WORKING CAPITAL MANAGEMENT Why should managers be familiar with working capital management?

When we work in any organization, we find that most of the time managers are concerned with working capital management. What I mean is: Ensuring that enough cash exists to pay bills; Ensuring that enough inventory exists to make and sell products; Ensuring that any excess cash is invested in interest-bearing securities; Ensuring that accounts receivable are at a level that maximizes earnings, Ensuring that short-term borrowings such as salaries payable and trade credit are used efficiently and at the lowest cost possible. What is Working capital management? You see, working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The basic goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable, accounts payable and cash This Topic extends the discussion to the management of the firms working capital needed. There is a trade-off between the risk of having too little working capital on hand and the reduced profitability that results from having excess working capital. What is Working capital? You can understand working capital in two different but interlinked senses. In the first sense, working capital refers to gross working capital and in second sense it is understood in terms of net working capital. We can explain both in following paragraphs: -

CONCEPTS OF WORKING CAPITAL

GROSS WORKING CAPITAL: It refers to the firms investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or within an operating cycle. You can include here cash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock. Gross working capital The firms total investment in current assets or assets that it expects to be converted into cash within a year or less. GWC focuses on Optimisation of investment in current Financing of current assets
NET WORKING CAPITAL: But the net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of

outsider, which are expected to mature for payment within an accounting year & include creditors, bills payable & the outstanding expenses. In other words you can say that this is the excess of current assets over current liabilities. Net working capital -Current assets and its current liabilities. Frequently when the term working capital is used, it is actually intended to mean net working capital. NWC focuses on :-Liquidity position of the firm Judicious mix of short-term and long-tern financing CURRENT ASSETS constitute the following: 1 Inventories: Inventories represent raw materials and components, work-in-progress and finished goods. 2 Trade Debtors: Trade Debtors comprise credit sales to customers. 3 Prepaid Expenses: These are those expenses, which have been paid for goods and services whose benefits have yet to be received. 4 Loan and Advances: They represent loans and advances given by the firm to other firms for a short period of time. 5 Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds. 6 Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive. Current liabilities form part of working capital that represent obligations which the firm has to clear to the outside parties in a short-period, generally within a year. CURRENT LIABILITIES comprise the following: 1. Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months. 2. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firms current accounts with banks 3. Short-term Loans: Short-terms borrowings by the firm from banks and others form part of current liabilities as short-term loans. 4. Provisions: These include provisions for taxation, proposed dividends and contingencies.

Working capital Current assets Current liabilities

Cash Accounts receivable Notes receivable Marketable securities Inventory prepaid expenses Total current assets Accounts payable Notes payable Accrued expenses Taxes payable Total current liabilities

Net working capital is current assets minus current liabilities.

Gross working capital concept focuses on two aspects: 1. How to optimize investment in current assets? 2. How should current assets be financed? The planning should be done keeping in mind two danger points i.e. excessive and inadequate investment in current assets. Investment in current assets needs to be adequate as it affects the profitability, solvency and liquidity. Why this issue comes up because it ultimately affects the objectives of financial management. Danger points to be kept in mind while planning 1. Excessive investment (Profitability) a. It results in unnecessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft & losses increase. b. It is an indication of defective credit policy & slack collection period. c. Excessive WC makes management complacent, which degenerates into managerial inefficiency. d. Tendencies of accumulating inventories tend to make speculative profits grow. 2. Inadequate investment (Liquidity) a. It stagnates growth. b. It become difficult to implement operating plans and achieve the firms operating profit target. c. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. d. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firms profitability would deteriorate. e. Paucity of WC funds render the firm unable to avail attractive credit opportunities. f. The firm loses its reputation when it is not in a position to honour its short-term obligations. Importance of working-Capital Working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. Solvency of the business Goodwill Regular supply of raw materials Regular payment of salaries, wages & other day to day commitments Exploitation of favourable market conditions Easy loans Cash discount Need or objects of working-Capital .To incur day to day expenses and overhead costs To maintain the inventories of raw material, work in progress, stores, spares and finished stock To meet the selling costs as packing, advertising, etc. To provide credit facilities to the customers

 To pay wages and salaries For the purchase of raw materials, components & spares Kinds of Working Capital 1. Permanent working capital: This component represents the value of the current assets required on a continuing basis over the entire year, and for several years. Permanent working capital is the minimum amount of current assets, which is needed to conduct a business even during the dullest season of the year. The minimum level of current assets is called permanent or fixed working capital as this part is permanently blocked in current assets. This amount varies from year to year, depending upon the growth of the company and the stage of the business cycle in which it operates. It is the amount of funds required to produce the goods and services, which are necessary to satisfy demand at a particular point of time. It represents the current assets, which are required on a continuing basis over the entire year. It is maintained as the medium as to continue the operations at any time.

Characteristics of Permanent working capital It is classified on the basis of the time period It constantly changes from one asset to another and continues to remain in the business process. Its size increase with the growth of business operations. 2. Temporary working capital: Contrary to the above you will find that temporary working capital represents a certain amount of fluctuations in the total current assets during a short period. These fluctuations are increased or decreased and are generally cyclical in nature. Additional current assets are required at different times during the operating year. Variable working capital is the amount of additional current asset that are required to meet the seasonal needs of a firm, so is also called as the seasonal working capital. For example: additional inventory will be required for meeting the demand during the period of high sales When the peak period is over variable working capital starts decreasing or very little during the normal period. It is temporarily invested in current assets. Say for an example a shopkeeper invests more money during winter season because he/ she requires to keep more amount of stock of woolen cloths. The same happens in a sugar factory how: the factory manager buys more quantity of sugarcane during the harvesting season and they continuously stops for some time. Characteristics of Temporary working capital It is not always gainfully employed, though it may change from one asset to another asset, as permanent working capital does. It is particularly suited to business of a seasonal or cyclical nature.

Diagrammatic representation of temporary and permanent working capital Permanent or temporary working capital in case of stable firm Figure(to be made) Permanent & temporary working capital in case of growing firm Figure(to be made)

Determinants of WC
We can explain the determinants of working capital as follows: Nature of business: The working capital requirements of an enterprise are basically related to the conduct of the business. Public utility undertakings like Electricity, Water supply, Railways, etc. need very limited working capital because they offer cash sales only and supply services, not products and as such no funds are ties up in inventories and receivables. But at the same time have to invest fewer amounts in fixed assets. The manufacturing concerns on the other hand require sizable working capital along with fixed investments, as they have to build up the inventories. Terms of sales and purchases: Credit sales granted by the concerns too its customers as well as credit terms granted by the suppliers also affect the working capital. If the credit terms of the purchases are more favorable and at the same time those of sales less liberal, less cash will be invested in the inventory. With more favorable credit terms, working capital requirements can be reduced. Manufacturing cycle: The length of manufacturing cycle influences the quantum of working capital needed. Manufacturing process always involves a time lag between the time when raw materials are fed into the production line and finished goods are finally turned out by it. The length of the period of manufacture in turn depends o the nature of product as well as production technology used by a concern. Shorter the manufacturing cycle; lesser the working capital required. Rapidity of turnover: If the inventory turnover is high, the working capital requirements will be low. With a better inventory control, a firm is able to reduce its working capital requirements. When a firm has to carry on a large slow moving stock, it needs a larger working capital as against another whose turnover is rapid. A firm should determine the minimum level of stock, which it will have to maintain throughout the period of its operation. Business cycle: Cyclical changes in the economy also influence quantum of working capital. In a period of boom i.e., when the business ism prosperous, there is s need of larger amount of working capital due to increases in sales, rise in price etc and vice-a-versa during period of depression. Changes in technology: Changes in technology may lead to improvements in processing of raw materials, savings in wastage, greater productivity, and more speedy production. All these improvements may enable the firm to reduce investments in inventory. Seasonal variation: The inventory of raw materials, spares and stores depends on the condition of supply. If the supply is prompt and adequate the firm can manage with small inventory. However, if the supply were

unpredictable and scant then the firm, to ensure the continuity of production, would have to acquire stocks as and when they are available and carry larger inventory on an average. Market conditions: The degree of competition prevailing in the market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required to promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet their needs. Seasonality of operation: Firms, which have marked seasonality in their operations usually, have highly fluctuating working requirements. Let us take an example to illustrate this point. Consider a firm manufacturing fans. The sale of fans reaches a peak during the summer months and drops sharply during the winter period. The working capital need of such a firm is likely to increase considerably in summer months and decrease significantly during winter season. Dividend policy: It has a dominant influence on the working capital position of a firm. If the firm is following a conservative dividend policy, the need for working capital can be met with retained earnings. Working capital cycle: Larger the working capital cycle, more is the requirement of working capital. NEED FOR WORKING CAPITAL The need for working capital to run the day-to-day business activities cannot be overemphasized. We will hardly find a business firm, which does not require any amount of working capital. Indeed, firms differ in their requirements of the working capital. We know that a firm should aim at maximizing the wealth of its shareholders. In its endeavor to do so, a firm should earn sufficient return from its operations. Earning a steady amount of profit requires successful sales activities. The firm has to invest enough founds in current for generating sales. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle involved in the conversion of sales into cash. Operating Cycle There is a difference between current and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investment in fixed assets such as plant and machinery or land and buildings. On the contrary, investment in current assets in turned over many times in a year. Investment in current assets such as inventories and debtors (accounts receivable) is realized during the firms operating cycle, which is usually less than a year. Operating Cycle is the time duration required to convert resources or inventories into sales and then into cash. The operating cycle of a manufacturing company involves three phases: Acquisition of resources: such as raw material, labor, power and fuel etc. Manufacture of the product: which includes conversion of raw material into work-in-progress into finished goods. Sales of the product: either for cash or on credit. Credit sales create account receivable for collection. In any of your business these phases affect cash flows, which most of the time, are neither synchronized because cash outflows usually occur before cash inflows. Cash inflows are not certain because sales and collections, which give rise to cash inflows, are difficult to forecast accurately. Cash outflows, on the other hand, are relatively certain. The firm is, therefore, required to invest in current assets for a smooth, uninterrupted functioning. It needs to maintain liquidity to purchase raw materials and pay expenses such as wages and salaries, other

manufacturing, administrative and selling expenses and taxes as there is hardly a matching between cash inflows and outflows. Cash is also held to meet any future exigencies. Stocks of raw material and work-in-process are kept to ensure smooth production and to guard against nonavailability of raw material and other components. The firm holds stock of finished goods to meet the demands of customers on continuous basis and sudden demand from some customers. Debtors (accounts receivable) are created because goods are sold on credit for marketing and competitive reasons. Thus, a firm makes adequate investment in inventories, and debtors, for smooth, uninterrupted production and sale. How is the length of an operating cycle determined? The length of the operating cycle of a manufacturing firm is the sum of: (i) Inventory conversion period (ICP) and Purchases Payment Credit sale Collection RMCP + WIPCP + FGCP Inventory conversion period Receivables conversion price Payables Net operating cycle Gross operating cycle (ii) Debtors conversion period (DCP). Here the inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: (a) Raw material conversion period (RMCP), (b) Work-in-process conversion period (WIPCP), and (c) Finished goods conversion period (FGCP). The debtors conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC) In practice, a firm may acquire resources (such as raw materials) on credit and temporarily postphone payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in current assets. The payables deferral period (PDP) is the length of time the firm is able to defer payments on various resource purchases. The difference between (gross) operating cycle and payable deferral period is net operating cycle (NOC). If depreciation is excluded from expenses in the commutation of operating cycle, the net operating cycle also represents the cash conversion cycle. It is net time interval between cash collections from sale of the product and cash payments for resources acquired by the firm. It also represents the time interval over which additional funds, called working capital, should be obtained in order to carry out the firms operations. The firm has to negotiate working capital from sources such as commercial banks. The negotiated sources of working capital financing are called nonspontaneous sources. If net operating cycle of a firm increases, it means further need for negotiated working capital. Let us now understand the computation of the length of operating cycle. Consider the statement of costs of sales for a firm given in Table :Table STATEMENT OF COST OF SALES _______________________ Items Actual 19x1 1. Purchase of aw material (credit) 4,653 2. Opening raw material inventory 523 3. Closing raw material inventory 827 4. Raw material consumed (1+2-3) 4,349 5. Direct labour 368 6. Depreciation 82 7. Other mfg. Expenses 553 8. Total cost (4+5+6+7) 5,352 (Rs. Lakh) 19x2 6,091 827 986 5,932 498 90 553 7,224

9. Opening work-in process inventory 185 10. Closing work-in-process inventory 325 11. Cost of production (8+9-10 ) 5.212 12. Opening finished goods inventory 317 13. Closing finished goods inventory 526 14. Cost of goods sold (11+12-13) 5,003 15. Selling, administrative and general exp. 304 16. Cost of sales (14+15) 5,307 The firms data for sales and book debts and creditors are given as under

325 498 7,051 526 995 6,582 457 7,039

SALES AND DEBTORS______________________(Rs. Lakhs) 19x1 19x2 Sales (credit) 6,087 8,006 Opening debtors 545 735 Closing debtors 735 1,040 Opening creditors 300 454 Closing creditors 454 642 The firms gross operating cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Gross operating cycle = Inventory conversion period + Debtors conversion period GOC=ICP+ DCP The inventory conversion (ICP) is the sum of raw material conversion period (RMCP), work-inprocess conversion period (WIPCP) and finished goods conversion period (FGCP): ICP=RMCP+WIPCP+FGCP What determines the inventory conversion period? The raw material conversion period should depend on: (a) raw material consumption per day, and (b) raw material inventory. Raw material consumption per day is given by the total raw material consumption divided by the number of days in the year ( say, 360). The raw material conversion period is obtained when raw material inventory is divided by raw material consumption per day. Similar calculations can be made for other inventories, debtors and creditors. The following formulate can be used: = Raw material Raw material consumption (RMC) Inventory (RMI) ------------------------------------------------360 RMC RMI x 360 = RMI 360 = RMC Work-in-process conversion period (WIPCP) = Work in-process Cost of production (COP) Inventory (WIPI) --------------------------------360 COP WIPI x 360 =WIPI 360 = COP Finished goods conversion period ( FGCP) Finished goods Cost of goods sold (CGS) Inventory (FGI) ------------------------------------360 CGC FGI x 360 =FGI 360 = CGS

Debtors conversion period (DCP) = Debtors (D) Credit sales at cost (CR SALES) 360 CRSALES D x 360 =D 360 = CR SALES Payables deferral period (PDP) = Creditors (CRS) Credit purchase (CR PUR) 360 CRPUR CRS x 360 =CRS 360 = CRPUR Net Operating cycle (NOC) is the difference between gross operating cycle and payables deferral period. Net operating cycle = Gross operating cycle payables deferral period NOC = GOC PDP Net operating cycle is also referred to as cash conversion cycle. Depreciation and profit should be excluded in the computation of cash conversion cycle since the firms concern is with cash flows associated with conversion at cost. A contrary view is that a firm has to ultimately recover total costs and make profits; therefore, the calculation of operating cycle should include depreciation, and even the profits. Also, in using the above mentioned formulate, average figures for the period may be used. Table 22.3 shows detained calculations of the components of a firms operating cycle. Table 22.4 provides the summary of calculations. Table 22.3 OPERATING CYCLE CALCULATIONS_________________ (Rs. Lakh) Items Actual Projected 19x1 19x2 1. Raw Material Conversion Period (a) Raw material consumption 4349 5932 (b) Raw material consumption per day 12.1 16.5 Raw material inventory 827 986 (d) Raw material inventory bolding days 68d 60d 2. Work-in-Process Conversion Period (a) Cost of production* 5130 6961 (b) Cost of production per day 14.3 19.3 Work-in-process inventory 325 498 (d) Work-in-process inventory holding days 23d 26d 3. Finished Goods Conversion Period (a) Cost of goods sold* 4921 6492 (b) Cost of production per day 13.7 18.0 Finished goods inventory 526 995 (d) Finished goods inventory holding days 38d 55d 4. Collection Period (a) Credit sales (at cost)** 5307 7039 (b) Sales per day 14.7 19.6 Book debts 735 1040 (d) Book debts outstanding days 50d 53d 5. Payment Deferral periods (a) Credit purchase 4653 6091 (b) Purchase per day 12.9 16.9 Creditors 454 642 (d) Creditors outstanding 35d 28d

*Depreciation is excluded on the assumption that the firm is interested in cash conversion period. Depreciation is a non-cash item. ** All sales are assumed on credit. Cost of sales figure should be used for calculation of collection period. During 19x1 the daily raw material consumption was Rs. 12.1 lakh and the company held an ending raw material inventory of Rs. 827 lakh. If we assume that this is the average inventory held by the company, the raw material consumption period works out to be 68 days. You may notice that for 19x2, the projected raw material conversion period is 60 days. This has happened because both consumption (Rs. 16.5 lakh per day) and level of inventory (Rs. 986 lakh) have increased, but the consumption rate has increased (by 36.4 per cent) much more than the increase in inventory holding (by 19.2 per cent). Thus, the raw material conversion period has declined by 8 days. Raw material is the result of daily raw material consumption and total raw material consumption during a period given the companys production targets. Thus, raw material inventory is controlled through control over purchases and production. We can similarly interpret other calculations in Table 22.3 SUMMARY OF OPERATING CYCLE CALCULATIONS____________ Actual Projected GROSS OPERATING CYCLE 1. Inventory Conversion Period (i) Raw material 68 60 (ii) Work-in-process 23 26 (iii) Finished goods 38 129 55 141 2. Debtors Conversion Period 50 53 3. Gross Operating Cycle ( 1+2) 179 194 Net Operating Cycle 4. Payment Deferral Period 35 38 5. Net Operating Cycle ( 3-4) 144 156 We note a significant change in the companys policy for 19x2 with regard to finished goods inventory. It is expected to increase to 55 days holding from 38 days in the previous year. One reason could be a conscious policy decision to avoid stock-out situations and carry more finished goods inventory to expand sales. But this policy has a cost; the company, in the absence of a significant increase in payables deferral period, will have to negotiate higher working capital funds. In the case of the firm in or example, its net operating (cash conversion) cycle is expected to increase from 144 days to 156 days It relates to a manufacturing firm. Non-manufacturing firms such as wholesalers and retailers will not have the manufacturing phase. They will acquire stock of finished goods and convert them into debtors (book debts) and debtors into cash. Further, service and financial enterprises will not have inventory of goods (cash will e their inventory). Their operating cycles will be the shortest. They need to acquire cash, then lend (create debtors) and again convert lending into cash. COMPUTATION OF OPEARTING CYCLE Formulae: RMCP = (RMI*360) / RMC WIPCP = (WIPI*360) / COP FGCP = (FGI*360) / COGS DCP = (DRS *360) / Cr.Sales PDP = (CRS*360) / Cr. purchases GROSS OP. CYCLE = ICP+DCP ICP = RMCP + WIPCP +FGCP NET OP. CYCLE = GOC-PDP

Where: RMC is the consumption of raw material RMI is the closing stock of raw material inventory WIPI is the closing stock of work-in process inventory FGI is the closing stock of finished goods inventory COP is the cost of production COGS is the cost of goods sold The important points to be considered Time value of money not important Liquidity position of a firm is dependent on investment in current assets Any short run, immediate need of the company whether it be cash or adjustments in sales can be made only through adjusting the levels of the various components of the current assets. This calls for efficient management of current assets, which form part of management of working capital. We have generally two sources of finance. One is your long-term sources and the other is of course the short term. a) Long term financing is done through issue of ordinary share capital, preference share capital, and debentures, long-term borrowings from financial institutions and banks and retained earnings. b) And short-term financing includes working capital funds from banks, capital funds from banks, public deposits, commercial paper, factoring of receivables etc. These sources of funds are for a period of one year or less. But in these short-term sources of capital you will come across one very important source that is the Spontaneous Sources of Financing. It refers to the automatic sources of short-term funds arising in a normal course of a business. Example: trade supplies & outstanding expenses. It seems very simple of how to finance your current assets but in actual its not so. In the financing of current assets too you have to think about the fulfillment of your financial objectives. And when one talks about it automatically becomes complicated. You need here to identify the accurate mixture of long term and short term sources of funds for financing your current assets. But the question is what mix may be most profitable. 1. Matching/ Hedging approach 2. Conservative approach 3. Aggressive approach MATCHING APPROACH :-A firm can meet its financing needs by using a matching approach in which the maturity structure of the firms liabilities is made to correspond exactly to the life of its assets.the fixed working capital is financed with the long-term capital& equity funds, whereas fluctuating current assets are financed with short-term debt. CONSERVATIVE APPROACH :-A firm in practice may adopt a conservative approach in financing its working capital where it depends on more of long-term funds the firm is financing its fixed /permanent working capital and also a part of its fluctuating working capital with longterm financing. Only a small portion is being financed through short-term financing. AGGRESSIVE APPROACH :-When a firm uses more of short-term sources for financing working capital; it is said to be followed aggressive policythe fixed working capital and a portion of fluctuating working capital is finance by short-term funds. Only a small portion of fluctuating working capital is being financed by short-term funds.

Level of CA: Level of fixed assets can be measured by relating Current Assets to Fixed Assets. Assuming a constant level of fixed assets, a higher CA/FA ratio indicates conservative current assets policy (greater liquidity & lower risk) and a lower CA/FA ratio means an aggressive current assets policy assuming other factors to be constant (higher risk & poor liquidity). In the above diagram, alternative A indicates the most conservative policy, where CA/FA ratio is greatest at every level of output. In the same way, Alternative C is

the mot aggressive policy & alternative C lies between the conservative & the aggressive and is the average one. Costs involved in maintaining a level of current assets Costs of liquidity: if the firms level of current assets is very high, it has excessive liquidity. Its return on assets will be low as funds ties up in idle cash and stocks earn nothing & high level of debtors produces nothing. Costs of illiquidity: is the cost of holding insufficient current assets. The firm will not be able to honour its obligations if it carries too little cash. This may force firm to borrow at high rate of interest.
A. Aggressive B. Conservative C. Average The Cost trade-off :-In determining the optimum level of current assets, the firm should balance the profitability-solvency tangle by minimizing total costs-cost of liquidity & cost of illiquidity. With the level of current assets, the cost of liquidity increases while the cost of illiquidity decreases. & Vice-a-versa. The firm should maintain its current assets at that level where the sum of these two costs is minimized. Summary Working-Capital Management Working capital is the amount of funds necessary to cover the cost of operating the enterprise. Concept of working capital a) Gross working capital b) Net working capital Gross working capital The firms total investment in current assets or assets that it expects to be converted into cash within a year or less. GWC focuses on Optimisation of investment in current Financing of current assets Net working capital -Current assets and its current liabilities. Frequently when the term working capital is used, it is actually intended to mean net working capital. NWC focuses on Liquidity position of the firm Judicious mix of short-term and long-tern financing Importance of working-Capital Working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. Solvency of the business Goodwill Regular supply of raw materials Regular payment of salaries, wages & other day to day commitments Exploitation of favourable market conditions Easy loans Cash discount Need or objects of working-Capital .To incur day to day expenses and overhead costs To maintain the inventories of raw material, work in progress, stores, spares and finished stock To meet the selling costs as packing, advertising, etc. To provide credit facilities to the customers To pay wages and salaries

 For the purchase of raw materials, components & spares Determinants of Working Capital Nature of business Market and demand Technology and manufacturing policy Current Assets cash, marketable securities, inventory, accounts receivable Long-Term Assets equipment, buildings, land Which earn higher rates of return?Which help avoid risk of illiquidity? Current Assets cash, marketable securities, inventory, accounts receivable Long-Term Assets equipment, buildings, land Risk-Return Trade-off: Current assets earn low returns, but help reduce the risk of illiquidity. Current Liabilities short-term notes, accrued expenses, accounts payable Long-Term Debt and Equity bonds, preferred stock, common stock Which are more expensive for the firm?Which help avoid risk of illiquidity? Current Liabilities short-term notes, accrued expenses, accounts payable Long-Term Debt and Equity bonds, preferred stock, common stock Risk-Return Trade-off: Current liabilities are less expensive, but increase the risk of illiquidity Balance Sheet Current Liabilities Current assets

Long-Term Debt Fixed Assets Preferred Stock Common Stock The Hedging Principle Permanent Assets (those held > 1 year) should be financed with permanent and spontaneous sources of financing Temporary Assets (those held < 1 year) should be financed with temporary sources of financing Spontaneous Financing accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes) Short-term financing unsecured bank loans, commercial paper, loans secured by A/R or inventory Permanent Financing intermediate-term loans, long-term debt, preferred stock, common stock Working Capital Cycle

Working capital or operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. Working capital cycle starts with the purchase of raw material and ends with the realisation of cash from the sale of finished products. The working capital cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work-in-progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle continues again from cash to purchase of raw material and so on. The working cycle of a manufacturing company involves three phases. -Acquisition of resources such as raw material, labour, power and fuel etc. -Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. -Sale of the product either for cash or on credit. Credit sales create account receivable for collection. The length of the working capital cycle of a manufacturing firm is the sum of: Length of working capital Cycle Inventory conversion period (ICP) Debtors (receivable) conversion period (DCP) Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: --------Raw material conversion period (RMCP) -------Work-in-process conversion period (WIPCP) -------Finished goods conversion period (FGCP) Debtors (receivable) conversion period (DCP) The debtors conversion period is the time required to collect the outstanding amount from the customers. Creditors deferral period Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases.

Debtors/Receivables Cash Raw Materials Finished Goods

Work-in process

Gross operating cycle The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC). Net operating cycle (NOC) NOC is the difference between GOC and CDP.

Cash conversion cycle (CCC) CCC is the difference between NOP and non-cash items like depreciation.

On The Basis of Concept

Gross Working Capital

On The Basis of Time

Net Working Capital

Permanent/Fixed Working Capital

Temporary/Variable Working Capital

Regular Working Capital

Reserve Working Capital

Seasonal Working Capital

Special Working Capital

Permanent or fixed working capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. Temporary or variable working capital Temporary or variable working capital is the amount of working capital which is required to meet the seasonal demands or some special exigencies. Regular working capital Regular working capital required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on. Reserve working capital Reserve working capital is the excess amount over the requirement for regular working capital which may be provided for contingencies that may arise at unexpected periods such as strike, rise in prices, depression, etc. Seasonal working capital The capital required to meet the seasonal needs of the firm is called seasonal working capital. n Special working capital Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research, etc. Cost of Short-Term Credit Interest = principal x rate x time Ex: borrow Rs 10,000 at 8.5% for 9 months Interest = Rs 10,000 x .085 x 3/4 year = Rs 637.50 We can use this simple relationship:

Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR) We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR) interest X 1 principal time interest 1 principal X time Sources of Short-term Credit Funds available for a period of one year or less are called short-term finance. In India, short-term funds are used to finance working-capital Trade credit Accrued expenses Deferred Income Factoring Bank credit- Loan, Cash credit, Overdraft, Letter of credit (L/c), Purchasing/discounting of bills Commercial paper Trade credit Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. The credit-worthiness of a firm and the confidence of its suppliers are main basis of securing trade credit. Accrued Expenses Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. The most important items are wages & salaries, interest and taxes. It is a spontaneous and free source of finance. Deferred Income Deferred income are incomes received in advance before supplying goods or services. These funds increase the liquidity of a firm and constitute an important source of short-term finance. Commercial Paper CP represents unsecured promisory notes issued by firms to raise short-term funds. In India, the RBI introduced CP in the Indian money market on the recommendations of the Working Group on Money Market (Vaghul Committee).

Cash Management
Cash is the most liquid asset of all and is vital for existence of any business firm. Its efficient management is crucial to the solvency of the business because as we all know cash is the focal point of the funds flows in a business. It can be understood in two senses, one is actual cash held by firm and deposits withdraw able on demand, and in another sense it includes marketable securities, which can be convertible into cash immediately. The goal of cash management is to reduce the amount of cash that is being used within the firm so as to increase profitability, but without reducing business activities or exposing the firm to undue risk in its financial obligations. Cash flows in connection with credit serve to introduce the concept of FLOAT which is the time lag or delay between the moment of disbursement of funds on the part of the customer and the

moment of receipt of funds on the part of the seller (i.e., mail time, processing time, and clearing time with the banking system). What factors must be considered when deciding on the appropriate amount of cash to hold? Cash in checking accounts must be held so that bills are paid on time (transactions balance), for emergencies such as strikes, weather disruptions, etc. (Precautionary balance), bank requirements for loans or other services provided (Compensating balance), and for taking advantage of bargains (speculative balance). Motives for holding cash 1. The transaction motive: Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have. 2. The precautionary motive: Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for. 3. Compensating motive: Banks provide a variety of services to business firms, such as clearance of cheque, supply of creditetc., for which a minimum balance is required to be kept with the bank, this balance is to compensate banks for services rendered. 4. The speculative motive: Economist Keynes described this reason for holding cash as creating the ability for a firm to take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount that is greater than the carrying costs of holding the inventory. Cash management is concerned with the managing of: 1. Cash flows into & out of the firm, 2. Cash flows within the firm 3. Cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Factors that affect the cash needs:Cash Cycle: Cash Outflow Cash Inflow

Cost of Cash Balance

Other Considerations FORMS OF LIQUIDITY AND CHOICE OF LIQUIDITY MIX: While a companys demand for cash has already been discussed above, it does not always keep the entire amount in the form of cash balance in the current account for the simple reason that the opportunity cost of idle cash is considerably high. That is why, companies try to maintain, besides cash, other liquid assets which provide some return but at the with relatively low risk. Let us first consider the forms of liquidity and then the choice of liquidity mix. Forms of Liquidity Cash Balance in the Current Account: This is the highest form of liquid asset a company can conceive of, but the return provided by it is nil. However, companies maintain approximately four to five per cent of their total assets, on the average, in this form despite no returns for reasons already explained. Keeping Reserve Drawing Power Under Cash Credit/ Overdraft Arrangement: This form of liquidity appears to be quite attractive as it can have access to bank borrowing. However, constraints imposed by to be. Close scrutiny of the quarterly budgets of the company by banks and imposition of penal interest of two per cent over and above the normal rate of interest on under- or over utilization make this form more tedious and time consuming. However, a built-in cushion may possibly be included while preparing the quarterly budgets and during some periods

the full amount may be drawn. The tax benefit on the interest makes effective after tax rate to be much less costly, even if part of it is held in the form of idle cash. This not only helps as a liquid source but also helps in obtaining equal or higher limits during the forthcoming year. Marketable Securities: These are short term securities of government such as treasury bills and other gilt edged securities whose default risk is nil and, for that very reason, the return is low. It is preferable to ensure the maturity structure of these short-term securities with the likely periods of excessive cash drain on the part of the company. Then, the transaction costs can be considerably minimized as early liquidation prior to maturity may result in low return from these assets. Investment in Inter-Corporate Deposits: A company can invest money with other companies in the form of short term deposits ranging from two or three months to five or six months at remunerative rates. However, these deposits being unsecured in nature, are subject to considerable risk, unless the companies accepting such deposits have excellent antecedents as to their paying habits. From among the different forms of liquidity available to a company a deliberate choice has to be made in selecting an appropriate mix that suits the liquidity requirements of the company and disposition of its management towards risk. CHOICE OF LIQUIDITY MIX The choice of selecting the portfolio of cash and near cash assets also known as the choice of liquidity mix is governed by a variety of factors which are briefly explained below: Uncertainty Surrounding Cash Flow Projections: It is generally said that the only certain factor in the corporate environment is its uncertainty. Even if cash flow projections have been made with the utmost care the general uncertainty can at times make the projections go awry. However the degree of uncertainty is more in certain types of industries than in others. For example general engineering industry is more recession prone than others. Consequently, the onset of recession which was not anticipated may call for a thorough revision of cash flows and policy changes in respect of products plans, dividend payments etc. Similarly tea plantations can get adversely affected with an untimely hailstorm. Even within the same company which is stable and growing certain types of cash flows, especially collections and payables tend to be more uncertain than others. When the degree of uncertainty is high as evidenced by the sensitivity of cash forecasts to adverse changes in some of the underlying assumptions, the company will do well to have the liquidity mix tilted largely towards cash balance and in so far as possible reserve drawing powe3r under the cash credit / overdraft arrangement and to a less extent gilt edged securities. On the other hand certain types of industries such as synthetic fabrics, electrical appliances enjoy stable and growing demand. Once a company has established its image the degree of uncertainty surrounding cash flow projections will be comparatively less. Consequently the liquidity mix of such companies will be tilted more towards marketable securities and intercorporate deposits. Attitude of the Management towards Risk: When the management of the company attaches greater importance to a given percentage increase in return than to the same percentage increase in liquidity, the portfolio of liquidity mix chosen tends to have a higher proportion of cash balance and marketable securities and cash balances. When the attitude of the management towards risk is quite conservative the liquidity mix chosen tends to have a higher proportion of cash balance and marketable securities and a lower proportion of intercorporate deposits. Ability to Raise Non bank funds and / or Control its Cash Flows: When a company is favourably placed in a position have ready access to non bank funds it can afford to have less proportion of cash and more of intercorporate deposits and marketable securities. This ind of a situation arises mostly in the case of group companies. For example, when a manufacturing company promoted by a group faces cash shortage, a

Finance and Investment Company promoted by the same group can come to its rescue by providing funds. Such a company need not maintain a large portion of its liquid assets in the form of cash. Similarly, companies, which can control its cash flows effectively, need not hold a large proportion of idle cash in their liquidity mix. This kind of situation can arise in the cash of companies that have horizontal or vertical integration. For example a manufacturing company, which has got substantial interest and / or has promoted another company for the supply of raw materials the company can exercise greater control on payables. On the other hand, companies which do not enjoy ready access to non bank sources of funds and / or not in a position to control cash flows may have to have greater proportion of cash and reserve drawing power in their liquidity mix. Cash Planning Cash planning is a technique to plan and control the use of cash. Cash Forecasting and Budgeting Cash budget is the most significant device to plan for and control cash receipts and payments. Cash forecasts are needed to prepare cash budgets. Short-term Cash Forecasts The important functions of short-term cash forecasts To determine operating cash requirements To anticipate short-term financing To manage investment of surplus cash. Short-term Forecasting Methods The receipt and disbursements method The adjusted net income method. Receipt and Disbursements Method The virtues of the receipt and payment methods are: It gives a complete picture of all the items of expected cash flows. It is a sound tool of managing daily cash operations. This method, however, suffers from the following limitations: Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be delayed, or unanticipated demands may cause large disbursements. It fails to highlight the significant movements in the working capital items. Adjusted Net Income Method The benefits of the adjusted net income method are: It highlights the movements in the working capital items, and thus helps to keep a control on a firms working capital. It helps in anticipating a firms financial requirements. The major limitation of this method is: It fails to trace cash flows, and therefore, its utility in controlling daily cash operations is limited. Long-term Cash Forecasting The major uses of the long-term cash forecasts are: It indicates as companys future financial needs, especially for its working capital requirements. It helps to evaluate proposed capital projects. It pinpoints the cash required to finance these projects as well as the cash to be generated by the company to support them. It helps to improve corporate planning. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully. Managing Cash Collections and Disbursements Accelerating Cash Collections

 Decentralised Collections Controlling Disbursements Lock-box System Disbursement or Payment Float Features of Instruments of Collection in India

Instrument 1.Cheques

Pros

No charge Payable thro Can be disco Low discoun Requires cus changeable wi

2.Drafts
i)

How to accelerate cash collections? Decentralized collections Lock-box system Prompt payment by Customers Early conversion of payment into cash Objective of Cash Management

Meeting the cash outflows

Payable in lo Chances of b

3.Documentary bills

4.Trade bills

ii) Minimizing the Cash Balance Ways to Improve Collection of Cash A. Changing customer paying habits 1.Letters, telephone calls, or personal visits 2.Economic incentive for paying bills faster; offer discounts B. Improve the Delivery system (reduce the negative float) 1.Regional banking (customers pay bills to banks since they can transfer funds more quickly than mail order delivery). 2.Lockbox collection system (firm rents a post office box in a particular city and the bank monitors the lockbox periodically). 3.Electronic communications (i.e., data-phone wire systems). C. Bypass the problem (Factoring of receivables). ii) Optimum Cash Balance

Low discoun Theoretically payments are m

No charge ex Can be disco

Optimum Cash Balance under Certainty: Baumols Model Optimum Cash Balance under Uncertainty: The MillerOrr Model Baumols ModelAssumptions The firm is able to forecast its cash needs with certainty. The firms cash payments occur uniformly over a period of time. The opportunity cost of holding cash is known and it does not change over time. The firm will incur the same transaction cost whenever it converts securities to cash Baumols Model The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the return foregone on the marketable securities. If the opportunity cost is k, then the firms holding cost for maintaining an average cash balance is as follows:

Holding cost = k (C / 2)
The firm incurs a transaction cost whenever it converts its marketable securities to cash. Total number of transactions during the year will be total funds requirement, T, divided by the cash balance, C, i.e., T/C. The per transaction cost is assumed to be constant. If per transaction cost is c, then the total transaction cost will be:

Transaction cost = c(T / C )

The total annual cost of the demand for cash will be: TOTAL COST = k (C/2)+c(T/C) The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for the optimum cash balance is as follows:

C* =
IllustrationBaumols Model

2cT k

The MillerOrr Model The MO model provides for two control limitsthe upper control limit and the lower control limit as well as a return point. If the firms cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point).

Advani Chemical Limited estima C = 2cT / k companys opportunity cost of funds transaction when it converts its s balance. How much is the total ann many deposits will have to be made d
*

C* =

2(150)(20,000,000) = Rs 200,000 0.15

Total cost = 150(2,00,000/2,00,000) + 0.15(2,00,000/2) = 150(100) + 0.15(1,00,000) = 15,000 + 15,000 = Rs 30,000

Similarly, when the firms cash flows wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level (the return point). The Miller-Orr Model The difference between the upper limit and the lower limit depends on the following factors:

the interest rate, (i) (i the standard deviation () of net cash flows ( The formula for determining the distance between upper and lower control limits (called Z) is as follows:Upper limit lower limit =(3/4*transaction cost*cash flow variance int.rate) =(3/4*transaction

the transaction cost (c) (c

Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z The net effect is that the firms hold the average the cash balance equal to: Average Cash Balance = Lower Limit + 4/3Z
Investing Surplus Cash in Marketable Securities Selecting Investment Opportunities: safety, Maturity, and marketability Short-term Investment Opportunities: Treasury bills Commercial papers Certificates of deposits Bank deposits Inter-corporate deposits Money market mutual funds

Inventory Management
Inventory is needed as supplies for operations, raw materials and work-in-progress for production, and finished goods for sale. Inventory does not earn interest, and is costly to store, order, insure, protect, and be without (stock-out costs), so inventory should be held so as to hold enough to operate, but not too much. Stock-out costs are the hardest to measure since it is uncertain how many customers are lost as a result of being turned away for lack of products in inventory.

Inventory management thus consists of deciding on the appropriate level of inventory to hold. Too less or too much inventory is harmful for any concern because it will increase

the overall inventory cost. Let us now discuss the need for carrying inventory and the nature of inventory management.
Need & nature of inventory management NATURE OF INVENTORIES Inventories as you know are stock of the product a company is manufacturing for sale and components that make up the product. Various forms in which inventories exist in a manufacturing company are: raw materials, work-in-process and finished goods. Raw materials are those basic inputs that are converted into finished product through the manufacturing process. Thus, raw materials inventories are those units, which have been purchased and stored for future production. Work-in-process inventories are semi-manufactured products. They represent products that need more work before they become finished products for sale. Finished goods inventories are those completely manufactured products, which are ready for sale. Stocks of raw materials and work-in-process facilitate production, while stock of finished goods is required for smooth marketing operations. Thus, inventories serve as a link between the production and consumption of goods. The levels of three kinds of inventories for a firm depend on the nature of its business. A manufacturing firm will have substantially high levels of all three kinds of inventories, while a retail or wholesale firm will have a very high level of finished goods inventories and no raw material and work-in-process inventories. Within manufacturing firms, there will be differences. Large heavy engineering companies produce long production cycle products; therefore, they carry large inventories. On the other hand, inventories of a consumer product company will not be large because of short production cycle and fast turnover. A fourth kind of inventory, supplies (or stores and spares), is also maintained by firms. Supplies include office and plant cleaning materials like soap, brooms, oil, fuel, light bulbs etc. These materials do not directly enter production, but are necessary for production process. Usually, these supplies are small part of the total inventory and do not involve significant investment. Therefore, a sophisticated system of inventory control may not be maintained for them Maintaining inventories involves tying up of the company's funds and incurrence of storage and handling costs. There are three general motives for holding inventories: Transactions motive emphasizes the need to maintain inventories to facilitate smooth production and sales operations. For uninterrupted and proper running of any firm it is necessary to have an appropriate level of inventory. Precautionary motive necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors. Speculative motive influences the decision to increase or reduce inventory levels to take advantage of price fluctuations. A company should maintain adequate stock of materials for a continuous supply to the factory for an uninterrupted production. It is not possible for a company to procure raw materials whenever it is needed. A time lag exists between demand for materials and its supply. Also, there exists uncertainty in procuring raw materials in time on many occasions. The procurement of materials may be delayed because of such factors as strike, transport disruption or short supply. Therefore, the firm should maintain sufficient stock of raw materials at a given time to streamline production. The firm may purchase large quantities of

raw materials than needed for the desired production and sales levels to obtain quantity discounts of bulk purchasing. At times, the firm would like to accumulate raw materials in anticipation of price rise. Work-in-process inventory builds up because of the 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 production cycle completes, stock of work-in-process has to be maintained. Efficient firms constantly try to make production cycle smaller by improving their production techniques. Stock of finished goods has to be held because production and sales are not instantaneous. A firm cannot produce immediately when customers demand goods. Therefore, to supply finished goods on a regular basis, their stock has to be maintained. Stock of finished goods has also to be maintained for sudden demands from customers. In case the firm's sales are seasonal in nature, substantial finished goods inventories should be kept to meet the peak demand. Failure to supply products to customers, when demanded, would mean loss of the firm's sales to competitors. The level of finished goods inventories would depend upon the coordination between sales and production as well as on production time. OBJECTIVES OF INVENTORY MANAGEMENT No activity is undertaken without some aim/objective. Lets now come to the objectives of inventory management. In the context of inventory management, the firm is faced with the problem of meeting two conflicting needs: To maintain a large size of inventory for efficient and smooth production and sales operations. To maintain a minimum investment in inventories to maximize profitability because idle blocking of funds earn nothing. As we discussed earlier, both excessive and inadequate inventories are not desirable. These are two danger points within which the firm should operate. The objective of inventory management should be to determine and maintain optimum level of inventory investment. The optimum level of inventory will lie between the two danger points of excessive and inadequate inventories. Firms should always avoid a situation of over investment or under-investment in inventories. The major dangers of over investment are: (a) Unnecessary tie-up of the firm's funds and loss of profit, (b) Excessive carrying costs, and (c) Risk of liquidity. The excessive level of inventories consumes funds of the firm, which cannot be used for any other purpose, and thus, it involves an opportunity cost. The carrying costs, such as the costs of storage, handling, insurance, recording and inspection, also increase in proportion to the volume of inventory. These costs will impair the firm's profitability furtherYou have to understand that excessive inventories carried for long-period increase chances of loss of liquidity. It may not be possible to sell inventories in time and at full value. Raw materials are generally difficult to sell as the holding period increases. There are exceptional circumstances where it may pay to the company to hold stocks of raw materials. This is possible under conditions of inflation and scarcity. Work-in-process is far more difficult to sell. Similarly, difficulties may be faced to dispose off finished goods inventories as time lengthens. The downward shifts in market and the seasonal factors may cause finished goods to be sold at low prices.

Another danger of carrying excessive inventory is the physical deterioration of inventories while in storage. Such loss is as you know a complicated issue for any business. Goods or raw materials deterioration occurs with the passage of time, or it may be due to mishandling and improper storage facilities. These factors are within the control of management; unnecessary investment in inventories can, thus, be cut down maintaining an inadequate level of inventories is also dangerous. The consequences of underinvestment in inventories are: (a) Production hold-ups and (b) Failure to meet delivery commitments. Inadequate raw materials and work-in-process inventories will result in frequent production interruptions. Similarly, if finished goods inventories are not sufficient to meet the demand of cus-tomers regularly, they may shift to competitors, which will amount to a permanent loss to the firm. The aim of inventory management, thus, should be to avoid excessive and inadequate levels of inventories and to maintain sufficient inventory for the smooth production and sales operations. Efforts should be made to place an order at the right time with the right source to acquire the right quantity at the right price and quality. As you can gather from our discussion, inventory management to be effective should: Ensure a continuous supply of raw materials to facilitate uninterrupted production, Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes, Maintain sufficient finished goods inventory for smooth sales operation, and efficient customer service, Minimise the carrying cost and time, and Control investment in inventories and keep it at an optimum level. Till now, we have discussed the need & nature of inventory management. Lets move on to discuss the various techniques of inventory management. INVENTORY MANAGEMENT TECHNIQUES Inventories are stock of the product a company is manufacturing for sale and components that make up the product. Inventory management involves the control of the assets used in the production process or produced to be sold in the normal course of the firms operations. As we have already discussed that every management technique should be in consonance with the shareholders, wealth maximization principle. To achieve this, the firm should determine the optimum level of inventory. Efficiently controlled inventories make the firm flexible. Inefficient inventory control results in unbalanced inventory and inflexibility-the firm may sometimes run out of stock and sometimes may pile up unnecessary stocks. This increases the level of investment and makes the firm unprofitable. To manage inventories efficiency, we should seek answers to the following two questions: How much should be ordered? When should it be ordered? The first question, how much to order, relates to the problem of determining economic order quantity (EOQ), and is answered with an analysis of costs of maintaining certain level of inventories. The second question, when to order, arises because of uncertainty and is a problem of determining the re-order point. Economic Order Quantity (EOQ)

Inventory Management Techniques Economic order quantity (EOQ) One of major problem with inventory management is how much inventory should be added when inventory is replenished. The quantity to be purchased should neither be small nor big because cost of buying and carrying is very high.EOQ is the size of the lot to be purchased which is economically viable. This is the quantity of materials which can be purchased at minimum costs. Economic order quantity (EOQ) ordering costs: requisitioning, order placing, transportation, receiving, inspecting and storing, administration carrying costs: warehousing, handling, clerical and staff, insurance, depreciation and obsolescence EOQ=Under root 2ao/c Suppose a firm expects total demand for its product over the planning period to be 5,000 units, whereas the ordering cost per order is Rs 200, and the carrying cost per unit is Rs 2. The EOQ will be EOQ = 2 x 5,000 x 200 2 = 10,00,000 = 1,000 units Inventory Investment Analysis Estimation of incremental operating profit Estimation of incremental investment in inventory Estimation of the incremental rate of return (IRR) Comparison of the incremental rate of return with the required rate of return (RRR) Optimum inventory: IRR = RRR 1. If the firm is buying raw materials, it has to decide lots in which it has to be purchased on replenishment. 2. If the firm is planning a production run, the issue is how much production to schedule (or how much to make).

These problems are called order quantity problems, and the task of the firm is to determine the optimum or economic order quantity (or economic lot size). Determining an optimum inventory level involves two types of costs: (a) Ordering costs and (b) Carrying costs. The economic order quantity is that inventory level, which minimizes the total of ordering and carrying costs. Ordering Costs Lets see if you remember what ordering costs are? The term ordering costs is used in case of raw materials (or supplies) and includes the entire costs of acquiring raw materials. They include costs incurred in the following activities: requisitioning, purchase ordering, transporting, receiving, inspecting and storing (store placement).

Ordering costs increase in proportion to the number of orders placed. The clerical and staff costs, however, do not vary in proportion to the number of orders placed, and one view is that so long as they are committed costs, they need not be reckoned in computing ordering cost. Alternatively, it may be argued that as the number of orders increases, the clerical and staff costs tend to increase. If the number of orders are drastically reduced, the clerical and staff force released now can be used in other departments. Thus, these costs may be included in the ordering costs. It is more appropriate to include clerical and staff costs on a pro rata basis. Ordering costs increase with the number of orders; thus the more frequently inventory is acquired, the higher the firm's ordering costs. On the other hand, if the firm maintains large inventory levels, there will be few orders placed and ordering costs will be relatively small. Thus, ordering costs decrease with increasing size of inventory. Carrying Costs Do you have any idea what carrying costs are? Costs incurred for maintaining a given level of inventory are called carrying costs. They include storage, insurance, taxes, deterioration and obsolescence. The storage costs comprise cost of storage space (warehousing cost), stores handling costs and clerical and staff service costs (administrative costs) incurred in recording and providing special facilities such as fencing, lines, racks etc. ORDERING AND CARRYING COSTS Lets take a quick look at the various cost items that come under ordering and carrying costs respectively. Ordering Costs Requisitioning Order placing Transportation Receiving, inspecting and storing Clerical and staff Carrying Costs Warehousing Handling Clerical and staff Insurance Deterioration and obsolescence Carrying costs vary with inventory size. This behavior is contrary to that of ordering costs, which decline with increase in inventory size. The economic size of inventory would thus depend on trade-off between carrying costs and ordering costs. Where, Formula: EOQ =

2AO

C Lets take an example so that you understand it better. Example: Your firm buys casting equipment from outside suppliers @Rs.30/unit. Total annual needs are 800 units. You have with you following further data:

Annual return on investment, 10% Rent, insurance, taxes per unit per year, Re.1 Cost of placing an order, Rs.100 How will you determine the economic order quantity? This can be solved as follows: We already know the formula for EOQ, EOQ = 2AO C In this problem, the annual demand i.e. A = 800 units. Ordering cost i.e. O = Rs.100. Total cost = 800 x 30 i.e. Rs.24000 Total interest cost = 10% of 24000 = Rs.2400 Interest cost per unit = 2400 = Rs.3 800 Carrying cost = 3 + 1 = Rs.4 per unit EOQ = 2 x 800 x 100 4 = 200 units. A = annual demand O = ordering cost per order C = carrying cost per unit Re-order Point We have now solved the problem of how much to order by determining the economic order quantity, we have yet to seek the answer to the second problem, when to order. This is a problem of determining the re-order point. Lets see what re-order point is? The re-order point is that inventory level at which an order should be placed to replenish the inventory. To determine the re-order point under certainty, we should know: (a) Lead time, (b) Average usage, and (c) Economic orders quantity. Under such a situation, re-order point is simply that inventory level which will be maintained for consumption during the lead-time. That is:

Reorder point = lead time in days x daily usage

Lead-time It is the time normally taken in replenishing inventory after the order has been placed. By certainty we mean that usage and lead-time do not fluctuate. Safety stock The demand for material may fluctuate from day to day or from week to week. Similarly, the actual delivery time may be different from the normal lead-time. If the actual usage increases or the delivery of inventory is delayed, the firm can face a problem of stock-out, which can prove to be costly for the firm. Therefore, in order to guard against the stock-out, the firm may maintain a safety-stock-some minimum or buffer inventory as cushion against expected increased usage and/or delay in delivery time. SELECTIVE INVENTORY CONTROL: ABC ANALYSIS Usually a firm has to maintain several types of inventories. It is not desirable to keep the same degree of control on all the items. The firm

should pay maximum attention to those items whose value is the highest. The firm should, therefore, classify inventories to identify which items should receive the most effort in controlling. The firm should be selective in its approach to control investment in various types of inventories. This analytical approach is called the ABC analysis and tends to measure the significance of each item of inventories in terms of its value. The high-value items are classified as 'A items' and would be under the tightest control. 'C items' represent relatively least value and would be under simple control. 'B items' fall in between these two categories and require reasonable attention of management. The ABC analysis concentrates on important items and is also known as control by importance and exception (CIE). As the items are classified in the importance of their relative value, this approach is also known as proportional value analysis. (PVA). . The following steps are involved in implementing the ABC analysis: 1. Classify the items of inventories, determining the expected use in units and the price per unit for each item. 2. Determine the total value of each item by multiplying the expected units by its units price 3. Rank the items in accordance with the total value, giving first rank to the item with highest total value and so on. 4. Compute the ratios (percentage) of number of units of each item to total units of all items and the ratio of total value of each item to total value of all items. 5. Combine items on the basis of their relative value to form three categories: -A, B and C.

MATERIALS REQUIREMENT PLANNING (MRP) SYSTEM

You have seen in the previous discussions almost about the inventory management. Now lets come to a new area that is materials requirement planning (MRP) system to determine what to order, when to order, and what priorities to assign to ordering materials. Many companies are taking up this process now a day. MRP uses EOQ concepts to determine how much to order. Using a computer, it simulates each product's bill of materials structure, inventory status, and manufacturing process. The bill of materials structure simply refers to every pan or material that goes into making the finished product. On the basis of the time it takes for a product that is in process to move through the various production stages and the lead time required to get materials, the MRP system determines when orders should be placed for the various items on the bill of materials. The advantage of the MRP system is that it forces the firm to more thought- fully consider its inventory needs and plan accordingly. The objective is to lower the firm's inventory investment without impairing production. If the firm's opportunity cost of capital for investments of equal risk is 15 percent, every Rs.1.00 of investment released from inventory increases before-tax profits by Rs.15.

JUST-IN-TIME (JIT) SYSTEM As you must have guessed from the

name, under this system materials arrive exactly at the time they are needed for production. The just-in-time (JIT) system is used to minimize inventory investment. The philosophy is that materials should arrive at exactly the time they are needed for production. Ideally, the firm would have only work-in-process inventory. Because its objective is to minimize inventory investment, a JIT system uses no, or very little, safety stocks. Extensive coordination must exist between the firm, its suppliers, and shipping companies to ensure that material inputs arrive on time. Failure of materials to arrive on time results in a shutdown of the production line until the materials arrive. Likewise, a JIT system requires high-quality parts from suppliers. When quality problems arise, production must be stopped until the problems are resolved. The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining efficiency by emphasizing quality in terms of both the materials used and their timely delivery. When JIT is working properly, it forces process inefficiencies to surface and be resolved. A JIT system requires cooperation among all parties involved in the process-suppliers, shipping companies, and the firm's employees. Now that you have understood the concepts, lets have a review to test your knowledge. CASE STUDY Good CustomersBad Receivables The normal reaction to learning that a customer is delinquent in their account with your firm is to say "No more credit". This reaction, however, may not be best course of action. When a firm has a large customer the relationship between the two firms can be very complex. The financial demise of the customer could in fact, lead to the demise of the supplier. For a look at how reliant a firm can be upon an individual customer as well as how a firm can respond to a financially distressful situation facing a large customer, read the article by Howard Brownstein and Edward Gavin. Answer the following questions based on the information provided by the article.

TALKING IT OVER AND THINKING IT THROUGH! Company A supplies products to Company B. Company B is currently delinquent in the payment of their invoices from Company A. What factors besides the delinquent account balance need to be considered before Company A denies future credit to Company B?
1. Under what circumstances might a customer sue their supplier should the supplier deny future credit? 2. What is a turnaround professional? 3. What are the three key items mentioned in the article that are essential for a distressed firm to successfully turn their business situation around? 4. When a credit manager realizes a key customer is experiencing financial distress, whom should they discuss the situation with prior to taking any action? THINKING ABOUT THE FUTURE!

Establishing the ideal credit policy is tough. If the credit policy is too stringent, sales and net profits will be forfeited. If the credit policy is too lenient, bad debts will be incurred. To determine the best credit policy, credit managers must work with other managers throughout the firm to determine the benefits and costs of issuing credit and establishing the policy that appears to produce the best results over the long term. These managers must also determine how to handle customers who become delinquent. This is often done on a case-by-case basis with the action taken being determined by the specifics of the situation

Case Study
Just-in-Time Inventory Creates Volatility Just-in-time (JIT) delivery systems have had a dramatic impact on efficiency and profitability. Firms can reduce inventory to bare bones levels. Lead time, the time between ordering and shipping, is down substantially. One manufacturer indicates lead time is now one to three days, less than half what is was five years ago. Lantech, a manufacturer of machines used to wrap plastic around pallets, is an example of a company that has taken substantial advantage of JIT techniques. Lantech can now build a special order machine in ten hours. The same machine took five weeks to build ten years ago. All companies have been forced to adapt to the instantaneous nature of orders. A customer will call in the morning wanting goods for the next day, or even that afternoon. Gone are the days of ordering weeks in advance. Even those companies that can't speed up the manufacturing process are reluctant to stockpile inventory. Worthington Industries, a steel producer, indicated that it will pass on some orders needing quick delivery rather than build up inventory. Many firms no longer attempt to forecast demand for their products, they merely react to new orders as rapidly as possible. The economic result is increased volatility. Excluding defense orders, capital goods orders were up 4.6% in February, down 3.1% in March, and up 1.9% in April. TALKING IT OVER AND THINKING IT THROUGH! 1. How does JIT increase profits? 2. What impact does JIT have on inventory obsolescence? 3. How does JIT increase volatility? 4. What is the danger of not holding product in inventory? THINKING ABOUT THE FUTURE! JIT inventory systems have greatly increased our efficiency. However, they also appear to have increased our economic volatility. In the future, I suspect that this trend will continue and contribute to the development of even more flexible manufacturing systems that can be reconfigured rapidly to accommodate vastly different products. Only those firms that can readily adapt will be able to remain competitive in the new marketplace.

Exercises
True or False 1 . Inventory management weighs the costs of carrying inventory against lost sales. (a) True (b) False 2 . It is generally better to have lower accounts receivable and inventory levels than to have higher levels.

(a) True (b) False 3 . The current ratio is a better measure of liquidity than the quick ratio. (a) True (b) False 4 . Providing credit to customers will automatically increase total sales and net income. (a) True (b) False 5 . On May 3rd, Kristen purchased some plumbing supplies costing $604.95. The credit terms were 1/5, n30. Kristen can pay her bill in full on May 7th by paying $598.90. (a) True (b) False

6 . Inventory ordering costs vary with the size of the order while inventory carrying costs vary with both the size and frequency of orders. (a) True (b) False 7 . Locking diamonds in a safe at night while leaving silver platters in a display case is an example of the ABC inventory classification system. (a) True (b) False 8 . When inventory carrying costs are high and space is limited, a firm should implement the ABC inventory system. (a) True (b) False 9 . A collection call is one method of keeping track of a customer's situation. (a) True (b) False 10 . The long-term debt and equity sections of the balance sheet will always remain unchanged when preparing pro-forma financial statements as part of the net present value approach to analyzing inventory policies. (a) True (b) False 11 . Inventory that is becoming obsolete should be sold even if a big loss is taken on an item. (a) True (b) False
Answers to above Question 1: True is the correct Question 7: True is the correct answer answer Question 2: True is the correct Question 8: False is the correct answer answer Question 3: False is the correct Question 9: True is the correct answer answer Question 4: False is the correct Question 10: False is the correct answer answer Question 5: True is the correct Question 11: True is the correct answer answer

Question 6: False is the correct answer

Accounts Receivable and Inventory

Multiple Choice
1 . Which one of the following would NOT tighten a firm's credit policy? (a) implementing a more stringent credit standard (b) shortening the net due period (c) lengthening the discount period (d) requiring a cash down payment on any purchase 2 . Fernando has been analyzing the accounts receivables of his firm. Based on the current credit policy, 21% of the customers pay in 14 days, 76% pay in 41 days and 3% pay in 112 days. Based on his best estimates and a new policy that he is proposing, Fernando feels that 42% of the customers would pay in 21 days, 56% would pay in 35 days and 2% would pay in 90 days. What is the effect of the new credit policy proposal on the average collection period? (a) the ACP would decrease by 7 days (b) the ACP would decrease by 4 days (c) the ACP would increase by 4 days (d) the ACP would increase by 7 days 3. Marilee, Inc. expects annual sales of Rs2.45 million next year. They have a strict credit policy of 2/10, net 20. Based on a 365-day year, 1% of their customers pay in 1 day, 41% pay in 10 days, 56% pay in 23 days and 2% pay in 60 days. What is the expected value of their accounts receivable for next year? (a) Rs122,097 (b) Rs126,583 (c) Rs409,639 (d) Rs455,699 4 . Albertsen's is analyzing two separate credit policies. Policy A will produce annual sales of Rs645,000 and annual interest expense of Rs11,500. Cost of goods sold (COGS) will equal 53% of sales and bad debts will be 3% of sales. The tax rate is 35%. In comparison, Policy B would have 5% less sales, interest expense of Rs6,000, 53% COGS, and bad debts equal to 1% of sales. All other expenses are equal to Rs121,000 under both policies. Which one of the following statements is correct concerning these two credit policies? (a) Policy A produces Rs34,250 more in sales than Policy B. (b) Policy B produces Rs8,317 more in net income than Policy A. (c) Policy A has Rs19,350 more in bad debts than Policy B. (d) Policy B produces Rs2,317 more in net income than Policy A. 5 . Pete's Garden is considering changing their credit policy. The incremental cash flows associated with this change are as follows: increase in sales of Rs13,100, increase in cost of goods sold of Rs6,900, increase in bad debts of Rs1,500, increase in other costs of Rs2,700 and an increase in taxes of Rs750. The incremental initial cash outflow at time zero is Rs16,450. The applicable discount rate is 9.5%. What is the net present value (NPV) of this proposed change in the credit policy? (a) Rs(3,292) (b) Rs(1,089)
(c) Rs3,950 (d) Rs13,158 6 . Maxie's has annual sales of 209,000 units at an average selling price of Rs19.95. The ordering costs are Rs80 per order and the carrying costs per year are Rs70.46 per unit. What is the optimal order quantity?

(a) 78 (b) 209 (c) 487 (d) 689

7 . Sakthi's Specialty Items maintains an average inventory of 129,000 items. Each item is totally unique and hand-crafted. The ordering costs are Rs160 each due to the time required to find such unusual items. The carrying costs are Rs254.00 a year per item. Sakthi's sells about 49,000 items per year. What are the total ordering and carrying costs per year for Sakthi's Specialty Items? (a) Rs29,134,690 (b) Rs32,785,520 (c) Rs32,797,520 (d) Rs33,160,870 8 . Which one of the following is a disadvantage of the just-in-time (JIT) inventory system? (a) lower inventory carrying costs (b) less inventory storage space (c) more efficient use of assets (d) production shutdowns for lack of parts 9 . The strength of a firm's cash flows is measured by which one of the Five Cs of Credit? (a) character (b) conditions (c) capacity (d) capital 10 . Which one of the following correctly applies to a credit scoring system? (a) Borrowers with low credit scores should be granted higher credit limits. (b) Borrowers with higher incomes should be granted a higher score than borrowers with lower incomes. (c) A business selling luxury items should be granted a higher score during periods of weak economic growth. (d) The more collateral provided by a firm, the lower the credit score assigned. 11 . Selling accounts receivable to a third party at a reduced price is part of the collection process known as (a) settling. (b) writing off. (c) suing. (d) factoring. 12 . Which one of the following represents the correct order of the collections cycle? (a) making the contact, reporting, prioritizing, preparation, follow-up (b) prioritizing, preparation, making the contact, follow-up, reporting (c) prioritizing, making the contact, preparation, follow-up, reporting (d) reporting, preparation, making the contact, prioritizing, follow-up 13 . Which one of the following would help reduce the amount of accounts receivable delinquencies? (a) easing the credit approval process (b) know your customers situation (c) refuse to extend payments (d) stop sending reminder letters Question 1: c Question 2: a Question3: a Question 4: d Question 5: a Question 6: d Question 8:d Question 9: c Question 10: b Question 11: d Question12: b Question 13: b

Question 7: c

Receivables Management
Receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business.The purpose of maintaining or investing in receivables is to meet competition, and to increase the sales and profits

The purpose of receivables can be understood if we can grasp the basic objective of receivables management. The objective of receivables management is to promote sales and profits until that point is reached where the returns that the company gets from funding of receivable is less than the cost that the company has to incur in order to fund these receivables. Hence, the purpose of receivables is less than the cost that the company has to incur in order to fund these receivables. Hence, the purpose of receivables is directly connected with the companys objectives of making credit sales, which are: Increasing total sales as, if a company sells goods on credit, it will be in a position to sell more goods than if it insists on immediate cash payment. Increasing profits as a result of increase in sales not only in volume, but also because companies charge a higher margin of profit on credit sales as compared to cash sales. In order to meet increasing competition, the company may have to grant better credit facilities than those offered by its competitors.
So this is the purpose of receivables, now you will agree with me that a firm does incur some cost on receivables, let us discuss the costs. Cost of maintaining Receivables Additional fund requirement for the company: When a firm maintains receivables, some of the firms resources remain blocked in them because there is a time lag between the credit sale to customer and receipt of cash from them as payment. To the extent that the firms resources are blocked in its receivables, it has to arrange additional finance to meet it own obligations toward its creditors andemployees, like payments for purchases, salaries and other production and administrative expenses. Where this additional finances is met from its own resources or from outside, it involves a cost to the firm in terms of interest ( if financed from outside or opportunity costs (if internal resources which could have been put to some other use are taken). Administrative costs: When a company maintains receivables, it has to incur additional administrative expenses in the form of salaries to clerks who maintain records of debtors, expenses on investigating the creditworthiness of debtors etc. Collection costs: These are costs, which the firm has to incur for collection of the amount at the appropriate time from he customers. Defaulting cost: When customers make default in payment not only is the collection effort to be increased but the firm may also have to incur losses from bad debts.

Isnt that quite a lot? So the solutions is easy compare costs with the benefits & go for the best alternative. Management always requires decision-making Now let us decide on what should be the size of receivables? What do you say how to decide on that? The size of receivables or investment in receivables is determined by the firms credit policy and the level of it sales. The following aspects of receivables management are discussed in this lesson: Formulation of credit policy, Credit evaluation. Credit granting decision. Monitoring receivables.

Credit policy
The credit policy of a company can be regarded as a kind of trade-off betweens increased credit sales leading to increased in profit and the cost of having larger amount of cash locked up in the form of receivables and the loss due to the incidence of bad debts. In competitive market, the credit policy adopted by a company is considerably influenced by the practices followed by the industry. A change in the credit policy of a company, say, by extending credit policy of a company, say, by extending credit period to 30 days, when the other companies are following a credit period of 15 days can result in such a high demand for the companys product that it cannot cope with. Further, other companies also may have to fall in line in the long run. It is assumed generally that such factors have already been taken into consideration before making changes in the credit policy of a company. The term credit policy encompasses the policy of a company in respect of the credit standards adopted, the period over which credit is extended to customers, any incentive in the form of cash discount offered, as also the period over which credit is extended to customers, any incentive in the form of cash discount offered, as also the period over which the discount can be utilized by the customers and the collection effort made by the company. This is quite simple isnt it? So let us discuss the variables associated with credit policy. The various variables associated with credit policy are: 1. Credit standards 2. Credit period 3. Cash discount 4. Collection program

All these variables underlying a companys credit policy influence sales, the amount locked up in the form of receivables and some of the receivables turning sour and eventually become bad debts. While the variables of credit policy are related to each other, for the purpose of clarity in understanding, we shall follow what is technically known as comparative static analysis by considering each variable independently, holding some or all other constant, to study the impact of a change in that variable on the companys profit. It is also assumed that the company is making profits and has adequate unutilized capacity to meet the increased sales caused by a change in some variables without incurring additional fixed costs like wage and salaries, rent, etc. We have to make assumptions as you all know very well.

Credit standards
When a company is confronted with the question of the standards to be applied to customers before deciding whether to extend credit or not, application of very stiff standards for the classification of customers to whom credit can be extended and to whom it cannot be extended is likely to result in a low level of sales, less amount of money locked up in the form of receivables, virtually no bad debt losses and less amount to be spent for collection. On the other hand, indiscriminate extension of credit without bothering much about the credit standards expected of the customers is likely to increase sales. But in its wake the company is more likely to be saddled with a large quantum of money locked up in the form of accounts receivable, higher incidence of bad debt losses and increases expenses on the collection front. In the United States, there are excellent professional credit rating agencies such as Dun and Brad Street whose services can be utilized for a consideration. I have later on included in the lecture a detail on How to Make Better Credit Decisions from Dun and Brad Street site. In the Indian situation, no such reputed agencies exist except for credit rating of public issues. Let us assume for the time being (because in the section on credit evaluation we shall consider these aspects) that the company has rated the customers into four

categories ranging from high, good, fair and limited in the descending order of credit rating. Let us also assume that the company has been foregoing sales from fair and limited categories. The company has been contemplating to increase its sales from its existing level by liberalizing or relaxing its credit standard to some extent. What course of action should it take: liberalize or not? The answer to the above question lies in making a comparison of the incremental benefits associated with a liberalized policy and the associated incremental costs. The decision to liberalize will be justified only when the net incremental benefits are positive. Before going into the analysis we have to reckon with the factor that the earlier customers may take a lenient view in their paying habit once they come to know that the lowly rated customers of the company are taking a longer period for payment than what they themselves have been taking to pay. With a view to facilitating the exposition it is assumed that the existing customer will into alter their paying habit even after liberalization of credit by the company (list they be relegated to the lower rated groups) and the company can meet the increase in sales demand without incurring additional fixed cost as stated earlier on. Let us now consider the items of incremental benefits and incremental costs under the simplified assumptions. A numerical illustration will help in understanding the incremental cost benefit analysis. Example The existing sales of Aditi Company are Rs. 2 crores. The current customers are drawn from companies having high or good credit rating. With partially liberalized credit standards the companys sale are likely to go up by Rs. 24 lakhs, the mix of new customers being 67 per cent and 33 percent from the group rated fair and limited respectively. The average collection period is likely to be 45 days and the incidence of bad debt losses 10 percent for the new customers. The contribution to sales ratio for Aditi Company is 20 percent and the cost of funds is 15 percent.

Solution Additional profit from increased sales Contribution = Increase in sales revenues X ----------------Sales revenue 20 = Rs. 24,00,000 X ------- = Rs. 4,80,000 (a) 100 Additional receivables Additional Sales revenue = -------------------------------- X Collection period 360 days 24,00,000 = --------------------------- X 45 days = Rs. 3,00,000 360 Additional investment in receivables Variable cost = Amount of receivables X ----------------Sales revenue 80 = 3,00,000 X ------- = Rs. 2,40,000 100

Cost of financing the additional investment in receivables 15 = Rs. 2,40,000 X ------ = Rs. 36,000..(b) 100 Total amount of bad debt losses = New sales % Bad debt percentage 10 = Rs. 24,00,000 X ---- = Rs. 2,40,000..( c ) 100 We have now calculated the relevant amounts in terms of additional benefits and additional costs. a. Additional profit or new sales = Rs. 4,80,000 Additional Costs : b. Cost of financing additional investment in receivables = Rs. 36,000 c. Amount of bad debt losses on new sales = Rs. 2,40,000 Total of additional costs (b+C) = Rs. 2,76.000 Net additional benefit (a-b-c) = Rs. 2,04,000 Since the net additional benefit is positive being Rs. 2,04,000 liberalization of credit standards is to the advantage of the company and should, therefore, be followed. This requires simple logic. There is nothing to mug up here. The effect of relaxing the credit standard on profit may also be estimated by using the following formula.

p = S (1-V) -kI-bn s Where P = change in profit S = Increase in sales V = variable costs to sales ratio k = cost of capital 1 = Increase in receivables management s = ------- X Average collection period (ACP) X V 360 bn = bad debts loss ratio on new sales Using the above equation to find out the effect of relaxing the credit standards on profit as follows can rework example 1: Let us do example one again. 24,00,000 P = 24,00,000 X 0.2 0.15 X ------------ X 45 360 X 0.8 0.1 X 24,00,000 = 4,80,000 36,000 2,40,000 = Rs. 2,04,000 Credit policy must be clear to you by now, let us move on to credit period. What do you think is credit period? Credit Period

The credit period refers to the length of time allowed to customers to pay for their purchases. It generally various from 15 days to 60 days. If a firm allows, say, 45 days of credit with no discount to induce early payment its credit terms are stated as net 45. Lengthening of the credit period pushes sales up by inducing existing customers to purchase more and attracting additional customers. At the same time it increases the incidence of bad debts loss. A shortening of credit period will tend to lower sales, as customers decrease investment in receivables, and reduce the incidence of bad debt loss. Let us consider the impact of lengthening the credit period by means of an example. Example The Nitin Companys existing sales are Rs. 180 lakhs. It is currently extending a credit period of net 30days to its customers. The company is contemplating to increase it sales by Rs. 16 lakhs to be achieving by means of lengthening the existing period to net 45 days. The bad debt losses on additional sales are expected to be 5 percent. Should the company go in for a policy change or not? To answer the above question we have to consider the incremental benefits and costs associated with the policy change and a favorable decision taken only of the incremental benefits exceed the incremental costs. The calculation procedure is outlined below: Additional profit arising out of new sales Contribution = Amount of additional sales X -------------------Sales 20 = Rs. 16,00,000 X ------- = Rs. 3,20,000 .. (a) 100

As a result of lengthening in the credit period, the existing customers will pay after 45 days, instead of 30 days. Consequently the increase in receivables on existing sales will be 180,00,000 (45 30 ) X Rs.------------------- = Rs. 7,50,000 360 As the increase in receivables is only on existing sales, which have arisen because of lengthening credit period by15 days, the full amount of Rs. 7,50,000 will be regarded as investment in receivables. The amount of receivables arising out of new sales 45 = Amount of new sales X -------360 45 Or Rs. 16,00,000 X ----360 = Rs. 2,00,000 The investment in receivables on new sales Variable cost = Rs. 2,00,000 X ---------------Sales revenue 80 = Rs. 2,00,000 X -----100 = Rs. 1,60,000 The total amount of investment is receivables

= Rs. 7,50,000 + Rs. 1,60,000 = Rs. 9,10,000 The cost of additional investment in receivables 15 = Rs. 9,10,000 X -----100 = Rs. 1,36,500 .(b) The cost of bad debt losses on new sales 15 = Rs. 16,00,000 X -----100 = Rs. 80,000 ( c ) The amount of additional cost associated with increasing credit period = (b) + (c) = Rs. 1,36,500 + Rs. 80,000 or Rs. 2,16,500 The net additional benefit = a-(b+c) = Rs. 3,20,00 Rs. 2,16,500 = Rs. 1,03,500 As the net additional benefit is a positive amount of Rs. 1,03,500 the policy change is beneficial to the company.

The effects of increasing the credit period are similar to that of relaxing credit standards and hence we can also estimate the effect on profit of change in credit period using the same formula. P = S (1 V) - k 1 h n S The components of the formula are same excepting S0 S I = (ACP n ACPo) [-------] + V (ACPn) -------360 360 Where I = increase in investment ACPn = new ACP (after increasing credit period) ACP0 = old ACP V = ratio of variable cost to sales S increase in sales The above examples can be worked out as follows: P = S (1 V) - kI bn S S0 S I = (ACPn ACP 0) [ ------------] + V ( ACPn) ---------360 360 180 16 = (45 30 ) [ -----] + 0.8 X 45 X ------

360 360 = 7.5 + 1.6 = Rs. 9.1 lakhs P = 16 (0.2) 0.15 X 9.1 0.05 X 16 = 3.2 1.365 0.8 = Rs. 1,035 lakhs or Rs. 1,03,500 I think this much is enough for today. We will discuss cash discount and collection programme in my next class. I hope every thing is clear to you.

A. 1. Loans Secured by Receivables. Accounts receivable are amounts owed to a firm by its customers. They are created when trade credit is given to customers and are usually due within thirty to sixty days. a. A firm can pledge its accounts receivable as collateral to obtain short-term financing. b. A lender may advance 70 to 80 percent of the dollar amount of the receivables. 1. Usually, the lender conducts a thorough investigation to determine the quality of the receivables. 2. If a favorable determination is made, the loan is approved. c. When the borrowing firm collects from a customer whose account has been pledged as collateral, it must turn the money over to the lender as partial repayment of the loan. d. An alternative approach is to notify the borrowers credit customers to make their payments directly to the lender. B. Factoring Accounts Receivable. Accounts receivable can be sold to a factoring company, or factor. A factor is a firm that specializes in buying other firms accounts receivable. 1. The factor buys the accounts receivable for less than their face value, but it collects the full dollar amount when each account is due. 2. The factors profit is thus the difference between the face value of the accounts receivable and the amount the factor has paid for them. 3. Even though the firm selling its accounts receivable gets less than face value, it does receive needed cash immediately. 4. Moreover, it has shifted both the task of collecting and the risk of nonpayment to the factor, which now owns the accounts receivable.

. Nature of Credit Policy Credit policy credit standards credit terms collection efforts Investment in receivable

 volume of credit sales collection period Goals of Credit Policy:-Maximisation of sales Vs. incremental profit Marketing tool production and selling costs administration costs bad-debt losses Credit Policy Variables:-Credit standards- Tight or Lenient Credit analysis collection period default rate character capacity condition capital customer categories good accounts bad accounts marginal accounts Credit terms credit period cash discount Credit Evaluation of Customers Credit information financial statements bank references trade references Credit investigation and analysis analysis of credit file financial analysis (Ratio Analysis) Credit limit Collection efforts