE
ALSO K- GROUPS OBJECTIVE TO ACHIEVE GREATER PROFITABILITY

HIGHER PROFITABILITY LEADS TO :

1. MORE INVESTMENTS
2. FUNDS FOR MODERNISATION
3. MORE GROWTH
4. ABILITY TO GIVE BETTER REMUNERAT TO EMPLOYEES

LOWER PROFITABILITY WILL RESULT IN :

1. NO INVESTMENTS
2. NO NEW FACILITIES / MODERNISATION STAGNATION
3. CURTAILMENT OF BENEFITS TO EMPLOYEES

CREATING INCREASINGLY STABLE CASH FLOWS PROFITS :

WHOSE RESPONSIBILITY IS IT ?

NOT ACCOUNTS
BUT AS PART OF CHAIN

YOU HAVE A LARGE RESPONSIBILITY

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