Working Capital Management PDF

Working Capital Management
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This book contains the course content for Working Capital Management.
JNU, Jaipur
First Edition 2013
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Index
I. Content....................................................................... II
II. List of Figures..........................................................VI
III. List of Tables........................................................ VII
IV. Abbreviations......................................................VIII
V. Case Study.............................................................. 117
VI. Bibliography......................................................... 122
VII. Self Assessment Answers................................... 125
Book at a Glance
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Contents
Chapter I........................................................................................................................................................ 1
Working Capital Analysis............................................................................................................................ 1
Aim................................................................................................................................................................. 1
Objectives....................................................................................................................................................... 1
Learning outcome........................................................................................................................................... 1
1.1 Introduction . ............................................................................................................................................ 2
1.2 Meaning of Working Capital..................................................................................................................... 2
1.2.1 Importance of Adequate Working Capital................................................................................ 3
1.2.2 Optimum Working Capital........................................................................................................ 4
1.3 Determinants of Working Capital............................................................................................................. 4
1.4 Issues in the Working Capital Management............................................................................................. 5
1.4.1 Current Assets to Fixed Assets Ratio........................................................................................ 5
1.4.2 Liquidity versus Profitability.................................................................................................... 6
1.5 Estimating Working Capital Needs........................................................................................................... 6
1.6 Operating or Working Capital Cycle........................................................................................................ 6
1.7 Concept of Working Capital .................................................................................................................... 7
1.8 Requirements of Working Capital ........................................................................................................... 7
1.9 Classification of Working Capital . .......................................................................................................... 8
1.10 Significance of Working Capital Management ...................................................................................... 9
1.11 Factors Influencing Working Capital Requirements . ............................................................................ 9
1.12 Principles of Working Capital Management ........................................................................................ 10
1.13 Structure of Working Capital.................................................................................................................11
Summary...................................................................................................................................................... 13
References.................................................................................................................................................... 13
Recommended Reading.............................................................................................................................. 14
Self Assessment............................................................................................................................................ 15
Chapter II.................................................................................................................................................... 17
Cash Management...................................................................................................................................... 17
Aim............................................................................................................................................................... 17
Objectives..................................................................................................................................................... 17
Learning outcome......................................................................................................................................... 17
2.1 Introduction............................................................................................................................................. 18
2.2 General Principles of Cash Management:............................................................................................... 19
2.3 Functions of Cash Management.............................................................................................................. 20
2.4 Motives of Holding Cash........................................................................................................................ 21
2.5 Financing of Cash Shortage and Cost of Running Out of Cash............................................................. 22
2.6 Financing Current Assets........................................................................................................................ 23
Summary...................................................................................................................................................... 25
References.................................................................................................................................................... 25
Self Assessment............................................................................................................................................ 26
Chapter III................................................................................................................................................... 28
Cash Flow and Financial Planning............................................................................................................ 28
Aim............................................................................................................................................................... 28
Objectives..................................................................................................................................................... 28
3.1 Introduction............................................................................................................................................. 29
3.2 Depreciation............................................................................................................................................ 29
3.3 Classifying Inflows and Outflows of Cash............................................................................................. 30
3.4 Preparing the Statement of Cash Flows.................................................................................................. 31
3.5 Cash Planning: Cash Budgets................................................................................................................. 32
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3.5.1 The Sales Forecast.................................................................................................................. 32
3.5.2 Preparing the Cash Budget..................................................................................................... 33
3.6 Net Cash Flow, Ending Cash, Financing, and Excess Cash................................................................... 35
3.7 Cash Forecasting..................................................................................................................................... 36
Summary...................................................................................................................................................... 38
References.................................................................................................................................................... 38
RecommendedReading............................................................................................................................... 39
Self Assessment............................................................................................................................................ 40
Chapter IV................................................................................................................................................... 42
Liquidity and Working Capital Financing............................................................................................... 42
Aim............................................................................................................................................................... 42
Objectives..................................................................................................................................................... 42
4.1 Introduction............................................................................................................................................. 43
4.2 Traditional Measures............................................................................................................................... 43
4.2.1 An Alternative Method............................................................................................................ 43
4.3 Liquidity Ratios...................................................................................................................................... 44
4.3.1 Types of Liquidity Ratio......................................................................................................... 44
4.4 Net Working Capital............................................................................................................................... 45
4.4.1 Business Uses of Working Capital.......................................................................................... 45
4.5 Permanent and Cyclical Working Capital............................................................................................... 46
4.6 Forms of Working Capital Financing...................................................................................................... 47
4.6.1 Line of Credit.......................................................................................................................... 47
4.6.2 Accounts Receivable Financing.............................................................................................. 47
4.6.3 Factoring................................................................................................................................. 48
4.7 Inventory Financing................................................................................................................................ 48
4.8 Term Loan............................................................................................................................................... 49
4.9 Sources of Working Capital for Small Businesses.................................................................................. 50
4.10 Underwriting Issues in Working Capital Financing.............................................................................. 51
Summary...................................................................................................................................................... 52
References.................................................................................................................................................... 52
Recommended reading............................................................................................................................... 53
Self Assessment............................................................................................................................................ 54
Chapter V..................................................................................................................................................... 56
Cash Management and Financial Flexibility............................................................................................ 56
Aim............................................................................................................................................................... 56
Objectives..................................................................................................................................................... 56
5.1 Introduction............................................................................................................................................. 57
5.2 Corporate Cash Management.................................................................................................................. 57
5.3 Value-Based Strategy in Working Capital Management......................................................................... 60
5.4 Value-Based Strategy in Cash Management........................................................................................... 61
5.5 Cash Balance Forecasting....................................................................................................................... 64
5.6 Precautionary Cash Management - Safety Stock Approach................................................................... 65
Summary...................................................................................................................................................... 66
References.................................................................................................................................................... 66
Self Assessment............................................................................................................................................ 68
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Chapter VI................................................................................................................................................... 70
Inventory Management.............................................................................................................................. 70
Aim............................................................................................................................................................... 70
Objectives..................................................................................................................................................... 70
6.1 Introduction............................................................................................................................................. 71
6.2 Functions of Inventory............................................................................................................................ 72
6.3 Classification of Inventory Systems....................................................................................................... 72
6.3.1 Lot Size Reorder Point Policy................................................................................................ 72
6.3.2 Fixed Order Interval Scheduling Policy................................................................................. 73
6.3.3 Optional Replenishment Policy.............................................................................................. 74
6.4 Other Types of Inventory Systems.......................................................................................................... 74
6.5 Selective Inventory Management........................................................................................................... 74
6.5.1 ABC Analysis.......................................................................................................................... 75
6.5.2 VED Analysis......................................................................................................................... 76
6.5.3 FSN Analysis.......................................................................................................................... 76
6.6 Exchange Curve and Aggregate Inventory Planning.............................................................................. 76
6.7 Deterministic Inventory Models............................................................................................................. 77
Summary...................................................................................................................................................... 78
References.................................................................................................................................................... 78
Self Assessment............................................................................................................................................ 80
Chapter VII................................................................................................................................................. 82
Capital and Money Market........................................................................................................................ 82
Aim............................................................................................................................................................... 82
Objectives..................................................................................................................................................... 82
7.1 Introduction............................................................................................................................................. 83
7.2 Financial Market..................................................................................................................................... 83
7.3 Capital Market Efficiency....................................................................................................................... 84
7.3.1 Forms of Capital Market Efficiency....................................................................................... 85
7.4 Capital Market Operations...................................................................................................................... 86
7.5 Money Market......................................................................................................................................... 86
7.5.1 Characteristics of Money Market........................................................................................... 87
7.5.2 Functions of Money Market................................................................................................... 87
7.5.3 Importance of Money Market................................................................................................. 88
7.6 Indian Money Market Instruments.......................................................................................................... 89
7.7 Drawbacks of Indian Money Market...................................................................................................... 91
7.8 Reforms in Indian Money Market........................................................................................................... 92
Summary...................................................................................................................................................... 93
References.................................................................................................................................................... 93
Self Assessment............................................................................................................................................ 95
Chapter VIII................................................................................................................................................ 97
Receivable Management............................................................................................................................. 97
Aim............................................................................................................................................................... 97
Objectives..................................................................................................................................................... 97
8.1 Introduction . .......................................................................................................................................... 98
8.2 Receivable Management......................................................................................................................... 98
8.3 Cost of Maintaining Receivables.......................................................................................................... 101
8.4 Factors Affecting the Size of Receivables............................................................................................ 102
8.5 Principles of Credit Management......................................................................................................... 103
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8.6 Objectives of Receivable Management................................................................................................ 104
8.7 Aspects of Credit Policy........................................................................................................................ 105
8.8 Determination of Credit Policy............................................................................................................. 106
8.8.1 Credit Terms.......................................................................................................................... 106
8.8.2 Credit Standards.................................................................................................................... 108
8.8.3 Collection Policy................................................................................................................... 108
8.9 Collection of Accounts Receivables..................................................................................................... 109
8.9.1 Types of Collection Efforts................................................................................................... 109
8.9.2 Degree of Collection Efforts................................................................................................. 109
8.9.3 Collection Follow-Up System...............................................................................................110
8.10 Credit Control......................................................................................................................................110
8.11 Control of Receivables.........................................................................................................................111
8.11.1 Payment Pattern Approach...................................................................................................111
Summary.....................................................................................................................................................113
References...................................................................................................................................................114
Recommended Reading.............................................................................................................................114
Self Assessment...........................................................................................................................................115
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List of Figures
Fig. 1.1 The angles of working capital management...................................................................................... 2
Fig. 1.2 Permanent and temporary working capital........................................................................................ 3
Fig. 1.3 Alternative current assets policies..................................................................................................... 5
Fig. 3.1 The firm’s cash flow........................................................................................................................ 30
Fig. 3.2 The short-term financial planning process...................................................................................... 32
Fig. 4.1 Cash flow and the working capital cycle......................................................................................... 46
Fig. 5.1 Liquid assets influence on value of the corporation........................................................................ 58
Fig. 5.2 Reasons for holding cash by companies and their relation to the risk............................................ 60
Fig. 5.3 BAT model....................................................................................................................................... 62
Fig. 5.4 Beranek model................................................................................................................................. 63
Fig. 5.5 Miller –Orr model............................................................................................................................ 63
Fig. 5.6 Stone model..................................................................................................................................... 64
Fig. 6.1 Typical inventory balances for EOQ- reorder point policy............................................................. 73
Fig. 6.2 Fixed reorder cycle policy............................................................................................................... 73
Fig. 6.3 Typical inventory balances in policy............................................................................................... 74
Fig. 6.4 ABC analysis................................................................................................................................... 75
Fig. 7.1 The financial system........................................................................................................................ 84
Fig. 8.1 Flowchart showing the purpose of maintaining receivables......................................................... 101
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List of Tables
Table 3.1 The general format of the cash budget.......................................................................................... 33
Table 3.2 A schedule of projected cash receipts for Coulson Industries ($000)........................................... 34
Table 3.3 A sensitivity analysis of Coulson industries cash budget.............................................................. 35
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Abbreviations
JIT - Just In Time
EOQ - Economic order quantity
MACRS - Modified accelerated cost recovery system
OCF - operating cash flow
FCF - free cash flow
NFAI - Net fixed asset investment
NCAI - Net current asset investment
A/R - accounts receivable
R&D - receipts and disbursements
ANI - adjusted net income
EBIT - Earnings Before Interest, Taxes
PBS - Pro forma balance sheet
ARM - Accrual reversal method
FCFF - free cash flows to firm
NWC - net working capital growth
CA - Current Assets
CL - Current Liabilities
CCI - Controller of Capital Issues
CP - Commercial paper
APY - Annual Percentage Yield
APR - Annual Percentage Rate
MMMFs - Money Market Mutual Fund
DFHI - Discount and Finance House of India
LAF - Liquidity Adjustment Facility
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Chapter I
Working Capital Analysis
Aim
The aim of this chapter is to:
• define the goal of working capital management
• elucidate the concept of work capital
• explain the importance of working capital
Objectives
The objectives of this chapter are to:
• explain the types of working capital
• explicate the issues in the working capital management
• elucidate the determinants of working capital
Learning outcome
At the end of this chapter, you will be able to:
• understand the current assets to fixed assets ratio
• identify the working capital cycle
• recognise the significance of working capital management
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1.1 Introduction
Working Capital Management involves managing the balance between firm’s short-term assets and its short-term
liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and
that it has sufficient cash flow to satisfy both maturing short-term debts and upcoming operational expenses. The
interaction between current assets and current liabilities is, therefore, the main theme of the theory of working
capital management.
There are many aspects of working capital management which makes it an important function of financial
management.
• Time: Working capital management requires much of the finance manager’s time.
• Investment: Working capital represents a large portion of the total investment in assets.
• Credibility: Working capital management has great significance for all firms, but it is very critical for small
firms.
• Growth: The need for working capital is directly related to the firm’s growth.
1.2 Meaning of Working Capital

The concept of working capital can also be explained through two angles.
Working Capital
Management
OR
Value Time
Gross Working Net Working Permanent Temporary

Capital Capital
Fig. 1.1 The angles of working capital management
Value
From the value point of view, working capital can be defined as gross working capital or net working capital.
Gross working capital refers to the firm’s investment in current assets. Current assets are those assets which can be
converted into cash within an accounting year. Current Assets include: Stocks of raw materials, Work-in-progress,
Finished goods, Trade debtors, Prepayments, Cash balances, etc.
Net working capital refers to the difference between current assets and current liabilities. Current liabilities are
those claims of outsiders which are expected to mature for payment within an accounting year. Current Liabilities
include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends payable and
Short-term loans. A positive working capital means that the company is able to payoff its short-term liabilities. A
negative working capital means that the company currently is unable to meet its short-term liabilities.
Time
From the point of view of time, the term working capital can be divided into two categories viz., permanent and
temporary.
Permanent working capital refers to the hard core working capital. It is that minimum level of investment in the
current assets that is carried by the business at all times to carry out minimum level of its activities.
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Temporary working capital refers to that part of the total working capital, which is required by a business over and
above the permanent working capital. It is also called variable working capital. Since the volume of temporary working
capital keeps on fluctuating from time to time according to the business activities, it may be financed from short-term
sources. The following diagrams show permanent and temporary or fluctuating or variable working capital:
Fig. 1.2 Permanent and temporary working capital
Both kinds of working capital, i.e. permanent and fluctuating (temporary) are necessary to facilitate production and
sales through the operating cycle.
1.2.1 Importance of Adequate Working Capital

Management of working capital is an essential task of the finance manager. He has to ensure that the amount of
working capital available with his concern is neither too large nor too small for its requirements.
A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company
has to pay huge amount as interest on such funds. If the firm has inadequate working capital, such firm runs the
risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its
liabilities. Various studies conducted by the Bureau of Public Enterprises have shown that one reason for the poor
performance of public sector undertakings in our country has been the large amount of funds locked up in working
capital. This results in over-capitalisation. Overcapitalisation implies that a company has too large funds for its
requirements, resulting in a low rate of return a situation which implies a less than optimal use of resources. A firm
has, therefore, to be very careful in estimating its working capital requirements. Maintaining an adequate working
capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival
of the business in the long-term as well. When business makes investment decisions, they must not only consider
the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account
of the additional current assets that are usually required with any expansion of activity. For e.g.:
• Increased production leads to hold additional stocks of raw materials and work in progress.
• An increased sale usually means that the level of debtors will increase.
• A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital.
A question then arises what an optimum amount working capital is for a firm? We can say that a firm should neither
have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to
estimate the requirements of working capital carefully and determine the optimum level of investment in working
capital.
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1.2.2 Optimum Working Capital

If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that
want their money quickly. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement
it) has traditionally been considered the best indicator of the working capital situation. It is understood that a
current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital.
This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus
it is considered that there is a comfortable liquidity position, if liquid current assets are equal to current liabilities.
Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have,
for years, considered the current ratio at, ‘two’ and the acid test ratio at, ‘one’ as indicators of a good working capital
situation. As a thumb rule, this may be quite adequate.
However, it should be remembered that optimum working capital can be determined only with reference to the
particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the
sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet the firm may be sound.
In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as
inadequate working capital positions are dangerous.
1.3 Determinants of Working Capital

Working capital management is concerned with:-
• Maintaining adequate working capital (management of the level of individual current assets and the current
liabilities)
• Financing of the working capital
For the point a) above, a finance manager needs to plan and compute the working capital requirements for its business.
Once the requirement has been computed, he needs to ensure that it is financed properly. This whole exercise is
nothing but Working Capital Management.
Sound financial and statistical techniques, supported by judgement should be used to predict the quantum of working
capital required at different times. Some of the items/factors which need to be considered while planning for working
capital requirement are:
• Cash: Identify the cash balance which allows for the business to meet day-to-day expenses, but reduces cash
holding costs.
• Inventory: Identify the level of inventory which allows for uninterrupted production but reduces the investment
in raw materials and hence increases cash flow. The techniques like Just In Time (JIT) and Economic Order
Quantity (EOQ) are used for this.
• Debtors: Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any
impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on
Capital (or vice versa). The tools like discounts and allowances are used for this.
• Short-term financing options: Inventory is ideally financed by credit granted by the supplier; dependent on the
cash conversion cycle, it may however, be necessary to utilise a bank loan (or overdraft), or to “convert debtors
to cash” through “factoring” in order to finance working capital requirements.
• Nature of business: For e.g., in a business of restaurant, most of the sales are in cash. Therefore, the need for
working capital is very less.
• Market and demand conditions: For e.g., if an item demand far exceeds its production, the working capital
requirement would be less as investment in finished good inventory would be very less.
• Technology and manufacturing policies: For e.g., in some businesses, the demand for goods is seasonal. In
that case, a business may follow a policy for steady production through out over the whole year or instead may
choose policy of production only during the demand season.
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• Operating efficiency: A company can reduce the working capital requirement by eliminating waste, improving
coordination, etc.
• Price level changes: For e.g., rising prices necessitate the use of more funds for maintaining an existing level
of activity. For the same level of current assets, higher cash outlays are required. Therefore, the effect of rising
prices is that a higher amount of working capital is required.
1.4 Issues in the Working Capital Management

Working capital management entails the control and monitoring of all components of working capital, i.e., cash,
marketable securities, debtors (receivables) and stocks (inventories) and creditors (payables). Finance manager has
to pay particular attention to the levels of current assets and their financing. To decide the levels and financing of
current assets, the risk return trade off must be taken into account.
1.4.1 Current Assets to Fixed Assets Ratio

The finance manager is required to determine the optimum level of current assets, so that the shareholders’ value is
maximised. A firm needs fixed and current assets to support a particular level of output. As the firm’s output and sales
increases, the need for current assets also increases. Generally, current assets do not increase in direct proportion
to output; current assets may increase at a decreasing rate with output. As the output increases, the firm starts using
its current assets more efficiently.
The level of the current assets can be measured by creating a relationship between current assets and fixed assets.
Dividing current assets by fixed assets gives current assets/fixed assets ratio. Assuming a constant level of fixed
assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current
assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant.
A conservative policy implies greater liquidity and lower risk, whereas an aggressive policy indicates higher risk
and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies.
The current assets policy of most of the firms may fall between these two extreme policies.
The following diagram shows alternative current assets policies:
Fig. 1.3 Alternative current assets policies
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1.4.2 Liquidity versus Profitability

Risk return trade off − A firm may follow a conservative, aggressive or moderate policy as discussed above. However,
these policies involve risk, return trade off. A conservative policy means lower return and risk. An aggressive policy
produces higher returns and risks.
The two important aims of the working capital management are profitability and solvency. A liquid firm has less
risk of insolvency, that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost
associated with maintaining a sound liquidity position. However, to have higher profitability the firm may have
to sacrifice solvency and maintain a relatively low level of current assets. This will improve firm’s profitability as
fewer funds will be tied up in idle current assets, but its solvency would be threatened and exposed to greater risk
of cash shortage and stock outs.
1.5 Estimating Working Capital Needs

Operating cycle is one of the most reliable methods of computation of working capital. However, other methods
like ratio of sales and ratio of fixed investment may also be used to determine the working capital requirements.
These methods are briefly explained as follows:
• Current assets holding period: To estimate working capital needs based on the average holding period of
current assets and relating them to costs based on the company’s experience in the previous year. This method
is essentially based on the Operating Cycle Concept.
• Ratio of sales: To estimate working capital needs as a ratio of sales on the assumption that current assets change
with changes in sales.
• Ratio of fixed investments: To estimate working capital requirements as a percentage of fixed investments.
A number of factors will, however, be impacting the choice of method of estimating Working Capital. Factors such
as seasonal fluctuations, accurate sales forecast, investment cost and variability in sales price would generally be
considered. The production cycle and credit and collection policies of the firm will have an impact on working capital
requirements. Therefore, they should be given due weightage in projecting working capital requirements.
1.6 Operating or Working Capital Cycle

A useful tool for managing working capital is the operating cycle. The operating cycle analyses the accounts
receivable, inventory and accounts payable cycles in terms of number of days. For example:
• Accounts receivable are analysed by the average number of days it takes to collect an account.
• Inventory is analysed by the average number of days it takes to turn over the sale of a product (from the point
it comes in the store to the point it is converted to cash or an account receivable).
• Accounts payable are analysed by the average number of days it takes to pay a supplier invoice.
Working capital cycle indicates the length of time between a company’s payment to procure materials, entering it
into stock and receiving cash from the sales of finished goods. It can be determined by adding the number of days
required for each stage in the cycle. For example, a company holds raw materials on an average for 60 days, it gets
credit from the supplier for 15 days, production process needs 15 days, finished goods are held for 30 days and
30 days credit is extended to debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total
working capital cycle.
Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts
payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by
the net profits generated internally or by externally borrowed funds or by a combination of the two.
The faster a business expands the more cash it will need for working capital and investment. The cheapest and best
sources of cash exist as working capital right within a business. Good management of working capital will generate
cash which will help to improve profits and reduce risks. The cost of providing credit to customers and holding
stocks can represent a substantial proportion of a firm’s total profits.
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1.7 Concept of Working Capital
There are two concepts of working capital. These are:
Gross Working Capital (Total Current Assets)

The gross working capital, simply called as working capital refers to the firm’s investment in current assets. Current
assets are the assets, which can be converted into cash within an accounting year or operating cycle. Thus, gross
working capital, is the total of all current assets. It includes:
• Inventories (Raw materials and Components, Work-in-Progress, Finished Goods, etc.)
• Trade Debtors
• Loans and Advance
• Cash and Bank Balances
• Bills Receivables
• Short-term Investment
Net Working Capital (Total Current Assets – Total Current Liabilities)

Net working capital refers to the difference between current assets and current liabilities. Current liabilities are
those claims of outsiders, which are expected to mature for payment within an accounting year. Net working capital
may be positive or negative. A positive net working capital will arise when current assets exceed current liabilities
and a negative net working capital will arise when current liabilities exceed current assets, i.e., there is no working
capital, but there is a working capital deficit. It includes:
• Trade Creditors
• Bills Payable
• Accrued or Outstanding Expenses
• Trade Advances
• Short-term Borrowings (Commercial Banks and Others)
• Provisions
• Bank Overdraft
Working capital represents the amount of current assets that have not been supplied by current, short-term creditors.
Gross working capital refers to the amount of funds invested in current assets that are employed in the business
process while, Net working capital refers to the difference between current assets and current liabilities.
Working capital is the excess of current assets that has been supplied by the long-term creditors and the stockholders.
The two concepts of working capital, gross working capital and net working capital are exclusive. Both are equally
important for the efficient management of working capital. The gross working capital focuses attention on two
aspects, how investment can be optimised in current assets and how current assents should be financed? Net working
capital concept is qualitative. It indicates the liquidity position of the firm and suggests the extent to which working
capital needs may be financed by permanent sources of funds.
1.8 Requirements of Working Capital

There are no set rules or formula to determine the working capital requirements of the firms. A large number of
factors influence the working capital need of the firms. All factors are of different importance and also importance
change for the firm over time. Therefore, an analysis of the relevant factors should be made in order to determine
the total investment in working capital. Generally, the following factors influence the working capital requirements
of the firm:
• Nature and size of the business
• Seasonal fluctuations
• Production policy
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• Taxation
• Depreciation policy
• Reserve policy
• Dividend policy
• Credit policy:
• Growth and expansion
• Price level changes
• Operating efficiency
• Profit margin and profit appropriation
1.9 Classification of Working Capital

The quantitative concept of working capital is known as gross working capital while that under qualitative concept
is known as net working capital. Working capital can be classified in various ways. The important classifications
are as given below:
Conceptual classification
There are two concepts of working capital, viz., quantitative and qualitative. The quantitative concept takes into
account as the current assets while the qualitative concept takes into account the excess of current assets over current
liabilities. Deficit of working capital exists where the amount of current liabilities exceeds the amount of current
assets. The above can be summarised as follows:
• Gross working capital = Total current assets
• Net working capital = Excess of current assets over current liabilities
• Working capital deficit = Excess of current liabilities over current assets.
Classification on the basis of financial reports

The information of working capital can be collected from Balance Sheet or Profit and Loss Account; as such the
working capital may be classified as follows:
• Cash Working Capital – This is calculated from the information contained in profit and loss account. This
concept of working capital has assumed a great significance in recent years as it shows the adequacy of cash
flow in business.
• Balance Sheet Working Capital – The data for balance sheet working capital is collected from the balance
sheet. On this basis, the working capital can also be divided in three more types, viz., gross working capital,
net working capital and working capital deficit.
Classification on the basis of variability

Gross working capital can be divided in two categories, viz., (i) permanent or fixed working capital and (ii) Temporary,
seasonal or variable working capital. Such type of classification is very important for hedging decisions.
• Temporary working capital – Temporary working capital is also called as fluctuating or seasonal working capital.
This represents additional investment needed during prosperity and favourable seasons. It increases with the
growth of the business. Temporary working capital is the additional assets required to meet the variations in
sales above the permanent level.
• Permanent working capital – It is a part of total current assets which is not changed due to variation in sales.
There is always a minimum level of cash, inventories, and accounts receivables which is always maintained
in the business even if sales are reduced to a minimum. Amount of such investment is called as permanent
working capital. Permanent working capital is the amount of working capital that persists over time regardless
of fluctuations in sales. This is also called as regular working capital.
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1.10 Significance of Working Capital Management
Funds are needed in every business for carrying on day-to-day operations. Working capital funds are regarded as the
life blood of a business firm. A firm can exist and survive without making profit but cannot survive without working
capital funds. If a firm is not earning profit it may be termed as ‘sick’, but, not having working capital may cause
its bankruptcy. Each firm must decide how to balance the amount of working capital it holds, against the risk of
failure. Working capital has acquired a great significance and sound position in the recent past for the twin objects
of profitability and liquidity. In period of rising capital costs and scarce funds, the working capital is one of the most
important areas requiring management review.
It is rightly observed that,

Constant management review is required to maintain appropriate levels in the various working capital accounts.
Mainly the success of a concern depends upon proper management of working capital. Hence, working capital
management has been looked upon as the driving seat of a financial manager. It consumes a great deal of time to
increase profitability as well as to maintain proper liquidity at minimum risks. There are many aspects of working
capital management which make it an important function of the finance manager. In fact, we need to know when to
look for working capital funds, how to use them and how to measure, plan and control them.
A study of working capital management is very important for internal and external experts. Sales expansion, dividend
declaration, plants expansion, new product line, increase in salaries and wages, rising price level, etc., put added
strain on working capital maintenance. Failure of any enterprise is undoubtedly due to poor management and absence
of management skills. Importance of working capital management stems from two reasons, viz., (i) A substantial
portion of total investment is invested in current assets, and (ii) level of current assets and current liabilities will
change quickly with the variation in sales. Though fixed assets investment and long-tem borrowing will also respond
to the changes in sales, but its response will be weak.
1.11 Factors Influencing Working Capital Requirements

Numerous factors can influence the size and need of working capital in a concern. So, no set rule or formula can be
framed. It is rightly observed that, there is no precise way to determine the exact amount of gross or net working
capital for every enterprise. The data and problem of each company should be analysed to determine the amount of
working capital. Briefly, the optimum level of current assets depends upon the following determinants.
• Nature of business: Trading and industrial concerns require more funds for working capital. Concerns engaged
in public utility services need less working capital. For example, if a concern is engaged in electric supply, it
will need less current assets, firstly due to cash nature of the transactions and secondly due to sale of services.
However, it will invest more in fixed assets. In addition to it, the investment varies concern to concern, depending
upon the size of business, the nature of the product, and the production technique.
• Conditions of supply: If the supply of inventory is prompt and adequate, less funds will be needed. But, if the
supply is seasonal or unpredictable, more funds will be invested in inventory. Investment in working capital
will fluctuate in case of seasonal nature of supply of raw materials, spare parts and stores.
• Production policy: In case of seasonal fluctuations in sales, production will fluctuate accordingly and ultimately
the requirement of working capital will also fluctuate. However, sales department may follow a policy of off-
season discount, so that sales and production can be distributed smoothly throughout the year and sharp variations
in working capital requirements are avoided.
• Seasonal operations: It is not always possible to shift the burden of production and sale to slack period. For
example, in case of sugar mill, more working capital will be needed at the time of crop and manufacturing.
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• Credit availability: If credit facility is available from banks and suppliers on favourable terms and conditions,
less working capital will be needed. If such facilities are not available, more working capital will be needed to
avoid risk. Credit policy of enterprises-- in some enterprises, most of the sale is in cash and even it is received in
advance. In other enterprises, mostly credit sales happen and payments are received only after a month or two.
In former case, less working capital is needed than the latter. The credit terms depend largely on norms of the
industry. In order to ensure that unnecessary funds are not tied up in book debts, the enterprise should follow a
rationalised credit policy based on the credit standing of the customers and other relevant factors.
• Growth and expansion: The need of working capital is increasing with the growth and expansion of an enterprise.
It is difficult to precisely determine the relationship between volume of sales and the working capital needs. The
critical fact, however, is that the need for increased working capital funds does not follow growth in business
activities but precedes it. It is clear that advance planning is essential for a growing concern.
• Price level change: With the increase in price level, more and more working capital will be needed for the same
magnitude of current assets. The effect of rising prices will be different for different enterprises.
• Circulation of working capital: Less working capital will be needed with the increase in circulation of working
capital and vice-versa. Circulation means time required to complete one cycle, i.e., from cash to material,
from material to work-in-progress, from work-in-progress to finished goods, from finished goods to accounts
receivable and from accounts receivable to cash.
• Volume of sale: This is directly indicated with working capital requirement, with the increase in sales more
working capital is needed for finished goods and debtors. Its vice versa is also true.
• Liquidity and profitability: There is a negative relationship between liquidity and profitability. When working
capital in relation to sales is increased it will reduce risk and profitability on one side and will increase liquidity
on the other side.
• Management ability: Proper co-ordination in production and distribution of goods may reduce the requirement
of working capital, as minimum funds will be invested in absolute inventory, non-recoverable debts, etc.
• External environment: With development of financial institutions, means of communication, transport facility,
etc., needs of working capital is reduced because it can be available as and when needed.
1.12 Principles of Working Capital Management

The following are the principles of working capital management:
• Principles of the risk variation: Risk here refers to the inability of firm to maintain sufficient current assets to
pay its obligations. If working capital is varied relative to sales, the amount of risk that a firm assumes is also
varied and the opportunity for gain or loss is increased. In other words, there is a definite relationship between
the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases.
As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk
increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, amount
of risk goes down, and vice-versa, the opportunity for gain is likewise adversely affected.
• Principle of equity position: According to this principle, the amount of working capital invested in each component
should be adequately justified by a firm’s equity position. Every rupee invested in the working capital should
contribute to the net worth of the firm.
• Principle of cost of capital: This principle emphasises that different sources of finance have different cost of
capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital
results in decline in the cost of capital.
• Principle of maturity of payment: A company should make every effort to relate maturity of payments to its
flow of internally generated funds. There should be the least disparity between the maturities of a firm’s short-
term debt instruments and its flow of internally generated funds, because a greater risk is generated with greater
disparity. A margin of safety should, however, be provided for any short-term debt payments.
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1.13 Structure of Working Capital
The study of structure of working capital is another name for the study of working capital cycle. In other words, it
can be said that the study of structure of working capital is the study of the elements of current assets, viz., inventory,
receivable, cash and bank balances and other liquid resources like short-term or temporary investments. Current
liabilities usually comprise bank borrowings, trade credits, assessed tax and unpaid dividends or any other such
things. The following points relate to the various elements of working capital:
Inventory
Inventory is a major item of current assets. The management of inventories – raw material, goods-in-process and
finished goods is an important factor in the short-run liquidity positions and long-term profitability of the company.
Raw material inventories– uncertainties about the future demand for finished goods, together with the costs of adjusting
production to change in demand will cause a financial manager to desire some level of raw material inventory. In
the absence of such inventory, the company could respond to increased demand for finished goods only by incurring
explicit clerical and other transaction costs of ordinary raw material for processing into finished goods to meet that
demand. If changes in demand are frequent, these order costs may become relatively large.
Moreover, attempts to purchase hastily the needed raw material may necessitate payment of premium purchases
prices to obtain quick delivery and, thus, raise cost of production. Finally, unavoidable delays in acquiring raw
material may cause the production process to shut down and then re-start again raising the costs of production.
Under these conditions the company cannot respond promptly to changes in demand without sustaining high costs.
Hence, some level of raw materials inventory has to be held to reduce such costs. Determining its proper level
requires an assessment of costs of buying and holding inventories and a comparison with the costs of maintaining
insufficient level of inventories.
Work-in-process inventory
This inventory is built up due to production cycle. Production cycle is the time-span between introduction of raw
material into production and emergence of finished product at the completion of production cycle. Till the production
cycle is completed, the stock of work-in-process has to be maintained.
Finished goods inventory

Finished goods are required for reasons similar to those causing the company to hold raw materials inventories.
Customer’s demand for finished goods is uncertain and variable. If a company carries no finished goods inventory,
unanticipated increases in customer demand would require sudden increases in the rate of production to meet the
demand. Such rapid increase in the rate of production may be very expensive to accomplish. Rather than loss of
sales, because the additional finished goods are not immediately available or sustain high costs of rapid additional
production, it may be cheaper to hold a finished goods inventory. The flexibility afforded by such an inventory
allows a company to meet unanticipated customer demands at relatively lower costs than if such an inventory is
not held.
Thus, to develop successfully optimum inventory policies, the management needs to know about the functions of
inventory, the cost of carrying inventory, economic order quantity and safety stock. Industrial machinery is usually
very costly and it is highly uneconomical to allow it to lie idle. Skilled labour also cannot be hired and fired at will.
Modern requirements are also urgent. Since requirements cannot wait and since the cost of keeping machine and
men idle is higher, than the cost of storing the material, it is economical to hold inventories to the required extent.
The objectives of inventory management are:
• To minimise idle cost of men and machines causes by shortage of raw materials, stores and spare parts.
• To keep down:
Inventory ordering cost
Inventory carrying cost
Capital investment in inventories
Obsolescence losses
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Receivables
Many firms make credit sales and as a result thereof carry receivables as a current asset. The practice of carrying
receivables has several advantages as follows:
• Reduction of collection costs over cash collection
• Reduction in the variability of sales, and
• Increase in the level of near-term sales.
While immediate collection of cash appears to be in the interest of shareholders, the cost of that policy may be very
high relative to costs associated with delaying the receipt of cash by extension of credit. Imagine, for example, an
electric supply company employing a person at every house constantly reading electricity meter and collecting cash
from him every minute as electricity is consumed. It is far cheaper for accumulating electricity usage and bill once
a month. This of course, is a decision to carry receivables on the part of the company. It may also be true that the
extension of credit by the firm to its customers may reduce the variability of sales over time. Customers confined to
cash purchases may tend to purchase goods when cash is available to them. Erratic and perhaps cyclical purchasing
patterns may then result unless credit can be obtained elsewhere. Even if customers do obtain credit elsewhere,
they must incur additional cost of search in arranging for a loan costs that can be estimated when credit is given by
a supplier. Therefore, extension of credit to customers may well smooth out of the pattern of sales and cash inflows
to the firm over time since customers need not wait for some inflows of cash to make a purchase. To the extent that
sales are smoothed, cost of adjusting production to changes in the level of sales should be reduced.
Finally, the extension of credit by firms may act to increase near-term sales. Customers need not wait to accumulate
necessary cash to purchase an item but can acquire it immediately on credit. This behaviour has the effect of shifting
future sales close to the present time. Therefore, the extension of credit by a firm and the resulting investment in
receivables occurs because it pays a firm to do so. Costs of collecting revenues and adapting to fluctuating customer
demands may make it desirable to offer the convenience associated with credit to firm’s customers.
Cash and interest-bearing liquid assets

Cash is one of the most important tools of day-to-day operation, because it is a form of liquid capital which is
available for assignment to any use. Cash is often the primary factor which decides the course of business destiny.
The decision to expand a business may be determined by the availability of cash and the borrowing of funds will
frequently be dictated by cash position. Cash-in-hand, however, is a non-earning asset. This leads to the question
as to what the optimum level of this idle resource is. This optimum depends on various factors, such as the
manufacturing cycle, the sale and collection cycle, age of the bills and on the maturing of debt. It also depends
upon the liquidity of other current assets and the matter of expansion. While a liberal maintenance of cash provides
a sense of security, a lack of sufficiency of cash hampers day-to-day operations. Prudence, therefore, requires that
no more cash should be kept on hand than the optimum required for handling miscellaneous transactions over the
counter and petty disbursements, etc.
It has not become a practice with business enterprises to avoid too much redundant cash by investing a portion of
their earnings in assets which are susceptible to easy conversion into cash. Such assets may include government
securities, bonds, debentures and shares that are known to be readily marketable and that may be liquidated at a
moment’s notice, when cash is needed.
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Summary
• Working Capital Management involves managing the balance between firm’s short-term assets and its short-
term liabilities.
• The interaction between current assets and current liabilities is the main theme of the theory of working capital
management.
• Gross working capital refers to the firm’s investment in current assets.
• Net working capital refers to the difference between current assets and current liabilities.
• A positive working capital means that the company is able to payoff its short-term liabilities.
• Permanent working capital refers to the hard core working capital. It is that minimum level of investment in
the current assets that is carried by the business.
• Temporary working capital refers to that part of total working capital, which is required by a business over and
above permanent working capital.
• Working capital management entails the control and monitoring of all components of working capital.
• The level of the current assets can be measured by creating a relationship between current assets and fixed
assets.
• Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative
current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy
assuming all factors to be constant.
• A conservative policy implies greater liquidity and lower risk, whereas an aggressive policy indicates higher
risk and poor liquidity.
• The two important aims of the working capital management are profitability and solvency.
• Operating cycle is one of the most reliable methods of computation of working capital.
• A useful tool for managing working capital is the operating cycle.
• Working capital cycle indicates the length of time between a company’s payment for materials, entering into
stock and receiving the cash from sales of finished goods.
• Current assets are the assets, which can be converted into cash within an accounting year or operating cycle.
• Net working capital refers to the difference between current assets and current liabilities.
• Working capital is the excess of current assets that has been supplied by the long-term creditors and the
stockholders.
• The quantitative concept of working capital is known as gross working capital while that under qualitative
concept is known as net working capital.
• Cash is one of the most important tools of day-to-day operation, because it is a form of liquid capital which is
available for assignment to any use.
• While a liberal maintenance of cash provides a sense of security, a lack of sufficiency of cash hampers day-to-
day operations.
References
• Working Capital [Online] Available at: <http://www.scribd.com/doc/24525667/Working-Capital-analysis>
[Accessed 12 July 2013].
• Work capital Analysis [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/705/13/14_chapter5.
pdf> [Accessed 12 July 2013].
• Working capital Management [Video online] Available at <http://www.youtube.com/watch?v=KQWe-2G23kw>
• Working Capital Management Principal and Approaches [Video online] Available at <http://www.youtube.com/
watch?v=zJCiEIqAxbs> [Accessed 12 July 2013].
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• Preve, L. And Allende, V.S., 2010. Working Capital Management. Oxford University Press, USA.
• Sagner, J., 2010. Essentials of Working Capital Management. Wiley.
Recommended Reading
• Weide, J. H.V. and Maier, S. F., 1984. Managing Corporate Liquidity: An Introduction to Working Capita. John
Wiley & Sons Inc.
• Kimmel, P.D. and Weygandt, J.J., 2008. Financial Accounting: Tools for Business Decision Making. 5th ed.,
Wiley.
• Laurens, B., 1998. Managing capital flows. International Monetary Fund, Monetary and Exchange Affairs
Department.
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Self Assessment
1. The goal of _________________ is to ensure that the firm is able to continue its operations and that it has
sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
a. investment
b. working capital management
c. credibility
d. gross working capital
2. _________________ refers to the firm’s investment in current assets.

a. Working capital
b. Cash balance
c. Current liabilities
d. Gross working capital
3. _______________ refers to the difference between current assets and current liabilities.
a. Net working capital
b. Short-term liabilities
c. Permanent working capital
d. Fluctuating working capital
4. Which of the following is also called variable working capital?

a. Permanent working capital
b. Temporary working capital
c. Current liabilities
d. Gross working capital
5. Which of the following is not a function of financial management?

a. Time
b. Credibility
c. Growth
d. Assets
6. Which of the following is not a factor which is considered while planning for working capital requirement?
a. Credibility
b. Cash
c. Inventory
d. Debtors
7. The ___________________ is required to determine the optimum level of current assets, so that the shareholders
value is maximised.
a. firm
b. asset
c. current asset
d. finance manager
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8. A _________________ implies greater liquidity and lower risk, whereas an aggressive policy indicates higher
risk and poor liquidity.
a. current assets policy
b. return trade off
c. risk trade off
d. conservative policy
9. Which of the following is not a method used to determine the working capital requirements?
a. Ratio of sales
b. Ratio of variable investment
c. Ratio of fixed investment
d. Current assets holding period
10. The _______________ analyses the accounts receivable, inventory and accounts payable cycles in terms of
number of days.
a. working capital cycle
b. operating cycle
c. total current assets
d. total current liabilities
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Chapter II
Cash Management
Aim
• define cash management
• elucidate the principles of cash management
• explain the functions of cash management
Objectives
• explain the financing of cash shortage
• explicate the cost of running out of cash
• elucidate the concept of financing current assets
Learning outcome
• understand the three approaches of financing current assets
• identify the cash flow statement
• recognise the motives of holding cash
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2.1 Introduction
Cash, like the blood stream in the human body, gives vitality and strength to a business enterprise. Though, cash
holds the smallest portion of total current assets. However, cash is both the beginning and end of working capital
cycle - cash, inventories, receivables and cash. It is the cash, which keeps the business going. Hence, every enterprise
has to hold necessary cash for its existence. Moreover, steady and healthy circulation of cash throughout the entire
business operations is the basis of business solvency. Now-a-days, non-availability and high cost of money have
created a serious problem for the industry. Nevertheless, cash like any other asset of a company is treated as a tool
of profit. Further, today the emphasis is on the right amount of cash, at the right time, at the right place and at the
right cost.
In the words of R.R. Bari, “Maintenance of surplus cash by a company unless there are special reasons for doing
so, is regarded as a bad sign of cash management.” Holding of cash balance has an implicit cost in the form of its
opportunity cost.
Cash may be interpreted under two concepts. In narrow sense, cash is a very important business asset, but although
coin and paper currency can be inspected and handled, the major part of the cash of most enterprises is in the form
of bank checking accounts, which represent claims to money rather than tangible property. While in a broader sense,
cash consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks. In general, nothing
should be considered unrestricted cash, unless it is available to the management for disbursement of any nature.
Thus, from the above quotations we may conclude that in narrow sense, cash means cash in hand and at bank but
in wider sense, it is the deposits in banks, currency, cheques, bank drafts, etc., in addition to cash in hand and at
bank. Cash management includes management of marketable securities also, because in modern terminology money
comprises marketable securities and actual cash in hand or in bank.
The concept of cash management is not new and it has acquired a greater significance in the modern world of business
due to changes that took place in the conduct of business and ever increasing difficulties and the cost of borrowing.
Apart from the fact that it is the most liquid of all the current assets, cash is the common denominator to which all
current assets can be reduced because the other current assets, i.e., receivables and inventory get eventually converted
into cash. This underlines the significance of cash management. The term cash management refers to the management
of cash resource in such a way that generally accepted business objectives could be achieved. In this context, the
objectives of a firm can be unified as bringing about consistency between maximum possible profitability and liquidity
of a firm. Cash management may be defined as the ability of a management in recognising the problems related
with cash which may come across in future course of action, finding appropriate solutions to curb such problems
if they arise, and finally delegating these solutions to the competent authority for carrying them out. The choice
between liquidity and profitability creates a state of confusion. It is cash management that can provide solution to
this dilemma. Cash management may be regarded as an art that assists in establishing equilibrium between liquidity
and profitability to ensure undisturbed functioning of a firm towards attaining its business objectives.
Cash itself is not capable of generating any sort of income on its own. It rather is the prime requirement of income
generating sources and functions. Thus, a firm should go for minimum possible balance of cash, yet maintaining its
adequacy for the obvious reason of firm’s solvency. Cash management deals with maintaining sufficient quantity of
cash in such a way that the quantity denotes the lowest adequate cash figure to meet business obligations.
Cash management involves managing cash flows (into and out of the firm), within the firm and the cash balances
held by a concern at a point of time. The words, ‘managing cash and the cash balances’ as specified above does not
mean optimisation of cash and near cash items but also point towards providing a protective shield to the business
obligations. Cash management is concerned with minimising unproductive cash balances, investing temporarily
excess cash advantageously and to make the best possible arrangement for meeting planned and unexpected demands
on the firms’ cash.
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2.2 General Principles of Cash Management
Harry Gross has suggested certain general principles of cash management that, essentially add efficiency to cash
management. These principles reflecting cause and effect relationship having universal applications give a scientific
outlook to the subject of cash management. While, the application of these principles in accordance with the changing
conditions and business environment requiring high degree of skill and tact which places cash management in the
category of art. Thus, we can say that cash management like any other subject of management is both science and
art. It has well-established principles capable of being skilfully modified as per the requirements. The principles of
management are follows:
Determinable variations of cash needs

A reasonable portion of funds, in the form of cash is required to be kept aside to overcome the period anticipated
as the period of cash deficit. This period may either be short and temporary or last for a longer duration of time.
Normal and regular payment of cash leads to small reductions in the cash balance at periodic intervals. Making
this payment to different employees on different days of a week can equalise these reductions. Another technique
for balancing the level of cash is to schedule cash disbursements to creditors during that period, when accounts
receivables collected amounts to a large sum but without putting the goodwill at stake.
Contingency cash requirement

Certain instances which fall beyond the forecast of the management may arise. These constitute unforeseen calamities,
which are too difficult to be provided for, in the normal course of the business. Such contingencies always demand for
special cash requirements that was not estimated and provided for in the cash budget. Rejections of wholesale product,
large amount of bad debts, strikes, lockouts, etc., are a few among these contingencies. Only a prior experience and
investigation of other similar companies prove helpful as a customary practice. A practical procedure is to protect
the business from such calamities like bad-debt losses, fire, etc., by way of insurance coverage.
Availability of external cash

Another factor that is of great importance to the cash management is the availability of funds from outside sources.
There resources aid in providing credit facility to the firm, which materialised the firm’s objectives of holding
minimum cash balance. As such, if a firm succeeds in acquiring sufficient funds from external sources like banks
or private financiers, shareholders, government agencies, etc., the need for maintaining cash reserves diminishes.
Maximising cash receipts

Every financial manager aims at making the best possible use of cash receipts. Again, cash receipts if tackled prudently,
results in minimising cash requirements of a concern. For this purpose, the comparative cost of granting cash discounts
to customers and the policy of charging interest expense for borrowing must be evaluated on continuous basis to
determine the futility of either of the alternatives or both of them during that particular period for maximising cash
receipts. Yet, the under mentioned techniques proved helpful in this context:
• Concentration banking: Under this system, a company establishes banking centres for collection of cash in
different areas. Thereby, the company instructs its customers of adjoining areas to send their payments to those
centres. The collection amount is then deposited with the local bank by these centres as early as possible. Whereby,
the collected funds are transferred to the company’s central bank accounts operated by the head office.
• Local box system: Under this system, a company rents out the local post offices boxes of different cities and
the customers are asked to forward their remittances to it. These remittances are picked by the authorised lock
bank from these boxes to be transferred to the company’s central bank operated by the head office.
• Reviewing credit procedures: It aids in determining the impact of slow payers and bad debtors on cash. The
accounts of slow paying customers should be reviewed to determine the volume of cash tied up. Besides this,
evaluation of credit policy must also be conducted for introducing essential amendments. As a matter of fact, too
strict a credit policy involves rejections of sales. Thus, curtailing the cash in flow. On the other hand, too lenient
a credit policy would increase the number of slow payments and bad debts again decreasing the cash inflows.
• Minimising credit period: Shortening the terms allowed to the customers would definitely accelerate the cash
inflow side-by-side revising the discount offered would prevent the customers from using the credit for financing
their own operations profitably.
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• Others: Introducing various procedures for special handling of large to very large remittances or foreign
remittances such as, personal pick up of large sums of cash using airmail, special delivery and similar techniques
to accelerate such collections.
Minimising cash disbursements

The motive of minimising cash payments is the ultimate benefit derived from maximising cash receipts. Cash
disbursement can be brought under control by preventing fraudulent practices, serving time draft to creditors of
large sums, making staggered payments to creditors and for payrolls, etc.
Maximising cash utilisation

Surplus of cash is a luxury. Moreover, proper and optimum utilisation of cash always makes way for achievement
of the motive of maximising cash receipts and minimising cash payments. At times, a concern finds itself with funds
in excess of its requirement, which lay idle without bringing any return to it. At the same time, the concern finds
it unwise to dispose it, as the concern shall soon need it. In such conditions, efforts should be made in investing
these funds in some interest bearing securities. There are certain basic strategies suggested by Gitman, which prove
evidently helpful in managing cash if employed by the cash management. They are:
• Pay accounts payables as late as possible without damaging the firm’s credit rating, but take advantage of the
favourable cash discount, if any.
• Turnover, the inventories as quickly as possible, avoiding stock outs that might result in shutting down the
productions line or loss of sales.
Collect accounts receivables as early as possible without losing future loss sales because of high-pressure collections
techniques. Cash discounts, if they are economically justifiable, may be used to accomplish this objective.
2.3 Functions of Cash Management

Cash management is concerned with minimising unproductive cash balances, investing temporarily excess cash
advantageously and to make the best possible arrangements for meeting planned and unexpected demands on the
firm’s cash. Cash Management must aim to reduce the required level of cash, but minimise the risk of being unable
to discharge claims against the company as they arise. All these aims and motives of cash management largely
depend upon the efficient and effective functioning of cash management. Cash management functions can be studied
under five heads, namely, cash planning, managing cash flow, controlling cash flow, optimising the cash level and
investing idle cash. All these functions are discussed below in details:
Cash planning
Good planning is the very foundation of attaining success. For any management decision, planning is the foremost
requirement. Planning is basically an intellectual process, a mental pre-disposition to do things in an orderly way,
to think before acting and to act in the light of facts rather than of a guess. Cash planning is a technique, which
comprises of planning for and controlling of cash. It is a management process of forecasting the future needs of cash,
its available resources and various uses for a specified period. Cash planning, thus, deals at length with formulation
of necessary cash policies and procedures in order to carry on business continuously and on sound lines. Good cash
planning aims at providing cash, not only for regular, but also for irregular and abnormal requirements.
Managing cash flows

The heading simply suggests an idea of managing properly the flow of cash coming inside the business, i.e., cash
inflow and cash moving out of the business, i.e., cash outflow. These two are said to be properly managed only,
if a firm succeeds in accelerating the rate of cash inflow together with minimising the cash outflow. As observed
expediting collections, avoiding unnecessary inventories, improving control over payments, etc., contribute to better
management of cash. Whereby, a business can conserve cash and thereof would require lesser cash balance for its
operations.
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Controlling the cash flows
As forecasting is not an exact science because it is based on certain assumptions. Therefore, cash planning will
inevitably be at variance with the results actually obtained. For this reason, control becomes an unavoidable function
of cash management. Moreover, cash controlling becomes essential as it increases the availability of usable cash
from within the enterprise. As it is obvious that greater the speed of cash flow cycle, greater would be the number
of times a firm can convert its goods and services into cash and so lesser will be the cash requirement to finance
the desired volume of business during that period. Furthermore, every enterprise is in possession of some hidden
cash, which if traced out substantially decreases the cash requirement of the enterprise.
Optimising the cash level

A financial manager should concentrate on maintaining sound liquidity position, i.e., cash level. All his efforts
relating to planning, managing and controlling cash should be diverted towards maintaining an optimum level of
cash. The foremost need of maintaining optimum level of cash is to meet the necessary requirements and to settle
the obligations well in time. Optimisation of cash level may be related to establishing equilibrium between risk and
the related profit expected to be earned by the company.
Investing idle cash

Idle cash or surplus cash refers to the excess of cash inflows over cash outflows, which do not have any specific
operations or any other purpose to solve currently. Generally, a firm is required to hold cash for meeting working
needs facing contingencies and to maintain as well as develop goodwill of bankers. The problem of investing this
excess amount of cash arises simply because it contributes nothing towards profitability of the firm as idle cash
precisely earns no returns. Further, permanent disposal of such cash is not possible, as the concern may again need
this cash after a short while. But, if such cash is deposited with the bank, it definitely would earn a nominal rate of
interest paid by the bank. A much better returns than the bank interest can be expected if a company deploys idle
cash in marketable securities. There are yet another group of enterprises that neither invest in marketable securities
nor are willing to get interest. They prefer to deposit excess cash for improving relations with banks by helping
them in meeting bank requirements for compensating balances for services and loans.
2.4 Motives of Holding Cash

Every business transaction whether carried on credit or on cash basis ultimately results in either cash inflow or cash
outflows. The pivotal point in present day financial management is to maximise cash generation and to minimise
cash outflows in relation to the cash inflows. Keynes postulated three motives for holding cash:
• Transaction Motive,
• Precautionary Motive, and
• Speculative Motive.
To which one more motive for holding cash has been added:
• Compensation Motive
Transaction motive
It refers to holding of cash for meeting routine cash requirements and financing transactions carried on by the
business in the normal course of action. This motive requires cash for payment of various obligations like purchase
of raw materials, the payment of usage and salaries, dividend, income tax, various other operating expenses, etc.
However, there exists regular and counter inflow of cash in the business by way of return on investments, sales, etc.
However, cash receipts and cash payments do not perfectly synchronise with each other. Therefore, a firm requires
an additional cash balance during the periods when payments are in excess of cash receipts. Thus, transaction
motive stresses on holding cash to meet anticipated obligations that are not counter balanced by cash receipts due
to disparity of timings.
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Precautionary motive
Under precautionary motive, the need to hold cash arises for meeting any unforeseen, unpredicted contingencies
or unexpected disbursements. Such motives provide a cushion to withstand unexpected cash requirements arising
spontaneously at short notice due to various causes. In this regard, two factors largely influence the precautionary
cash balance, degree of predictability and availability of short-term credit. If a cash management succeeds in
estimating the cash requirements adequately, it escapes from maintaining big cash balance for emergency. Likewise,
if a management is capable and efficient enough to borrow the required cash from short-term creditors small balance
would be held and vice-versa.
Speculative motive
The speculative motive finds its origin out of the desire of an enterprise to avail itself the benefits of the opportunities
arising at unexpected moments that do not happen to exist in the normal course of business. This motive represents
a positive and aggressive approach. Reasonable cash reserve is maintained by concerns for exploiting profitable
opportunities like bulk purchase of raw materials at discounted prices, purchasing securities when interest rates are
expected to fall, postpone purchase of raw material if decline in prices is anticipated, etc.
Compensation motive
Such motives require holding cash balance in case the concern enters into some loan agreement with the bank. Bank
provides a great variety of services to its customers. For some of such services, it charges commission or fee. While for
other an indirect compensation is demanded by it by asking its customers to keep a minimum bank balance sufficient
to earn a return equal to cost of services provided by it. Such balances are termed as compensating balances.
2.5 Financing of Cash Shortage and Cost of Running Out of Cash

A situation arises, when the cash outflows of a firm exceeds its inflows during a certain period. Such situation creates
cash shortage in a firm. Shortage of cash is highly undesirable in all sorts of business holdings for the reason of
dreadful consequences that it bears. A management is deemed to be over-cautious and highly careful while dealing
with the problem of cash shortage even if cash inflows are anticipated in the near future; else a concern may even
reach the stage of final liquidation. Cash flow statement should be prepared to acknowledge the repercussions of
transactions involving the movement of cash.
As cash flow statement is made to show the impact of various transactions on the cash position of a firm, it takes
into consideration only such transactions that have relationship with cash.
In case of temporary shortage of cash, a concern is required to procure essential cash immediately for the anticipated
short duration, so as the curb it at the very stage instead of sustaining the long-term implication later on. The
immediate source to fall back upon remains the bank credit. In fact, bank credit is a means to meet cash shortages
as well as source of financing the current assets. The various methods from which a firm can procure funds during
the period when its outflows exceed the inflows are stated below:
• Using bank credit tine
• Raising loans from institutions and creditors other than banks
• Liquidity marketable securities
• Resorting to bills discounting schemes
• Disposing off surplus fixed assets
• Shedding the quantity of raw materials
• Unloading finished goods even at loss
• By delaying payments
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It is recommended by the financial experts that a cash management should not start searching for external finance at
the very instance when the cash shortage is anticipated. At the initial stage, a management should take appropriate
steps to avoid or minimise the undesirable situation of emerging cash shortage by exercising effective control over
internal resources. In this respect, the matters of special consideration that can be gainfully employed by the concern
for overpowering the situation of cash shortage are:
• Increasing efforts to speedup collection
• Reduction in purchase of inventories
• Increasing cash sales
• Selling-off redundant assets
• Selling short-term investments
• Deferment of capital expenditure
• Postponing and delaying payments
These considerations are nothing but mere use of tact and skill to overcome a shortage of cash. They are much
economical than any other resources (internal or external) for they cost neither interest nor any expenses. Even if an
external resource has to be found, this might be seen as a bridging operation pending the ability to bring on stream
an alternative internal source. When a firm becomes aware of the approaching shortage of cash, it should concentrate
its efforts towards the eradication of such situation. The sooner the shortage is provided for, the better it is. Every
concern escapes itself from lending into such a situation as it makes way for numerous costs because of running
out of cash. A firm bears not only the burden of unnecessary costs, but is subjected to various types of pressures
pertaining to its dealings. All these factors adversely affect the morale of management, causes damages to the hard-
earned reputation and financial credit-worthiness, etc. A firm is forced to borrow funds at high rates of interest has
to accept higher price demand of suppliers, loses cash discount on payments, enters into further negotiations with
banks and other financial institutions on account of slow payment.
2.6 Financing Current Assets

Current assets of enterprises may be financed either by short-term sources or long-term sources or by combination of
both. The main sources constituting long-term financing are shares, debentures, and debts form banks and financial
institutions. The long-term source of finance provides support for a small part of current asset-requirements which
is called the working capital margin. Working capital margin is used here to express the difference between current
assets and current liabilities. Short-term financing of current assets includes sources of short-term credit, which a firm
is mostly required to arrange in advance. Short-term bank loans, commercial papers, etc., are a few of its components.
Current liabilities like accruals and provisions, trade credit, short-term bank finance, short-term deposits and the like
warranting the current assets are also referred to a short-term term sources of finance. Spontaneous financing can
also finance current assets, which includes creditors, bills payable and outstanding receipts. A product firm would
always opt for utilising spontaneous sources fully since it is free of cost. Concerns that can no more be financed
by spontaneous sources of financing has to decide between short-term and long-term source of finance along with
relevant proportion of the two. There are three approaches of financing current assets that are popularly used:
Matching approach
As the name itself suggests, a financing instrument would offset the current asset under consideration, being financing
instrument bearing approximately same maturity. In simple words, under this approach a match is established
between the expected lives of current asset to be financed with the source of fund raised to finance the current
assets. For this reason, a firm would select long-term financing to finance or permanent current assets to finance
temporary or variable current assets. Thus, a ten-year loan may be raised for financing machinery bearing expected
life of ten years. Similarly, one-month stock can be financed by means of one-month bank loan. This is also termed
as hedging approach.
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Conservative approach
Conservative approach takes an edge over and above matching approach, as it is practically not possible to plan an
exact match in all cases. A firm is said to be following a conservative approach when it depends more on long-term
financial sources for meeting its financial needs. Under this financing policy, the fixed assets, permanent current
assets and even a part of temporary current assets are provided with long-term sources of finance and this makes it
less risky. Another advantage of following this approach is that in the absence of temporary current assets, a firm
can invest surplus funds into marketable securities and store liquidity.
Aggressive approach
As against conservative approach, a firm is said to be following aggressive financing policy when depends relatively
more on short-term sources than warranted by the matching plan. Under this approach, the term finance includes
not only its temporary current assets but also a part of permanent current assets with short-term sources of finance.
In nutshell, it may be concluded that for financing of current assets, a firm should decide upon two important
constraints; firstly, the type of financing policy to be selected (whether short-term or long-term and secondly, the
relative proportion of modes of financing. This decision is totally based on trade-off between risk and return, as,
short-term financing is less costly but risky, long-term financing is less risky but costly.
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Summary
• Steady and healthy circulation of cash throughout the entire business operations is the basis of business
solvency.
• Cash consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks.
• Cash management includes management of marketable securities also, because in modern terminology money
• The term cash management refers to the management of cash resource in such a way that generally accepted
business objectives could be achieved.
• Cash management may be regarded as an art that assists in establishing equilibrium between liquidity and
profitability to ensure undisturbed functioning of a firm towards attaining its business objectives.
• Cash management involves managing cash flows (into and out of the firm), within the firm and the cash balances
held by a concern at a point of time.
• Normal and regular payment of cash leads to small reductions in the cash balance at periodic intervals.
• Another technique for balancing the level of cash is to schedule cash disbursements to creditors during that
period when accounts receivables collected amounts to a large sum but without putting the goodwill at stake.
• Every financial manager aims at making the best possible use of cash receipts.
• The motive of minimising cash payments is the ultimate benefit derived from maximising cash receipts.
• Cash planning is a technique, which comprises of planning for and controlling of cash.
• Idle cash or surplus cash refers to the excess of cash inflows over cash outflows, which do not have any specific
operations or any other purpose to solve currently.
• It is recommended by the financial experts that a cash management should not start searching for external finance
at the very instance when the cash shortage is anticipated.
• Short-term financing of current assets includes sources of short-term credit, which a firm is mostly required to
arrange in advance.
• A firm is said to be following conservative approach when it depends more on long-term financial sources for
meeting its financial needs.
• Conservative approach takes an edge over and above matching approach, as it is practically not possible to plan
an exact match in all cases.
References
• Analysis of Cash Management [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_
chapter%207.pdf> [Accessed 12 July 2013].
• Cash management [Online] Available at: <http://www.investopedia.com/terms/c/cash-management.asp>
• Financial Management - Lecture 05 [Video online] Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>
• Financial Management: Lecture 4 [Video online] Available at: <http://www.youtube.com/watch?v=ZRE1glkq9zA>
• Ward, M. A. and Sagner, J., 2003. Essentials of Managing Corporate Cash Wiley.
• Jones, E. B. and Jones, E. B., 2001. Cash Management.R&L Education.
Recommended Reading
• Cooper, R., 2004. Corporate Treasury and Cash Management (Finance and Capital Markets). Palgrave
Macmillan.
• Linzer, R.S. and Linzer, A.O., 2007. Cash Flow Strategies: Innovation in Nonprofit Financial Management.
Jossey-Bass.
• Driscoll, M.C., 1983. Cash Management: Corporate Strategies. John Wiley & Sons Inc.
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Self Assessment
1. Which of the following is not a part of working capital cycle?
a. Cash
b. Inventory
c. Receivable
d. Accounts
2. ____________ consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks.
a. Inventory
b. Accounts
c. Receivable
d. Cash
3. _______________ includes management of marketable securities also, because in modern terminology money
a. Cash management
b. Receivable management
c. Inventory management
d. Financial management
4. Which of the following statement is not a principle of cash management?

a. Determinable variations of cash needs
b. Contingency cash requirement
c. Availability of internal cash
d. Maximising cash receipts
5. Under ________________ system, a company establishes banking centres for collection of cash in different
areas.
a. local box system
b. concentration banking
c. minimising credit
d. reviewing credit
6. Under _________________ system, a company rents out the local post offices boxes of different cities and the
customers are asked to forward their remittances to it.
a. local box system
c. minimising credit
d. reviewing credit
7. The motive of ____________________ is the ultimate benefit derived from maximising cash receipts.
a. cash utilisation
c. minimising cash payments
d. credit period
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8. ______________________ is a technique, which comprises of planning for and controlling of cash.
a. Cash planning
b. Cash management
c. Forecasting
d. Cash flow
9. Which of the following increases the availability of usable cash from within the enterprise?
a. Cash controlling
b. Cash flow
c. Cash forecasting
d. Cash finance
10. __________ refers to the excess of cash inflows over cash outflows, which do not have any specific operations
or any other purpose to solve currently.
a. Cash investment
b. Forecast
c. Idle cash
d. Profitability
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Chapter III
Cash Flow and Financial Planning
Aim
• define cash flow
• elucidate depreciation in financial management
• classify the inflows and outflows of cash
Objectives
• explain the statement of cash flow
• explicate the financial planning process
• elucidate cash planning
Learning outcome
• understand the preparation of cash budget
• identify the net cash flow
• recognise the do’s and don’ts of cash forecasting
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3.1 Introduction
Cash flow is the primary focus of financial management. The goal is twofold, to meet the firm’s financial obligations
and to generate positive cash flow for its owners. Financial planning focuses on the firm’s cash and profits—both
of which are key elements of continued financial success, and even survival. This chapter outlines how the firm
analyses its cash flows, including the effect of depreciation, and the use of cash budgets and proforma statements
as tools of financial planning.
Cash flow, the lifeblood of the firm, is the primary focus of the financial manager both in managing day-to-day
finances and in planning and making strategic decisions aimed at creation of shareholder value. An important factor
affecting a firm’s cash flow is depreciation (and any other non-cash charges). From a strict financial perspective,
firms often focus on both operating cash flow, which is used in managerial decision making and free cash flow,
which is closely watched by participants in the capital market. We begin our analysis of cash flow by considering
the key aspects of depreciation, which is closely related to the firm’s cash flow.
3.2 Depreciation
Business firms are permitted for tax and financial reporting purposes to charge a portion of the costs of fixed assets
systematically against annual revenues. This allocation of historical costs over a period of time is called depreciation.
For tax purposes, the depreciation of business assets is regulated by the Internal Revenue Code. Because the objectives
of financial reporting are sometimes different from those of tax legislation, firms often use different depreciation
methods for financial reporting than those required for tax purposes. Tax laws are used to accomplish economic
goals, such as providing incentives for business investment in certain types of assets, whereas the objectives of
financial reporting are of course quite different.
Keeping two different sets of records for these two different purposes is legal. Depreciation for tax purposes is
determined by using the Modified Accelerated Cost Recovery System (MACRS); a variety of depreciation methods
are available for financial reporting purposes. Before we discuss the methods of depreciating an asset, you must
understand the depreciable value of an asset and the depreciable life of an asset.
Depreciable value of an asset

Under the basic MACRS procedures, the depreciable value of an asset (the amount to be depreciated) is its full cost,
including outlays for installation. No adjustment is required for expected salvage value.
Depreciable life of an asset

The time period, over which an asset is depreciated, its depreciable life can significantly affect the pattern of cash
flows. The shorter the depreciable life, the more quickly the cash flow created by the depreciation write-off will be
received.
Depreciation methods
For financial reporting purposes, a variety of depreciation methods like straight-line, double-declining balance, and
sum-of-the-years can be used.
Developing the statement of cash flows

The statement of cash flows summarises the firm’s cash flow over a given period of time. Before discussing the
statement and its interpretation, we will review the cash flow through the firm and the classification of inflows and
outflows of cash.
The firm’s cash flows

Figure 3.1 illustrates the firm’s cash flows. Note that marketable securities are considered the same as cash because
of their highly liquid nature. Both cash and marketable securities represent a reservoir of liquidity, that is, increased
by cash inflows and decreased by cash outflows. Also, note that the firm’s cash flows can be divided into:
• Operating flows
• Investment flows
• Financing flows
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The operating flows are cash inflows and outflows directly related to sale and production of the firm’s products
and services. Investment flows are cash flows associated with purchase and sale of both fixed assets and business
interests.
Clearly, purchase transactions would result in cash outflows, whereas sales transactions would generate cash inflows.
The financing flows result from debt and equity financing transactions. Incurring (or repaying) either short-term or
long-term debt would result in a corresponding cash inflow (or outflow). Similarly, the sale of stock would result
in a cash inflow; the payment of cash dividends or repurchase of stock would result in a financing outflow. In
combination, the firm’s operating, investment, and financing cash flows during a given period affect the firm’s cash
and marketable securities balances.
3.3 Classifying Inflows and Outflows of Cash

The statement of cash flows in effect summarises the inflows and outflows of cash during a given period.
(1 ) O p e r a t in g Flo w s (2 ) In v e s t m e n t Flo w s
Payment of Accruals
Accrued
Labor
Wages
Payment
of Credit Purchase
Purchases
Raw Accounts
Sale Fixed Assets
Materials Payable
Depreciation
Work in Overhead Business

Process Expenses Interests
Finished Purchase
Goods
Sale
Cash
Operating (incl.
and
Depreciation) and
Marketable
Interest Expense (3) Financing Flows
Securities
Borrowing
Payment
Repayment Debt
Taxes (Short-Term and
Refund Long-Term)
Cash Sales Sale of Stock

Sales
Repurchase of Stock
Equity
Payment of Cash Dividends
Accounts Collection of Credit Sales

Receivable
Fig. 3.1 The firm’s cash flow
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3.4 Preparing the Statement of Cash Flows
The statement of cash flows for a given period is developed using the income statement for the period, along with
the beginning and end-of-period balance sheets.
Interpreting the statement

The statement of cash flows allows the financial manager and other interested parties to analyse the firm’s cash
flow. The manager should pay special attention both to the major categories of cash flow and to the individual items
of cash inflow and outflow to assess whether any developments have occurred that are contrary to the company’s
financial policies. In addition, the statement can be used to evaluate progress towards projected goals or to isolate
inefficiencies. For example, increases in accounts receivable or inventories resulting in major cash outflows may
signal credit or inventory problems, respectively. The financial manager also can prepare a statement of cash flows
developed from projected financial statements. This approach can be used to determine whether planned actions
are desirable in view of the resulting cash flows.
Operating cash flow

A firm’s Operating Cash Flow (OCF) is the cash flow it generates from its normal operations, producing and selling
its output of goods or services. A variety of definitions of OCF can be found in the financial literature. We’ve already
been introduced to the simple accounting definition of cash flow from operations in equation.
OCF= EBI-Taxes + Depreciation
Free cash flow

The firm’s Free Cash Flow (FCF) represents the amount of cash flow available to investors, the providers of debt
(creditors) and equity (owners) after the firm has met all operating needs and paid for investments in net fixed assets
and net current assets. It is called “free” not because it is “without cost” but because it is “available” to investors. It
represents the summation of the net amount of cash flow available to creditors and owners during the period. Free
cash flow can be defined by equation:
FCF= OCF - Net fixed asset investment (NFAI) - Net current asset investment (NCAI)
The financial planning process

Financial planning is an important aspect of the firm’s operations because it provides road maps for guiding,
coordinating, and controlling the firm’s actions to achieve its objectives. Two key aspects of the financial planning
process are cash planning and profit planning. Cash planning involves preparation of the firm’s cash budget. Profit
planning involves preparation of pro forma statements. Both the cash budget and the pro forma statements are useful
for internal financial planning; they also are routinely required by existing and prospective lenders.
The financial planning process begins with long-term, or strategic, financial plans. These in turn guide the formulation
of short-term, or operating, plans and budgets. Generally, the short-term plans and budgets implement the firm’s long-
term strategic objectives. Although the remainder of this chapter places primary emphasis on short-term financial
plans and budgets, a few preliminary comments on long-term financial plans are in order.
Long-term (strategic) financial plans

Long-term (strategic) financial plans lay out a company’s planned financial actions and the anticipated impact of
those actions over periods ranging from 2 to 10 years. Five-year strategic plans, which are revised as significant
new information becomes available, are common. Generally, firms that are subject to high degrees of operating
uncertainty, relatively short production cycles, or both, tend to use shorter planning horizons.
Long-term financial plans are part of an integrated strategy that, along with production and marketing plans,
guides the firm toward strategic goals. Those long-term plans consider proposed outlays for fixed assets, research
and development activities, marketing and product development actions, capital structure, and major sources of
financing. Also included would be termination of existing projects, product lines, or lines of business; repayment
or retirement of outstanding debts; and any planned acquisitions. Such plans tend to be supported by a series of
annual budgets and profit plans.
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Short-term (operating) financial plans

Short-term (operating) financial plans specify short-term financial actions and the anticipated impact of those
actions. These plans most often cover a 1 to 2-year period. Key inputs include the sales forecast and various forms
of operating and
Information Needed
Sales
Forecast Output for Analysis
Production Long-Term
Plans Financing
Plan
Pro Forma Cash Fixed Asset

Income Budget Outlay
Statement Plan
Current-
Period
Balance
Sheet
Pro Forma
Balance Sheet
Fig. 3.2 The short-term financial planning process
financial data. Key outputs include a number of operating budgets, the cash budget, and pro forma financial statements.
The entire short-term financial planning process is outlined in Fig. 3.2.
Short-term financial planning begins with the sales forecast. From it, production plans are developed that take into
account lead (preparation) times and include estimates of the required raw materials. Using the production plans, the
firm can estimate direct labour requirements, factory overhead outlays, and operating expenses. Once these estimates
have been made, the firm’s pro forma income statement and cash budget can be prepared. With the basic inputs (pro
forma income statement, cash budget, fixed asset outlay plan, long-term financing plan, and current-period balance
sheet), the pro forma balance sheet can finally be developed.
3.5 Cash Planning: Cash Budgets

The cash budget, or cash forecast, is a statement of the firm’s planned inflows and outflows of cash. It is used by the
firm to estimate its short-term cash requirements, with particular attention to planning for surplus cash and for cash
shortages. Typically, the cash budget is designed to cover a 1-year period, divided into smaller time intervals. The
number and type of intervals depend on the nature of the business. The more seasonal and uncertain a firm’s cash
flows, the greater the number of intervals. Because many firms are confronted with a seasonal cash flow pattern, the
cash budget is quite often presented on a monthly basis. Firms with stable patterns of cash flow may use quarterly
or annual time intervals.
3.5.1 The Sales Forecast

The key input to the short-term financial planning process is the firm’s sales forecast. This prediction of the firm’s
sales over a given period is ordinarily prepared by the marketing department. On the basis of the sales forecast, the
financial manager estimates the monthly cash flows that will result from projected sales receipts and from outlays
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related to production, inventory and sales. The manager also determines the level of fixed assets required and the
amount of financing, if any, needed to support the forecast level of sales and production. In practice, obtaining good
data is the most difficult aspect of forecasting. The sales forecast may be based on an analysis of external data,
internal data, or a combination of the two.
An external forecast is based on the relationships observed between the firm’s sales and certain key external economic
indicators such as the Gross Domestic Product (GDP), new housing starts, consumer confidence, and disposable
personal income. Forecasts containing these indicators are readily available. Because the firm’s sales are often
closely related to some aspect of overall national economic activity, a forecast of economic activity should provide
insights into future sales.
Internal forecasts are based on a build up, or consensus, of sales forecasts through the firm’s own sales channels.
Typically, the firm’s salespeople in the field are asked to estimate how many units of each type of product they
expect to sell in the coming year. These forecasts are collected and totalled by the sales manager, who may adjust
the figures using the knowledge of specific markets or of the salesperson’s forecasting ability. Finally, adjustments
may be made for additional internal factors, such as production capabilities.
Firms generally use a combination of external and internal forecast data to make the final sales forecast. The internal
data provides insights into sales expectations, and the external data provides a means of adjusting these expectations
to take into account general economic factors. The nature of the firm’s product also often affects the mix and types
of forecasting methods used.
3.5.2 Preparing the Cash Budget

The general format of the cash budget is presented in Table 3.1.
Jan. Feb. Nov. Dec.

.....
Cash receipts $XXX $XXG $XXM $XXT
Less: Cash disbursements XXA XXH XXN XXU

.........
Net cash flow $XXB $XXI $XXO $XXV
Add: Beginning cash XXC XXD XXJ XXP XXQ
Ending cash $XXD $XXJ $XXQ $XXW
Less: Minimum cash balance XXE XXK XXR XXY

...........
Required total financing XXL $XXS
Excess cash balance $XXF $XXZ
Table 3.1 The general format of the cash budget
Cash Receipts
Cash receipts include all of a firm’s inflows of cash in a given financial period. The most common components of
cash receipts are cash sales, collections of accounts receivable, and other cash receipts.
Example:
Coulson Industries, a defence contractor, is developing a cash budget for October, November, and December.
Coulson’s sales in August and September were $100,000 and $200,000, respectively. Sales of $400,000, $300,000
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and $200,000 have been forecast for October, November and December, respectively. Historically, 20% of the
firm’s sales have been for cash, 50% have generated accounts receivable collected after 1 month, and the remaining
30% have generated accounts receivable collected after 2 months. Bad-debt expenses (uncollectible accounts) have
been negligible. In December, the firm will receive a $30,000 dividend from stock in a subsidiary. The schedule of
expected cash receipts for the company is presented in Table 3.8. It contains the following items:
• Forecast sales: This initial entry is merely informational. It is provided as an aid in calculating other sales-
related items.
• Cash sales: The cash sales shown for each month represent 20% of the total sales forecast for that month.
• Collections of A/R: These entries represent the collection of accounts receivable (A/R) resulting from sales in
earlier months.
• Lagged 1 month: These figures represent sales made in the preceding month that generated accounts receivable
collected in the current month. Because 50% of the current month’s sales are collected 1 month later, the
collections of A/R with a 1-month lag shown for September represent 50% of the sales in August, collections
for October represent 50% of September sales, and so on.
• Lagged 2 months: These figures represent sales made 2 months earlier that generated accounts receivable
collected in the current month. Because 30% of sales are collected 2 months later, the collections with a 2-month
lag shown for October represent 30% of the sales in August, and so on.
• Other cash receipts: These are cash receipts expected from sources other than sales. Interest received, dividends
received, proceeds from the sale of equipment, stock and bond sale proceeds, and lease receipts may show up
here.
Forecast sales Aug. $100 Sept. $200 Oct. $400 Nov. $300 Dec. $200
Cash sales (0.20) $20 $40 $80 $60 $40
Collections of A/R:
Lagged 1 month (0.50) 50 100 200 150
Lagged 2 month (0.50) 30 60 120
Other cash receipts 30
Total cash receipts $210 $320 $340
Table 3.2 A schedule of projected cash receipts for Coulson Industries ($000)
Cash disbursements
Cash disbursements include all outlays of cash by the firm during a given financial period. The most common cash
disbursements are:
• Cash purchases
• Fixed-asset outlays
• Payments of accounts payable
• Interest payments
• Rent (and lease) payments
• Cash dividend payments
• Wages and salaries
• Principal payments (loans)
• Tax payments
• Repurchases or retirements of stock
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It is important to recognise that depreciation and other noncash charges are NOT included in the cash budget,
because they merely represent a scheduled write-off of an earlier cash outflow. The impact of depreciation, as we
noted earlier, is reflected in the reduced cash outflow for tax payments.
3.6 Net Cash Flow, Ending Cash, Financing, and Excess Cash
The firm’s net cash flow is found by subtracting the cash disbursements from cash receipts in each period. Then,
we add beginning cash to the firm’s net cash flow to determine the ending cash for each period. Finally, we subtract
the desired minimum cash balance from ending cash to find the required total financing or the excess cash balance.
If the ending cash is less than the minimum cash balance, financing is required. Such financing is typically viewed
as short-term and is therefore represented by notes payable. If the ending cash is greater than the minimum cash
balance, excess cash exists. Any excess cash is assumed to be invested in a liquid, short-term, interest-paying vehicle,
that is, in marketable securities.
Evaluating the cash budget

The cash budget indicates whether a cash shortage or surplus is expected in each of the months covered by the forecast.
Each month’s figure is based on the internally imposed requirement of a minimum cash balance and represents the
total balance at the end of the month.
Coping with uncertainty in the cash budget

Aside from careful estimation of cash budget inputs, there are two ways of coping with the uncertainty of the cash
budget. One is to prepare several cash budgets based on pessimistic and optimistic forecasts. From this range of cash
flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation.
The use of several cash budgets, based on differing assumptions, also should give the financial manager a sense of
the riskiness of various alternatives. This sensitivity analysis, or ‘what if’ approach, is often used to analyse cash
flows under a variety of circumstances. Computers and electronic spreadsheets simplify the process of performing
sensitivity analysis.
Table 3.3 presents the summary of Coulson Industries’ cash budget prepared for each month of concern using
pessimistic, most likely and optimistic estimates of total cash receipts and disbursements. The most likely estimate
is based on the expected outcomes presented earlier.
O ct o b er N o vem b er D ecem b er
Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti-

mistic likely mistic mistic likely mistic mistic likely mistic
Total cash
receipts $160 $210 $285 $210 $320 $ 410 $275 $340 $422
Less: Total cash
disbursements 200 213 248 380 418 467 280 305 320
Net cash flow ($ 40) ($ 3) $ 37 ($170) ($ 98) ($ 57) ($ 5) $ 35 $102
Add: Beginning
cash 50 50 50 10 47 87 ( 160) ( 51) 30
Ending cash $ 10 $ 47 $ 87 ($160) ($ 51) $ 30 ($165) ($ 16) $132
Less: Minimum
cash balance 25 25 25 25 25 25 25 25 25
Required total
financing $ 15 — — $185 $ 76 — $190 $ 41 —
Excess cash
balance — $ 22 $ 62 — — $ 5 — — $107
Table 3.3 A sensitivity analysis of Coulson industries cash budget
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3.7 Cash Forecasting

A cash flow forecast aims to predict a company’s future financial liquidity over a specific period of time, using
tried and tested financial models. While cash normally refers to the liquid assets in a company’s bank account, the
forecast usually estimates its treasury position, which is cash plus short-term investments minus short-term debts.
The cash flow itself refers to the change in the cash or treasury position from one period to the next. The cash flow
forecast is an important way to value assets, work out budgets, and determine appropriate capital structures. It will
provide a good indicator of a company’s financial health for potential investors.
Several methods are generally used to forecast cash flow—one direct, and three indirect. The direct method is
most suitable for short-term forecasts of anywhere from 30 days up to a year, since it is based on actual data from
which the projections are extrapolated. The data used are the company’s cash receipts and disbursements (R&D).
Receipts primarily include accounts from recent sales, sales of other assets, proceeds of financing, etc. Disbursements
include salaries, payments for recent purchases, dividends, and debt servicing. Many of the R&D entries are based
on projected future sales.
All the other methods use a company’s projected income statements and balance sheets as their basis. The first
method is Adjusted Net Income (ANI), which first examines the operating income (EBIT or EBITDA), and then
looks at changes on the balance sheet such as receivables, payables, and inventory to forecast cash flow. The Pro
forma Balance Sheet (PBS) method looks at the projected book cash account, if projections for all other balance
sheet accounts are correct, then the cash flow will also be correct. Both these methods can be used to make short-
term (up to 12 months) and long-term (multiple year) forecasts. Since they use the monthly or quarterly intervals
of a company’s financial plan, they must be adjusted to account for the differences between the book cash and the
actual bank balance, and these may be significantly different.
The third method uses the Accrual Reversal Method (ARM), which reverses large accruals (revenues and expenses that
are recognised when they are earned or incurred, disregarding the actual receipt or dispersal of cash) and calculates
the cash effects based on statistical distributions and algorithms. This allows the forecasting period to be weekly or
even daily. It can also be used to extend the R&D method beyond the 30-day horizon because it eliminates the inherent
cumulative errors. This is the most complicated of all methods and is best suited for medium-term forecasts.
Advantages
• Cash flow projections offer a useful indicator of a company’s financial health.
• Cash flow forecasts enable you to predict the peaks and troughs in your cash balance, helping you to plan
borrowings, and they tell you how much surplus cash you may have at a given time. Most banks insist on
forecasts before considering a loan.
Disadvantages
• A cash flow forecast never tells the whole story about a company’s financial situation and should not be relied
on as the sole indicator.
Dos and Don’ts

Dos
• Use the most appropriate method, depending on how long you want your forecasting horizon to be.
• Remember that a cash flow forecast can only determine the short-term sustainability of a company.
• The longer the forecast horizon, the higher the chance of an inaccurate projection.
• Bear in mind that the forecast is dynamic—you will need to adjust it frequently depending on business activity,
payment patterns and supplier demands.
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Don’ts
• Don’t rely solely on a cash flow forecast to determine a company’s financial stability—look at the other financial
statements and forecasts, such as an income statement and a balance sheet, to see what’s actually going on.
• Don’t forget to incorporate warning signals into your cash flow forecast. For example, if predicted cash levels
come close to your overdraft limits, this should sound an alarm and trigger action to bring cash back to an
acceptable level.
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Summary
• Cash flow is the primary focus of financial management.
• Financial planning focuses on the firm’s cash and profits—both of which are key elements of continued financial
success, and even survival.
• An important factor affecting a firm’s cash flow is depreciation.
• Depreciation for tax purposes is determined by using the modified accelerated cost recovery system.
• The time period, over which an asset is depreciated, its depreciable life can significantly affect the pattern of
cash flows.
• Both cash and marketable securities represent a reservoir of liquidity that is increased by cash inflows and
decreased by cash outflows.
• The operating flows are cash inflows and outflows directly related to sale and production of the firm’s products
and services.
• Investment flows are cash flows associated with purchase and sale of both fixed assets and business interests.
• The financing flows result from debt and equity financing transactions.
• The statement of cash flows allows the financial manager and other interested parties to analyse the firm’s cash
flow.
• A firm’s operating cash flow (OCF) is the cash flow it generates from its normal operations, producing and
selling its output of goods or services.
• Both the cash budget and the pro forma statements are useful for internal financial planning; they also are
routinely required by existing and prospective lenders.
• Long-term financial plans are part of an integrated strategy that, along with production and marketing plans,
guides the firm toward strategic goals.
• Short-term (operating) financial plans specify short-term financial actions and the anticipated impact of those
actions.
• Internal forecasts are based on a build up, or consensus, of sales forecasts through the firm’s own sales
channels.
• Firms generally use a combination of external and internal forecast data to make the final sales forecast.
• The internal data provide insight into sales expectations, and the external data provide a means of adjusting
these expectations to take into account general economic factors.
• Cash receipts include all of a firm’s inflows of cash in a given financial period.
• Cash disbursements include all outlays of cash by the firm during a given financial period.
• The firm’s net cash flow is found by subtracting the cash disbursements from cash receipts in each period.
• A cash flow forecast aims to predict a company’s future financial liquidity over a specific period of time, using
tried and tested financial models.
• The cash flow forecast is an important way to value assets, work out budgets and determine appropriate capital
structures.
• The Pro forma Balance Sheet (PBS) method looks at the projected book cash account—if the projections for
all other balance sheet account are correct, then the cash flow will also be correct.
References
• Preparing a Cash Flow Forecast [Online] Available at: <http://www.qfinance.com/contentFiles/QF02/
g1xqynvv/12/1/preparing-a-cash-flow-forecast.pdf> [Accessed 12 July 2013].
• Cash flow and financial planning [Pdf] Available at: <http://wps.aw.com/wps/media/objects/222/227412/ebook/
ch03/chapter03.pdf> [Accessed 12 July 2013].
• CFA Level I Cash Flow Statement [Video online] Available at: <http://www.youtube.com/watch?v=hkcOqTNPiTo>
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• Chap 17 Lecture: Statement of Cash Flows. [Video online] Available at: <http://www.youtube.com/
watch?v=M7xhaJVx-WE> [Accessed 12 July 2013].
• Ramsey, D., 2009. The Total Money Makeover: A Proven Plan for Financial Fitness. 3rd ed., Thomas
Nelson.
• Jury, T., 2012. Cash Flow Analysis and Forecasting. Wiley.
RecommendedReading
• Tracy, J.A. and Tracy, T., 2011. Cash Flow For Dummies. For Dummies
• O’Berry, D., 2006. Small Business Cash Flow: Strategies for Making Your Business a Financial Success.
Wiley.
• CPF Board, 2013. CFP Board Financial Planning Competency Handbook. Wiley.
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Self Assessment
1. ______________ is the primary focus of financial management.
a. Business firm
b. Cash flow
c. Financial planning
d. Capital market
2. ______________ are used to accomplish economic goals, such as providing incentives for business investment
in certain types of assets.
a. Tax laws
b. MACRS
c. Cash profits
d. Tax purposes
3. Which of the following is not one of the divisions of cash flow?

a. Operating flows
b. Investment flows
c. Purchase flows
d. Financing flows
4. The statement of _____________ allows the financial manager and other interested parties to analyse the firm’s
cash flow.
a. business firm
b. cash flows
c. financial planning
d. capital market
5. _____________________ represents the summation of the net amount of cash flow available to creditors and
owners during the period.
a. OCF
b. EBI
c. NCAI
d. FCF
6. Two key aspects of the financial planning process are cash planning and ____________ planning.
a. process
b. loss
c. receivable
d. profit
7. ___________________ planning involves preparation of pro forma statements.

a. Process
b. Loss
c. Receivable
d. Profit
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8. Which of the following statement is false?
a. Long-term (strategic) financial plans lay out a company’s planned financial actions and the anticipated impact
of those actions over periods ranging from 2 to 10 years.
b. The financial planning process begins with long-term, or strategic, financial plans.
c. Long-term financial plans are part of an integrated strategy that, along with production and marketing plans,
guides the firm toward strategic goals.
d. Long-term (operating) financial plans specify short-term financial actions and the anticipated impact of
those actions.
9. The _______________ is a statement of the firm’s planned inflows and outflows of cash.
a. cash budget
b. short-term financial planning
c. long-term financial planning
d. sale forecast
10. An/A _______________ is based on the relationships observed between the firm’s sales and certain key external
economic indicators, such as the Gross Domestic Product (GDP).
a. internal forecast
b. external forecast
c. final forecast
d. cash flow
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Chapter IV
Liquidity and Working Capital Financing
Aim
• define traditional measures of liquidity
• elucidate the liquidity ratios
• explain the types of liquidity ratio
Objectives
• explain net working capital
• explicate the business uses of working capital
• elucidate permanent working capital
Learning outcome
• understand the cyclical working capital
• identify the working capital financing
• recognise the forms of working capital financing
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4.1 Introduction
Liquidity refers to the ability of a company to meet its immediate obligations without any trouble or strain. The
obligations for a business may consist of items, such as accounts payable for the suppliers of raw materials, taxes
payable, utilities payable and other accrued expenses. How does a company pay all these obligations? It is through
cash.
Where from an organisation gets the required cash for meeting all these obligations? It gets cash from the existing
cash balance in hand, bank account balances and realisation of cash by converting the current assets such as account
receivable, note receivable and inventories into cash. The above explanation shows that liquidity contributes to
profitability. So what will happen to the organisation whose performance suffers from a poor liquidity position?
This means that this organisation is finding it hard to meet its payment obligations to outsiders, such as suppliers/
vendors of material.
If this situation continues, the vendors will not supply the required materials for the production activities and may
even blacklist the company. Poor liquidity position thus can bring upon many challenges, which could even result
in liquidation, if not addressed properly.
4.2 Traditional Measures

Business entities have so far relied on two major measures to gauge their liquidity position. One is current ratio
and the other one is liquidity or quick ratio (popularly known as the acid-test ratio). The current ratio is computed
by dividing the total of current assets by the total of current liabilities. Here, current assets are defined as assets
that are convertible into cash in one year or one operating cycle, whichever is higher. Examples include cash in
hand, cash at bank, short-term marketable securities, accounts receivable, notes receivable, inventories and pre-
paid expenses. Current liabilities are those obligations that are to be settled in one year or one operating cycle,
whichever is longer.
A current ratio of 2:1 is considered to be satisfactory in theory. This indicates that the company has twice the amount
of money invested in current assets than that of the amount required for meeting its current liabilities. However,
practicality suggests that the judgement on whether a company’s liquidity position is good or bad should be based
on the industry standards or benchmark.
Here, quick ratio is a better measure of the actual liquidity position of a company compared to the current ratio. The
major flaw in using current ratio is that it uses inventories and pre-paid expenses in its definition of liquid assets,
while they are the least liquid assets in reality. Quick ratio removes this error by dividing the liquid assets by the
current liabilities of a firm. Here, quick or liquid assets include all the current assets except inventories and pre-paid
expenses. A quick ratio of one is considered satisfactory in theory. Again, investors need to look at the industry
standards for the right interpretation about a company’s liquidity position.
4.2.1 An Alternative Method

However, investors must not take a call on the liquidity position of a company just by going through the traditional
liquidity measures alone. They need to look at the liquidity position of a firm based on the alternative method too.
You can do this by dividing the excess of long-term financing over the net fixed assets by the net working capital
requirements of a firm. Here long-term financing is computed by adding the owners’ equity with the non-current
liabilities. Net fixed assets can be arrived at by deducting accumulated depreciation from the gross fixed assets,
and net working capital by subtracting the total of current liabilities from the total of current assets excluding cash
balance. This method suggests the following:
• Long-term funds available should be greater than the amount locked up in net fixed assets.
• The amount of current assets [excluding cash] should exceed the amount of current liabilities of the
organisation.
Some analysts also compute absolute cash ratio where liquidity is measured by dividing the sum of cash and near-
cash assets by the sum of current liabilities.
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4.3 Liquidity Ratios

Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations. This is done by
comparing a company’s most liquid assets (or, those that can be easily converted to cash), its short-term liabilities.
In general, the greater the coverage of liquid assets to short-term liabilities, the better, as it is a clear signal that a
company can pay its debts that are due in the near future and still fund its ongoing operations. On the other hand,
a company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will
have difficulty running its operations and meeting its obligations. The biggest difference between each ratio is the
type of assets used in the calculation. While each ratio includes current assets, the more conservative ratios will
exclude some current assets as they aren’t as easily converted to cash.
4.3.1 Types of Liquidity Ratio

The types of liquidity ratios are:
Current ratio
The current ratio is a popular financial ratio used to test a company’s liquidity (also referred to as its current or
working capital position) by deriving the proportion of current assets available to cover current liabilities. The
concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable
securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current
portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.
Formula:
Quick ratio
The quick ratio or the quick assets ratio or the acid-test ratio is a liquidity indicator that further refines the current
ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio
is more conservative than the current ratio because it excludes inventory and other current assets, which are more
difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.
Formula:
Cash ratio
The cash ratio is an indicator of a company’s liquidity that further refines both the current ratio and the quick ratio
by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current
liabilities.
Formula:
Cash conversion cycle

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables
and pay its accounts payable. The Cash Conversion Cycle (CCC) measures the number of days a company’s cash
is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its
creditors. The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known
as the “cash” or “operating” cycle.
Formula: Cash conversion Cycle= DIO+DSO-DPO
Where:
DIO= Days Inventory Outstanding
DSO- Days Sales Outstanding
DPO= Days Payable Outstanding
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4.4 Net Working Capital
Net Working Capital (which is also known as “Working Capital” or the initials “NWC”) is a measurement of the
operating liquidity available for a company to use in developing and growing its business. The working capital can
be calculated very simply by subtracting a company’s total current liabilities from its total current assets.Through
this formula, a working capital amount can be determined to be either positive or negative. Naturally, this will rely
largely on the amount of debt owed by the company. It should not come as a surprise that, having plenty of working
capital tends to help companies achieve more success. This follows because working capital allows companies to
grow smoothly and make necessary improvements to their corporate operations.
On the other hand, companies that are operating with negative working capital may not have the financial support or
flexibility to grow and/or improve, even when such developments would be indicated. Hence, working capital can be
an indicator of the overall strength of a company. There are three main indicators used in calculating working capital.
Elements of the “current assets” side of the equation will include accounts receivable, as well as any inventory of
goods on hand. “Current liabilities” will include accounts payable.
A positive change in a company’s working capital will generally indicate one of two developments. Either the
company has increased its current assets by receiving cash (or some other form of assets), or it has minimised its
liabilities – often by paying off short-term creditors.
4.4.1 Business Uses of Working Capital

Just as working capital has several meanings, firms use it in many ways. Most fundamentally, working capital
investment is the lifeblood of a company. Without it, a firm cannot stay in business. Thus, the first, and most
critical, use of working capital is providing the ongoing investment in short-term assets that a company needs to
operate. A business requires a minimum cash balance to meet basic day-to-day expenses and to provide a reserve
for unexpected costs. It also needs working capital for prepaid business costs, such as licenses, insurance policies
or security deposits.
Furthermore, all businesses invest in some amount of inventory, from a law firm’s stock of office supplies to the large
inventories needed by retail and wholesale enterprises. Without some amount of working capital finance, businesses
could not open and operate. A second purpose of working capital is addressing seasonal or cyclical financing needs.
Here, working capital finance supports the build up of short-term assets needed to generate revenue, but which
come before the receipt of cash. For example, a toy manufacturer must produce and ship its products for the holiday
shopping season several months before it receives cash payment from stores. Since most businesses do not receive
prepayment for goods and services, they need to finance these purchase, production, sales, and collection costs prior
to receiving payment from customers.
Fig. 4.1 illustrates this short-term cash flow and financing cycle. Another way to view this function of working
capital is providing liquidity. Adequate and appropriate working capital financing ensures that a firm has sufficient
cash flow to pay its bills as it awaits the full collection of revenue. When working capital is not sufficiently or
appropriately financed, a firm can run out of cash and face bankruptcy. A profitable firm with competitive goods or
services can still be forced into bankruptcy, if it has not adequately financed its working capital needs and runs out
of cash. Working capital is also needed to sustain a firm’s growth. As a business grows, it needs larger investments
in inventory, accounts receivable, personnel, and other items to realise increased sales.
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New facilities and equipments are not the only assets required for growth; firms also must finance the working
capital needed to support sales growth. A final use of working capital is to undertake activities to improve business
operations and remain competitive, such as product development, ongoing product and process improvements, and
cultivating new markets. With firms facing heightened competition, these improvements often need to be integrated
into operations on a continuous basis. Consequently, they are more likely to be incurred as small repeated costs than
as large infrequent investments. This is especially true for small firms that cannot afford the cost and risks of large
fixed investments in research and development projects or new facilities. Ongoing investments in product and process
improvement and market expansion, therefore, often must be addressed through working capital financing.
AR
converted cash
to cash
Collect sales
accounts
receivable order
cash
converted to
prepaid
Deliver produce expenses and
goods or goods or inventory
services services
Goods or Services
converted to Accounts
Receivable
Fig. 4.1 Cash flow and the working capital cycle
4.5 Permanent and Cyclical Working Capital

Firms need both a long-term (or permanent) investment in working capital and a short-term or cyclical one. The
permanent working capital investment provides an ongoing positive net working capital position, that is, a level of
current assets that exceeds current liabilities. This allows the firm to operate with a comfortable financial margin
since short-term assets exceed short-term obligations and minimises the risk of being unable to pay its employees,
vendors, lenders, or the government (for taxes). To have positive net working capital, a company must finance part
of its working capital on a long-term basis. Since total assets equal total liabilities and owner’s equity, when current
assets exceed current liabilities, this excess is financed by the long-term debt or equities. Since the demand for goods
and services varies over the course of a year, firms need to finance both inventories and other costs to prepare for
their peak sales period and accounts receivable until cash is collected.
Cyclical working capital is best financed by short-term debt since the seasonal build up of assets to address seasonal
demand will be reduced and converted to cash to repay borrowed funds within a short predictable period. By matching
the term of liabilities to the term of the underlying assets, short-term financing helps a firm manage inflation and
other financial risks. Short-term financing is also preferable since it is usually easier to obtain and priced lower than
long-term debt.
Working capital financing is a key financing need and challenge for small firms. Small businesses have less access
to long-term sources of capital than large businesses, including limited access to equity capital markets and fewer
sources of long-term debt. Thus, many small firms are heavily dependent on short-term debt, much of which is tied
to working capital.
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However, limited equity and reliance on short-term debt increases the demand on a firm’s cash flow, reduces liquidity,
and increases financial leverage—all of which heighten the financial risks of extending credit. Consequently, small
firms may have trouble raising short-term debt while at the same time facing obstacles to securing the longer-term
debt necessary to improve their financial position and liquidity, and lessen their credit risk. Development finance
has an important role in addressing this problem, either by offering working capital loans when private loans are not
available or by providing debt terms that reduce a firm’s financial risks and help it access private working capital
financing. In particular, practitioners can help businesses finance permanent working capital to reduce their short-
term financial pressures.
4.6 Forms of Working Capital Financing

Working capital financing comes in many forms, each of which has unique terms and offers certain advantages and
disadvantages to the borrower. This section introduces the five major forms of debt used to finance working capital
and discusses the relative advantages of each one.
The purpose of this information is to provide insights into the different ways in which debt can be structured and
prepare practitioners to choose and structure a debt tool best suited to a firm’s financial situation and needs.
4.6.1 Line of Credit

A line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any time
during the loan period. This arrangement allows a company flexibility to borrow funds when the need arises for the
exact amount required. Interest is paid only on the amount borrowed, typically on a monthly basis. A line of credit
can be either unsecured, if no specific collateral is pledged for repayment, or secured by specific assets such as
accounts receivable or inventory. The standard term for a line of credit is 1 year with renewal subject to the lender’s
annual review and approval. Since a line of credit is designed to address cyclical working capital needs and not to
finance long-term assets, lenders usually require full repayment of the line of credit during the annual loan period
and prior to its renewal. This repayment is sometimes referred to as the annual cleanup.
Two other costs, beyond interest payments, are associated with borrowing through a line of credit. Lenders require
a fee for providing the line of credit, based on the line’s credit limit, which is paid whether or not the firm uses the
line. This fee, usually in the range of 25 to 100 basis points, covers the bank’s costs for underwriting and setting up
the loan account in the event that a firm does not use the line and the bank earns no interest income.
A second cost is the requirement for a borrower to maintain a compensating balance account with the bank. Under
this arrangement, a borrower must have a deposit account with a minimum balance equal to a percentage of the line
of credit, perhaps 10% to 20%. If a firm normally maintains this balance in its cash accounts, then no additional costs
are imposed by this requirement. However, when a firm must increase its bank deposits to meet the compensating
balance requirement, then it is incurring an additional cost. In effect, the compensating balance reduces the business’s
net loan proceeds and increases its effective interest rate.
The advantages of a line of credit are twofold. First, it allows a company to minimise the principal borrowed and
the resulting interest payments. Second, it is simpler to establish and entails fewer transaction and legal costs,
particularly when it is unsecured. The disadvantages of a line of credit include the potential for higher borrowing
costs when a large compensating balance is required and its limitation to financing cyclical working capital needs.
With full repayment required each year and annual extensions subject to lender approval, a line of credit cannot
finance medium-term or long-term working capital investments.
4.6.2 Accounts Receivable Financing

Some businesses lack the credit quality to borrow on an unsecured basis and must instead pledge collateral to obtain
a loan. Loans secured by accounts receivable are a common form of debt used to finance working capital. Under
accounts receivable debt, the maximum loan amount is tied to a percentage of the borrower’s accounts receivable.
When accounts receivable increase, the allowable loan principal also rises. However, the firm must use customer
payments on these receivables to reduce the loan balance. The borrowing ratio depends on the credit quality of the
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firm’s customers and the age of the accounts receivable. A firm with financially strong customers should be able
to obtain a loan equal to 80% of its accounts receivable. With weaker credit customers, the loan may be limited to
50% to 60% of accounts receivable. Additionally, a lender may exclude receivables beyond a certain age (e.g., 60
or 90 days) in the base used to calculate the loan limit. Older receivables are considered indicative of a customer
with financial problems and less likely to pay.
Since accounts receivable are pledged as collateral, when a firm does not repay the loan, the lender will collect
the receivables directly from the customer and apply it to loan payments. The bank receives a copy of all invoices
along with an assignment that gives it the legal right to collect payment and apply it to the loan. In some accounts
receivable loans, customers make payments directly to a bank-controlled account (a lock box).
Firms gain several benefits with accounts receivable financing. With the loan limit tied to total accounts receivable,
borrowing capacity grows automatically as sales grow. This automatic matching of credit increases to sales growth
provides a ready means to finance expanded sales, which is especially valuable to fast-growing firms. It also provides
a good borrowing alternative for businesses without the financial strength to obtain an unsecured line of credit.
Accounts receivable financing allows small businesses with creditworthy customers to use the stronger credit of their
customers to help borrow funds. One disadvantage of accounts receivable financing is the higher costs associated
with managing the collateral, for which lenders may charge a higher interest rate or fees. Since accounts receivable
financing requires pledging collateral, it limits a firm’s ability to use this collateral for any other borrowing. This
may be a concern if accounts receivable are the firm’s primary asset.
4.6.3 Factoring
Factoring entails the sale of accounts receivable to another firm, called the factor, who then collects payment from
the customer. Through factoring, a business can shift the costs of collection and the risk of non payment to a third
party. In a factoring arrangement, a company and the factor work out a credit limit and average collection period for
each customer. As the company makes new sales to a customer, it provides an invoice to the factor. The customer
pays the factor directly, and the factor then pays the company based on the agreed upon average collection period,
less a slight discount that covers the factor’s collection costs and credit risks.
In addition to absorbing collection risks, a factor may advance payment for a large share of the invoice, typically
70% to 80%, providing the company with immediate cash flow from sales. In this case, the factor charges an interest
rate on this advance and then deducts the advance amount from its final payment to the firm when an invoice is
collected.
Factoring has several advantages for a firm over straight accounts receivable financing. First, it saves the cost of
establishing and administering its own collection system. Second, a factor can often collect accounts receivable at
a lower cost than a small business, due to economies of scale, and transfer some of these savings to the company.
Third, factoring is a form of collection insurance that provides an enterprise with more predictable cash flow from
sales. On the other hand, factoring costs may be higher than a direct loan, especially when the firm’s customers have
poor credit that lead the factor to charge a high fee. Furthermore, once the collection function shifts to a third party,
the business loses control over this part of the customer relationship, which may affect overall customer relations,
especially when the factor’s collection practices differ from those of the company.
4.7 Inventory Financing

As with accounts receivable loans, inventory financing is a secured loan, in this case with inventory as collateral.
However, inventory financing is more difficult to secure since inventory is riskier collateral than accounts receivable.
Some inventory becomes obsolete and loses value quickly, and other types of inventory, like partially manufactured
goods, have little or no resale value. Firms with an inventory of standardised goods with predictable prices, such
as automobiles or appliances, will be more successful at securing inventory financing than businesses with a large
amount of work in process or highly seasonal or perishable goods. Loan amounts also vary with the quality of the
inventory pledged as collateral, usually ranging from 50% to 80%. For most businesses, inventory loans yield loan
proceeds at a lower share of pledged assets than accounts receivable financing. When inventory is a large share of
a firm’s current assets, however, inventory financing is a critical option to finance working capital.
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Lenders need to control the inventory pledged as collateral to ensure that it is not sold before their loan is repaid.
Two primary methods are used to obtain this control:
• Warehouse storage
• Direct assignment by product serial or identification numbers
Under one warehouse arrangement, pledged inventory is stored in a public warehouse and controlled by an
independent party (the warehouse operator). A warehouse receipt is issued when the inventory is stored, and the
goods are released only upon the instructions of the receipt-holder. When the inventory is pledged, the lender has
control of the receipt and can prevent release of the goods until the loan is repaid. Since public warehouse storage
is inconvenient for firms that need on-site access to their inventory, an alternative arrangement, known as a field
warehouse, can be established. Here, an independent public warehouse company assumes control over the pledged
inventory at the firm’s site. In effect, the firm leases space to the warehouse operator rather than transferring goods
to an off-site location. As with a public warehouse, the lender controls the warehouse receipt and will not release
the inventory until the loan is repaid. Direct assignment by serial number is a simpler method to control inventory
used for manufactured goods that are tagged with a unique serial number. The lender receives an assignment or trust
receipt for the pledged inventory that lists all serial numbers for the collateral. The company houses and controls
its inventory and can arrange for product sales. However, a release of the assignment or return of the trust receipt
is required before the collateral is delivered and ownership transferred to the buyer. This release occurs with partial
or full loan repayment.
While inventory financing involves higher transaction and administrative costs than other loan instruments, it
is an important financing tool for companies with large inventory assets. When a company has limited accounts
receivable and lacks the financial position to obtain a line of credit, inventory financing may be the only available
type of working capital debt.
Moreover, this form of financing can be cost effective when inventory quality is high and yields a good loan-to-
value ratio and interest rate.
4.8 Term Loan

While the four prior debt instruments address cyclical working capital needs, term loans can finance medium-term
noncyclical working capital. A term loan is a form of medium-term debt in which principal is repaid over several
years, typically in 3 to 7 years. Since lenders prefer not to bear interest rate risks, term loans usually have a floating
interest rate set between the prime rate and prime plus 300 basis points, depending on the borrower’s credit risk.
Sometimes, a bank will agree to an interest rate cap or fixed rate loan, but it usually charges a fee or higher interest
rate for these features.
Term loans have a fixed repayment schedule that can take several forms. Level principal payments over the loan
term are most common. In this case, the company pays the same principal amount each month plus interest on the
outstanding loan balance. A second option is a level loan payment in which the total payment amount is the same,
every month but the share allocated to interest and principle varies with each payment. Finally, some term loans
are partially amortising and have a balloon payment at maturity. Term loans can be either unsecured or secured; a
business with a strong balance sheet and a good profit and cash flow history might obtain an unsecured term loan,
but many small firms will be required to pledge assets. Moreover, since loan repayment extends over several years,
lenders include financial covenants in their loan agreements to guard against deterioration in the firm’s financial
position over the loan term. Typical financial covenants include minimum net worth, minimum net working capital
(or current ratio), and maximum debt-to-equity ratios. Finally, lenders often require the borrower to maintain a
compensating balance account equal to 10% to 20% of the loan amount.
The major advantage of term loans is their ability to fund long-term working capital needs. As discussed at the
beginning of the chapter, businesses benefit from having a comfortable positive net working capital margin, which
lowers the pressure to meet all short-term obligations and reduces bankruptcy risk. Term loans provide the medium-
term financing to invest in the cash, accounts receivable, and inventory balances needed to create excess working
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capital. They also are well suited to finance the expanded working capital needed for sales growth. Furthermore, a
term loan is repaid over several years, which reduces the cash flow needed to service the debt. However, the benefits
of longer term financing do not come without costs, most notably higher interest rates and less financial flexibility.
Since a longer repayment period poses more risks to lenders, term loans carry a higher interest rate than short-term
loans.
When provided with a floating interest rate, term loans expose firms to greater interest rate risk since the chances of a
spike in interest rates increase for a longer repayment period. Due to restrictive covenants and collateral requirements,
a term loan imposes considerable financial constraints on a business. Moreover, these financial constraints are in
place for several years and cannot be quickly reversed, as with a 1-year line of credit. Despite these costs, term
loans can be of great value to small firms, providing a way to supplement their limited supply of equity and long-
term debt with medium-term capital.
4.9 Sources of Working Capital for Small Businesses

Commercial banks are the largest financing source for external business debt, including working capital loans, and
they offer a large range of debt products. With banking consolidation, commercial banks are multistate institutions
that increasingly focus on lending to small business with large borrowing needs that pose limited risks.
Consequently, alternate sources of working capital debt become more important. Savings banks and thrift lenders
are increasingly providing small business loans, and, in some regions, they are small business and commercial real
estate lenders.
Although savings banks offer fewer products and may be less familiar with unconventional economic development
loans, they are more likely to provide smaller loans and more personalised service. Commercial finance companies
are important working capital lenders. As non-regulated financial institutions, they can make high-risk loans. Some
finance companies specialise in serving specific industries, which allows them to assess their risk and creditworthiness
in a better manner and extend loans that general lenders would not make. Another approach used by finance
companies is asset-based lending in which a lender carefully evaluates and lends against asset collateral value,
placing less emphasis on the firm’s overall balance sheet and financial ratios. An asset-based lending approach can
improve loan availability and terms for small firms with good quality assets but weaker overall credit. Commercial
finance companies also are more likely to offer factoring than banks. Trade credit extended by vendors is a fourth
alternative for small firms. While trade credit does not finance permanent or long-term working capital, it helps to
address short-term borrowing needs.
Extending payment periods and increasing credit limits with major suppliers is a fast and cost-effective way to
finance some working capital needs that can be part of a firm’s overall plan to manage seasonal borrowing needs.
Venture capital firms also finance working capital, especially permanent working capital to support rapid growth.
While venture capitalists typically provide equity financing, some also provide debt capital. A growing set of
mezzanine funds, often managed by venture capitalists, supply medium-term subordinate debt and take warrants
that increase their potential returns. This type of financing is appropriate to finance long-term working capital needs
and is a lower-cost alternative to raising equity. However, the availability of venture capital and mezzanine debt
is limited to fast-growing firms, often in industries and markets viewed as offering the potential for high returns.
Government and non-profit revolving loan funds also supply working capital loans. While small in total capital,
these funds help firms to access conventional bank debt by providing subordinate loans, offering smaller loans, and
serving firms that do not qualify for conventional working capital credit.
Many entrepreneurs and small firms also rely on personal credit sources to finance working capital, especially credit
cards and second mortgage loans on the business owner’s home. These sources are easy to come by and involve few
transaction costs, but they have certain limits. First, they provide only modest amounts of capital. Second, credit card
debt is expensive with interest rates of 18% or higher, which reduces cash flow for other business purposes. Third,
personal credit links the business owner’s personal assets to the firm’s success, putting important household assets,
such as the owner’s home, at risk. Finally, credit cards and second mortgage loans are not viable for entrepreneurs
who do not own a home or lack a formal credit history.
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Immigrant or low-income business owners, in particular, are least able to use personal credit to finance a business.
Given these many limitations, it is desirable to move entrepreneurs from informal and personal credit sources into
formal business working capital loans that are structured to address the credit needs of their firms.
4.10 Underwriting Issues in Working Capital Financing

Since repayment is closely linked to short-term cash flow, especially for cyclical working capital loans, finance
practitioners need to scrutinise these projections in detail. Borrowers will need to provide monthly or quarterly cash
flow projections for the next 1 to 2 years to facilitate this analysis. Moreover, this requirement helps to assess how
carefully the firm plans and monitors cash flow and helps to identify weaknesses in these key management areas.
Detailed monthly projections can also uncover ways to improve cash flow that may reduce borrowing needs and
improve the firm’s capacity to repay and qualify for a loan. For example, a firm may be able to reduce its inventory,
offer incentives for more rapid payment of invoices, or improve supplier credit terms. For working capital loans,
lenders will pay special attention to liquidity ratios and the quality of current assets since these factors are most
critical to loan repayment.
Finally, the underwriting analysis needs to evaluate the applicant’s need for permanent versus cyclical working capital
debt. Small businesses with limited long-term capital are under heavy pressure to meet short-term cash flow needs.
Adding short-term working capital loans does not address this problem and may make matters worse. Thus, it is
important to analyse why the firm is seeking debt, what purpose the loan will serve, and how these relate to short-
term cyclical needs versus long-term permanent working capital needs. In some cases, practitioners need to revise
the borrower’s loan request and structure debt that better reflects the firm’s needs. This might entail proposing a term
loan in place of a line of credit when the business needs permanent working capital or combining short-term and
medium-term debt instruments to create a good balance between cyclical and permanent working capital debt.
These alternatives can improve a firm’s cash flow and liquidity to partially offset the greater repayment risk that
results from extending loan repayment. Loan guarantees and subordinate debt can reduce this additional risk and help
convince conventional lenders to both supply credit and provide it on terms that fit a borrower’s financial needs.
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Summary
• Liquidity refers to the ability of a company to meet its immediate obligations without any trouble or strain.
• The current ratio is computed by dividing the total of current assets by the total of current liabilities.
• A company with a low coverage rate should raise a red flag for investors as it may be a sign that the company
will have difficulty running its operations, as well as meeting its obligations.
• Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations.
• A company with a low coverage rate should raise a red flag for investors as it may be a sign that the company
will have difficulty meeting running its operations, as well as meeting its obligations.
• The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets,
which are more difficult to turn into cash.
• The cash ratio is an indicator of a company’s liquidity that further refines both the current ratio and the quick
ratio by measuring the amount of cash; cash equivalents or invested funds there are in current assets to cover
current liabilities.
• The Cash Conversion Cycle (CCC) measures the number of days a company’s cash is tied up in the production
and sales process of its operations and the benefit it gets from payment terms from its creditors.
• The working capital can be calculated very simply by subtracting a company’s total current liabilities from its
total current assets.
• A business requires a minimum cash balance to meet basic day-to-day expenses and to provide a reserve for
unexpected costs.
• The permanent working capital investment provides an ongoing positive net working capital position.
• To have positive net working capital, a company must finance part of its working capital on a long-term
basis.
• Cyclical working capital is best financed by short-term debt since the seasonal build up of assets to address
seasonal demand will be reduced.
• A line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any
time during the loan period.
• The disadvantages of a line of credit include the potential for higher borrowing costs when a large compensating
balance is required and its limitation to financing cyclical working capital needs.
• Accounts receivable financing allows small businesses with creditworthy customers to use the stronger credit
of their customers to help borrow funds.
• Factoring entails the sale of accounts receivable to another firm, called the factor, who then collects payment
from the customer.
• A warehouse receipt is issued when the inventory is stored, and the goods are released only upon the instructions
of the receipt-holder.
• The major advantage of term loans is their ability to fund long-term working capital needs.
• Term loans provide the medium-term financing to invest in the cash, accounts receivable, and inventory balances
needed to create excess working capital.
• Due to restrictive covenants and collateral requirements, a term loan imposes considerable financial constraints
on a business.
References
• Working Capital Finance [Pdf] Available at: <http://www.sagepub.com/upm-data/5005_Seidman_Chapter_5.
• The right measure of liquidity [Pdf] Available at: <http://www.thehindubusinessline.com/features/investment-
world/young-investor/the-right-measure-of-liquidity/article2354246.ece> [Accessed 12 July 2013].
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• Finance, leverage, liquidity, solvency, and the Macroeconomy [Video online] Available at: <http://www.youtube.
com/watch?v=g_mb1QRrpIg> [Accessed 12 July 2013].
• CFA Level I Working Capital Management [Video online] Available at: <http://www.youtube.com/
watch?v=7orxxjow1I4> [Accessed 12 July 2013].
• Matz, L., 2011. Liquidity Risk Measurement and Management. Xlibris.
• Soprano, A., 2013. Liquidity Management: A Funding Risk Handbook.Wiley.
Recommended reading
• Choudhry, M., 2012. The Principles of Banking. Wiley.
• Banks, E., 2004. Liquidity Risk: Managing Asset and Funding Risks. Palgrave Macmillan.
• Blum, L., 1995. Free Money for Small Businesses and Entrepreneur. 4th ed., Wiley.
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Self Assessment
1. _________________ refers to the ability of a company to meet its immediate obligations without any trouble
or strain.
a. Profitability
b. Liquidity
c. Entities
d. Current ratio
2. _____________________ are defined as assets that are convertible into cash in one year or one operating cycle,
whichever is higher.
a. Current assets
b. Quick ratios
c. Liquid assets
d. Current ratios
3. ________________ attempt to measure a company’s ability to pay off its short-term debt obligations.
a. Quick ratios
b. Current ratios
c. Liquidity ratios
d. Liquidity assets
4. Which of the following is not one of the types of liquidity ratio?

a. Current ratio
b. Quick ratio
c. Asset ratio
d. Cash ratio
5. The _________________ measures the number of days a company’s cash is tied up in the production and sales
process of its operations and the benefit it gets from payment terms from its creditors.
a. DIOS
b. DSO
c. CCC
d. DPO
6. ___________________ is a measurement of the operating liquidity available for a company to use in developing
and growing its business.
a. Liquidity
b. Flexibility
c. DPO
d. Net working capital
7. A ________________ is an open-ended loan with a borrowing limit that the business can draw against or repay
at any time during the loan period.
a. second cost
b. first cost
c. line of credit
d. interest payment
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8. A firm with financially strong customers should be able to obtain a loan equal to 80% of its accounts
______________.
a. benefit
b. receivable
c. inventory
d. financing
9. _________________ entails the sale of accounts receivable to another firm, called the factor, who then collects
payment from the customer.
a. Factoring
b. Credit risk
c. Inventory financing
d. Lenders
10. A term ______________ is a form of medium-term debt in which principal is repaid over several years, typically
in 3 to 7 years.
a. loan
b. working capital
c. net working capital
d. inventory capital
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Chapter V
Cash Management and Financial Flexibility
Aim
• define financial flexibility
• elucidate corporate cash management
• explain liquidity management
Objectives
• explain profitability
• explicate liquid assets
• elucidate value-based strategy
Learning outcome
• understand net working capital
• identify current asset financing
• recognise the various models in value-based strategies of cash management
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5.1 Introduction
In recent years, financial flexibility is receiving a growing interest among researchers and has become one of the most
important determinants in capital structure decisions of a financial executive. Classical capital structure theories,
such as the trade-off and the pecking order theory, fail to explain the puzzling corporate behaviour regarding capital
structure decisions of firms. Over the years, a theoretical framework has been established that remains to be the
critical missing link for an empirically viable theory in explaining firm behaviour with respect to capital structure
decisions.
The term financial flexibility is defined differently in the financial literature and requires a clear definition in order to
use its full explanatory power. Some authors see financial flexibility in preserving the borrowing capacity and thus
considering only debt. However, financial flexibility theory may also explain why firms tend to hoard high amounts
of cash even though high economic costs, such as taxes, are normally associated with cash holdings. Thus, not
only free debt capacity provides a company with financial flexibility, but also cash. The overall goal of establishing
financial flexibility for a firm for both sourcing scenarios is the same. To be able to mobilise financial resources in
case of unanticipated shocks, e.g., earnings shortfalls, crises, investment opportunities, etc.
The financial crisis resulting from consumer defaults on subprime mortgages had remarkable effects on the
U.S. financial sector and later on the whole economy. The supply of external capital was radically restricted and
companies were forced to rely on internal sources. The changing economic circumstances resulting from the current
financial crisis creates an exemplary opportunity to examine the effect of different sources of financial flexibility
and investigate how firms use different funds in order to attain financial flexibility and what economic significance
in terms of real decisions they have.
5.2 Corporate Cash Management

Corporate cash management depends on demands for cash in a firm. The aim of cash management is such that
limiting cash levels in the firm maximises owner wealth. Cash levels must be maintained, so as to optimise the
balance between costs of holding cash and the costs of insufficient cash. The type and the size of these costs are
partly specific to the financial strategy of the firm. In addition, cash management influences firm value, because its
cash investment levels entail the rise of alternative costs, which are affected by net working capital levels. Both the
rise and fall of net working capital levels require the balancing of future free cash flows, and in turn, result in firm
valuation changes.
Liquidity management requires that a sufficient balance of cash and other working capital assets - receivables and
inventories should be ensured. If the level of liquid assets is not adequate, it enhances the company’s operating risk
– loss of liquidity. Maintenance of working capital assets generates costs, thus affecting the company’s profitability.
The problem of this paper is how liquidity can be combined with profitability.
If the level of liquid assets is too low, then a company may encounter problems with timely repayment of its
liabilities, while discouraging clients by an excessively restrictive approach to recovery of receivables or shortages
in the offered range of goods. Therefore, the level of liquid assets cannot be too low.
In addition, cash management influences firm value, because its cash investment levels entail the rise of alternative
costs, which are affected by net working capital levels. Both the rise and fall of net working capital levels require
the balancing of future free cash flows, and in turn, result in firm valuation changes.
Liquidity management requires that a sufficient balance of cash and other working capital assets - receivables and
inventories should be ensured. If the level of liquid assets is not adequate, it enhances the company’s operating risk
– loss of liquidity. Maintenance of working capital assets generates costs, thus affecting the company’s profitability.
The problem of this paper is how liquidity can be combined with profitability. If the level of liquid assets is too low,
then a company may encounter problems with timely repayment of its liabilities, while discouraging clients by an
excessively restrictive approach to recovery of receivables or shortages in the offered range of goods. Therefore,
the level of liquid assets cannot be too low.
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At the same time, surplus liquid assets may negatively affect the company’s profitability. This is because upon
exceeding the ‘necessary’ level of liquid assets, their surpluses, when the market risk remains stable, become a
source of ineffective utilisation of resources.
Along with an increased risk of the company’s daily operations, you should increase the level of liquid assets to
exceed the required levels as this will protect your company against negative consequences of unavailable liquid
assets. It is possible to measure profitability of liquidity management decision in two ways. Firstly, it is possible
to check how it affects the net profit and its relation to equity, total assets, or another item of assets. Secondly, it is
possible to assess profitability in relation to value of the company.
Individual elements influencing liquidity management decisions affect the level of Free Cash Flows to Firm (FCFF)
and thus the value of the company. Let us assume that the company is faced with a decision regarding the level of
liquid assets. As we know, a higher debtors turnover ratio and inventory turnover ratio (resulting from a more liberal
approach to granting a trade credit for the purchasers and offering a shorter turnaround on clients’ orders) will be
accompanied by more sales (larger cash revenues) but also higher costs.
Influence on k
Trade credit policy

changes influence cost of
capital
Influence on FCFF Influence on t

n
FC FF t
Vp t
Trade credit policy t 1 1 k
EVA NOPAT k (N WC Capex ) Trade credit policy
changes influence:
changes influence
costs
period of life of the
? NWC enterprise.
Fig. 5.1 Liquid assets influence on value of the corporation
Where: FCFF = Free Cash Flows to Firm; NWC = Net Working Capital growth; k = cost of the capital financing
the corporation; and t = the forecasted lifetime of the corporation and time to generate single FCFF.
Profitability measured by ROE indicates that ‘medium’ liquidity level is optimal. Similar results will be achieved if
estimating influence on the company’s value. Again, the optimal variant was one that assumed a ‘medium’ liquidity
level as applying such level of liquidity ensures potentially the highest increase in the company‘s value measured
by ∆V.
If the level of liquid assets is too low, it downsizes the sales thus discouraging clients with an overly restrictive trade
credit policy. On the other hand, excessive exposure to liquid assets under the ‘high’ level of liquid assets variant
generated higher sales revenues than under the ‘medium’ variant, but at the same time the positive result of increase
in the sales volumes has been offset by high level of generated costs.
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If the advantages of holding cash at a chosen level are greater than the influence of the alternative costs of holding
cash, thereby increasing net working capital, then firm’s value will also increase. The net working capital (current
assets less current liabilities) results from lack of synchronisation of the formal rising receipts and the real cash
receipts from each sale. Net working capital also results from divergence during time of rising costs and time, from
the real outflow of cash when a firm pays its accounts payable.
NWC= CA- CL= AAR+ ZAP +G- AAP
where, NWC = Net Working Capital, CA = Current Assets, CL = Current Liabilities, AAR = Accounts Receivables,
ZAP = Inventory, G = Cash and Cash Equivalents, AAP = Accounts Payables.
When marking free cash flows, cash possession and increased net working capital is the direct result of amounts of
cash allocated for investment in net working capital allocation. If an increase of net working capital is positive, then
we allocate more money for net working capital purposes and thereby decrease future free cash flow. It is important
to determine how changes in cash levels change a firm’s value.
Accordingly, we use equation, based on the premise that a firm’s value is the sum of its discounted future free cash
flows to the firm.
where, Vp = Firm Value Growth, FCFFt = Future Free Cash Flow to Firm Growth in
Period t, k = Discount Rate2.
Future Free Cash Flow, we have as:

FCFFt = (CRt - FCWD-VCt-NCE) X (1-T)+ NCE- ∆NWCt- Capext
where, CRt = Cash Revenues on Sales, FCWD = Fixed Costs, VCt = Variable Costs in Time t, NCE = Non-cash
Expenses (i.e., Depreciation), T = Effective Tax Rate, DNWC = Net Working Capital Growth, Capex = Operational
Investments Growth.
Changes in precautionary cash levels affect the net working capital levels and as well the level of operating costs
of cash management in a firm. Companies invest in cash reserves for three basic reasons.
First, firms are guided by transactional and intentional motives resulting from the need to ensure sufficient capital
to cover payments customarily made by the company. A firm retains transactional cash to ensure regular payments
to vendors for its costs of materials and raw materials for production. As well, a firm retains intentional cash for
tax, social insurance and other known non-transactional payment purposes.
Second, firms have precautionary motives to invest in cash reserves in order to protect the company from the potential
negative consequences of risk, which are unexpected, negative cash balances that can occur as a result of delays in
accounts receivable collection or delays in receiving other expected monies.
Third, companies have speculative motives to retain cash reserves. Speculative cash makes it possible for the firm
to use the positive part of the risk equation to its benefit. Companies hold speculative cash to retain the possibility
of purchasing assets at exceptionally attractive prices.
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FINANCIAL
OPERATIONAL RISK
RISK
TRANSACTIONAL
& INTENTIONAL PRECAUTIONARY SPECULATIVE
CASH CASH CASH
Fig. 5.2 Reasons for holding cash by companies and their relation to the risk
5.3 Value-Based Strategy in Working Capital Management

The issue discussed here attempts to address the question of which net working capital management strategy should
be applied to bring the best results for a specific type of business. Financial decisions of a company always focus
on selecting the anticipated level of benefits in conditions of risk and uncertainty. Decisions regarding net working
capital management strategy, whether focused on assets (strategy of investing in the net working capital) or liabilities
(strategy of financing the net working capital), affect free cash flows and, also the cost of capital-financing the
company. The principle of separating financial decisions from operating decisions, i.e., separating consequences
of operations from changes in the capital structure, calls for a need to take the net working capital management
decision first focusing on assets (it affects free cash flows to the company) and then on liabilities (it affects the
structure and cost of capital used for financing the company). Management of net working capital aimed at creation
of value of the company. If the benefits of maintaining net working capital at the level determined by the company
outweigh the negative influence of the alternative cost of such maintenance, then an increase in net worth of the
company will be reported.
Interesting from our point of view, determined by the need to obtain the main objective of the company’s financial
management, is how a change in the net working capital level may impact the value of the company.
Net working capital is, most generally, the portion of current assets financed with permanent funds. The net working
capital is a difference between current assets and current liabilities or a difference between permanent liabilities
and permanent assets. It is a consequence of dichotomy between the formal origination of the sales revenue and
the actual inflow of funds from recovery of receivables and different times when costs are originated and when the
funds covering the liabilities are actually paid out. When estimating free cash flows, maintaining and increasing net
working capital means, that the funds earmarked for raising that capital are tied. If the increase is positive, it means
ever higher exposure of funds, which reduces free cash flows for the corporation. An increase in production usually
means the need to boost inventories, receivables, and cash assets. A portion of this increase will be most probably
financed with current liabilities (which are also usually automatically up along with increased production volumes).
The remaining part (indicated as an increase in net working capital) will need an alternative source of financing.
Current asset financing policies are driven by the manner of financing current assets. Any changes to the selected
current asset financing policy affect the cost of capital but do not impact the level of free cash flows. The company
can choose one of the three policies:
• An aggressive policy whereby a major portion of the company’s fixed demand and the entirety of its volatile
demand for financing current assets is satisfied with short-term financing.
• A moderate policy aiming to adjust the period when financing is needed to the period when the company requires
given assets. As a result of such approach, a fixed portion of current assets is financed with long-term funds,
while the volatile portion of these assets is financed with short-term funds.
• A conservative policy whereby both fixed and volatile levels of current assets are maintained with long-term
financing.
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The aggressive policy will most probably mean the highest increase in the net worth of the company. However, this
result is not that obvious. This is because an increase in financing with an external short-term capital and a decrease
in financing with an external long-term capital (namely shifting from conservative to aggressive policy of financing
current assets) means enhanced risk level. Such increased risk level should be reflected in an increased cost of own
capital. This stems from increased costs of financial difficulties.
The aggressive policy of financing current assets is the least favourable, considering an increased cost of own capital.
Policies regarding investments in current assets are applied by the company as measures determining amounts and
structure of current assets. There are three major policies available:
• An aggressive policy, whereby the level of tangible assets is minimised and a restrictive approach to merchant
lending is applied. Minimising current assets results on the one hand, in savings which later translate to higher
free cash flows. On the other hand, insufficient level of current assets increases the operational risk. Too low
inventories may interrupt the production and sales process. Insufficient level of receivables will most often lead
to a restrictive merchant lending policy and, consequently, potentially lower sales revenue than in the case of a
liberal merchant lending policy. Insufficient transactional cash levels may disrupt settlement of liabilities and
as a result negatively affect the company’s reputation.
• A moderate policy, whereby the level of current assets, and in particular inventories and cash, is held on an
average level
• A conservative policy, whereby a high level of current assets (and especially inventories and cash) is maintained
at the company and ensuring a high level of receivables by using a liberal trade creditors’ recovery policy
If the company aims at maximising V, it should select the aggressive policy. However, similarly as in the preceding
item, it is worth considering the relation between the risk increase and the cost of own capital (and probably also
external capital). The more aggressive the current asset investment policy, the higher will be the risk. Higher risk,
on the other hand, should be accompanied by higher costs of own capital and probably also external capital.
Changes of the policy, from conservative to aggressive, cause an increase in the cost of capital financing the company’s
operations due to enhancement of risk. It is possible that in specific circumstances, the risks may drive the cost of
capital to such a high degree that the aggressive policy will be unfavourable.
In the discussed examples, the company should select a conservative current asset financing strategy and an aggressive
current asset investment policy. The primary objective of financing the company’s operations is to maximise the
company’s net worth. It can be estimated among others by totalling all the future free cash flows generated by
the company, discounted with the cost of capital. Decisions regarding management of net working capital should
also serve the purpose of achieving the primary objective, which is maximising the company’s net worth. These
decisions may impact both the level of free cash flows and the cost of capital used for financing the company’s
operations. The module discusses probably changes of the capital cost rate, resulting from changes in selection
of the net working capital management policy and, consequently, the anticipated impact of such decisions on the
company’s net worth.
5.4 Value-Based Strategy in Cash Management

The most liquid current assets are cash balances. The purpose of cash management is to determine the level of cash
resources at the company, so that it increases the wealth of the company owners. In other words, the objective is to
maintain such level of cash resources at the company that is optimal from the point of view of trade-off between
the costs of maintaining cash balances against the costs of holding insufficient cash balances. The type and amount
of these costs is partially driven by the particular financial policy applied by the company.
Based on observation of current inflows and outflows of the company, it may be noticed that there are four basic
situations at the company in terms of operational cash flows:
• When future inflows and outflows are foreseeable and inflows exceed outflows
• When future inflows and outflows are foreseeable and outflows exceed inflows
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• When future inflows and outflows are foreseeable but it is impossible to determine which are in excess of
which
• When future inflows and outflows are not foreseeable
Depending on the type and volumes of inflows and outflows at the company, it is possible to select one of the four
models of cash flow management. It is certainly not necessary for only one of the above situations to prevail at the
company. The same business may have periods when inflows exceed outflows on a permanent basis, as well as
periods when a reversed trend is noted or it is not possible to determine the trend. It is similar in case of projecting
future inflows and outflows. It is possible that in some periods of time, inflows and outflows can be projected without
any major difficulty, while in other periods such projection is very hard or completely impossible.
Using information about future cash inflows and outflows, we are able to apply, for example, the Baumol model
or the Beranek model. If we anticipate that cash inflows are greater than outflows, we are able to use the Beranek
model to determine cash flow management within a firm. On the other hand, if we predict that cash outflows are
greater than inflows we use Baumol model. When we cannot forecast long-term cash flows, for a period longer than
approximately 14 days, we are able to use the Stone model to determine cash flow management. However, when
we cannot predict future cash inflows and outflows at all, the Miller-Orr model can be used to determine cash flow
management.
According to the BAT model assumptions, the company receives both regular and periodic cash inflows, while it
spends cash in an ongoing manner, at a fixed rate. At the time of receiving funds, the company earmarks a sufficient
portion of these funds to cover its outflows. This is performed until the next inflow of cash. This model can be
recommended in a situation when future inflows and outflows related to operations of the company can be foreseen
and, at the same time, operational outflows exceed inflows. The BAT model comprises two types of assets: cash and
(external) marketable securities, which generate profit in the form of interest during each period.
cash
2C
C*
0
time
Fig. 5.3 BAT model
The BAT model has been developed for two reasons: in order to specify the optimal cash balance at the company
and to suggest how the company managers should proceed to ensure optimal cash management.
The company which decides to follow recommendations regarding cash management, arising from the BAT model,
determines an optimal cash level.
It stems from the BAT model that when cash is spent, the company should secure cash from non-operational sources
of cash. Most often, this means that it should sell (external) securities, close the held deposit, and/or raise a short-term
loan. The total amount of raised funds should be in each event twice as high as an average cash balance. The ratio
of the total demand for cash in a given period and one transfer provides information on how many such operations
must be performed during the year. It is clear that if conditions, which enable application of the BAT model, have
existed at the company for less than one year, then shorter periods should be taken into account.
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cash
2C
C*
0
time
Fig. 5.4 Beranek model
The basic assumption of the Miller-Orr model is that changes in cash balance at the company are unforeseeable.
The company managers react automatically when cash balance equals either the upper or lower level. This model
is presented in the figure.
cash level
U* Upper Limit
C* Target Cash Level
L Lower Limit
time
Fig. 5.5 Miller –Orr model
Reacting to the situation when the cash balance at the company reaches the upper or lower limit, the management
board buys or sells (external) short-term securities, opens or closes short-term deposits and/or repays or raises a
short-term loan in order to restore the target cash balance Cmo*.
This model is used traditionally in such a manner that the management board of the company first specifies the lower
limit of cash L that it finds acceptable. This value is specified subjectively based on experience of the company
managers. As in a sense it is a minimum level of cash balance, it depends on such factors as availability of the
company’s access to external financing sources. If in the opinion of the management board members, this access is
easy and relatively inexpensive, liquidity at the company is lower and L can be set on a relatively low level.
The Miller-Orr model assumes that the target cash balance C* depends on the (alternative) costs of holding funds,
costs of cash shortages (transfer) and variants of cash flows during the considered period (this period must equal
the period for which an interest rate has been set). The level of variance of cash flows during the analysed period is
best determined based on historic data.
The target cash balance according to the Miller-Orr model is calculated based on the formula for C* mo.
In this model, after setting the target cash balance Cmo* the upper limit U* is determined as a difference between
triple target cash balance and double lower control limit.
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The Stone model is a modification of the Miller-Orr model for the conditions when the company can forecast cash
inflows and outflows in a few-day perspective. Similarly to the Miller-Orr model, it takes into account control limits
and surpassing these limits is a signal for reaction. In case of the Stone model, however, there are two types of
limits, external and internal, but the main difference is that in case of the Stone model, such signal does not mean
an automatic correction of cash balance as in the Miller-Orr model.
cash level
H1
U* upper limit
C* target cash level
L lower limit
H0 cash reduction
time
Fig. 5.6 Stone model
If the cash balance exceeds the upper external limit H1 or the lower external limit H0, the management board analyses
future cash inflows by projecting future cash balance by calculating the S level.
If the S level (determining the cash balance after n days from the moment of surpassing either of the external control
limits) continues to surpass any of the internal limits, the management board should prevent variations from the
target balance by purchase or disposal of securities in the amount sufficient for the cash balance at the company to
be restored to its optimal level, .
This model shows that the cash balance has been growing as from the beginning of the analysed period. At some point,
it exceeded the upper internal limit U*. Then it exceeded the external control limit H1. At the time of exceeding the
external control limit, the management board of the company forecast future inflows and outflows. As the forecast
indicated that the cash balance would continue to exceed the internal control limit (the grey line), the management
board decided to adjust this level to the anticipated C*. After the appropriate adjustment, the cash balance started
to decrease after a few days and it surpassed the lower external control limit. Another forecast was prepared and it
turned out that for several days the cash balance would remain below the lower internal control limit. Therefore,
the cash balance was reduced down to
5.5 Cash Balance Forecasting

Maintaining the appropriate cash balance requires not only ongoing monitoring of the currently held current assets
and liabilities that mature in the forthcoming future, but also those that should be anticipated in the future. Therefore,
it is necessary to plan future cash inflows and outflows.
Cash forecast is performed based on cash budget. This tool contains a forecast of recovered receivables, expenditure
on inventories and repayment of liabilities. It provides information about the cash balance, as cash balance is a
result of inflows from sales (payment of receivables) and outflows due to purchase of materials and other costs of
the company.
Cash budget is most often prepared several periods in advance subject to the company’s information capabilities
and needs. The most popular version of a cash budget is one prepared for six monthly periods. However, there are
no reasons why cash budgets should not be prepared for six weeks or six biweekly periods. In any case, the rolling
wave planning is used, which requires that subsequent periods be added to the budget on an ongoing and regular basis
so that at any one time the company has a forecast for the fixed number of forecast periods (namely, if the budget
is prepared for 8 biweekly periods, then it should be adequately extended when required so that a sixteen-week
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budget is available at any time). This requirement ensures for the budget to be constantly valid and applicable. For
some companies, it is absolutely necessary to determine inflows and outflows for individual weeks and sometimes
even days. The more detailed the control of cash inflows and outflows, the more probable the precise and correct
control of cash flow levels.
When developing a cash budget, it is a matter of top priority to hold a forecast of the company’s sales revenues.
Preparing such forecast is the primary and hardest task. Next, the demand arising from the held fixed assets and
inventories, resulting from production of goods for sale is forecast. This information is combined with information on
delays in recovery of receivables. Also, tax due dates, interest due dates, and other factors are taken into account.
5.6 Precautionary Cash Management - Safety Stock Approach

Current models for determining cash management, for example Baumol, Beranek, Miller-Orr or Stone models,
assign no minimal cash level, and are based on the manager’s intuition. In addition, these models are based inventory
managements models. In this study, we address the potential for adaptation of these methods of determining safety
stock to determine minimal cash levels in the firm. Safety stock is a result of information about the risk of inventories.
To calculate safety stock, we use a result of information about the risk of inventories. To calculate safety stock we
use:
where: zb = Safety Stock, C = Cost of Inventories (in percentage), Q = One Order Quantity, v = Cost of Inventories
(Price), P = Yearly Demand for Inventories, s = Standard Deviation of Inventory Spending, Kbz = Cost of Inventories
Lack. It is also possible to apply the following equation to determine minimal cash level:
where:LCL = Low Cash Level (Precautionary Cash Level), k = Cost of Capital, G* = Average Size of One Cash
Transfer which are the basis of standard deviation calculation, P = the Sum of all Cash Inflows and Outflows in the
Period, s = Standard Deviation of Daily Net Cash Inflows/Outflows, Kbsp = Cost of Cash Lack.
Part of the information necessary to determine LCL, still requires the manager‘s intuition. For example, costs of
lack of cash, contains not only costs known from accountant records, but also other costs, such as opportunity costs.
Precautionary cash reserves are, first of all the result of anxieties before negative results of risk. Its measure is the
standard deviation.
Speculative Cash Balance Management - Option Approach All firms do not necessarily hold speculative cash balances.
Speculative cash is held in order to utilise the positive part of the risk equation. Firms want to retain opportunities
that result from price volatility. For example, in the ordinary practice of Polish firms, we see that speculative cash
balances can be useful to benefit from transactions in foreign exchanges. It can be profitable for firms to purchase
necessary products or services in foreign exchange at prices cheaper than its average purchase price. Such purchase
is possible, if the firm maintains speculative cash balances.
Speculative cash balances give the firm the ability to use of their purchasing power any time. Such cash superiority
over other assets shows option value of speculative cash balances.
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Summary
• The term financial flexibility is defined differently in the financial literature and requires a clear definition in
order to use its full explanatory power.
• The changing economic circumstances resulting from the current financial crisis creates an exemplary opportunity
to examine the effect of different sources of financial flexibility.
• Corporate cash management depends on demands for cash in a firm.
• Liquidity management requires that a sufficient balance of cash and other working capital assets - receivables
and inventories – should be ensured.
• Individual elements influencing liquidity management decisions affect the level of free cash flows to firm.
• Profitability measured by ROE indicates that ‘medium’ liquidity level is optimal.
• If the level of liquid assets is too low, it downsizes the sales thus discouraging clients with an overly restrictive
trade credit policy.
• If the advantages of holding cash at a chosen level are greater than the influence of the alternative costs of
holding cash, thereby increasing net working capital, then firm’s value will also increase.
• The net working capital (current assets less current liabilities) results from lack of synchronisation of the formal
rising receipts.
• If an increase of net working capital is positive, then we allocate more money for net working capital purposes
and thereby decrease future free cash flow.
• Changes in precautionary cash levels affect the net working capital levels and as well the level of operating
costs of cash management in a firm.
• Speculative cash makes it possible for the firm to use the positive part of the risk equation to its benefit.
• Financial decisions of a company always focus on selecting the anticipated level of benefits in conditions of
risk and uncertainty.
• If the benefits of maintaining net working capital at the level determined by the company outweigh the negative
influence of the alternative cost of such maintenance.
• The net working capital is a difference between current assets and current liabilities or a difference between
permanent liabilities and permanent assets.
• When estimating free cash flows, maintaining and increasing net working capital means that the funds earmarked
for raising that capital are tied.
• Current asset financing policies are driven by the manner of financing current assets.
• Insufficient transactional cash levels may disrupt settlement of liabilities and as a result negatively affect the
company’s reputation.
• Changes of the policy, from conservative to aggressive, cause an increase in the cost of capital financing the
company’s operations due to enhancement of risk.
• Depending on the type and volumes of inflows and outflows at the company, it is possible to select one of the
four models of cash flow management.
• The level of variance of cash flows during the analysed period is best determined based on historic data.
• The most popular version of a cash budget is one prepared for six monthly periods.
• Six-month budgets are most frequently prepared based on monthly time bands.
References
• Balances of Cash And The Firm Value [Pdf] Available at: <http://www.euba.sk/department-for-research-and-
doctoral-studies/economic-review/preview-file/er1_2009_michalski-10131.pdf> [Accessed 12 July 2013].
• Analysis of Cash Management [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_
• Bragg. S.M., 2012. Corporate Cash Management. Accounting Tools.
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• Tennent, J., 2012. Guide to Cash Management. Wiley.
• Financial Management. [Video online] Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>
[Accessed 12 July 2013]
• Financial Management. [Video online] Available at: <http://www.youtube.com/watch?v=oCH1Ll7riDQ>
[Accessed 12 July 2013]
Recommended Reading
• Cooper, R., 2004. Corporate Treasury and Cash Management. Palgrave Macmillan.
• Jones, E.V. and Jones, E.B., 2001. Cash Management. R&L Education.
• Driscoll, M.C., 1983. Cash Management: Corporate Strategies for Profit. John Wiley & Sons Inc.
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Self Assessment
1. __________________ management depends on demands for cash in a firm.
a. Corporate cash
b. Cash
c. Financial
d. Flexibility
2. If the level of ______________ is not adequate, it enhances the company’s operating risk – loss of liquidity.
a. cash flow
b. cash inflow
c. capital assets
d. liquid assets
3. Which of the following statements is true?

a. Cash management influences firm value, because its cash investment levels entail the rise of alternative
costs.
b. If the level of liquid assets is not adequate, it enhances the company’s operating risk – loss of liquidity.
c. Maintenance of working capital assets generates costs, thus affecting the company’s profitability.
d. If the level of liquid assets is high, then a company may encounter problems with timely repayment of its
liabilities.
4. _____________________ cash makes it possible for the firm to use the positive part of the risk equation to its
benefit.
a. Flow
b. Speculative
c. Flexibility
d. Financial
5. The ____________________ is a difference between current assets and current liabilities or a difference between
permanent liabilities and permanent assets.
a. net working capital
b. financial flexibility
c. free cash flow
d. capital asset
6. The most liquid current assets are _______________.

a. cash flows
b. flexibility
c. cash balances
d. liquid flow
7. According to the _______________ assumptions, the company receives both regular and periodic cash inflows,
while it spends cash in an ongoing manner, at a fixed rate.
a. Beranek’s model
b. BET model
c. Miller- Orr model
d. Stone model
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8. The basic assumption of the _______________ is that changes in cash balance at the company are
unforeseeable.
a. Beranek’s model
b. BET model
c. Miller- Orr model
d. Stone model
9. The _________________ is a modification of the Miller-Orr model for the conditions when the company can
forecast cash inflows and outflows in a few-day perspective.
a. BET model
b. Stone model
c. Beranek’s model
d. Miller- Orr model
10. ________________ tool contains a forecast of recovered receivables, expenditure on inventories and repayment
of liabilities.
a. Cash budget
b. Cash balance
c. Cash forecast
d. Cash outflow
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Chapter VI
Inventory Management
Aim
• define inventory management
• elucidate the importance of inventory management
• explain the functions of inventory management
Objectives
• classify inventory system
• explicate the types of inventory system
• elucidate selective inventory management
Learning outcome
• understand the VED analysis
• identify the aggregate inventory planning
• recognise the inventories model
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6.1 Introduction
Inventory may be defined as usable but idle resource. If resource is some physical and tangible object such as
materials, then it is generally termed as stock. Thus, stock and inventory are synonymous terms though inventory
has wider implications. Broadly speaking, the problem of inventory management is one of maintaining, for a given
financial investment, an adequate supply of something to meet an expected demand pattern. This could be raw
materials, work in progress, finished products or the spares and other indirect materials.
Inventory can be one of the indicators of the management effectiveness on the materials management front.
Inventory turnover ratio (annual demand/average inventory) is an index of business performance. A soundly managed
organisation will have higher inventory turnover ratio and vice-versa.
Inventory management deals with the determination of optimal policies and procedures for procurement of
commodities. Since it is quite difficult to imagine a real work situation in which the required material will be made
available at the point of use instantaneously, hence maintaining, inventories becomes almost necessary. Thus,
inventories could be visualised as `necessary evil’.
Inventory related costs

An inventory system may be defined as one in which the following costs are significant:
• Cost of carrying inventory: This is expressed in Rs. /item held in stock/unit time. This is the opportunity cost of
blocking material in the non-productive form as inventories. Some of the cost elements that comprise carrying
costs are-cost of blocking, capital (interest rate); cost of insurances; storage cost; cost due to obsolescence,
pilferage, deterioration, etc. It is generally expressed as a fraction of value of the goods stocked per year. For
example, if the fraction of carrying charge is 20% per year and a material worth Rs. 1,000 is kept in inventory
for one year, the unit carrying cost will be Rs. 200/item/year. It is obvious that for items that are perishable in
nature, the attributed carrying cost will be higher.
• Cost of incurring shortages: It is the opportunity cost of not having an item in stock when one is demanded. It
may be due to lost sales or backlogging. In the backlogging (or back ordering) case, the order is not lost but is
backlogged, to be cleared as soon as the item is available on stock. In lost sales case, the order is lost. In both
cases, there are tangible and intangible costs of not meeting the demand on time. It may include lost demand;
penalty cost; emergency replenishment; loss of good-will, etc. This is generally expressed as Rs. /item short/
unit time.
• Cost of replenishing inventory: This is the amount of money and efforts expended in procurement or acquisition
of stock. It is generally called ordering cost. This cost is usually assumed to be independent of the quantity
ordered, because the fixed cost component is generally more significant than the variable component. Thus, it
is expressed as Rs. /order.
These three types of costs are the most commonly incorporated in inventory analysis, though there may be other
cost parameters relevant in such an analysis such as inflation, price discounts, etc.
Importance of Inventory Management

Scientific inventory management is an extremely important problem area in the materials management function.
Materials account for more than half the total cost of any business and organisations maintain huge amount of stocks,
much of this could be reduced by following scientific principles. Inventory management is highly amenable to control.
In the Indian industries there is a substantial potential for cost reduction due to inventory control. Inventory being a
symptom of poor performance we could reduce inventories by proper design of procurement policies by reduction
in the uncertainty of lead times by variety reduction and in many other ways.
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6.2 Functions of Inventory

As mentioned earlier, inventory is a necessary evil. Necessary, because it aims at absorbing the uncertainties of
demand and supply by ‘decoupling’ the demand and supply sub-systems. Thus, an organisation maybe carrying
inventory for the following reasons:
• Demand and lead time uncertainties necessitate building of safety stock (buffer stocks) so as to enable various
sub-systems to operate somewhat in a decoupled manner. It is obvious that the larger the uncertainty of demand
and supply; the larger will have to be the amount of buffer stock to be carried for a prescribed service level.
b) Time lag in deliveries also necessitates building of inventories. If the replenishment lead times are positive,
then stocks are needed for system operation.
• Cycle stocks may be maintained to get the economics of scale, so that total system cost due to ordering, carrying
inventory and backlogging are minimised. Technological requirements of batch processing also build up cycle
stocks.
• Stocks may build up as pipeline inventory or work-in-process inventory due to finiteness of production and
transportation rates. This includes materials actually being worked on or moving between work centres or being
in transit to distribution centres and customers.
• When the demand is seasonal, it may become economical to build inventory during periods of low demand to
ease the strain of peak period demand.
• Inventory may also be built up for other reasons such as, quantity discounts being offered by suppliers, discount
sales, anticipated increase in material price, possibility of future non-availability, etc.
Different functional managers of an organisation may view the inventory from different viewpoints leading to
conflicting objectives. This calls for an integrated systems approach to planning of inventories, so that these
conflicting objectives can be scrutinised to enable the system to operate at minimum total inventory related costs-
both explicit such as purchase price, as well as implicit such as carrying, shortage, transportation and inspection
costs. Concepts and techniques useful in analysis these problems to arrive at sound policy decisions are the focal
point of presentation in this unit.
6.3 Classification of Inventory Systems

The inventory system can be classified as follows:
6.3.1 Lot Size Reorder Point Policy

Under this operating policy, the inventory status is continuously reviewed and as soon as the inventory level falls
to a prescribed value called ‘reorder point’. A fresh replenishment order of fixed quantity called Economic Order
Quantity (EOQ) is initiated. Thus, the order size is constant and is economically determined. This is one of the
very classical types of inventory policies and a lot of mathematical analysis has appeared on this type of policy.
Fig. 6.1 shows the typical stock balance under this type of inventory policy. The solid line in this figure represents
the actual inventory held in practical situation with a finite lead time, the lead time being defined as the time delay
between the placing of a replenishment order and its subsequent receipt. The broken line indicates the inventory
that would be held in the ideal situation, if no lead time existed. Lot size and reorder point are the two decision
variables involved in the design of the policy.
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Inventory level
lead
time
re-order
point
replenishment
order received
replenishment
order placed stock out
time
Fig. 6.1 Typical inventory balances for EOQ- reorder point policy.
6.3.2 Fixed Order Interval Scheduling Policy

Under this policy, the time between consecutive replenishment orders is constant. There is a maximum stock level(s)
prescribed and the inventory status is reviewed periodically with a fixed interval (T). At each review, an order of
size Q is placed which takes the stock on hand plus an order equal to the maximum stock level. Thus, order quantity
could vary from period to period. This policy ensures that when the level of stock on hand is high at review, a smaller
size replenishment order is placed. Fig. 6.1 shows the typical stock balances under this fixed reorder cycle policy.
S, the maximum stock level and T the review period are the decision variables under this policy.
lead
time
Inventory level
replenishment
order received
Review
replenishment order stock out
order placed
time
Fig. 6.2 Fixed reorder cycle policy.
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6.3.3 Optional Replenishment Policy

This is very popularly known as the (s, S) policy. Fig. 6.3 shows the typical stock balance under this policy. The
status of stock is periodically reviewed and maximum stock level (S) and minimum stock level (s) are prescribed.
$
Review takes
place- and
replenishment
ordered
Inventory level
lead
time
$
Review takes
place- on
replenishment
ordered stock
Review out
Period
time
Fig. 6.3 Typical inventory balances in policy.
If at the time of review, the stock on hand, is less than or equal to s, an order of size Q is placed so that stock on
hand plus on order equals the maximum stock level S. If stock on hand at review is higher than s, no order is placed
and the situation is reviewed at the time of next review period. S, s and T (review period) are the decision variables
in the design of such inventory policy.
6.4 Other Types of Inventory Systems

There may be other policies which may be special cases of the policies mentioned above or may be a combination
of these policies. As a special case of (s, S) policy we may have (S-1, S) policy or one-for-one order policy, when
the maximum stock level may be up to S and whenever there is demand for one unit, a replenishment of one unit
is ordered. Such a policy may be quite useful for slow moving expensive items. We may use a combination of lot-
size reorder point policy and fixed interval order scheduling policy. Yet, another variation of inventory policy could
be multiple reorder point policy, where more than one reorder points may be established. Other types of inventory
systems may be static inventory systems when a single purchase decision is to be made which should be adequate
during the entire project duration. Such decisions are not repetitive in nature. Other initial provisioning decisions may
be with respect to repairable assemblies such as engines, gearboxes, etc. in a bus which may have to be overhauled
and for which we have to find adequate number of spare engines to be provided initially.
The right choice of an inventory policy depends upon the nature of the problem; usage value of an item and
other situational parameters. We must first select an operating policy, before determining optimal values of its
parameters.
6.5 Selective Inventory Management

One of the major operating difficulties in the scientific inventory control is an extremely large variety of items stocked
by various organisations. These may vary from 10,000 to 100,000 different types of stocked items and it is neither
feasible nor desirable to apply rigorous scientific principles of inventory control in all these items.
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Such an indiscriminate approach may make cost of inventory control more than its benefits and therefore may
prove to be counter-productive. Therefore, inventory control has to be exercised selectively. Depending upon the
value, criticality and usage frequency of an item we may have to decide on an appropriate type of inventory policy.
The selective inventory management thus plays a crucial role so that we can put our limited control efforts more
judiciously to the more significant group of items. In selective management we group items in few discrete categories
depending upon value; criticality and usage frequency. Such analyses are popularly known as ABC, VED and FSN
Analysis respectively. This type of grouping may well form the starting point in introducing scientific inventory
management in an organisation.
6.5.1 ABC Analysis

This is based on a very universal Pareto’s Law that in any large number we have `significant few’ and ìnsignificant
many’. For example, only 20% of the items may be accounting for the 80% of the total material cost annually. These
are the significant few which require utmost attention.
100
90
Percent of average inventory investment
75
50
C
B
25
A
0
0 10 25 50 75 100
Percent of number of inventory items
Fig. 6.4 ABC analysis
Fig. 6.4 shows a typical ABC analysis showing percentage of number of inventory items and percentage of average
inventory investment (annual usage value). Annual usage value is the demand multiplied by unit price thus giving
monetary worth of annual consumption. It can be seen from this figure that 10% items are claiming 75% of the
annual usage value and thus constitute the ‘significant few’. These are called A-class items. Another 15% items
account for another 15% annual usage value and are called B-class items. A vast majority of 75% items account for
only 10% expenditure on material consumption and constitute ‘insignificant many’ and are called C-class items. To
prepare an ABC type curve we may follow the following simple procedure:
• Arrange items in the descending order of the annual usage value. Annual usage value = Annual demand x Unit
price.
• Identify cut off points on the curve when there is a perceptible sudden change o1 slope or alternatively find cut
off points at top 10% next 20% or so but do not interpret these too literally- rather as a general indicator.
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A very simple empirical way to classify items may be adopted as follows:
Average annual usage value X=
A-Class items 6X
C-Class items 0.5X
In between we have B-class items.

Once the items are grouped into A, B and C category, we can adopt different degree of seriousness in our inventory
control efforts. A class items require almost continuous and rigorous control. Whereas B-class items may have
relaxed control and C-class items may be procured using simple rules of thumb, as usual.
6.5.2 VED Analysis

This analysis attempts to classify items into three categories depending upon the consequences of material stock out
when demanded. As stated earlier, the cost of shortage may vary depending upon the seriousness of such a situation.
Accordingly the items are classified into V (Vital), E (Essential) and D (Desirable) categories. Vital items are the
most critical having extremely high opportunity cost of shortage and must be available in stock when demanded.
Essential items are quite critical with substantial cost associated with shortage and should be available in stock by
and large. Desirable group of items do not have very serious consequences, if not available when demanded, but
can be stocked items.
Obviously the % risk of shortage with the vital’ group of items has to be quite small, thus calling for a high level of
service. With Essential’ category we can take a relatively higher risk of shortage and for `Desirable’ category even
higher. Since even a C-class item may be vital or an A-class item may be `Desirable,’ we should carry out a two-
way classification of items grouping them in 9 distinct groups as A-V, A-E, AD, B-V, B-E, B-D, C-V, C-E and C.D.
Then, we are able to argue on the aimed at service-level for each of these nine categories and plan for inventories
accordingly.
6.5.3 FSN Analysis

Not all items are required with the same frequency. Some materials are quite regularly required, yet some others are
required occasionally and some materials may have become obsolete and might not have been demanded for years
together. FSN analysis groups them into three categories as fast-moving, slow-moving and non-moving (dead stock)
respectively. Inventory policies and models for the three categories have to be different. Most inventory models
in literature are valid for the fast-moving items exhibiting a regular movement (consumption) pattern. Many spare
parts come under the slow-moving category which has to be managed on a different basis. For non-moving dead
stock, we have to determine optimal stock disposal rules rather than inventory provisioning rules. Categorisation
of materials into these three types on value, criticality and usage enables us to adopt the right type of inventory
policy to suit a particular situation.
6.6 Exchange Curve and Aggregate Inventory Planning

Exchange curve (or optimal policy curve) is an effective technique to look at the inventories at an aggregate level in
the organisation. It is a plot between the total number of orders (TO) per year and the total investment in inventories
(TI) per year. The rationale is that for an optimal inventory policy the trade-off between total inventory and total
procurement effort as indicated by the total number of replenishment orders per year must be made, such that if total
number of orders is prescribed, we minimise total investment in inventories. Alternatively, if the total investment
in inventories (TI) is prescribed, then a rational inventory policy must aim at minimising (TO). Optimal inventory
policy must exchange (TI) for (TO) in such a manner that:
(TI). (TO) = K = constant

Value of constant K is given by
K=
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Where, Di = Annual requirement of ith item,
V, = Unit price for ith item, i = 1....N
Thus, a plot between (TI) and (TO) is a rectangular hyperbola and is called as èxchange curve’ or òptimal policy’
curve. A typical exchange curve for a situation, where the ordering cost is not explicitly known. It shows that any
point on the exchange curve is an optimal trade-off between investment in inventories and total number of orders.
Uses of exchange curve

Exchange curve is an effective instrument for aggregate inventory analysis to quickly determine the rationality (or
otherwise) of our existing stock provisioning policies. We first plot the exchange curve by computing the value of K
for a chosen group of items. Then, we determine the total number of orders (TO) and total investment in inventories
(TI) under current practice.
6.7 Deterministic Inventory Models

In this section, we discuss some elementary inventory models with deterministic demand and lead time situations.
The purpose is to provide an illustration of the mathematical analysis of inventory systems. The most classical of the
inventory models was first proposed by Harris in 1915 and further developed by Wilson in 1928. It is very popularly
known as EOQ (Economic Order Quantity) model or ‘Wilson’s Lot Size formula’.
When dealing with stocked items, the two important decisions to be made are, how much to order and when to
order. EOQ attempts to provide answer to former, while the Reorder Point (RoP) provides the answer to the latter.
The following assumptions are made in the standard Wilson lot size formula to obtain EOQ:
• Demand is continuous at a constant rate
• The process continues infinitely.
• No constraints are imposed on quantities ordered, storage capacity, budget etc.
• Replenishment is instantaneous (the entire order quantity is received all at one
time as soon as the order is released).
• All costs are time-invariant.
• No shortages are allowed
• Quantity discounts are not available.
• The inventory status under EOQ-RoP policy is continuously reviewed.
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Summary
• Inventory management deals with the determination of optimal policies and procedures for procurement of
commodities.
• Demand and lead time uncertainties necessitate building of safety stock (buffer stocks), so as to enable various
sub-systems to operate somewhat in a decoupled manner.
• Inventory can be one of the indicators of the management effectiveness on the materials management front.
• Inventory turnover ratio (annual demand/average inventory) is an index of business performance.
• It is the opportunity cost of not having an item in stock, when one is demanded.
• In the backlogging (or back ordering) case, the order is not lost but is backlogged, to be cleared as soon as the
item is available on stock.
• The right choice of an inventory policy depends upon the nature of the problem; usage value of an item and
other situational parameters.
• Annual usage value is the demand multiplied by unit price, thus giving monetary worth of annual
consumption.
• Exchange curve (or optimal policy curve) is an effective technique to look at the inventories at an aggregate
level in the organisation.
• Exchange curve is an effective instrument for aggregate inventory analysis to quickly determine the rationality
(or otherwise) of our existing stock provisioning policies.
• The most classical of the inventory models was first proposed by Harris in 1915 and further developed by
Wilson in 1928.
• When dealing with stocked items, the two important decisions to be made are-how much to order and when to
order.
• If the total investment in inventories (TI) is prescribed then a rational inventory policy must aim at minimising
(TO).
• Essential items are quite critical with substantial cost associated with shortage and should be available in stock
by and large.
• Vital items are the most critical having extremely high opportunity cost of shortage and must be available in
stock when demanded.
• The selective inventory management plays a crucial role, so that we can put our limited control efforts more
judiciously to the more significant group of items.
• In selective management, we group items in few discrete categories depending upon value; criticality and usage
frequency.
• The right choice of an inventory policy depends upon the nature of the problem; usage value of an item and
other situational parameters.
• When the demand is seasonal, it may become economical to build inventory during periods of low demand to
ease the strain of peak period demand.
References
• The Importance of Inventory Management [Online] Available at: <http://www.southernfulfillment.com/articles/
order-fulfillment/inventory-management/the_importance_of_inventory_management.htm> [Accessed 12 July
2013].
• Inventory Management [Online] Available at: <http://www.termpaperwarehouse.com/essay-on/4-3-1-Template-
Managers-Report/158537> [Accessed 12 July 2013].
• Muller, M., 2011. Essentials of Inventory Management. 2nd ed., AMACOM.
• Bragg, S.M., 2011. Inventory Best Practices 2nd ed., Wiley.
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• Inventory Management Best Practices [Video online] Available at: <http://www.youtube.com/
watch?v=C8Z3IApWCNQ> [Accessed 12 July 2013].
• Inventory Management - An Introduction. [Video online] Available at: <http://www.youtube.com/
watch?v=qkZQxXJuqKo> [Accessed 12 July 2013].
Recommended Reading
• Silver, E. A., Pyke, D. F. and Peterson, R., Inventory Management and Production Planning and Scheduling,
3rd ed., Wiley.
• Schreibfeder, J., 2003. Achieving Effective Inventory Management, 5th ed., Effective Inventory Management,
Inc.
• Bose, D.C., 2006. Inventory Management. PHI Learning Pvt. Ltd.
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Self Assessment
1. Which of the following is an index of business performance?
a. Financial management
b. Financial investment
d. Inventory turnover ratio
2. _________________ deals with the determination of optimal policies and procedures for procurement of
commodities.
a. Financial management
b. Financial investment
d. Inventory turnover ratio
3. __________________ is the opportunity cost of not having an item in stock, when one is demanded.
a. Cost of replenishing inventory
b. Cost of incurring shortages
c. Cost of carrying inventory
d. Cost of incorporated inventory
4. ______________________ is the amount of money and efforts expended in procurement or acquisition of

stock.
a. Inventory amount
b. Cost of replenishing inventory
c. Cost of incurring shortages
d. Cost of carrying inventory
5. Which of the following is also called as ordering cost?

a. Fixed cost
b. Cost of incurring shortage
c. Cost of carrying inventory
d. Cost of replenishing inventory
6. Which of the following is also known as (S, s) policy?

a. Selective inventory policy
b. Fixed order interval scheduling policy
c. Lot size reorder point policy
d. Optional replenishment policy
7. In selective management, we group items in few discrete categories depending upon _________; criticality and
usage frequency.
a. cash
b. analysis
c. inventory
d. situation
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8. _________________ value is the demand multiplied by unit price thus giving monetary worth of annual
consumption.
a. Cash
b. Consumption
c. Annual usage
d. Analytical
9. ________________ analysis attempts to classify items into three categories depending upon the consequences
of material stock out when demanded.
a. VED
b. FSN
c. ABC
d. ECA
10. _________________ is an effective instrument for aggregate inventory analysis to quickly determine the
rationality (or otherwise) of our existing stock provisioning policies.
a. Inventory model
b. Exchange curve
c. Inventory planning
d. Inventory management
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Chapter VII
Capital and Money Market
Aim
• define financial market
• elucidate the types of financial markets
• explain the functions of capital market
Objectives
• explaining capital market operations
• explicate the forms of capital market efficiency
• elucidate the term selective inventory management
Learning outcome
• understand the importance of money market
• identify the Indian money market system
• recognise the drawbacks of Indian money market
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7.1 Introduction
The economic development of a nation is reflected by the progress of the various economic units, broadly classified
into corporate sector, Government and household sector. While performing their activities, these units are placed in
surplus/deficit/balanced budgetary situations.
There are some people with surplus funds and some others with a deficit. A financial system or financial sector
functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A
financial system is a composition of various institutions, markets, regulations and laws, practices, money manager,
analysts, transactions and claims and liabilities.
7.2 Financial Market

A financial market can be defined as the market in which financial assets are created or transferred. As against a real
transaction that involves exchange of money for real goods or services, a financial transaction involves creation or
transfer of financial assets. Financial assets or financial instruments represent a claim to the payment of a sum of
money sometime in the future /or periodic payment in the form of interest or dividend.
A financial market can be categorised as money market, capital market, forex market and derivative market:
• Money market: The money market is a wholesale debt market for low-risk, highly-liquid, short-term instruments.
Funds are available in this market for periods ranging from a single day up to a year. This market is dominated
mostly by government, banks and financial institutions.
• Capital market: The capital market is designed to finance the long-term investments. The transactions taking
place in this market will be for periods over a year. Herbert K. Dougall defines the term capital market as “a
complex of institutions and mechanisms whereby, intermediate term funds (loans up to 10 years maturity)
and long lean funds (longer maturity loans and corporate stocks) are pooled and made available to business,
Government and individuals and where instruments that are already outstanding are transferred.” The capital
market is a medium through which small and scattered savings of investors are directed into productive activities
of corporate entities. It also provides the essential attributes of liquidity, marketability and safety of investments
to the investors.
• Forex market: The Forex market deals with the multicurrency requirements, which are met by the exchange of
currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market.
This is one of the most developed and integrated market across the globe.
• Credit market: Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans
to corporate and individuals.
• Derivative markets: The derivatives market is meant as the market, where exchange of derivatives takes place.
Derivatives are one type of securities, whose price is derived from the underlying assets. Value of these derivatives
is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks,
bonds, currencies, interest rates, commodities and market indices.
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Financial System
Financial
Financial Instrument Financial Market
Intermediaries
Capital Primary
Money Market Market Market
Instrument
Money Secondary
Market Market
Capital Market Derivative

Instrument Market
Credit
Market
Hybrid
Instrument Forex
Market
Fig. 7.1 The financial system
7.3 Capital Market Efficiency

Capital market facilitates the buying and selling of securities, such as shares and bonds or debentures. They perform
two valuable functions, liquidity and pricing securities.
Liquidity
Liquidity means the convenience and speed of transforming assets into cash, or transferring assets from one person
to another without any loss of value. Cash is the most liquid asset as it can be readily converted into any other asset,
or transferred to another person without any decline in value. Capital market makes securities liquid. They facilitate
the buying and selling of securities by a large number of investors continuously and instantaneously without incurring
significant costs. They help to reduce, if not eliminate, transaction costs. For ensuring the liquidity, capital markets
do require certain investors who are always ready to buy or sell securities. These market makers enhance liquidity
and reduce transaction costs.
Pricing securities
How are the prices of securities determined? Are these prices fair? In the capital markets, hundred of investors make
several deals a day. The screen-based trading makes these deals known to all in the capital market. Thus, a large
number of buyers and sellers interact in the capital markets. The demand and supply forces help in determining
the prices. Since all information is publicly available, and since no single investor is large enough to influence the
security prices, the capital markets provide a measure of fair price of securities.
A financial manager borrows and lends (invests) funds on the capital market. Capital markets facilitate the allocation
of funds between savers and borrowers. This allocation will be optimum, if the capital markets have an efficient
pricing mechanism.
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7.3.1 Forms of Capital Market Efficiency
The finance theory refers to three forms of capital market efficiency:
Weak form of market efficiency
The security prices reflect all the past information about the price movements in the weak-form of efficiency, it is,
therefore, not possible for any investor to predict future security price by analysing historical prices, and achieve a
performance (return) better than the stock market index such as Bombay Stock Exchange Share Price Index or the
Economic Times Share Price Index. It is so because the capital market has no money, and the stock market index
has already incorporated past information about the security prices in the current market price.
How does one know that the capital market is efficient in its weak form? To answer this question, it is necessary to
find out the correlation between the ‘security prices over time’. In an efficient capital market, there should not exist
a significant correlation between the security prices over time. Most empirical tests have shown that there exists
serial independence between the security prices over time. Hence, the weak form of efficiency is referred to as the
random walk hypothesis. An alternative method to testing the weakly efficient market hypothesis is to formulate the
trading strategies using the security prices and compare their performance with the stock market performance.
Semi-strong form of market efficiency

In semi-strong form of efficiency, asset prices already reflect all information that is publicly available, i.e., earnings,
dividends, analyst forecasts, expectations of the future, etc. Most tests show that material public announcements
are accompanied by an immediate change in price. In a semi-strong efficient market, the market’s reaction to new
and material information should be both instantaneous and unbiased, i.e., without any systematic pattern of over or
under-reaction. In addition, the market should only react to the extent that new information differs from what had
been expected. Semi-strong efficiency also means that most financial analysis work or fundamental analysis, based
on using public information, should not work.
Opportunities may occasionally exist that produce above normal or excess returns. However, after the information
or strategies become known to the public, they should no longer produce excess returns; for example, the January
effect in small stocks has vanished. Also, a talented investment analyst might still be able to beat the market, provided
that he/she is able to consistently interpret information better than his or her competitor.
Implications of semi-strong form of market efficiency are as detailed below:

• Stock prices are expected to increase over time, but future returns are expected to be consistent with the
systematic risk.
• Investments in financial assets are expected to be ZERO Net Present Value. This means that you should expect
to earn an average future return, which is, determined by the systematic risk of the investments.
What if no one performed security analysis? Then, the first person that becomes an analyst will find countless
mispriced assets and trading rules that earn excess or abnormal returns. Such profitable opportunities would certainly
lead to many more individuals entering the analyst field. Competition will quickly begin to eliminate most of the
mispriced assets.
Due to intense competition, it will become difficult to earn abnormal returns. The marginal benefit of analysis will
just equal the marginal cost of analysis for the average analyst or investor. It, thus, follows that individuals should
be exceedingly suspicious of anyone that advertises some investment technique that earns abnormal returns. If the
method really works, then any rational person would keep the technique undisclosed. This holds for the weak-form
market efficiency as well, as many attempt to sell methods for technical analysis.
Strong-form of market efficiency

In the strong-form of efficiency, the security prices reflect all published and unpublished, public and private
information, this is, a significantly strong assertion, and empirical studies have not borne out the validity of the
efficient market hypothesis in the strong form of efficiency, people with private or inside information have been
able to outperform the market.
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7.4 Capital Market Operations

Capital market operations consist mainly of primary market operations and secondary market operations. Primary
market or new issue market deals with the issue of new securities to the investors and facilitates the corporate sector
in raising funds. The primary market is made up of two components, where firms go public for the first time through
initial public offerings and where firms which have already traded raise additional capital through seasoned equity
offerings.
• Initial capital is raised by issuing only ordinary and preference shares, whereas further capital can be raised by
selling debentures as well.
• In order to effectively control the activities in the new issue market and to ensure that investments in the country
are made in a planned manner and in accordance with the priorities laid down in the plans, the Government has
instituted the Controller of Capital Issues (CCI) under the Capital Issues (Control) Act, 1947.
• CCI laid stringent controls on pubic and right issues and in their pricing. As a result, capital issues were generally
underpriced. But when Capital Issues (Control) Act was repealed and free pricing was introduced by SEBI in
1992 the market saw a plethora of issues.
• Hefty premiums were charged by the issuing companies as there was no restriction on fixing of premiums.
• Many fly-by-night companies also accessed capital market.
• But in many cases, investors lost heavily as the post issue listings were quoted far below issue prices.
• It is estimated that around 1000 companies which came out with issues and collected about Rs. 3000 crores in
1995 and 1996 have disappeared completely.
With a view to protect the interest of investors, Malegam Committee recommended the introduction of book building
as an alternative device to the existing system of fixed pricing and it was adopted by SEBI in 1996. Book building
helps to find a better price for an issue to be made. Under this method, the issuing company will mention an indicative
price at which securities will be offered and gives the investors an opportunity to bid collectively. Then, a consensus
price will be arrived at and allotment will be finalised at the agreed price.
Buy-back of shares is a device which facilitates capital restructuring of a company. It helps in arresting wide
fluctuation in share prices and paves the way for efficient allocation of resources. Earlier, buy-back of shares was
prohibited in India by the Companies Act, 1956, however, buy- back was allowed in India through an amendment
ordinance in 1998. Now, Indian companies are free to buy its own shares and other securities up to 25 per cent of
their net worth out of its free reserves, or securities premium account, or proceeds of an earlier issue other than a
fresh issue made specifically for buy-back purposes. In another development, companies are given the option to
issue shares of any denomination without a uniform par value.
7.5 Money Market

Money market means market where money or its equivalent can be traded. Money is synonymous to liquidity. Money
market consists of financial institutions and dealers in money or credit who wish to generate liquidity. It is better
known as a place where large institutions and Government manage their short-term cash needs. For generation of
liquidity, short-term borrowing and lending is done by these financial institutions and dealers. Due to highly liquid
nature of securities and their short-term maturities, money market is treated as a safe place.
Definitions of money market help to identify the basic characteristics of a money market. Various financial instruments
are used for transactions in a money market. There is perfect mobility of funds in a money market. The transactions
in a money market are of short -term nature.
According to the RBI, “The money market is the centre for dealing mainly of short character, in monetary assets;
it meets the short-term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where
short-term surplus investible funds at the disposal of financial and other institutions and individuals are bid by
borrowers, again comprising institutions and individuals and also by the government.”
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According to Nadler and Shipman, “A money market is a mechanical device through which short-term funds are
loaned and borrowed through which a large part of the financial transactions of a particular country or world are
degraded. A money market is distinct from but supplementary to the commercial banking system.”
7.5.1 Characteristics of Money Market

The important characteristics of money market are as follows:
Short-term Credit Market
In the money market, funds are made available for a short period only. The funds are borrowed or lent for one day,
a week or for three to six months or in exceptional cases for the period of more than six months but less than one
year.
Funds against different types of instruments

The funds are usually borrowed against different types of securities which are called as near-money. The important
instruments against which funds are borrowed are trade bills or bills of exchange, promissory notes, banker’s
acceptance, treasury bills or suitable commercial papers of maturity up to six months.
Composition of sub-markets
In the money market, funds are borrowed against various securities. The transactions of borrowing of funds against
a particular security are carried out in a particular part which is called as a sub-part or a sub-market of the money
market, i.e., transactions of borrowing against bills of exchange are carried out in a bill market, there are following
important sub-markets in the money market, which are:
• Call money market
• Acceptance market
• Bill market
• Treasury Bill market
• Collateral Loans market
No definite location
The money market has no definite location where borrowers and lenders meet. Negotiations between borrowers and
lenders may be carried on through telephone, telegraphs and through mails or any other arrangement. Thus, money
market is an arrangement that brings about a direct or indirect contract between the borrower and the lender.
Specific institutions
Some financial institutions deal in short-term finance and long-term finance once at the same time. But, there are
certain agencies which deal only in the short-term credit. For example, discount houses and acceptance houses.
Purpose of loans
The money market provides short-term loans for various purposes such as loan for meeting short-term financial
needs of industry, commerce, trade, agriculture, Government developmental activities and for meeting short-term
financial needs of stock exchange brokers, etc.
Settlement of financial transactions

From the definition given by Madden and Nadler, one can say that a money market is an agency through which many
financial transactions of the country are settled. In case of developed money market, many financial transactions of
the world are settled. This conveys the importance of money markets in the world economy.
7.5.2 Functions of Money Market

Money market is an important part of the economy. It plays very significant functions. As mentioned above, it is
basically a market for short-term monetary transactions. Thus, it has to provide facility for adjusting liquidity to
the banks, business corporations, Non-Banking Financial institutions (NBFs) and other financial institutions along
with investors.
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The major functions of money market are given below:

• To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money
for short-term monetary transactions
• To promote economic growth. Money market can do this by making funds available to various units in the
economy such as agriculture, small scale industries, etc.
• To provide help to trade and industry. Money market provides adequate finance to trade and industry. Similarly,
it also provides facility of discounting bills of exchange for trade and industry
• To help in implementing monetary policy. It provides a mechanism for an effective implementation of the
monetary policy
• To help in capital formation. Money market makes available investment avenues for short term period. It helps
in generating savings and investments in the economy
Money market provides non-inflationary sources of finance to Government. It is possible by issuing treasury bills
in order to raise short loans. However, this does not lead to increases in the prices Apart from these, money market
is an arrangement which accommodates banks and financial institutions dealing in short-term monetary activities,
such as the demand for and supply of money.
7.5.3 Importance of Money Market

A developed money market plays an important role in the financial system of a country by supplying short-term
funds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy.
Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed
money market helps the smooth functioning of the financial system in any economy in the following ways:
Development of trade and industry
Money market is an important source of financing trade and industry. The money market, through discounting
operations and commercial papers, finances the short-term working capital requirements of trade and industry and
facilities the development of industry and trade both – national and international.
Development of capital market

The short-term rates of interest and the conditions that prevail in the money market influence the long-term interest
as well as the resource mobilisation in capital market. Hence, the development of capital depends upon the existence
of a development of capital money market.
Smooth functioning of commercial banks

The money market provides the commercial banks with facilities for temporarily employing their surplus funds
in easily realisable assets. The banks can get back the funds quickly, in times of need, by resorting to the money
market. The commercial banks gain immensely by economising on their cash balances in hand and at the same
time meeting the demand for large withdrawal of their depositors. It also enables commercial banks to meet their
statutory requirements of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) by utilising the money
market mechanism.
Effective central bank control

A developed money market helps the effective functioning of a central bank. It facilitates effective implementation
of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the
economy in slump and siphons if off in boom. The central bank, thus, regulates the flow of money so as to promote
economic growth with stability.
Formulation of suitable monetary policy

Conditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it
serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon
the monetary conditions prevailing in the market.
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Non-inflationary source of finance to Government
A developed money market helps the Government to raise short-term funds through the treasury bills floated in the
market. In the absence of a developed money market, the Government would be forced to print and issue more money
or borrow from the Central Bank. Both ways would lead to an increase in prices and the consequent inflationary
trend in the economy.
7.6 Indian Money Market Instruments

Investment in money market is done through money market instruments. Money market instrument meets short-
term requirements of the borrowers and provides liquidity to the lenders. Common money market instruments are
as follows:
Treasury Bills (T-Bills)
Treasury Bills, one of the safest money market instruments, are short-term borrowing instruments of the Central
Government of the country issued through the Central Bank (RBI in India).
• They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market
as well as secondary market. It is a promise to pay a said sum after a specified period.
• T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three
month, six-month, and one-year maturity periods.
• The Central Government issues T-Bills at a price less than their face value (par value). They are issued with
a promise to pay full face value on maturity. So, when the T-Bills mature, the Government pays the holder its
face value.
• The difference between the purchase price and the maturity value is the interest income earned by the purchaser
of the instrument.
• T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-
competitively.
• In the second type of bidding, return required is not specified and the one determined at the auction is received
on maturity. Whereas, in case of competitive bidding, the return required on maturity is specified in the bid. In
case the return specified is too high then the T-Bill might not be issued to the bidder.
• At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182
day and 364-day. There are no treasury bills issued by State Governments.
• Treasury bills are available for a minimum amount of Rs.25K and in its multiples. While 91-day T-bills are
auctioned every week on Wednesdays, 182-day and 364-day T-bills are auctioned every alternate week on
Wednesdays.
• The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the banks’ website.
It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press
releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their/
custodian’s current account.
• T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their
bids on the system. NDS is an electronic platform for facilitating dealing in Government securities and money
market instruments.
• RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking
terms, this is called Reverse Repurchase (Reverse Repo).
• On the other hand, when RBI purchases back these instruments at a specified date mentioned at the time of
transaction, liquidity is infused in the market. This is called Repo (Repurchase) transaction.
Repurchase Agreements
• Repurchase transactions, called Repo or Reverse Repo are transactions or short-term loans in which two parties
agree to sell and repurchase the same security. They are usually used for overnight borrowing.
• Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved
securities, viz., GOI and State Govt. Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds, etc.
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• Under repurchase agreement, the seller sells specified securities with an agreement to repurchase the same at
a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to
resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when
viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective
of the buyer of the securities.
• Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the
transaction.
• The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty.
Effectively, the seller of the security borrows money for a period of time (Repo period) at a particular rate of
interest mutually agreed with the buyer of the security who has lent the funds to the seller.
• The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties
independently of the coupon rate or rates of the underlying securities and is influenced by overall money market
conditions.
Commercial Paper (CP)

• Commercial paper is a low-cost alternative to bank loans. It is a short-term unsecured promissory note issued
by corporate and financial institutions at a discounted value on face value.
• They are usually issued with fixed maturity between one to 270 days and for financing of accounts receivables,
inventories, and meeting short-term liabilities. Say, for example, a company has receivables of Rs 1 lakh with
credit period 6 months. It will not be able to liquidate its receivables before 6 months.
• The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at
discount of 10% on face value of Rs 1 lakh to be matured after 6 months. The company has strong credit rating
and finds buyers easily.
• The company is able to liquidate its receivables immediately and the buyer is able to earn interest of Rs 10K
over a period of 6 months.
• They yield higher returns as compared to T-Bills as they are less secure in comparison to these bills; however
chances of default are almost negligible but are not zero risk instruments.
• Commercial paper being an instrument not backed by any collateral, only firms with high quality credit ratings
will find buyers easily without offering any substantial discounts.
• They are issued by corporates to impart flexibility in raising working capital resources at market determined
rates.
• Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory
notes and are freely transferable in demat form.
Certificate of Deposit
• It is a short-term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in
form of a certificate entitling the bearer to receive interest.
• The certificate bears the maturity date, the fixed rate of interest and the value. It can be issued in any
denomination.
• They are stamped and transferred by endorsement. Its term generally ranges from three months to five years
and restricts the holders to withdraw funds on demand.
• However, on payment of certain penalty the money can be withdrawn on demand also.
• The returns on certificate of deposits are higher than T-Bills because it assumes higher level of risk.
• While buying Certificate of Deposit, return method should be seen. Returns can be based on Annual Percentage
Yield (APY) or Annual Percentage Rate (APR).
• In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest
calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated
by both APY and APR methods. However, if interest is paid more than once in a year, it is beneficial to opt
APY over APR.
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Banker’s Acceptance
• It is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment.
It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the
seller a certain specified amount at certain date.
• The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral.
• The person drawing the bill must have a good credit rating otherwise the banker’s acceptance will not be
tradable.
• The most common term for these instruments is 90 days. However, they can very from 30 days to180 days.
• For corporations, it acts as a negotiable time draft for financing imports, exports and other transactions in goods
and is highly useful when the credit worthiness of the foreign trade party is unknown.
• The seller need not hold it until maturity and can sell off the same in secondary market at discount from the
face value to liquidate its receivables.
7.7 Drawbacks of Indian Money Market

Though the Indian money market is considered as the advanced money market among developing countries, it still
suffers from many drawbacks or defects. These defects limit the efficiency of our market. Some of the important
drawbacks of the Indian money market are:
Absence of integration
The Indian money market is broadly divided into the organised and unorganised sectors. The former comprises
the legal financial institutions backed by the RBI. The unorganised segment of it includes various institutions such
as indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two
segments.
Multiple rate of interest

In the Indian money market, especially the banks, there exist too many rates of interests. These rates vary for lending,
borrowing, government activities, etc. Many rates of interests create confusion among the investors.
Insufficient funds or resources

The Indian economy with its seasonal structure faces frequent shortage of financial recourse. Lower income, lower
savings, and lack of banking habits among people are some of the reasons for it.
Shortage of investment instruments

In the Indian money market, various investment instruments such as Treasury Bills, Commercial Bills, Certificate
of Deposits, Commercial Papers, etc. are used. But taking into account, the size of the population and market these
instruments are inadequate.
Shortage of commercial bill

In India, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Similarly
since a large number of transactions are preferred in the cash form the scope for commercial bills are limited.
Lack of organised banking system

In India, even though we have a big network of commercial banks; still the banking system suffers from major
weaknesses such as the NPA, huge losses, and poor efficiency. The absence of the organised banking system is
major problem for Indian money market.
Less number of dealers

There are lesser number of dealers in the short-term assets who can act as mediators between the Government and
the banking system. This leads to the slow contact between the end lender and end borrowers.
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7.8 Reforms in Indian Money Market

Indian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the
Indian monetary system. Later, Narayanan Vaghul working group and Narasimham Committee was also set up. As
per the recommendations of these study groups and with the financial sector reforms initiated in the early 1990s,
the Government has adopted following major reforms in the Indian money market.
• Deregulation of the interest rate: In recent period, the Government has adopted an interest rate policy of
liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc.
Commercial banks are advised to see the interest rate change that takes place within the limit. There was a
further deregulation of interest rates during the economic reforms. Currently, interest rates are determined by
the working of market forces except for a few regulations.
• Money Market Mutual Fund (MMMFs): In order to provide additional short-term investment revenue, the RBI
encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed
to sell units to corporate and individuals. The upper limit of 50-crore investment has also been lifted. Financial
institutions such as the IDBI and the UTI have set up such funds.
Establishment of the DFI: The Discount and Finance House of India (DFHI) was set up in April 1988 to
impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial
Institutions. DFHI has played an important role in stabilizing the Indian money market.
Liquidity Adjustment Facility (LAF): Through the LAF, the RBI remains in the money market on a continue
basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection
of financial resources.
Electronic transactions: In order to impart transparency and efficiency in the money market transaction the
electronic dealing system has been started. It covers all deals in the money market. Similarly, it is useful
for the RBI to watchdog the money market.
Establishment of the CCIL: The Clearing Corporation of India limited (CCIL) was set up in April 2001.
The CCIL clears all transactions in Government securities, and repose reported on the negotiated dealing
system.
Development of new market instruments: The Government has consistently tried to introduce new short-term
investment instruments. Examples: Treasury Bills of various durations, Commercial papers, Certificates of
Deposits, MMMFs, etc. have been introduced in the Indian money market.
These are major reforms undertaken in the money market in India. Apart from these, the stamp duty reforms, floating
rate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude
that the Indian money market is developing at a good speed.
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Summary
• A financial system is a composition of various institutions, markets, regulations and laws, practices, money
manager, analysts, transactions and claims and liabilities.
• A financial market can be defined as the market in which financial assets are created or transferred.
• Financial assets or financial instruments represent a claim to the payment of a sum of money sometime in the
future and/or periodic payment in the form of interest or dividend.
• The capital market is designed to finance the long-term investments.
• The capital market is a medium through which small and scattered savings of investors are directed into productive
activities of corporate entities.
• The forex market deals with the multi-currency requirements, which are met by the exchange of currencies.
• Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate
and individuals.
• Derivatives are one type of securities whose price is derived from the underlying assets.
• Capital market facilitates the buying and selling of securities, such as shares and bonds or debentures.
• Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person
without any decline in value.
• For ensuring the liquidity, capital markets do require certain investors who are always ready to buy or sell
securities.
• Capital markers facilitate the allocation of funds between savers and borrowers.
• The security prices reflect all the past information about the price movements in the weak-form of efficiency.
• Capital market operations consist mainly of primary market operations and secondary market operations.
• Money market means market where money or its equivalent can be traded. Money is synonymous to
liquidity.
• A money market is a mechanical device through which short-term funds are loaned and borrowed through which
a large part of the financial transactions of a particular country or world are degraded.
• The important instruments against which funds are borrowed are trade bills or bills of exchange, promissory
notes, banker’s acceptance, treasury bills or suitable commercial papers of maturity up to six months.
• To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money
for short-term monetary transactions.
• Money market provides non-inflationary sources of finance to Government.
• A developed money market plays an important role in the financial system of a country by supplying short-term
funds adequately and quickly to trade and industry.
• The money market provides the commercial banks with facilities for temporarily employing their surplus funds
in easily realisable assets.
References
• Money Market and its Instruments [Pdf] Available at: <http://www.caalley.com/art/Money_Market_and_Money_
Market_Instruments.pdf > [Accessed 12 July 2013].
• Financial system [Online] Available at: < http://www.slideshare.net/chotu30/financial-system-11563132 >
• Ritter, L.S. and Silber, W.L., 2008. Principles of Money, Banking & Financial Markets. 12th ed. Prentice
Hall.
• Thau, A., The Bond Book, 3rd ed., McGraw-Hill.
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• Money Markets and Capital Markets [Video online] Available at: <http://www.youtube.com/watch?v=nv0a0GEc-
4s> [Accessed 12 July 2013].
• Financial Markets and Products [Video online] Available at: <http://www.youtube.com/watch?v=y_ti1PXDnLE>
Recommended Reading
• Kidwell, D. S., Blackwell, D. W., Whidbee, D. A. and Sias, R. W., 2011. Financial Institutions, Markets, and
Money. 11th ed. Financial Institutions, Markets, and Money, Wiley.
• Mishkin, F.S. and Eakins, S., 2011. Financial Markets and Institutions. 7th ed., Prentice Hall.
• Levinson, M., 2009. Guide to Financial Markets. Guide to Financial Markets. 5th ed., Bloomberg Press.
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Self Assessment
1. Which of the following is not one of the economic units?
a. Corporate sector
b. Private sector
c. Government sector
d. House hold sector
2. A _________________ can be defined as the market in which financial assets are created or transferred.
a. financial management
b. inventory management
c. cash flow
d. financial market
3. Which of the following is not one of the categorisation of financial market?

a. Derivative market
b. Capital market
c. Monetary market
d. Forex market
4. The ____________________ deals with the multicurrency requirements, which are met by the exchange of
currencies.
a. Forex market
b. Credit market
c. Capita market
d. Money market
5. The __________________ is meant as the market where exchange of derivatives takes place.
a. Underlying assets
b. Money markets
c. Derivatives market
d. Capital market
6. ___________________ means the convenience and speed of transforming assets into cash, or transferring assets
from one person to another without any loss of value.
a. Liquidity
b. Pricing
c. Derivative
d. Credit
7. Which of the following is not one of the forms of capital market efficiency?
a. Weak form of market efficiency
b. Semi strong primary market operations
c. Semi-strong form of market efficiency
d. Strong-form of market efficiency
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8. ___________________ means market where money or its equivalent can be traded. Money is synonym of
liquidity.
a. Capital market
b. Money market
c. Derivative market
d. Market operations
9. Which of the following is not one of the characteristics of money market?

a. Long term credit market
b. No definite location
c. Purpose of loans
d. Settlement of financial transaction
10. Which of the following is not one of the functions of money market?
a. To maintain momentary equilibrium
b. To promote economic growth
c. To provide help to Trade and Industry
d. To help in implementing Monetary Policy
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Chapter VIII
Receivable Management
Aim
• define management of receivables
• elucidate the receivable management
• explain the instruments indicating receivables
Objectives
• explain the cost of maintaining receivables
• explicate the factors affecting the size of receivables
• elucidate the principles of credit management
Learning outcome
• understand the objectives of receivable management
• identify the aspects of credit management
• recognise various credit periods
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8.1 Introduction
Management of trade credit is commonly known as management of receivables. Receivables are one of the three
primary components of working capital, the other being inventory and cash. Receivables occupy second important
place after inventories and thereby constitute a substantial portion of current assets in several firms. The capital
invested in receivables is almost of the same amount as that invested in cash and inventories. Receivables thus,
form about one third of current assets in India. Trade credit is an important market tool, as it acts like a bridge for
mobilisation of goods from production to distribution stages in the field of marketing. Receivables provide protection
to sales from competitions. It acts no less than a magnet in attracting potential customers to buy the product at terms
and conditions favourable to them as well as to the firm. Receivables management demands due consideration for
a financial executive not only because cost and risk are associated with this investment, but also for the reason that
each rupee can contribute to a firm’s net worth.
When goods and services are sold under an agreement permitting the customer to pay for them at a later date, the
amount due from the customer is recorded as accounts receivables; so, receivables are asset accounts representing
amounts owed to the firm as a result of the credit sale of goods and services in the ordinary course of business. The
value of these claims is carried on to the assets side of the balance sheet under titles such as accounts receivable,
trade receivables or customer receivables. This term can be defined as “debt owed to the firm by customers arising
from sale of goods or services in ordinary course of business.”
According to Robert N. Anthony, “Accounts receivables are amounts owed to the business enterprise, usually by
its customers. Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed by
customers, and the latter refers to amounts owed by employees and others.”
8.2 Receivable Management

Generally, when a concern does not receive cash payment in respect of ordinary sale of its products or services
immediately in order to allow them a reasonable period of time to pay for the goods they have received. The firm
is said to have granted trade credit. Trade credit thus, gives rise to certain receivables or book debts expected to
be collected by the firm in the near future. In other words, sale of goods on credit converts finished goods of a
selling firm into receivables or book debts. On their maturity, these receivables are realised and cash is generated.
According to Prasanna Chandra, “The balance in the receivables accounts would be; average daily credit sales x
average collection period.”
The book debts or receivables arising out of credit have three dimensions:
• It involves an element of risk, which should be carefully assessed. Unlike cash sales, credit sales are not risk-
less as the cash payment remains un-received.
• It is based on economics value. The economic value in goods and services passes to the buyer immediately
when the sale is made in return for an equivalent economic value expected by the seller from him to be received
later on.
• It implies futurity, as the payment for the goods and services received by the buyer is made by him to the firm
on a future date.
The customer who represents the firm’s claim or assets, from whom receivables or book-debts are to be collected in the
near future, are known as debtors or trade debtors. A receivable originally comes into existence at the very instance,
when the sale is affected. But, the funds generated as a result of these sales can be of no use until the receivables are
actually collected in the normal course of the business. Receivables may be represented by acceptance; bills or notes
due from others at an assignable date in the due course of the business. As sale of goods is a contract, receivables too
get affected in accordance with the law of contract, e.g., both the parties (buyer and seller) must have the capacity
to contract, proper consideration and mutual assent must be present to pass the title of goods and above all contract
of sale to be enforceable must be in writing. Moreover, extensive care is needed to be exercised for differentiating
true sales form what may appear to be as sales like bailment, sales contracts, consignments, etc. Receivables, as are
forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied
up in trade debtors. Hence, a great deal of careful analysis and proper management is exercised for effective and
efficient management of receivables to ensure a positive contribution towards increase in turnover and profits.
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When goods and services are sold under an agreement permitting the customer to pay for them at a later date, the
amount due from the customer is recorded as accounts receivables; so, receivables are asset accounts representing
amounts owed to the firm as a result of the credit sale of goods and services in the ordinary course of business. The
value of these claims is carried on to the assets side of the balance sheet under titles such as accounts receivable,
trade receivables or customer receivables. This term can be defined as “debt owed to the firm by customers arising
from sale of goods or services in ordinary course of business.”
According to Robert N. Anthony, “Accounts receivables are amounts owed to the business enterprise, usually by
its customers. Sometimes, it is broken down into trade accounts receivables; the former refers to amounts owed by
customers, and the latter refers to amounts owed by employees and others.”
Generally, when a concern does not receive cash payment in respect of ordinary sale of its products or services
immediately, in order to allow them a reasonable period of time to pay for the goods they have received. The firm
is said to have granted trade credit. Trade credit thus, gives rise to certain receivables or book debts expected to
be collected by the firm in the near future. In other words, sale of goods on credit converts finished goods of a
selling firm into receivables or book debts, on their maturity these receivables are realised and cash is generated.
According to Prasanna Chandra, “The balance in the receivables accounts would be; average daily credit sales x
average collection period.”
The book debts or receivables arising out of credit have three dimensions:
• It involves an element of risk, which should be carefully assessed. Unlike cash sales, credit sales are not risk
less as the cash payment remains un-received.
• It is based on economics value. The economic value in goods and services passes to the buyer immediately,
when the sale is made in return for an equivalent economic value expected by the seller from him to be received
later on.
• It implies futurity, as the payment for the goods and services received by the buyer is made by him to the firm
on a future date.
The customer who represents the firm’s claims or assets, from whom receivables or book-debts are to be collected
in the near future, are known as debtors or trade debtors. A receivable originally comes into existence at the very
instance when the sale is affected. But the funds generated as a result of these sales can be of no use until the
receivables are actually collected in the normal course of the business.
Receivables may be represented by acceptance; bills or notes and the like due from others at an assignable date in
the due course of the business. As sale of goods is a contract, receivables too get affected in accordance with the
law of contract, e.g., both the parties (buyer and seller) must have the capacity to contract, proper consideration and
mutual assent must be present to pass the title of goods and above all contract of sale to be enforceable must be in
writing. Moreover, extensive care is needed to be exercised for differentiating true sales from what may appear to
be as sales like bailment, sales contracts, consignments, etc.
Receivables are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums
of funds are tied up in trade debtors. Hence, a great deal of careful analysis and proper management is exercised
for effective and efficient management of receivables to ensure a positive contribution towards increase in turnover
and profits.
Instruments indicating receivables

Harry Gross has suggested three general instruments in a concern that provide proof of receivables relationship.
They are briefly discussed below:
Open book account
This is an entry in the ledger of a creditor, which indicates a credit transaction. There is no evidence of the existence
of a debt under the sales of goods.
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Negotiable promissory note

It is an unconditional written promise signed by the maker to pay a definite sum of money to the bearer, or to order
at a fixed or determinable time. Promissory notes are used, while granting an extension of time for collection of
receivables, and debtors are unlikely to dishonour its terms.
Increase in profit
As receivables will increase the sales, the sales expansion would favourably raise the marginal contribution
proportionately more than the additional costs associated with such an increase. This in turn would ultimately
enhance the level of profit of the concern.
Meeting competition
A concern offering sale of goods on credit basis always falls in the top priority list of people willing to buy those
goods. Therefore, a firm may resort granting of credit facility to its customers in order to protect sales from losing
it to competitors. Receivables act as a means for attracting potential customers and retaining the older ones at the
same time by weaning them away from the competitors.
Augment customer’s resources

Receivables are valuable to the customers on the ground that it augments their resources. It is favoured particularly
by those customers, who find it expensive and cumbersome to borrow from other resources. Thus, not only the
present customers but also the potential creditors are attracted to buy the firm’s product at terms and conditions
favourable to them.
Speedy distribution
Receivables play a very important role in accelerating the velocity of distributions. As a middleman would act
quickly enough in mobilising his quota of goods from the productions place, for distribution without any hassle of
immediate cash payment, as he can pay the full amount after affecting his sales. Similarly, the customers would hurry
for purchasing their needful even if they are not in a position to pay cash instantly. It is for these, the receivables are
regarded as a bridge for the movement of goods from production to distribution to the ultimate consumer.
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Start
Credit Sales
Credit Sales
Retaining Attracting Quick Potentiality

Present Potential Distribution to face
Customers Creditors of Goods Competition
Expansion of Sales
Higher Profit Level
More
Stop
Liquidity
Fig. 8.1 Flowchart showing the purpose of maintaining receivables
8.3 Cost of Maintaining Receivables

Receivables are a type of investment made by a firm. Like other investments, receivables too feature a drawback,
which are required to be maintained for long that it known as credit sanction. Credit sanction means tie-up of funds
with no purpose costing certain amount to the firm. Such costs associated with maintaining receivables are detailed
below:
Administrative cost
If a firm liberalises its credit policy for either maximizing sales or minimizing erosion of sales, it incurs two types
of costs:
• Credit Investigation and Supervision Costs
As a result of lenient credit policy, there happens to be a substantial increase in the number of debtors. As a
result, the firm is required to analyse and supervise a large volume of accounts at the cost of expenses related
with acquiring credit information either through outside specialist agencies or from its own staff.
• Collection Costs
A firm will have to intensify its collection efforts to collect the outstanding bills especially in case of customers
who are financially less sound. It includes additional expenses of credit department incurred on the creation and
maintenance of staff, accounting records, stationary, postage and other related items.
Capital cost
There is no denying that maintenance of receivables by a firm leads to blockage of its financial resources due to the
tie log that exists between the date of sale of goods to the customer and the date of payment made by the customer.
But, the bitter fact remains that the firm has to make several payments to the employees, suppliers of raw materials
and the like even during the period of time lag. As a consequence, a firm is liable to make arrangements for meeting
such additional obligations from sources other than sales. Thus, a firm in the course of expanding sales through
receivables makes way for additional capital costs.
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Production and selling cost

These costs are directly proportionate to the increase in sales volume. In other words, production and selling costs
increase with the very expansion in the quantum of sales. In this respect, a firm confronts two situations; firstly
when the sales expansion takes place within the range of existing production capacity. In that case, only variable
costs relating to the production and sale would increase. Secondly, when the production capacity is added due to
expansion of sales in excess of existing production capacity. In such a case, incremental production and selling
costs would increase both variable and fixed costs.
Delinquency cost
This type of cost arises on account of delay in payment on customer’s part or the failure of the customers to make
payments of the receivables as and when they fall due after the expiry of the credit period. Such debts are treated
as doubtful debts. They involve:
• Blocking of firm’s funds for an extended period of time,
• Costs associated with the collection of overheads, reminders, legal expenses and on initiating other collection
efforts.
Default cost
Similar to delinquency cost is default cost. Delinquency cost arises as a result of customers’ delay in payments of
cash or his inability to make the full payment from the firm of the receivables due to him. Default cost emerges
a result of complete failure of a defaulter (customer) to pay anything to the firm in return of the goods purchased
by him on credit. When despite all the efforts, the firm fails to realise the amount due to its debtors because of his
complete inability to pay for the same. The firm treats such debts as bad debts, which are to be written off, as it
cannot be recovered in any case.
8.4 Factors Affecting the Size of Receivables

The size of receivables is determined by a number of factors for receivables being a major component of current
assets. As most of them vary from business to business in accordance with the nature and type of business, therefore,
to discuss all of them would prove irrelevant and time-consuming. Some main and common factors determining the
level of receivables are discussed below:
Stability of sales
Stability of sales refers to the elements of continuity and consistency in the sales. In other words, the seasonal nature
of sales violates the continuity of sales in between the year. So, the sale of such a business in a particular season
would be large needing a large a size of receivables. Similarly, if a firm supplies goods on instalment basis, it will
require a large investment in receivables.
Terms of sale
A firm may affect its sales either on cash basis or on credit basis. As a matter of fact, credit is the soul of a business.
It also leads to higher profit level through expansion of sales. The higher the volume of sales made on credit, the
higher will be the volume of receivables and vice-versa.
The volume of credit sales

It plays the most important role in determination of the level of receivables. As the terms of trade remains more
or less similar to most of the industries. So, a firm dealing with a high level of sales will have large volume of
receivables.
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Credit policy
For a firm practising lenient or relatively liberal credit policy its size of receivables will be comparatively large than
the firm with more rigid or stringent credit policy. It is because of two prominent reasons:
• A lenient credit policy leads to greater defaults in payments by financially weak customers resulting in bigger
volume of receivables
• A lenient credit policy encourages the financially sound customers to delay payments again resulting in the
increase in the size of receivables.
Terms of sale
The period for which credit is granted to a customer duly brings about increase or decrease in receivables. The
shorter the credit period, the lesser is the amount of receivables as short-term credit ties the funds for a short period
only. Therefore, a company does not require holding unnecessary investments by way of receivables.
Cash discount
Cash discount on one hand attracts the customers for payments before the lapse of credit period. In this system, a
tempting offer of lesser payments is proposed to the customer, if he succeeds in paying within the stipulated period.
On the other hand, it reduces the working capital requirements of the concern. Thus, decreasing the receivables
management.
Collection policy
The policy, practice and procedure adopted by a business enterprise in granting credit, deciding as to the amount
of credit and the procedure selected for the collection of the same also greatly influence the level of receivables of
a concern. The more lenient or liberal to credit and collection policies, the more receivables are required for the
purpose of investment.
Collection collected
If an enterprise is efficient enough in en-cashing the payment attached to the receivables within the stipulated period
granted to the customer. Then, it will opt for keeping the level of receivables low. Whereas, enterprise experiencing
undue delay in collection of payments will always have to maintain large receivables.
Bills discounting and endorsement

If the firm opts for discounting its bills with the bank or endorsing the bills to the third party for meeting its obligations,
it would lower the level of receivables required in conducting business.
Quality of customer
If a company deals specifically with financially sound and credit worthy customers, then it would definitely receive
all the payments in due time. As a result, the firm can comfortably do with a lesser amount of receivables than in
case, where a company deals with customers having financially weaker positions.
8.5 Principles of Credit Management

Joseph L. Wood is of the opinion, “The purpose of any commercial enterprise is the earning of profit, credit in itself
is utilised to increase sales, but sales must return a profit.” The primary objective of management or receivables
should not be limited to expansion of sales but should involve maximisation of overall returns on investment. So,
receivables management should not be confined to mere collection or receivables within the shortest possible period,
but is required to focus due attention to the benefit-cost trade-off relating to numerous receivables management.
In order to add profitability, soundness and effectiveness to receivables management, an enterprise must make it
a point to follow certain well-established and duly recognised principles of credit management.”The first of these
principles relate to the allocation of authority pertaining to credit and collections of some specific management. The
second principle puts stress on the selection of proper credit terms. The third principle emphasises a thorough credit
investigation before a decision on granting a credit is taken. And the last principle touches upon the establishment
of sound collection policies and procedures.”
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In the light of this quotation, the principles of receivables management can be stated as:
Allocation or authority
The efficiency of a credit management in formulation and execution of credit and collection policies largely depend
upon the location of credit department in the organisational structure of the concern. The aspect of authority
allocation can be viewed under two concepts. As per the first concept, it is placed under the direct responsibility of
chief finance officer for it being a function primarily financed by nature. Further, credit and collection policies lay
direct influence on the solvency of the firm. “For these reasons, the credit and collection function should be placed
under the direct supervision of the individuals who are responsible for the firm’s financial position.” “There are
others who suggest that business firms should strictly enforce upon their sales departments the principles that sales
are insolate until the value thereof is realised.
Those favouring this aspect plead to place the authority of allocation under the direct charge of the marketing
executive or the sales department. To conclude, the reasonability to administer credit and collections policies may
be assigned either to a financial executive or to marketing executive or to both of them jointly depending upon the
organisational structure and the objectives of the firm.”
Selection of proper credit terms

The receivables management of an enterprise is required to determine the terms and conditions on the basis of which
trade credit can be sanctioned to the customers. The nature of the credit policy of an enterprise is decided on the
basis of components of the credit policy. These components include; credit period, cash discount and cash discount
period. In practice, the credit policy of firms, vary within the range of lenient and stringent. A firm that tends to
grant long period credits and its debtors include even those customers whose financial position is doubtful. Such a
firm is said to be following lenient credit policy. Contrary to this, a firm providing credit sales for a relatively short
period of time on highly selective basis only to those customers who are financially strong and have proven their
credit worthiness is said to be following a stringent credit policy.
Credit investigation
A firm if it desires to maintain effective and efficient receivables management of receivables must undertake a
thorough investigation before deciding to grant credit to a customer. The investigation is required to be carried
on with respect to the credit worthiness and financial soundness of the debtors, so as to prevent the receivables
for falling into the category of bad debts later on at the time of collection. Credit investigation is not only carried
on beforehand. But in the case of firms practicing liberal credit policy, such investigation may be required to be
conducted when debtors fail to make payments of receivables due from him, even after the expiry of credit sale, so
as to save doubtful debts from becoming bad debts.
Sound collection policies and procedures

Receivables management is linked with a good degree of risk. As a few debtors are slow payers and some are non-
payers. How-so-ever efficient and effective a receivables management may be, the element of risk cannot be avoided
altogether, but can be minimised to a great extent. It is for this reason; the essence of sound collection policies
and procedures arise. A sound collection policy aims at accelerating collection from slow payers and reducing bad
debts losses. As good collection polices ensure prompt and regular collection by adopting collection procedures in
a clear-cut sequence.
8.6 Objectives of Receivable Management

The objective of receivables management is to promote sales and profit until that is reached where the return on
investment in further finding of receivable is less than the cost of funds raised to finance that additional credit (i.e.,
cost of capital). The primary aim of receivables management in minimising the value of the firm while maintaining
a reasonable balance between risk (in the form of liquidity) and profitability. The main purpose of maintaining
receivables is not sales maximisation or minimisation of risks involved by way of bad debts. Had the main objective
been growth of sales, the concern would have opened credit sales for all sorts of customers. Contrary to this, if the
aim had been minimisation of risk of bad debts, the firm would not have made any credit sale at all. That means, a
firm should indulge in sales expansion by way of receivables only until the extent to which the risk remains within
an acceptably manageable limit.
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All in all, the basic target of management of receivables is to enhance the overall return on the optimum level of
investment made by the firm in receivables. The optimum investment is determined by comparing the benefits to
be derived from a particular level of investment with the cost of maintaining that level. The costs involve not only
the funds tied up in receivables, but also losses from accounts that do not pay. The latter arises from extending
credit too leniently.
A brief inference of objectives of management of receivables may be given as under:

• To attain not maximum possible, but optimum volume of sales.
• To exercise control over the cost of credit and maintain it on a minimum possible
• level.
• To keep investments at an optimum level in the form of receivables.
• To plan and maintain a short average collection period.
Granting of credit and its proper and effective management is not possible without involvement of any cost. These
costs are credit administrative expenses bad debts losses, opportunity costs, etc. As mentioned before, these costs
cannot be possibly eliminated altogether but should essentially be regulated and controlled. Elimination of such costs
simply means reducing the cost of zero, i.e., no credit grant is permitted to the debtors. In that case, firm would no
doubt escape from incurring the costs, yet the other face of coin would reflect that the profits foregone on account
of expected rise in sales volume made on credit amounts will be much more than the costs eliminated. Thus, a firm
would fail to materialise the objective of increasing overall return of investment. The period goal of receivables
management is to strike a golden mean among risk, liquidity and profitability turns out to be effective marketing
tool. It helps in capturing sales volume by winning new customers besides retaining to old ones.
8.7 Aspects of Credit Policy

The discharge of the credit function in a company embraces a number of activities for which the policies have
to be clearly laid down. Such a step will ensure consistency in credit decisions and actions. A credit policy thus,
establishes guidelines that govern grant or reject credit to a customer, what should be the level of credit granted to
a customer, etc. A credit policy can be said to have a direct effect on the volume of investment a company desires
to make in receivables.
A company falls prey to many factors pertaining to its credit policy. In addition to specific industrial attributes like
the trend of industry, pattern of demand, pace of technology changes, factors like financial strength of a company,
marketing organisation, growth of its product, etc., also influence the credit policy of an enterprise. Certain
considerations demand greater attention while formulating the credit policy like a product of lower price should
be sold to customer bearing greater credit risk. Credit of smaller amounts results, in greater turnover of credit
collection. New customers should be least favoured for large credit sales. The profit margin of a company has
direct relationship with the degree or risk. They are said to be inter-woven. Since, every increase in profit margin
would be counterbalanced by increase in the element of risk. As observed by Harry Gross, “Two very important
considerations involved in incurring additional credit risks are, the market for a company’s product and its capacity
to satisfy that market. If the demand for the seller’s product is greater than its capacity to produce, then it would be
more selective in granting credit to its customers. Conversely, if the supply of the product exceeds the demand, the
seller would be more likely to lower credit standards with greater risks.”
Such a condition would appear in case of a company having excess capacity coupled with high profitability
and increased sales volume. Credit policy of every company is at large influenced by two conflicting objectives
irrespective of the native and type of company. They are liquidity and profitability. Liquidity can be directly linked
to book debts. Liquidity position of a firm can be easily improved without affecting profitability by reducing the
duration of the period for which the credit is granted and further by collecting the realised value of receivables as
soon as they fails due. To improve profitability, one can resort to lenient credit policy as a booster of sales, but the
implications are: -
• Changes of extending credit to those with weak credit rating.
• Unduly long credit terms.
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• Tendency to expand credit to suit customer’s needs; and

• Lack of attention to over dues accounts.
8.8 Determination of Credit Policy

The evaluation of a change in a firm’s credit policy involves analysis of:
• Opportunity cost of lost contribution.
• Credit administration cost and risk of bad debt losses.
Optimum credit policy does not mean the point at which balance between liquidity and profitability can be maintained.
Instead, an optimum credit policy is one that maximises the firm’s is achieved when marginal rate of return i.e.
incremental rate of return on investment becomes equal to marginal cost of capital, i.e., incremental cost of funds
used to finance the investment. The incremental rate of return is obtained by dividing incremental investment in
receivables. The incremental cost of funds is the rate of return expected by firm granting the credit. This rate of
return is not equal to borrowing rate. As in case of firm following loose credit policy, higher rate of return means
higher risks to invest in A/c’s receivables due to slow paying and defaulting accounts.
To sum up, in order to achieve the goal of maximising the value of the firm the evaluation of investment in receivables
accounts should involve the following four steps:
• Estimation of incremental operating profit,
• Estimation of incremental investment in accounts receivables,
• Estimation of the incremental rate of return of investment,
• Comparison of incremental rate of return with the required rate of return.
It is rather a difficult task to establish an optimum credit policy as the best combination of variables of credit policy is
quite difficult to obtain. The important variables of credit policy should be identified before establishing an optimum
credit policy. The three important decisions variables of credit policy are:
8.8.1 Credit Terms

Credit terms refer to the stipulations recognised by the firms for making credit sale of the goods to its buyers. In
other words, credit terms literally mean the terms of payments of the receivables. A firm is required to consider
various aspects of credit. Customers, approval of credit period, acceptance of sales discounts, provisions regarding
the instruments of security for credit to be accepted are a few considerations which need due care and attention.
The selection of credit customers can be made on the basis of firms’ capacity to absorb the bad debt losses during a
given period of time. However, a firm may opt for determining the credit terms in accordance with the established
practices in the light of its needs. The amount of funds tied up in the receivables is directly related to the limits of
credit granted to customers. These limits should never be ascertained on the basis of the subjects’ own requirements.
They should be based upon the debt paying power of customers and his ledger record of the orders and payments.
There are two important components of credit terms which are detailed below:
Credit period
According to Martin H. Seiden, “Credit period is the duration of time for which trade credit is extended. During
this time, the overdue amount must be paid by the customers.” The credit period lays its multi-faced effect on many
aspects, the volume of investment in receivables; its indirect influence can be seen on the net worth of the company.
A long period credit term may boost sales, but it also increases investment in receivables and lowers the quality of
trade credit. While determining a credit period, a company is bound to take into consideration various factors like
buyer’s rate of stock turnover, competitors’ approach, the nature of commodity, margin of profit and availability
of funds, etc.
The period of credit differs from industry to industry. In practice, the firms of same industry grant varied credit
periods to different individuals. as most of such firms decide upon the period of credit to be allowed to a customer
on the basis of his financial position in addition to the nature of commodity, quality involved in transaction, the
difference in the economic status of customers that may considerably influence the credit period.
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The general way of expressing credit period of a firm is to coin it in terms of net date, that is, if a firm’s credit terms
are “Net 30”, it means that the customer is expected to repay his credit obligation within 30 days. Generally, a
free credit period granted, to pay for the goods purchased on accounts tends to be tailored in relation to the period
required for the business and in turn, to resale the goods and to collect payments for them.
A firm may tighten its credit period, if it confronts fault cases too often and fears occurrence of bad debt losses. On
the other side, it may lengthen the credit period for enhancing operating profit through sales expansion. Anyhow,
the net operating profit would increase, only if the cost of extending credit period will be less than the incremental
operating profit. But the increase in sales alone with extended credit period would increase the investment in
receivables too because of the following two reasons:
i. Incremental sales result into incremental receivables,
ii. The average collection period will get extended, as the customers will be granted more time to repay credit
obligation.
Determining the options of credit period, therefore, involves locating the period where marginal profit and increased
sales are exactly off set by the cost of carrying the higher amount of accounts receivables.
Cash discount terms

The cash discount is granted by the firm to its debtors, in order to induce them to make the payment earlier than
the expiry of credit period allowed to them. Granting discount means reduction in prices entitled to the debtors, so
as to encourage them for early payment before the time stipulated, i.e., the credit period. According to Theodore
N. Beckman,
“Cash discount is a premium on payment of debts before due date and not a compensation for the so called prompt
payment.” Grant of cash discount beneficial to the debtor is profitable to the creditor as well. A customer of the firm,
i.e., debtor would be realised from his obligation to pay soon at discounted prices. On the other hand, it increases
the turnover rate of working capital and enables the creditor firm to operate a greater volume of working capital. It
also prevents debtors from using trade credit as a source of working capital.
Cash discount is expressed as a percentage of sales. A cash discount term is accompanied by (a) the rate of cash
discount, (b) the cash discount period, and (c) the net credit period. For instance, a credit term may be given as
“1/10 Net 30” that means a debtor is granted 1 percent discount, if he settles his accounts with the creditor before
the tenth day starting from the day after the date of the invoice. But in case the debtor does not opt for discount, he
is bound to terminate his obligation within the credit period of thirty days.
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Change in cash discount can either have positive or negative implication and at times both. Any increase in cash
discount would directly increase the volume of credits sale. As the cash discount reduces the price of commodity for
sale, the demand for the product ultimately increases leading to more sales. On the other hand, cash discount lures
the debtors for prompt payment, so that they can relish the discount facility available to them. This in turn reduces
the average collection period and bad debt expenses thereby, bringing about a decline in the level of investment in
receivables. Ultimately, the profits would increase. Increase in discount rate can negatively affect the profit margin
per unit of sale due to reduction of prices. A situation exactly reverse of the one stated above will occur in case of
decline in cash discount.
As pointed out by N.K. Agarwal, “we market products through established dealers. If sometimes payment is not
received within the credit period, it is just not possible to deny discount as it would spoil business relations.” Yet,
the management of business enterprises should always take note of the point that cash discount, as a percentage
of invoice prices, must not be high as to have an uneconomic bearing on the financial position of the concern. It
should be seen in this connection that terms of sales include net credit period, so that cash discount may continue
to retain its significance and might be prevented from being treated by the buyers just like quantity discount. To
make cash discount an effective tool of credit control, a business enterprise should also see that it is allowed to
only those customers who make payments at due date. And finally, the credit terms of an enterprise on the receipt
of securities while granting credit to its customers. Credit sales may be secured by furnishing instruments such as
trade acceptance, promissory notes or bank guarantees.
8.8.2 Credit Standards

Credit standards refer to the minimum criteria adopted by a firm for the purpose of short listing its customers for
extension of credit during a period of time. Credit- rating, credit reference and average payments provide a quantitative
basis for establishing and enforcing credit standards. The nature of credit standard followed by a firm can be directly
linked to changes in sales and receivables. In the opinion of Van Home, “There is the cost of additional investment
in receivables, resulting from increased sales and a slower average collection period.”
A liberal credit standard always tends to push up the sales by luring customers into dealings. The firm, as a consequence
would have to expand receivables investment along with sustaining costs of administering credit and bad-debt losses.
A liberal extension of credit may cause certain customers to be less conscientious in paying their bills on time.
On the contrary, strict credit standards would mean extending credit to financially sound customers only. This saves
the firm from bad debt losses and the firm has to spend lesser by a way of administrative credit cost. But, this reduces
investment in receivables besides depressing sales. In this way, profit sacrificed by the firm on account of losing
sales amounts is more than the costs saved by the firm.
Prudently, a firm should opt for lowering its credit standards only up to that level, where profitability arising through
expansion in sales exceeds various costs associated with it. That way, optimum credit standards can be determined
and maintained by inducing trade-off between incremental returns and incremental costs.
8.8.3 Collection Policy

Collection policy refers to the procedures adopted by a firm (creditor) in collecting the amounts from its debtors,
when such amount becomes due after the expiry of credit period. R.K. Mishra States, “A collection policy should
always emphasise promptness, regularity and systematisation in collection efforts. It will have a psychological
effect upon the customers, in that; it will make them realise the obligation of the seller towards the obligations
granted.” “The requirements of collection policy arises on account of the defaulters, i.e., the customers not making
the payments of receivables in time. Some turns out to be, slow payers and some others, non-payers. A collection
policy shall be formulated with a whole and sole aim of accelerating collection from bad-debt losses by ensuring
prompt and regular collections.
Regular collection on one hand indicates collection efficiency through control of bad debts and collection costs
as well as by inducing velocity to working capital turnover. On the other hand, it keeps debtors alert in respect of
prompt payments of their dues. A credit policy is needed to be framed in the context of various considerations like
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short-term operations, determinations of level of authority, control procedures, etc. Credit policy of an enterprise
shall be reviewed and evaluated periodically and if necessary amendments shall be made to suit the changing
requirements of the business.
It should be designed in such a way that it co-ordinates activities of concerned departments to achieve the overall
objective of the business enterprises. Finally, poor implementation of good credit policy will not produce optimal
results.
8.9 Collection of Accounts Receivables

Despite a firm’s best precautionary efforts in escaping the bad and doubtful debts, there always exists a certain
number of unpaid accounts on the due date. Three well-known causes of failure of such payments on the part of
debtors (i.e., firm’s customer) can be cited as:
• It may happen at times that the due date of payment slips from debtor’s mind and he delays in making good
the payments at the right time.
• It may incidentally occur at the time of grant of credit that a firm fails to access and interpret the character,
capacity, capital, collateral and conditions correctly and appropriately.
• There may arise a considerable change in the financial position of a debtor after the credit has been granted to
him by the firm.
All the above stated reasons compel a firm to formulate a collection programme to obtain recovery or receivables
from delinquent account. Such programme may consist of following steps:
• Monitoring the state of receivables.
• Dispatch of letters to customers whose due date is near.
• Telegraphic and telephone advice to customers around the due date.
• Threat of legal action to overdue accounts, and
• Legal actions against overdue accounts.
8.9.1 Types of Collection Efforts

A well-established collection policy always attempts at enlisting clear-cut guidelines in order of a sequence, that
too in precise terms for collection overdue from the customers. As a cord of suggestion, the sequence adopted must
be capable of bringing effectiveness and efficiency in collection policy. For instance, if the credit period granted to
the customer lapses and he does not pay. The firm should begin with a polite letter of reminder reflecting demand
of payment. This may be followed by telegram or telephone or even a personal visit by firm’s representative. After
that, a firm may proceed for legal action, if the amount of receivables will remains unpaid. It should be noted that
as an account becomes more and more overdue, the collection efforts become more personal and strict. But before
initiating any legal action, the financial position of the debtor must be considered. A legal action against a customer,
who bears a wear financial condition would be of no good to the firm, instead will cause customers’ bankruptcy
reducing the chance of even a marginal amount of payment. Thus, a concern should face such a situation with
patience and try to settle the account by accepting a reduced payment.
8.9.2 Degree of Collection Efforts

The efforts on collection policy can be better explained by categorising the collection efforts of a company as strict,
liberal and lenient. Strict collection policy is characterised by debtor’s payment on or before the due date. As a
result, many times debtor benefits himself with cash discount. Whereas, a lenient policy is featured by defaulters in
payments of receivables, forfeiture of cash discount, etc.
A rigorous collection policy shortens the average collection period, pulls down sales and bad-debt percentage along
with increasing collection expenses. A relaxed collection programme would push up sales and bad-debts percentage,
lengthen the average of collection period and reduce collection expenses but enhances credit administrative cost.
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A concern must make use of financial default and risk analysis; it is willing to favour liberal credit policy. Similarly,
a firm can help being cautious while adopting strict collection policy for, it may offend tie customers forcing them
to switch over to the competitors.
Between the two extremes of rigorous and soft collection policies, there also exists flexible collection policy, which
involves reminding the customers through correspondence before the due date. Optimum collection policy may be
achieved by comparing costs and benefits, which will be consistent with the goal of attaining maximum value of
the firm.
8.9.3 Collection Follow-Up System

The element of regularity is always desired in collection efforts, which primarily depends upon two pre-requisites; the
development of a suitable system of collection and the establishment of a congenial collection follow-up system.
As far as development and adoption of suitable collection period is concerned, it varies from industry to industry
or at times from firm to firm. Therefore a congenial collection follow-up system can be established through various
practices. Some of them are mentioned below:
Accounts receivable report
This device is regarded as highly useful in timely collections of receivables from debtors. It makes a successful attempt
at keeping a keen eye over almost all outstanding accounts of the firm. Hence, enabling a firm to initiate appropriate
and timely measure against defaulters as per the guidelines framed by the collection policy of a concern,
Ledger plan or card tickler system

In order to establish a sound collection follow-up system, ledger plan of the collection follow-up system is based on
the creditor‘s ledger record. The card tickler system involves maintenance of cards in the name of each delinquent
filed date wise in a proper sequence. The card specifies information regarding the amount, terms due date, collection
actions taken so far, etc., at length in detail.
Computer and credit management

Of late, the use of computers has also come in vogue for the purpose or credit management. Computer helps a great
deal in availing essential up-to-date information. For a quick access to various sorts of information, all information
previously placed on receivable ledger can be placed on punched cards or tapes. Computer can also provide report
on summary of all billings, payments, discount taken, amount still owned, etc. In addition to this, complete report
on delinquent accounts can be obtained along with timely and accurate information regarding the five Cs of the
customer.
Further, special reports can be prepared for a particular span of period supplemented with categorisation and
comparison of customer as well as adopted credit policies.
8.10 Credit Control

Credit control is a complex process, which costs both time and administrative costs. Broadly, speaking, the function
of credit control incorporates the following elements:
Checking customers credit worthiness
This step relates to applicant’s ability to pay for the goods or services opted by him. The decision pertaining to credit
grant and its volume largely depends upon this assessment. The assessment can be done on the basis of financial
soundness, general behaviour, past records, business habits and traits. Trade reference, banker’s records available with
the geriatric, etc. are a few of certain elements that provide relevant information for conducting this assessment.
Prompt invoicing and follow-up

This is an executive action involving prompt issue of invoice and equally close follow-up action. A continuous
personal attention is required for reviewing amounts of bills receivables. Methods are selected among the various
possible alternatives available to ensure that the time period is the least between realisation of payments and
converting it into bank’s credit account.
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Credit insurance
This point pertains to credit exports. As credit sales do not fall under any credit insurance policy coverage in India,
it is export credit guarantee department, which formulates appropriate rules and issues credit insurance policies for
exports on payments of a nominal premium. These facilities are of high importance for credit control of exports.
Financial statements
Financial statement is an important document that presents desirable sources of information to the seller regarding
the financial position of customer for credit control. For the companies carrying out seasonal business, interim
statements instead of financial statements are preferred. For acquiring authenticated information, audited financial
statements should be favoured rather than unaudited figures enclosing possibility of fraud.
Use of electronic data processing equipment

In the modern world, the importance of computers cannot be possibly denied. Electronic data processing equipment
holds its own individual importance in providing timely and accurate information pertaining to the status of accounts.
The computer can provide a vast array of detailed information, previously impractical to obtain that may be useful
not only to the credit manager but to other management as well. In addition to processing data, the computer can
be programmed to make certain routine credit decisions.
8.11 Control of Receivables

Control of receivables largely depends upon the system of credit control practiced by a business enterprise. It
becomes a part of organisation’s obligation to obtain full and relevant information complete in all respects before
deciding upon the right customer for the right amount of credit grant. Whenever an order is placed by an applicant,
financial position and credit worthiness become essential. Only after ensuring the degree of safety, an order should
be accepted and delivered.
A firm is expected to prepare sales invoice and credit notes as early as possible; side by side, it should also ensure
that they are dispatched at specified regular intervals for effective control of receivables. It is always considered good
on the part of the firm to keep a separate ledger for the accounts of bad and doubtful debtors. Such segregation not
only helps in easy assessment of the position of bad and doubtful debtors in relation to the total debtor’s position.
A considerable amount of reduction in debtors can be achieved by offering cash discount to the customers.
Even in case of export sales, segregation of credit sales into separate ledger adds effectiveness to control of receivables.
Sometimes large contracts, payable by instalments, involve credit for several years. The price fixed in these cases
should be sufficiently high not only to cover export credit insurance, but also to cover a satisfactory rate of interest
on the diminishing balances of debt expected to the outstanding during the credit period.
There are two methods of controlling accounts receivables, which are traditional in nature; days sales outstanding
and ageing schedule. Though they are popularly used, they suffer from a serious deficiency. Both these methods
are based on aggregation of sales and receivables due to which the changes in the pattern of payment cannot be
easily detected. In order to overcome this drawback of traditional methods, a firm can make use of payments pattern
approach.
8.11.1 Payment Pattern Approach

The payment pattern approach is the key issue in controlling accounts receivables as it focuses on payment behaviour.
This approach is pioneered by B.R. Stone. W.G. Lewellen and R.W. Johnson. Pattern of payments are expressed
mostly in terms of proportions and at times as percentage. In general:
Pi=P0+ PO+ P2+ P3+ ........................ ...Pn
Here, Pi represents the proportion of credit sales paid in T month and “n” is the payment horizon. And also,
Po+ P2+ P3+ • .......................... Pn=1
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This is the payment pattern which is related to receivables pattern given as where, ‘Ri’ represents the receivables
collected at the end of T months and ‘n-V denotes the horizon. Aggregating the receivables and payments, we
obtain:
Ri=1-(P0+ PO+ P2+ P3+ .........Pn +Pi
A conversion matrix is prepared to show the credit sales in each month relating it to the pattern of collection associated
with it. The payment pattern approach is dependent of sales level. It simply involves matching collections and
receivables to sales in the month or origin. As a result, this approach is free from the limitation observed in traditional
methods. Moreover, this method is capable of presenting payment pattern on monthly basis as against combined sales
and payment patterns. The main drawback, which we come across in this method, is that conversion matrix cannot
be prepared only on the basis of published financial statements like traditional methods; it also requires internal
financial data. Still payment pattern does not require as the data as required in case of ageing schedule method.
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Summary
• Management of trade credit is commonly known as management of receivables.
• Receivables are one of the three primary components of working capital, the other being inventory and cash.
• Trade credit is an important market tool, as it acts like a bridge for mobilization of goods from production to
distribution stages in the field of marketing.
• Receivables, as are forms of investment in any enterprise manufacturing and selling goods on credit basis, large
sums of funds are tied up in trade debtors.
• The customer who represents the firm’s claim or assets, from whom receivables or book-debts are to be collected
in the near future, are known as debtors or trade debtors.
• As sale of goods is a contract, receivables too get affected in accordance with the law of contract.
• A concern offering sale of goods on credit basis always falls in the top priority list of people willing to buy
those goods.
• Receivables act as a bridge attracting potential customers and retaining the older ones at the same time by
weaning them away firm the competitors.
• Receivables are valuable to the customers on the ground that it augments their resources.
• Receivables play a very important role in accelerating the velocity of distributions.
• Credit sanction means tie up of funds with no purpose to solve yet costing certain amount to the firm.
• Delinquency cost arises as a result of customers’ delay in payments of cash or his inability to make the full
payment from the firm of the receivables due to him.
• The size of receivables is determined by a number of factors for receivables being a major component of current
assets.
• Stability of sales refers to the elements of continuity and consistency in the sales.
• The primary objective of management or receivables should not be limited to expansion of sales but should
involve maximisation of overall returns on investment.
• The receivables management of an enterprise is required to determine the terms and conditions on the basis of
which trade credit can be sanctioned to the customers are of vital importance for an enterprise.
• A sound collection policy aims at accelerating collection from a slow payer and reducing bad debts losses.
• As good collection polices ensure prompt and regular collection by adopting collection procedures in a clear-
cut sequence.
• The main purpose of maintain receivables is not sales maximisation or minimisation of risk involved by way
of bad debts.
• The goal of receivables management is to strike a golden mean among risk, liquidity and profitability. It is an
effective marketing tool.
• The discharge of the credit function in a company embraces a number of activities for which the policies have
to be clearly laid down.
• Credit period is the duration of time for which trade credit is extended. During this time, the overdue amount
must be paid by the customers.
• Collection policy refers to the procedures adopted by a firm (creditor) to collect the amount from its debtors
when such amount becomes due after the expiry of credit period.
• A credit policy is needed to be framed in the context of various considerations like short-term operations,
determinations of level of authority, control procedures, etc.
• Credit control is a complex process, which costs both time and administrative costs.
113/JNU OLE
References
• Analysis of Receivable Management [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/
bitstream/10603/723/11/11_chapter%206.pdf> [Accessed 12 July 2013].
• Impact of receivables management on working capital and Profitability [Pdf] Available at: < http://shodhganga.
inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf> [Accessed 12 July 2013].
• Salek, J.G., 2005. Accounts Receivable Management Best Practices. Wiley.
• Brigham, E.F. and Ehrhardt, M.C., 2010. Financial Management: Theory & Practice, 13th ed., Cengage
Learning.
• Accounts Receivable and Uncollectible Accounts [Video online] Available at: <http://www.youtube.com/
watch?v=Gg2_BO61sVk> [Accessed 12 July 2013].
• Accounts Receviable Lecture [video online] Available at: <http://www.youtube.com/watch?v=DkFsfdNG93w>
Recommended Reading
• Madura, J., 2011. International Financial Management. 11th ed., Cengage Learning.
• Bukics, R.L. and Loven, W.T., 1987. The Handbook of Credit and Accounts Receivable. Probus Pub Co.
114/JNU OLE
Self Assessment
1. What is management of trade credit also known as?
a. Management of finance
b. Management of cash
c. Management of receivables
d. Management of cash flow
2. __________________ provide protection to sales from competitions.

a. Receivables
b. Trade credit
c. Debt owed
d. Trade
3. Which of the following is not one of the dimensions of book-debts or receivables arising out of credit?
a. It involves an element of risk.
b. It is based on daily trade sales.
c. It is based on economics value.
d. It implies futurity.
4. _______________________ are amounts owed to the business enterprise, usually by its customers.
a. Accounts receivables
b. Trade credit
c. Open book account
d. Assets account
5. __________________ means tie up of funds with no purpose to solve yet costing certain amount to the firm.
a. Administrative cost
b. Credit investigation
c. Supervision cost
d. Credit sanction
6. ____________________ costs are directly proportionate to the increase in sales volume.

a. Delinquency
b. Capital
c. Production and selling
d. Default
7. Which of the following is not the factor that determines the level of receivables?
a. Stability of sales
b. The volume of credit sales
c. Credit policy
d. Trade policy
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8. The purpose of any _________________ is the earning of profit, credit in itself is utilised to increase sale, but
sales must return a profit.
a. commercial enterprise
b. financial management
c. credit management
d. collection policy
9. A _______________ policy aims at accelerating collection form slow payer and reducing bad debts losses.
a. current
b. credit
c. sound collection
d. collection
10. __________________ refers to the stipulations recognised by the firms for making credit sale of the goods to
its buyers.
a. Credit period
b. Credit discount
c. Credit terms
d. Cash discount
116/JNU OLE
Case Study I
iPhone Inventory Management
Introduction
When Steve Jobs announced the new revolutionary mobile communication in his Macworld presentation, iPhone
was judged as a triumph of design and functionality, not to mention its X-factor. Similar to other hot electronic
products, such as Xbox, PS3, Wii, etc., – analysts expected big shortages when the iPhones would go for sale across
counters, but that didn’t happen, instead iPhone turned out to be the triumph of inventory management along its
supply chain.
Selling 270,000 iPhones in 30 hours of transaction, a million units in 3 months, and 3.75 million units in 6 months
show the meticulous planning of its inventory control and management along its entire supply chain. Key to this
success was:
• Choosing right suppliers and partners
• Establishing synchronisation in the value delivery chain
Choosing Right Suppliers and Partners

• Choosing the hardware suppliers from USA, China, Taiwan, Japan, etc., worked out in Apple’s favour. They
were able to manufacture the iPhone initially at $200-220 per set including distribution cost. They sold over a
million units at $499-599 shooting their profits to $6.22 billion. Apple then was able to bring down the prices
by almost 40% and yet generate huge profits by increasing the volume to 3.75 million units, through stable
supply chain management in 6 months
• Selecting AT&T for distribution was a strategic move. The buyers were committed a 3-minute activation time,
and customers were offered across-the-counter activation for those who buy them at the AT&T stores
• Fedex Express was another strategic partner who ensured smooth distribution of products from China to US,
and to distribute those products to individual stores on time, just few hours before the launch time of 6 PM
• They partnered with Yahoo!, Google, Flicker, etc., for the applications that were relevant to the US market
Establishing Synchronisation in the Inventory Chain

• A value inventory chain consists of suppliers, production, distribution, partners, etc. Typically every single step
where some value is added from production to consumption of the product.
• First, the communication layer was synchronised, and all the partners and suppliers shared a single version of
the truth. The market research data was shared with its suppliers along with its management’s goal in terms of
the number of units to be sold each month. This enabled the partners to plan their capacity and production well
in advance.
• The assemblers of the product in China had manufactured the expected quantities well before the launch dates.
The distributors had it sent to US a whole week before the products were to be sold. The goods were sent to
the retailers few hours before the lunch break so that stores could close and reopen at 6 PM to prepare for sales
till midnight.
• Retailers had also made some changes with respect to merchandising the products. iPhones were sold near the
entrance area of the shop.
Bringing together all these components .and synchronising helped a historical launch of this product resulted in
exceeding the expected sales during the first few days of the launch.
(Source: iPhone: A best case study of efficient inventory management [Online] Available at: <http://scienceofbusiness.
wordpress.com/2009/08/26/iphone-a-best-case-study-of-efficient-inventory-management/> [Accessed 16 July
2013]).
117/JNU OLE
Questions
1. What was the reason of success of iPhone mobile?
Answer
The key to the success of iPhone was:
• Choosing right suppliers and partners
• Establishing synchronisation in the value delivery chain
2. What does value inventory chain consists of?

Answer
The value inventory chain consists of suppliers, production, distribution, partners, etc.
3. How was synchronisation in the inventory chain established?

Answer
The synchronisation in the inventory chain was established as:
• First, the communication layer was synchronised, and all the partners and suppliers shared a single version
of the truth. The market research data was shared with its suppliers along with its management’s goal in
terms of the number of units to be sold each month. This enabled the partners to plan their capacity and
production well in advance.
• The assemblers of the product in China had manufactured the expected quantities well before the launch
dates. The distributors had it sent to US a whole week before the products were to be sold. The goods
were sent to the retailers few hours before the lunch break so that stores could close and reopen at 6 PM
to prepare for sales till midnight.
• Retailers had also made some changes with respect to merchandising the products. iPhones were sold near
the entrance area of the shop.
118/JNU OLE
Case Study II
Indian Capital Market
Company Profile
A major financial services company based in Japan, providing knowledge and IT solutions for financial business
worldwide. Anshinsoft has been a very key strategic outsourcing partner for design and development of a
comprehensive back-office IT solution.
Business Situation
Indian capital market systems have evolved to be at par with the advanced systems of the world in the last 10 years.
Business process, functionality, monitoring/regulating mechanisms, hardware, software, etc., are all revamped to
compete with the global leaders. With the internal systems and monitoring mechanism properly in place, the time
is ripe for India to join itself to the global capital market network. At present, India stands in the door step of full
convertibility of the Indian Rupee in capital account. Cross border trading in the securities market is a very bright
possibility in the near future.
One major customer of the IT solution provider, a leading securities broker based in Japan, has shown keen interest
in venturing into the Indian Capital Market. The company has asked Anshinsoft to provide a very high level overview
of the Indian Secondary market.
Technical Situations
The IT solution provider has been looking for credible market research in the Indian capital market space, keeping
in mind that their end-customer has shown keen interest in venturing into the Indian market in near future. Getting
an overview of the market is extremely important – since eventually the brokerage firm would like to use the same
back-office solution while operating in the Indian market. The initial overview document is a stepping stone towards
large scale gap analysis of their existing solution.
Solution
Anshinsoft delivered a very high level overview of the Indian Secondary Market with emphasis on the following
areas:
• Key secondary market intermediaries
• Trading and settlement systems
• Settlement cycle
• Legal framework of the securities market
• Typical activity flow and downloadable reports for a broker firm
• Key Indian vendors in the securities market product space
Benefits
Even though lots of information and market research documents are available in today’s world, the company
specifically selected Anshinsoft to prepare a report that objectively answers what they have been looking for. They
were extremely satisfied with the report that Anshinsoft prepared not only did it cover the major areas of the Indian
secondary market, but it also provided information that are specific to the Indian market in particular so that they
could spot the operational differences quite early. Also, being the long-term back office solution development partner
of the same company, Anshinsoft could highlight important gaps in their existing solution having known the fact
that they would eventually customise and deploy the solution for Indian operations as well. The report encouraged
their senior management to conduct a detailed gap analysis of the existing solution, where Anshinsoft will be one
of the key partners.
119/JNU OLE
Services Used
Anshinsoft solely relied on the experience and expertise of its own business analysts and market experts to prepare
the report. Public market data available in the internet was included for reference purpose.
(Source: Securities Trading Back Office Solutions Overview [Online] Available at: < http://www.anshinsoft.com/
files/Back_Office_Solutions_Case_Study.pdf > [Accessed 7 August 2013]).
Questions
1. How is the current scenario of Indian capital market system explained?
2. Who is showing keen interest in venturing into the Indian capital market?
3. What is the high level overview of the Indian secondary market mentioned above?
120/JNU OLE
Case Study III
Accounts Receivables Management and Medical Billing
The Customer
An Urgent Care practice in Maryland
The Challenge
O2I was initially approached by the clinic to take care of Account Receivables Management. The client was also
facing a problem on the billing side like:
• The billing was not completed within 24 hours
• Steep decrease in collections
• Poor quality of work done by in-house billers
The Client wanted to hand over the billing side to us in 2 months if he gets satisfied with our ability on the AR
Management (we did a good job and the owner of the clinic handed over the billing part as promised).
We had to use a new software namely AdvancedMD for carrying out the operations. We got cross-trained over phone
on the practice management software.
The Project:
• To provide Full Service Billing.
• To handle average of 700 claims every month
The Solution
The following measures were taken to improve collections and productivity:
• A dedicated account manager and team were deputed to handle the clients account
• The team consisted of full-time employees for medical billing, medical coding and an AR expert
• Evolved a medical billing process and an AR process to make sure that billing takes place within 24 hours
• Follow-up on denied claims
• Address issues with insurance company and get them resolved
• Maintain knowledge base of issues and solutions
The Results
By outsourcing their medical billing functions to O2I, the CLIENT was able to:
• Witness that the average AR days were brought down from 34 to 23 days within 6 months
• Witness that the collection percentage increased from 53% to 61% within 6 months
• Have significant improvement in the cash flow as a result of increase in collection ratios
• Concentrate on patient care and see more patients, with the availability of more time, and a clutter free office
• Decrease reliance on employees and eliminate fluctuations associated with backlogged claims and employee
turnover
• Increase operating efficiency and reduce administrative costs
(Source: Case Study on Accounts Receivables Management & Medical Billing [Online] Available at: <http://www.
outsource2india.com/Healthcare/success_stories/ar-management-billing.asp> [Accessed 16 July, 2013]).
Questions
1. What was the problem faced by O2I?
2. What were the measures taken to improve collections and productivity?
3. What was the software used to carry out the account receivable management project?
121/JNU OLE
Bibliography
References
• Accounts Receivable and Uncollectible Accounts. [Video online] Available at: http://www.youtube.com/
watch?v=Gg2_BO61sVk> [Accessed 12 July 2013].
• Accounts Receviable Lecture. [video online] Available at: <http://www.youtube.com/watch?v=DkFsfdNG93w>
• Analysis of Cash Management. [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_
• Analysis of Receivable Management. [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/
bitstream/10603/723/11/11_chapter%206.pdf > [Accessed 12 July 2013].
• Balances of Cash And The Firm Value. [Pdf] Available at: <http://www.euba.sk/department-for-research-and-
doctoral-studies/economic-review/preview-file/er1_2009_michalski-10131.pdf> [Accessed 12 July 2013].
• Bragg, S.M., 2011. Inventory Best Practices. 2nd ed., Wiley.
• Bragg. S.M., 2012. Corporate Cash Management. Accounting Tools.
• Brigham, E.F. and Ehrhardt, M.C., 2010. Financial Management: Theory & Practice. 13th ed., Cengage
Learning.
• Cash flow and financial planning. [Pdf] Available at: <http://wps.aw.com/wps/media/objects/222/227412/ebook/
ch03/chapter03.pdf> [Accessed 12 July 2013].
• Cash management. [Online] Available at: <http://www.investopedia.com/terms/c/cash-management.asp>
• CFA Level I Cash Flow Statement. [Video online] Available at: <http://www.youtube.com/watch?v=hkcOqTNPiTo>
• Chap 17 Lecture: Statement of Cash Flows. [Video online] Available at: <http://www.youtube.com/
watch?v=M7xhaJVx-WE> [Accessed 12 July 2013].
• Financial Management - Lecture 05. [Video online] Available at: <http://www.youtube.com/
watch?v=aiduHQMrd88> [Accessed 12 July 2013].
• Financial Management. [Video online] Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>
• Financial Management. [Video online] Available at: <http://www.youtube.com/watch?v=oCH1Ll7riDQ>
• Financial Management: Lecture 4.[Video online] Available at: <http://www.youtube.com/watch?v=ZRE1glkq9zA>
• Financial Markets and Products. [Video online] Available at: <http://www.youtube.com/watch?v=y_ti1PXDnLE>
• Financial system. [Online] Available at: <http://www.slideshare.net/chotu30/financial-system-11563132>
• Impact of receivables management on working capital and Profitability [Pdf] Available at: < http://shodhganga.
inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf> [Accessed 12 July 2013].
• Inventory Management - An Introduction. [Video online] Available at: <http://www.youtube.com/
watch?v=qkZQxXJuqKo> [Accessed 12 July 2013].
• Inventory Management. [Online] Available at: <http://www.termpaperwarehouse.com/essay-on/4-3-1-Template-
Managers-Report/158537 > [Accessed 12 July 2013].
• Inventory Management Best Practices. [Video online] Available at: <http://www.youtube.com/
watch?v=C8Z3IApWCNQ> [Accessed 12 July 2013].
• Jones, E.B. and Jones, E.B., 2001. Cash Management. R&L Education.
• Jury, T., 2012. Cash Flow Analysis and Forecasting, Wiley.
122/JNU OLE
• Money Market and its Instruments. [Pdf] Available at: <http://www.caalley.com/art/Money_Market_and_Money_
Market_Instruments.pdf > [Accessed 12 July 2013].
• Money Markets and Capital Markets. [Video online] Available at: <http://www.youtube.com/watch?v=nv0a0GEc-
4s> [Accessed 12 July 2013].
• Muller, M., 2011. Essentials of Inventory Management. 2nd ed., AMACOM.
• Preparing a Cash Flow Forecast. [Online] Available at: <http://www.qfinance.com/contentFiles/QF02/
g1xqynvv/12/1/preparing-a-cash-flow-forecast.pdf> [Accessed 12 July 2013].
• Preve, L. And Allende, V.S., 2010. Working Capital Management. Oxford University Press, USA.
• Ramsey, D., 2009. The Total Money Makeover: A Proven Plan for Financial Fitness. 3rd ed., Thomas
Nelson.
• Ritter, L.S. and Silber, W.L., 2008. Principles of Money, Banking & Financial Markets. 12th ed., Prentice
Hall.
• Salek, J.G., 2005. Accounts Receivable Management Best Practices. Wiley.
• Tennent, J., 2012. Guide to Cash Management. Wiley.
• Thau, A., The Bond Book. 3rd ed., McGraw-Hill.
• The Importance of Inventory Management. [Online] Available at: <http://www.southernfulfillment.com/articles/
order-fulfillment/inventory-management/the_importance_of_inventory_management.htm > [Accessed 12 July
2013].
• Ward, M.A. and Sagner, J., 2003. Essentials of Managing Corporate Cash. Wiley.
• Work capital Analysis. [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/705/13/14_chapter5.
• WORKING CAPITAL. [Online] Available at: <http://www.scribd.com/doc/24525667/Working-Capital-analysis>
• Working capital Management. [Video online] Available at <http://www.youtube.com/watch?v=KQWe-2G23kw>
• Working Capital Management Principal and Approaches. [Video online] Available at <http://www.youtube.
com/watch?v=zJCiEIqAxbs> [Accessed 12 July 2013].
Recommended Reading
• Bukics, R.L. and Loven, W.T., 1987. The Handbook of Credit and Accounts Receivable Probus Pub Co.
• Cooper, R., 2004. Corporate Treasury and Cash Management (Finance and Capital Markets). Palgrave
Macmillan.
• CPF Board, 2013. CFP Board Financial Planning Competency Handbook. Wiley.
• Driscoll, M.C., 1983. Cash Management: Corporate Strategies for Profit. John Wiley & Sons Inc.
• Jones, E.V. and Jones, E.B., 2001. Cash Management. R&L Education.
• Kidwell, D.S., Blackwell, D.W., Whidbee, D.A. and Sias, R.W., 2011. Financial Institutions, Markets, and
Money. 11th ed., Financial Institutions, Markets, and Money. Wiley.
• Kimmel, P.D. and Weygandt, J.J., 2008. Financial Accounting: Tools for Business Decision Making. 5th ed.,
Wiley.
• Laurens, B., 1998. Managing capital flows. International Monetary Fund, Monetary and Exchange Affairs
Department.
• Levinson, M., 2009. Guide to Financial Markets. Guide to Financial Markets. 5th ed., Bloomberg Press.
• Linzer, R.S. and Linzer, A.O., 2007. Cash Flow Strategies: Innovation in Nonprofit Financial Management.
Jossey-Bass.
• Madura, J., 2011. International Financial Management. 11th ed., Cengage Learning.
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• Mishkin, F.S. and Eakins, S., 2011. Financial Markets and Institutions. 7th ed., Prentice Hall.
• O’Berry, D., 2006. Small Business Cash Flow: Strategies for Making Your Business a Financial Success.
Wiley.
• Schreibfeder, J., 2003. Achieving Effective Inventory Management. 5th ed., Effective Inventory Management,
Inc.
• Silver, E.A., Pyke, D.F. and Peterson, R., Inventory Management and Production Planning and Scheduling.
3rd ed., Wiley.
• Tracy, J.A. and Tracy, T., 2011. Cash Flow For Dummies. For Dummies
• Weide, J.H.V. and Maier, S.F., 1984. Managing Corporate Liquidity: An Introduction to Working Capital. John
Wiley & Sons Inc.
124/JNU OLE
Self Assessment Answers
Chapter I
1. b
2. d
3. a
4. b
5. d
6. a
7. d
8. d
9. b
10. a
Chapter II
1. d
2. d
3. a
4. c
5. b
6. a
7. c
8. a
9. a
10. c
Chapter III
1. b
2. a
3. c
4. b
5. d
6. d
7. d
8. d
9. a
10. b
Chapter IV
1. b
2. a
3. c
4. c
5. c
6. d
7. d
8. b
9. a
10. a
125/JNU OLE
Chapter V
1. a
2. d
3. d
4. b
5. a
6. c
7. b
8. c
9. b
10. c
Chapter VI
1. d
2. c
3. d
4. b
5. d
6. d
7. a
8. c
9. a
10. b
Chapter VII
1. b
2. d
3. c
4. a
5. c
6. a
7. b
8. d
9. a
10. a
Chapter VIII
1. c
2. a
3. b
4. a
5. d
6. c
7. d
8. a
9. c
10. c
126/JNU OLE

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Working Capital Management

This book is a part of the course by Jaipur National University, Jaipur.

The content in the book is copyright of JNU. All rights reserved.

II. List of Figures..........................................................VI

III. List of Tables........................................................ VII

V. Case Study.............................................................. 117

VI. Bibliography......................................................... 122

VII. Self Assessment Answers................................... 125

• define the goal of working capital management

• elucidate the concept of work capital

• explain the importance of working capital

• explain the types of working capital

• explicate the issues in the working capital management

• elucidate the determinants of working capital

• understand the current assets to fixed assets ratio

• identify the working capital cycle

• recognise the significance of working capital management

1.2 Meaning of Working Capital

Gross Working Net Working Permanent Temporary

Fig. 1.1 The angles of working capital management

Fig. 1.2 Permanent and temporary working capital

1.2.1 Importance of Adequate Working Capital

1.2.2 Optimum Working Capital

1.3 Determinants of Working Capital

1.4 Issues in the Working Capital Management

1.4.1 Current Assets to Fixed Assets Ratio

The following diagram shows alternative current assets policies:

Fig. 1.3 Alternative current assets policies

1.4.2 Liquidity versus Profitability

1.5 Estimating Working Capital Needs

1.6 Operating or Working Capital Cycle

Gross Working Capital (Total Current Assets)

Net Working Capital (Total Current Assets – Total Current Liabilities)

1.8 Requirements of Working Capital

1.9 Classification of Working Capital

Classification on the basis of financial reports

Classification on the basis of variability

It is rightly observed that,

1.11 Factors Influencing Working Capital Requirements

1.12 Principles of Working Capital Management

Finished goods inventory

Cash and interest-bearing liquid assets

2. _________________ refers to the firm’s investment in current assets.

4. Which of the following is also called variable working capital?

5. Which of the following is not a function of financial management?

• define cash management

• elucidate the principles of cash management

• explain the functions of cash management

• explain the financing of cash shortage

• explicate the cost of running out of cash

• elucidate the concept of financing current assets

• understand the three approaches of financing current assets

• identify the cash flow statement

• recognise the motives of holding cash

Determinable variations of cash needs

Contingency cash requirement

Availability of external cash

Maximising cash receipts

Minimising cash disbursements

Maximising cash utilisation

2.3 Functions of Cash Management

Managing cash flows

Optimising the cash level