Preface
The importance of Working Capital Management, as a field of
study and practice, is being increasingly realized in schools, colleges,
universities, commercial and industrial organizations both in India and
abroad.
Finance is the life blood of a business and every business requires
certain amount of working capital in it to perform day to day activities of the
business. Sufficient amount of working capital is the indicator of the
efficiency and success of its business.
It is a practical subject and learning of it means familiarizing oneself
with many new principles and concepts of working capital. This Study
Material is intended to serve as a Study Material for students of MFC III
Semester Course of Amity University. This Study Material of Working
Capital Management, is student oriented and written in teach yourself
style.
The primary objective of this study material is to facilitate clear
understanding of the subject of Working Capital Management. This
Material contains a wide range of theoretical and practical questions varying
in content, length and complexity. Most of the illustrations and exercise
problems have been taken from the various university examinations. This
material contains a sufficiently large number of illustrations to assist better
grasp and understanding of the subject. For the convenience of the students I
have also included multiple questions and case study in this Study Material
for better understanding of the subject.
I hope that this Material will prove useful to both students and
teachers. The contents of this Study Material are divided into six modules
covering various aspects of the syllabus of MFC and other related courses.
At the end of this Material three assignments have been provided which are
related with the subject matter.
Course Contents:Module I
Module II
Management of Cash
Meaning and Nature of Cash
Motives for holding Cash
Cash Management:- Meaning, features and objectives
Managing Cash Flows and Determining Optimum Cash Balance
Cash Management Models
Role of Cash in Working Capital Cycle
Describe methods of Managing Bank Overdraft
Management of Marketable Securities
Module III
Management of Receivables
Meaning of Receivables, Cost of Maintaining Receivables, Factors
Influencing Size of Receivables, Forecasting the Receivables
Meaning and Objective of Receivables Management
Dimensions of Receivables Management
Formulation and Execution of Credit Policy, Analyse and Evaluate Financial
implications of different Credit Policies
Formulating and Execution of Collection Policy
Factoring and Receivables Management
Module IV
Management of Creditors
Module V
Inventory Management
Meaning, Nature and Purpose of Holding Inventory
Inventory Management:- meaning and objectives
Role of Inventory in Working Capital Cycle
Tools and Techniques of Inventory Management
Module VI
INDEX
S. No.
Chapter No.
1.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
1.1
1.2
1.3
1.3.i
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
1.18
1.19
1.20
1.21
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
1.22
1.23
1.24
1.25
1.26
1.27
1.28
1.29
1.30
1.31
1.32
1.33
1.34
1.35
1.36
Subject
Page No.
11
11
13
15
16
17
17
17
20
22
23
23
25
27
28
31
32
36
36
39
40
41
41
42
43
44
45
46
48
49
50
52
56
58
59
60
62
63
39.
40.
41.
42.
43.
44.
1.37
1.38
1.39
1.40
1.41
Operating cycle
Working capital financing
Advantage of trade credit
Sources of additional working capital
Elements of working capital
End Chapter Quizzes
66
68
69
74
75
80
45.
46.
47.
48.
49.
50.
51.
52.
53.
54.
55.
56.
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
83
83
83
85
87
87
89
90
95
96
98
57.
58.
59.
60.
61.
2.12
2.13
2.14
2.15
Management of cash
Management of current assets
Cash management
Needs for holding cash
Objectives of cash management
Functions of cash management
Factors determining cash management
Factors affecting cash level
Cash forecasting and budget
Estimation of cash receipts and payments
Factors for efficient cash management
Centralized purchases and payments
to suppliers
Cash management control
Management of sundry debtors
Aspects of management of debtors
Optimal cash models
End Chapter Quizzes
62.
63.
64.
65.
66.
67.
68.
69.
70.
71.
3
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Management of receivables
Introduction
Objectives of receivables
Receivable management
Objectives of receivable management
Advantages of receivable management
Steps involved in the mgmt. of receivables
Formulation of credit policy
Handling receivables
End Chapter Quizzes
114
114
115
116
117
118
119
126
127
133
72.
73.
74.
75.
76.
77.
78.
79.
80.
4
4.1
4.2
4.3
4.4
4.5
4.6
4.6.i
4.7
Management of creditors
Management of current liabilities
Current liabilities
Different current liabilities
Test of a companys financial strength
Creditors
Trade credit
Advantages & disadvantages of trade credit
Current liability management
136
136
136
137
140
140
141
144
145
100
103
105
106
107
111
81.
4.8
82.
83.
84.
85.
86.
4.9
4.10
4.11
4.11.i
87.
88.
89.
90.
91.
92.
93.
94.
95.
96.
97.
98.
99.
100.
101.
102.
103.
104.
105.
106.
107.
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
118.
119.
120.
121.
153
5
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
5.14
5.15
Inventory management
Introduction
Characteristics if inventory
Functions of inventory
Purpose of inventory
Types of inventory
Importance of inventory
Need to hold inventory
Inventory management
Objectives of inventory management
Importance of inventory mgmt.
Techniques of inventory mgmt.
Role of inventory in working capital
Economic Order Quantity
Determination of optimum production quantity
Safety stock
End Chapter Quizzes
170
170
171
171
172
174
176
177
178
181
182
183
190
196
200
203
207
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.11.i
6.12
6.13
6.13.i
6.14
6.15
156
159
160
163
167
210
210
211
212
213
214
216
218
221
223
233
234
235
237
239
240
244
251
122.
123.
124.
125.
126.
127.
128.
129.
6.16
253
257
260
261
263
265
267
278
10
MODULE ONE
1. INTRODUCTION:- WORKING CAPITAL
MANAGEMENT
1.1 INTRODUCTION
"Cash is the lifeblood of business" is an often repeated maxim
amongst financial managers. Working capital management refers to the
management of current or short-term assets and short-term liabilities.
Components of short-term assets include inventories, loans and advances,
debtors, investments and cash and bank balances. Short-term liabilities
include creditors, trade advances, borrowings and provisions. The major
emphasis is, however, on short-term assets, since short-term liabilities arise
in the context of short-term assets. It is important that companies minimize
risk by prudent working capital management.
Working capital is one of the most important measure of a companys
financial strength. If the company has sufficient amount of working capital,
it can easily complete or meet out its day to day activities. If however a
company is below cash or there is shortage of cash, it will face a lot of
problems in completing the activities in day to day business and will not be
able to complete the demands of its customers.
Working capital, also known as "WC", is a financial metric which
represents operating liquidity available to a business. Along with fixed assets
such as plant and equipment, working capital is considered a part of
operating capital. It is calculated as current assets minus current liabilities. If
current assets are less than current liabilities, an entity has a working capital
deficiency, also called a working capital deficit. Net working capital is
11
working capital minus cash (which is a current asset) and minus interest
bearing liabilities (i.e. short term debt). It is a derivation of working capital,
that is commonly used in valuation techniques such as DCFs (Discounted
cash flows).
12
13
finished products are supplied to its customers, it is then very important and
difficult to collect payment from the debtors or customers with in a
reasonable time limit. This is the another type of capital known as working
capital which is needed for short term purposes for meeting the day to day
workings. Capital invested for this purpose is used to meet out the daily
expenses, it is invested in short term assets like cash, bank, debtors, short
term securities & stock. The total of the current assets of any organization
may be termed as Gross working capital.
Current Assets Current assets are those assets, which are easily
convertible into cash in the normal functioning of the business. These assets
are convertible into short term that's why these assets are also called as
short-term assets; this period may range from one day to one year. Current
Assets are helpful in meeting day to day requirements of the business.
Without sufficient and adequate amount of Current Assets the business
cannot meet out its day to day activities. The sufficient amount of Current
Assets is an indication of the soundness of the business. Normally the
current assets include cash, debtors receivable and inventory. However the
other Current Assets also include cash at bank, short term investments,
accrued incomes and advance payment towards expenses.
Working capital may be regarded as the life blood of business.
Working capital is of major importance to internal and external analysis
because of its close relationship with the current day-to-day operations of a
business.
Every
business
needs
funds
for
two
purposes.
14
* Short term funds are required for the purchase of raw materials, payment
of wages, and other day-to-day expenses. It is other wise known as revolving
or circulating capital.
It is nothing but the difference between current assets and current
liabilities. i.e. Working Capital = Current Asset Current Liability.
Businesses use capital for construction, renovation, furniture,
software, equipment, or machinery. It is also commonly used to purchase
inventory, or to make payroll. Capital is also used often by businesses to put
a down payment down on a piece of commercial real estate. Working capital
is essential for any business to succeed. It is becoming increasingly
important to have access to more working capital when we need it.
15
16
unprofitable for any business. But out of these two the shortage of WC is
more dangerous for the well being of the firms.
quantitative aspect.
1.5 GROSS WORKING CAPITAL CONCEPT
Companys investment in total current assets signifies the Working
Capital. Amount of current liabilities is not considered and hence not
deducted from total current assets. Gross Working Capital is also known as
Circulating Capital or Current Capital. Bonnevilley and Deway have said
that any fund received which increases the Current Assets can be termed as
Working Capital.
1.6 NET WORKING CAPITAL CONCEPT
Current assets minus current liabilities is known as Working Capital.
When current assets exceed current liabilities a positive Working Capital
17
arises and when current assets are less than current liabilities, negative
Working Capital occurs. Really the Working Capital is the difference
between current assets and current liabilities. Normally the Working Capital
of any concern is invested in stock of raw materials, Stock of semi finished
goods, finished goods, receivables, marketable securities and cash. Capital
invested in all these forms continuously are being converted into cash and
this cash again goes out in the form of other current assets. Thus, it
circulates all the time continuously. If the current assets of a company is
higher than its current liabilities the position of the company from the
Working Capital point of view is considered to be sound and satisfactory if
current assets and current liabilities are equal, It may be concluded that the
company has resorted to short term funds for financing the Working Capital
and long term sources of funds have been used to finance the acquisition of
fixed assets.
18
Net Working Capital:- The Term Net Working Capital refers to the
difference (excess) of Total Current Assets over Total Current Liabilities.
Since both Gross Working Capital and Net Working Capital are
obtained from the data combined in the Balance Sheet, working capital
viewed in either sense denotes the position of Current Asset s(or Net Current
Assets) as at the end of a company's accounting year. An important aspect of
current assets is conventionally considered to be their convertibility into
cash within a single accounting year unlike Fixed Assets which provide the
'production capacity' for the manufacture of Finished Goods for Sale.
19
ii.
iii.
Stock or Inventory of
(a)
(b)
Works in progress
(c)
Finished goods
iv.
advances.
20
v.
vi.
Accrued incomes.
ii.
iii.
iv.
Bank Overdrafts
vii.
21
22
current liabilities, so that the company can reduce the locking up of funds in
Working Capital and can improve the return on capital employed in the
business.
ii.
To manage the firms current assets in such a way that the marginal
return of investment in these assets is not less than the cost of capital
employed to finance of current assets.
23
i. In-time payment of Vendors or Creditors :The payment to the persons from whom purchases made is done with
in due time. It increases the credit of the business and sometimes cash
discount is availed by making payment promptly. It reduces the cost of
production.
ii. Saving of Interest :When there is enough Working Capital in the business, they need not
to take Short Term Bank Loan or Bank Overdraft and therefore the interest
is not paid. This increases the profit of the business. In addition, the
businessmen who makes payment after the due date have to pay interest with
the purchase price. Thus if there is sufficient Working Capital, there will be
saving of interest which will increase the profit of the business.
iii. Distribution of Adequate Dividend :Sometimes, there is a difficulty in making distribution of dividend due
to shortage of Working Capital even if there are enough profits in the
business. But the companies which have sufficient Working Capital are able
to distribute reasonable amount of dividend to their share holders at proper
time.
Due to this whenever the company requires additional capital for future
projects, it is easy to get capital from investors.
iv. Increase in Borrowing Power :Banks provide prompts and sufficient finance to those concerns which
have sufficient Working Capital, because they expect the return of money
gives us loan at proper time. This makes the business successful
continuously. The companies which distribute reasonable dividend at proper
time, have good credit in the market. If such companies issue debentures,
these are purchased by investors promptly.
24
v. Advantage of favourable Opportunities :Some times there is fall in the prices of raw materials in the market. The
companies having sufficient Working Capital can make purchase of raw
materials in large quantities and have much gain on such opportunities.
vi. Ability to Face Business Crisis :In the business there are occasional booms and depressions. At the
time of depression a few companies have to face a crisis due to decrease in
sales and accumulation of stock. At such time, the companies having
sufficient Working Capital are able to face the crisis successfully.
vii. Increase in productivity of Fixed Assets :If there is shortage of Working Capital in a business the productivity
of the Fixed Assets also comes down. Just as a without sufficient Working
Capital. If the amount of working capital is short, the stock of raw material
will also be less.
viii. Increase in Efficiency :Sufficient amount of Working Capital increases the enthusiasm of
management and directors, employees get incentive if salaries are paid to
them at proper time. This increases the efficiency of the business.
1.11
MEASURES
TO
IMPROVE
WORKING
CAPITAL
MANAGEMENT
1. The essence of effective working capital management is proper cash flow
forecasting. This should take into account the impact of unforeseen events,
market cycles, loss of a prime customer, and actions by competitors. The
effect of unforeseen demands on working capital should be factored in.
25
26
Following factors are responsible for determining the working capital :i. Type of Business :Some of the business units require very huge amount of Fixed Capital
but others require very less amount of Working Capital. But mostly in
manufacturing concerns the amount of capital required is of both types, i.e.
Working as well as Fixed.
ii. Size of Business :The amount of Working Capital needed is calculated by determining
the size of the business. If the size of business is large, than amount of
27
Cash Requirement :If in a business, cash payments are continuously made for expenses,
require much amount of cash balance so they require much Working Capital
in the business.
So units like manufacturing concerns require large amount of cash as
payments of wages, material, labour, manufacturing expenses are high.
1.13
MAIN
DIMENSIONS
OF
WORKING
CAPITAL
MANAGEMENT
Working Capital Management is concerned with the management of
current assets and current liabilities properly. The following views indicates
the important and main dimensions of Working Capital Management that
should be followed by every finance manager. He should concentrate on the
28
29
30
31
funds in other words it should plan its cash inflow in such a way that it could
easily cover its cash out flows or else it will fail to meet its obligation in
time.
i. Ratio Analysis :The working capital can be analyzed by computing the following
ratios
i. (a) Current Ratio :
It is also known as Working Capital Ratio. It is calculated as under
Working Capital Ratio or Current Ratio =
Current Assets/Current Liabilities
This ratio clarifies the relationship between current assets and current
liabilities. Generally this ratio should be 2:1 i.e. current assets should be
double than the current liabilities. If this ratio is less, an effort should be
made to improve it, so, that the Working Capital should remain sufficient in
the business and current liabilities may be paid on the due time.
32
i. (b). Liquid RatioIt is also known as Acid Test Ratio or Quick Ratio its formula is as
follows :Liquid Ratio = Liquid Assets/ Current liabilities
This ratio makes clear the relationship between liquid assets and current
liabilities. All the current assets except stock and prepaid expenses are
treated as liquid assets which are converted into cash again and again. It is
necessary to have liquid ratio approximately 1:1 as current liabilities are paid
out of liquid assets only. If liquid assets are less, the efforts should be made
to bring them at the level of current liabilities.
i.(c) Cash Ratio :The Cash ratio can be calculated as follows :Cash Ratio = Cash and Bank Balance/Current Liabilities
A business must have sufficient amount of cash and bank balance also, so
that routine payments can be made. If cash and bank balance is 25% of total
current liabilities, it is worth while because out of payments received from
debtors the payment to creditors will be made. Cash balance is necessary for
the payment of routine expenses and for contingencies.
33
i. (e) Ratio of Net Working Capital to Total Assets :This ratio helps to measure the relationship between Net Working
Capital to Total Assets. It can be calculated as follows:
Ratio of Net Working Capital to Total Assets =
Net Working Capital / Total Assets x 100
i. (f) Ratio of Capital Employed to Net Working Capital :This ratio can be used to compare and analyze the Ratio of Capital
Employed to Net Working Capital. It is helpful in the comparative study of
Capital Employed in the business with Net Working Capital. It can be
calculated as follows :Ratio of Capital Employed to Net Working Capital =
Net Working Capital/Capital Employed x 100
i. (g) Cash to Net Working Capital Ratio :Cash to Net Working Capital Ratio is calculated to judge the position
of cash in comparison to working capital of the company. Higher ratio
shows the better performance of the company and its management. It can be
calculated as follows :-
34
i. (h) Receivables to Net Working Capital Ratio :Receivables to Net Working Capital Ratio is used to check the
position of receivables in comparison to Net Working Capital. It can be
calculated with the help of the following formula :Receivables to Net Working Capital Ratio =
(Receivables / Net Working Capital) * 100
i. (i) Inventory to Net Working Capital Ratio:This ratio can be used to compare the Inventory with Net Working
Capital. This ratio indicates the percentage of Inventory to Net Working
Capital. It can be calculated by using the following formula :Inventory to Net Working Capital =
Inventory / Net Working Capital
i. (j) Current Assets Turnover Ratio :Current Assets Turnover Ratio is used to measure the effective
utilization of Current Assets. It is the ratio between cost of sales or sales and
Current Assets. This ratio is very significant for non-manufacturing concerns
or for concerns using lesser amount of fixed assets. Adequate highlights may
be thrown on the basis of this ratio on the efficiency in the use of Current
Assets or state of over-investment and under-investment in Current Assets. It
may be pointed out that over or under-investment in Current Assets may
indirectly affect the solvency position of the concern also.
This ratio can be calculated as follows :Current Assets Turnover Ratio = Sales or Cost of sales / Current
Assets
35
i. (k) Net Working Capital Turnover Ratio :In order to know the position and utilization of Net Working Capital,
this ratio is calculated by using the following formula :Net Working Capital Turnover Ratio =
Cost of Goods sold or Net Sales / Net Working Capital
This ratio is calculated by dividing the Cost of Goods sold by the Net
Working Capital. Greater the ratio means better the efficiency of the
business.
36
Current Assets
Cash in hand / at bank
Bills Receivable
Sundry Debtors
Short term loans
Investors/ stock
Temporary investment
Prepaid expenses
Accrued incomes
Current Liabilities
Bills Payable
Sundry Creditors
Outstanding expenses
Accrued expenses
Bank Over draft
37
changes in working capital and their implications; otherwise, you may miss
some warning signs that can lead to business failure. The most important
component of working capital is cash, far the most important asset of any
business, particularly a small business. Without it, the business will fail. So
it is of paramount importance for you as the business owner to control all
cash transactions.
be
expected
and
will
the
cash
flow
cover
it?
38
39
40
1.20
FACTORS
REQUIRING
CONSIDERATION
WHILE
1.21
FACTORS
DETERMINING
REQUIREMENTS
Nature of business
Size of business
Production policy
Manufacturing process
Seasonal variations
41
WORKING
CAPITAL
Formulae
Result
Stock
Turnover
(in days)
= x days
Receivables
Ratio
(in days)
Debtors * 365/
Sales
= x days
Payables
Ratio
(in days)
Creditors * 365/
Cost of Sales (or
Purchases)
= x days
= x times
Interpretation
On average, you turn over the value of your entire stock
every x days. You may need to break this down into product
groups for effective stock management.
Obsolete stock, slow moving lines will extend overall stock
turnover days. Faster production, fewer product lines, just
in time ordering will reduce average days.
It take you on average x days to collect monies due to you.
If your official credit terms are 45 day and it takes you 65
days... why ?
One or more large or slow debts can drag out the average
days. Effective debtor management will minimize the days.
On average, you pay your suppliers every x days. If you
negotiate better credit terms this will increase. If you pay
earlier, say, to get a discount this will decline. If you simply
defer paying your suppliers (without agreement) this will
also increase - but your reputation, the quality of service
and any flexibility provided by your suppliers may suffer.
Current Assets are assets that you can readily turn in to
cash or will do so within 12 months in the course of
business. Current Liabilities are amount you are due to pay
within the coming 12 months. For example, 1.5 times
means that you should be able to lay your hands on $1.50
for every $1.00 you owe. Less than 1 times e.g. 0.75
means that you could have liquidity problems and be under
pressure to generate sufficient cash to meet oncoming
42
Quick Ratio
Working
Capital Ratio
Other
working
capital
demands.
Similar to the Current Ratio but takes account of the fact
that it may take time to convert inventory into cash.
A high percentage means that working capital needs are
high relative to your sales.
measures
include
the
following:-
43
could be that the company's sales volumes are decreasing, and as a result, its
accounts receivables number continues to get smaller and smaller.
Working capital also gives investors an idea of the company's
underlying operational efficiency. Money that is tied up in inventory or
money that customers still owe to the company cannot be used to pay off
any of the company's obligations. So, if a company is not operating in the
most efficient manner (slow collection), it will show up as an increase in the
working capital. This can be seen by comparing the working capital from
one period to another; slow collection may signal an underlying problem in
the company's operations.
44
45
If you have insufficient working capital and try to increase sales, you
can easily over-stretch the financial resources of the business. This is called
overtrading. Early warning signs include:
* Pressure on existing cash
* Exceptional cash generating activities e.g. offering high discounts
for early cash payment
* Bank overdraft exceeds authorized limit
* Seeking greater overdrafts or lines of credit
* Part-paying suppliers or other creditors
* Paying bills in cash to secure additional supplies
* Management pre-occupation with surviving rather than managing
* Frequent short-term emergency requests to the bank (to help pay
wages, pending receipt of a cheque).
1.26
IMPACT/HARM
OF
REDUNDANT
OR
EXCESSIVE
WORKING CAPITAL
* Excessive WC means idle funds, which earn no profits for the business,
cannot earn proper rate of return on its investment.
* When there is a redundant WC, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances if theft, waste and losses.
* Excessive WC implies excessive debtors and defective credit policy,
which may cause higher incidences of bad debts.
* It may result into overall inefficiency in the organizations.
* When there is excessive WC relation with banks and other financial
institutions may not be maintained.
* The redundant WC gives rise to speculative transaction.
46
* Due to low rate of return on investments the value of shares may also fall.
* In case of redundant WC there is always a chance of financing long terms
assets from short terms funds, which is very harmful in long run for any
organization.
OPERATING CYCLE
Operating cycle is the time duration required to convert sales, after the
conversion of resources into inventories, into cash. Investment in current
assets such as inventories and debtors is realized during the firm's operating
cycle, which is usually less than a year.
The operating cycle of a manufacturing company involves three
phases: 1. Acquisition of resources such as raw material, labor, power and fuel etc.
2. Manufacture of the product which includes conversion into work-inprogress into finished goods.
3. Sale of the product either for cash or on credit.
These phases affect cash flows because sometimes sale is done on credit and
it takes sometimes to realize.
47
48
49
The three approaches based on the mix of long and short-term mix
are:1. Matching Approach: When the firm follows matching approach (also
known as hedging approach), long term financing will be used to finance
Fixed Assets and permanent Current Assets and short-term financing to
finance temporary or variable Current Assets. The justification for the exact
matching is that, since the purpose of financing is to pay for assets, the
source of financing and the assets should be relinquished simultaneously so
that financing becomes less expensive and inconvenient. However, exact
matching is not possible because of the uncertainty about the expected lives
of assets.
2. Conservative Approach: The financing policy of the firm is said to be a
conservative when it depends more on long-term funds for financing needs.
Under a conservative plan, the firm finances its permanent assets and also a
part of temporary Current Assets with long term financing. In the periods
when the firm has no need for temporary Current Assets, the idle long-term
50
51
52
facilities to ensure better credit discipline and co relation between credit and
production. The Group was headed by Sh. K.B. Chore of RBI and was
named Chore Committee.
Another group headed by Sh. P.R. Nayak (Nayak Committee) was
entrusted the job of looking into the difficulties faced by Small Scale
Industries due to the sophisticated nature of Tandon & Chore Committee
recommendations. His report is applicable to units with credit requirements
of less than Rs.50 lacs.
The recommendations made by Tandon Committee and reinforced by
Chore Committee were implemented in all Banks and Bank Credit became
much more organised. However, the recommendations were perceived as too
strict by the industry and there has been a continuous clamour from the
Industry for movement from mandatory control to a voluntary market related
restraint. With recent liberalisation of economy and reforms in the financial
sector, RBI has given the freedom to the Banks to work out their own norms
for inventory and the earlier norms are now to be taken as guidelines and not
a mandate. In fact, beginning with the slack season credit policy of 1997-98,
RBI has also given full freedom to all the Banks to devise their own method
of assessing the short term credit requirements of their clients and grant lines
of credit accordingly. Most banks, however, continue to be guided by the
principles enunciated in Tandon Committee report.
53
Bank of India till 1994. This control was exercised on the lines suggested by
the recommendations of a study group headed by Shri Prakash Tandon.
The study group headed by Shri Prakash Tandon, the then Chairman
of Punjab National Bank, was constituted by the RBI in July 1974 with
eminent personalities drawn from leading banks, financial institutions and a
wide cross-section of the Industry with a view to study the entire gamut of
Bank's finance for working capital and suggest ways for optimum utilisation
of Bank credit. This was the first elaborate attempt by the central bank to
organise the Bank credit. The report of this group is widely known as
Tandon Committee report. Most banks in India even today continue to look
at the needs of the corporates in the light of methodology recommended by
the Group.
As per the recommendations of Tandon Committee, the corporates
should be discouraged from accumulating too much of stocks of current
assets and should move towards very lean inventories and receivable levels.
The committee even suggested the maximum levels of Raw Material, Stockin-process and Finished Goods which a corporate operating in an industry
should be allowed to accumulate. These levels were termed as inventory and
receivable norms. Depending on the size of credit required, the funding of
these current assets (working capital needs) of the Corporate could be met
by one of the following methods:-
54
term borrowings. This approach was considered suitable only for very small
borrowers i.e. where the requirements of credit were less than Rs.10 lacs.
55
RBI has mandated a certain way of analyzing the balance sheets. The
requirements of this break-up of assets and liabilities differs slightly from
that mandated by the Company Law Board (CLB). The analysis of balance
sheet in CMA data is said to give a more detailed and accurate picture of the
affairs of a corporate. The corporate are required by all banks to analyze
their balance sheet in this specific format called CMA data format and
submit to banks. While most qualified accountants working with the firms
are aware of the method of classification in this format, professional help is
also available in the form of Chartered Accountants, Financial Analysts for
this analysis.
As can be seen above, the basic foundation of all banks' appraisal of
the needs of creditors is the level of current assets. The classification of
assets and balance sheet analysis, therefore, assumes a lot of importance.
RBI has mandated a certain way of analyzing the balance sheets. The
requirements of this break-up of assets and liabilities differs slightly from
that mandated by the Company Law Board (CLB). The analysis of balance
sheet in CMA data is said to give a more detailed and accurate picture of the
affairs of a corporate. The corporate are required by all banks to analyze
their balance sheet in this specific format called CMA data format and
submit to banks. While most qualified accountants working with the firms
are aware of the method of classification in this format, professional help is
also available in the form of Chartered Accountants, Financial Analysts for
this analysis.
56
ii.
iii.
iv.
57
v.
58
59
revenue and hence Return on Capital (or vice versa); see Discounts
and allowances.
Short term financing. Identify the appropriate source of financing,
given the cash conversion cycle: the inventory is ideally financed by
credit granted by the supplier; however, it may be necessary to utilize
a bank loan (or overdraft), or to "convert debtors to cash" through
"factoring".
60
61
Liquidity
2.
Profitability
1) Liquidity
The quantum of Investment in Current Assets has to be made in a
manner that it not only meets the needs of the forecasted sales but also
provides a built in cushion in the form of safety stocks to meet unforeseen
contingencies arising out of factors such as delays in arrival of Raw
Material, sudden spurts in demand etc. Consequently, the investment in
current assets for a given level of forecasted sales will be higher if the
management follows a conservative attitude than when it follows an
aggressive attitude. Thus, a company following a conservative approach is
subject to a lower degree of risk than the one following an aggressive
62
2) Profitability
Once we recognize the fact that the total amount of financial resources
at the disposal of a company is limited and these can be put to alternative
uses, the larger the amount of investment in current assets, the smaller will
be the amount available for investment in other profitable avenues at hand
with the company. A conservative approach in respect of Investment in
Current Assets leaves fewer amounts for other Investments than an
aggressive approach does. Further, since the Current Assets will be more for
a given level of Sales forecast under the conservative approach, the turnover
of Current Assets (calculated as ratio of Net Sales to Current Assets) will be
less than what they would be under the aggressive approach. Even if we
assume the same level of Sales Revenue, operating Profit before Interest and
Tax and Net (Operating) fixed assets, the company following a conservative
policy will have a low percentage of operating profitability as compared to
its counter part following an aggressive approach.
Nature of Business
63
2.
3.
64
4.
goods inventory. For example, if the finished goods have a short span of
'shelf-life' as in the case of cigarettes the finished goods inventory will
constitute a very low percentage of current assets.
In the case of companies the demand for whose finished goods is
seasonal in nature, as in the case of fans, the inventory of finished goods will
constitute a high percentage of total current assets. This is mainly because
from the point of view of the fixed costs to be incurred by the company it
would be more economical to maintain an optimum level of production
throughout the year than by stepping up production operations during the
busy season.
5.
6.
65
being equal, growth Industries require more working capital than those that
are static. The Critical fact however, is that the need for increased working
capital funds does not follow the growth in business activities but precedes
it. Advance planning of working capital, is therefore a continuing necessity
for a growing concern.
2.
3.
The operating cycle which is a continuous process has been shown in the
following figure.
66
Phase 1
2.
Phase 2
In Phase 2 of the cycle, the Inventory is converted into Receivables as
Credit Sales are made to customers. Firms which do not sell on Credit
obviously don't have the Phase 2 of the operating Cycle.
3.
Phase 3
67
The Last Phase i.e. Phase 3 of the Operating Cycle, represents the
stage when Receivables are collected. This phase completes the operating
cycle. Thus, the firm has moved from cash to inventory, to receivables and
to cash again.
Trade Credit
2.
Bank Credit
3.
Commercial Paper
4.
Factoring
TRADE CREDIT
Trade Credit refers to the credit extended by the supplier of goods and
services in the normal course of transaction. According to Trade practices,
cash is not paid immediately for purchases but after an agreed period of
time. Thus, deferral of payment (Trade Credit) represents a source of finance
for Credit Purchases.
There is however, no formal/specific negotiation for Trade Credit. It is
an Informal agreement between the buyer and the seller. There are legal
instruments/acknowledgements of debt which are granted on open account
68
basis. Such Credit appears in the records of the buyer of goods as Sundry
Creditors/Accounts Payable.
69
For example:- If the terms of the credit sales are, say, 45 days net, the
payable amount to the supplier of goods is the same whether paid on the date
of purchase or on the 45th day and therefore, trade credit has no cost, that is
it is cost free. But if the credit terms are, say, 2/15 net 45,implying that the
buyer is entitled to 2% discount for payment made within 15 days when the
entire payment is to be made within 45 days. The trade credit beyond the
discount period (i.e. 15 days) has a cost equal to
Discount
(1-Discount)
360 days
(Credit Period - Discount Period)
To sum up, as the cost of trade credit is generally very high beyond the
discount period, firms should avail of the discount on prompt payment.
Bank Credit
Bank Credit is the primary institutional source of finance for any
organization. In fact, it represents the most important source for financing of
Current Assets. The Working Capital is provided by the banks in 5 ways:1.
Cash Credits/Overdrafts
2.
Loans
3.
Purchase/Discount Bills
70
4.
5.
Cash Credit/Overdrafts
Under Cash credit/ Overdraft form/ arrangement of Bank Finance, the
Bank specifies a pre-determined borrowing/credit Limit. The Borrower can
draw/borrow up to the stipulated Credit/Overdraft Limit. Within the
specified limits, any number of drawls/drawings is possible to the extent of
his requirements periodically. Similarly, repayments can be made whenever
desired during the period. The Interest is determined on the basis of the
running balance/ amount actually utilized by the borrower and not on the
sanctioned limit. However, a minimum (commitment) charge may be
payable on the unutilized balance irrespective of the level of borrowing for
availing of facility. This form of Bank Financing of Working Capital is
highly attractive to the borrowers because:1.
The borrower has the freedom to draw the amount in advance as and
when required while the Interest Liability is only on the amount actually
outstanding.
Loans
Under this arrangement, the entire amount of borrowing is credited to
the current account of the borrower or released in cash. The borrower has to
pay interest on the total amount. The loans are repayable on demand or in
periodic installments. They can also be renewed from time to time. As a
71
Bills Purchased/Discounted
The modus operandi of bill finance as a source of working capital
financing is that a bill arises out of a trade sale-purchase transaction on
credit. The seller of goods draws the goods on the purchaser of goods,
payable on demand on or after a period. On acceptance of the bill by the
purchaser, seller offers it back to the bank for discount/purchase. On
discounting the bill, the bank releases the funds to the seller. The bill is
presented by the bank to the purchaser/accepter of the bill on due date for
payment. The bills can also be rediscounted with the other banks.
Letter of Credit
While the other forms of financing in which banks provide funds as
well as bear risk, letter of credit is an indirect form of working capital
financing and banks assume only the risk, the credit period being provided
by the supplier himself.
The purchaser of goods on credit obtains a letter of credit from a bank.
The bank undertakes the responsibility to make payment to the supplier in
case the buyer fails to meet his obligations. Thus, the modus operandi of
letter of credit is that the supplier sells goods on credit/extends credit
(finance) to the purchaser, the bank gives a guarantee and bears the risk only
in case of default by the purchaser.
COMMERCIAL PAPER
72
2.
7.
Investors get a high return than what they can get from the banking
system.
73
As the CP's are issued at a discount and redeemed at its face value, their
effective pre-tax/interest yield is
Face Value - Net Amount Realized
X
360______
Net Amount Realized
Maturity Period
Where Net Amount Realized = Face Value - Discount - Agent Charges
360
90
23.30%
74
If you have insufficient working capital and try to increase sales, you
can easily over-stretch the financial resources of the business. This is called
overtrading. Early warning signs include:
Pressure on existing cash
Exceptional cash generating activities e.g. offering high discounts
for early cash payment
Bank overdraft exceeds authorized limit
Seeking greater overdrafts or lines of credit
Part-paying suppliers or other creditors
Paying bills in cash to secure additional supplies
Management pre-occupation with surviving rather than managing
Frequent short-term emergency requests to the bank (to help pay
wages, pending receipt of a cheque).
75
76
Business cycles.
Rate at which business grows.
Changes in pricing.
Dividend policy and capacity of earning.
We now know how important working policy is, but what happens to
the business when there isnt sufficient working capital? Immediately
affected will be the fixed assets that wont be able to function properly
because of lack of working capital. There is always the risk of dissolving the
company because it cannot sustain on the lack of working capital. The
credibility of the company will also be affected; all these will just result in
bad losses and like mentioned before the liquidation of the business to cope
with these losses.
PRACTICAL QUESTIONS:Illustration 1:From the following particulars, prepare a funds flow statement for the year
ended 31st March, 2005.
Net profit for the year
64500
10500
Dividend paid
24000
30000
Purchase of machinery
60000
25000
Sale of investments
20000
Payment of loan
16000
77
Sources of funds
Issue of shares
Sale of investments
Funds from investments
Net profit
64500
Rs.
30000
20000
+ depreciation
75000
10500
Uses of funds
Payment of dividend
Purchase of machinery
Payment of loan
Increase in working
capital
125000
Rs.
24000
60000
16000
25000
125000
2600 tons
4 weeks
Processing period
2 weeks
6 weeks
8 weeks
4 weeks
70% of sales
20% of sales
Selling price
Rs. 20000
Solution:-
78
28000
16000
54000
72000
Cash balance
20000
190000
79
28000
162000
MODULE - ONE
END CHAPTER QUIZES
1. The phenomenon of overtrading in working capital is characterized bya. Less amount of cash invested in current assets
b. Over capitalized of the company as compared to volume of sales
c. High amount of cash invested in current assets
d. Both a and c above
3. Which of the following is/are not measure (s) as to curb the situation of
under trading?
a. Changing the capital structure to bring down dept/equity ratio
b. Selling of some fixed assets
c. Hastening the collection process
d. Reducing inventory levels
4. Which of the following items does not figure while calculating finished
goods storage period?
a. Excise duty
80
81
82
MODULE TWO
2. MANAGEMENT OF CASH
2.1 MANAGEMENT OF CURRENT ASSETS
Current Assets play an important role in judging the financial position
and status of the enterprises. Every Company tries to utilize its available
resources in forming the Current Assets also. It includes the following items
effectively
i. Cash Management
ii. Receivable Management
iii. Inventory Management
83
84
85
for which cash is required. So it should be the policy of the business to meet
out its payments well with in due dates.
ii. Speculative Motives A business should decide to maintain cash balance to such extent from
where it can exploit profitable opportunity for the business as and when the
arise for example:- suppose the prices of raw material has decrease 20% than
the business should have adequate amount of cash so that it can avail this
opportunity. Now the business can purchase material in cheaper rates and
sale them at higher prices and will be in a position to gain more & more
profit.
iii. Pre-cautionary Motive It is very important for every business to hold a balance of cash for
meeting the unknown or contingent, needs or liabilities for which the
business cannot forecast but these may happen in any business. For
example:- Loss by fire, strikes by the worker, lock outs etc. So sufficient
amount of cash balance should be maintain as a precaution. This is one of
the important reason for holding cash.
iv. Compensative Motive Apart from the above three objectives of holding cash another motive
called as compensative motive also relates with holding cash. Specially the
bank balance is called as compensative motive. Bank offers a number of
services to its customers for which it compels its customers to leave a
minimum balance in their accounts so that the banker may earn some
interest and can compensate to its clients and providing cost free services.
86
87
interest for gone. Therefore the finance manager will look upon to hold cash
to that point where the business will not loose the opportunity to earn
interest. This is whole understand in Cash Management.
So the function of Cash Management is to give an education how
much cash is required and how balance of cash should be kept in the
business to meet out its requirement. So a cash management system not only
tells the organization about the optimum cash balance but also implements
processes and given procedure to speed up the collection and payment of
cash. The function of an effective cash management & system is to forecast
cash requirements of the business, taking in to account, past record of the
business present situation, and future expectations and seasonal changes in
the business activity.
The main functions of cash management can be discussed as follows:i. Eliminating idle cashOne of the important function of cash management is to tell the
business how it can eliminate the idle cash. Idle cash is that amount of cash
which is presently not required in the business but is available with the
business as it is not required at present and also not providing any benefit to
the business. So it called as idle cash. The
main
function
of
Cash
Management is to tell how we can eliminate this idle cash. To find out the
amount of idle cash which is required to forecast the amount of cash needed
to meet cash requirements in future. The finance manager must minimize
cash balance in the balance sheet to prepare and present a successful
working capital programme.
ii. Facilitating Payments
88
iii. Depositing Collections The funds on amount in hand is always better to have bills receivable
because cash is always convertible immediately but bills receivables are
convertible after the expiry of certain time limit so cash is easier to convert.
So we can complete our transaction quickly with cash in comparison to bills
receivable when funds are due from the bills receivables or from investments
they should be converted into cash immediately to meet out the requirements
of the cash.
89
which can be easily convertible into cash, the amount of cash hold can be
reduced. But business must have as much as required to meet out unexpected
transactions and contingencies when they occur and to meet out daily needs.
Different types of businesses will have different policies on the amount of
cash which should be held.
ii. Collection Policy If the collection policy adopted by the business is effective and
impressive, the business will receive cash from time to time on a regular
basis and the amount of bad debts will be reduced. So there will be less
requirement for holding the cash on the other hand if the collection policy is
not effective and business not able to receive the dues from customers on the
regular basis then heavy amount of cash balance will be required.
iii. Production Process If production process is lengthy then higher amount of cash balance
will be required to meet out its expenses but when the production process of
90
short nature and consumes less time then lower cash balance will be
sufficient.
iv. Production Policy If the production policy of the business is to produced according to the
present demand and quantity of raw materials to be purchased according to
present demand, the business has to maintain lower amount of cash.
v. Terms of Sale and Purchase If the business gets raw materials at easy terms and conditions and
also able to sell finished goods either for cash or on credit for shorter
duration then less amount of cash will be required.
vi. Nature of the Business
Some businesses such as public utilities for example Water supply
companies, Gas companies, Railways, Electricity Companies, Road &
Transport companies, Communication department may have sufficient cash
in flows. This will enable to hold lower cash balances but if the business is
seasonal then the business have to maintain higher amount of cash balance.
vii. Availability of Opportunities
When it is expected to receive profitable opportunity it may not be
wise to hold a large cash balance but if opportunities are not good then
suitable amount of cash balance is required.
91
PRACTICAL QUESTIONS:ILLUSTRATION:- 1
From the following information, prepare a Cash Budget for the period of
January to April:
Months
Cash sales
Rs.
January
60,000
45,000
February
50,000
72000
March
70,000
60,000
April
60,000
56,000
In January a machine will be purchased for Rs. 40000; Wages will be paid
Rs. 18000 every month; Cash balance expected on Ist January Rs. 10000 it
has been decided by the management that:
(a)
In case of deficit upto Rs. 10000 arrangement can be made with the
bank.
(b)
In case of deficit exceeding Rs. 10000 but upto Rs. 50000 debentures
will be issued in multiples of Rs. 10000.
92
(c)
Solution:Opening Balance
Salaes for 4 months
Total
Rs.
10000
2,40000
250000
233000
40000
72000 345000
Deficit
95000
As deficit is more than Rs. 50000shares will be issued for Rs. 1,00,000
which is multiple of Rs. 20,000.
Cash budget (for 4 months ended April 20)
Months
Jan.
Feb.
Mar.
Cash balance Rs.
Rs.
Rs.
opening
10000
67000
27000
Receipts
Issue of
1,00000
_
_
shares
Cash sales
60000
50000
70000
Total
1700000
117000
97000
Payments
Purchases of 40000
_
_
machine
Cash
45000
72000
60000
purchases
Payment of
18000
18000
18000
wages
Total
103000
90000
78000
Cash balance 67000
27000
19000
closing
93
Apr.
Rs.
19000
_
60000
79000
_
56000
18000
74000
5000
Illustration 2:From the following forecast, prepare a cash budget for three months
commencing from Ist June cash balance on Ist June was Rs. 50000:
Months
Sales
Purchases
Wages
Expenses
Rs.
Rs.
Rs.
Rs.
April
80000
41000
6000
12000
May
75000
45000
5000
15000
June
78000
40000
6000
18000
July
90000
37000
5000
20000
August
85000
35000
5000
18000
1.
2.
3.
4.
5.
Solution:-
Months
Cash balance
opening
Receipts
Collection from
debtors
Total
Payments
Payments to
creditors
Payment of
wages
Payment of
expenses
Purchase of
Cash budget
(for three months ending on August 20)
June
July
August
Rs.
Rs.
Rs.
50000
61000
56000
80000
75000
78000
130000
136000
134000
45000
40000
37000
6000
5000
5000
18000
20000
18000
94
65000
machine
Pay of dividend
Total
Cash balance
closing
69000
61000
15000
80000
56000
125000
9000
Illustration 3:If a firms annual expenses are Rs. 60 Lakhs and period of cash cycle is 25
days. The firm maintains cash ratio of 10% of working capital. If working
days in a year are taken as 300, then how much of cash balance will be
required?
Working capital required = Cash expenses per annum / Cash turnover period
= 60 Lakhs / 12
= Rs. 5 Lakhs
Cash balance required = 10% of 5.0 Lakhs
= Rs. 0.5 Lakhs
Or Rs. 50000.
95
of better monitoring and control, however the year is divided into quarters,
quarters into months and months into weeks. Under critical conditions a
week is further divided into days.
Basis of Estimation
Sales Forecast. The proportion of Cash Sales and
Credit Sales are based on averages of recent past.
Proceeds from sale of Based on the past proportion of these items to sales
scrap and/or byproducts
Receipts of Interest Based on Company's Investment Portfolio and the
and Dividends
returns expected.
96
Wages and Salary Based on the Payroll Accounts of the Previous Year
Payments
with suitable adjustments, manning pattern and the
structure of Wages and salaries along with prerequisites.
Payments for other Based on the production Plan and the Past
Manufacturing
experiences
Expenses
Payments for Selling Based on the Sales Promotion Plans, Distribution
&
Distribution Costs, and Salary Structure of the personnel in the
expense
Marketing Dep't. ,
Interest Payment and Based on the existing structure of Fixed Return
Repayment of Loans Bearing Securities and the Financing Plan.
Payment
Dividends
Payments for the Based on the capital expenditure budget and the
purchase of Capital payment pattern.
Assets
Lease Rentals
Taxes
97
an idea of cash by scrutinizing the pattern and the amount of Inflows and
outflows to see whether some of the items of outflows can either be
advanced or postponed so that the outflows are not clustered during certain
months.
This is possible only with discretionary payments, such as, payment
for the purchase of capital equipment, non-recurring items of outflows for
Research and Development activities etc. While these are important, no
significant impact on the profitability of the company is likely to be felt if
these items of Cash outflows are differed by a couple of Months.
In the case of an organization it was observed that the time lag was as
high as one week. Subsequently scrutiny revealed that the reason for the
98
delay was the practice of preparing bills and mailing them in 'bunches'. As a
result the bills on the earlier sales got delayed resulting in late realization.
Once the reason for the delay was identified, corrective measures were taken
to prevent the accumulation of the bills. This reduced the delay in
remittances. Thus accelerating the process of preparing and mailing bills will
help reduce the delay in remittances and early realization of Cash.
Illustration
An organization having branches in all districts of California had been
selling fertilizers to a great extent by a vast network of consignees receiving
a margin for the services rendered. Quite often the consignees would make
remittances to the head office in Los Angeles resulting in delays in Cash
realization. An in-depth study revealed that the delays could be considerably
reduced by adopting the following procedure:The consignee should be asked to prepare the Invoice on Credit Sales
which would cut-short the work of raising separate bills
Non-Operating Collection accounts had to be opened in the district
level branches of the head office bank into which the checks and cash
from sales are to be deposited by the consignees, under advice to the
branch Manager. The amounts so deposited are to be transferred to the
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2.11
CENTRALIZED
PURCHASES
AND
PAYMENTS
TO
SUPPLIERS
The company can gain some advantages, as listed below, when purchases
and payments to suppliers are centralized at the head office:
By the sheer size of purchases there is scope to obtain bulk purchase
discounts on certain items which will effectively reduce the cost
As Cash Receipts get consolidated at the Head Office, the
disbursement schedule can be more effectively implemented. As far as
possible, the company can make arrangements with suppliers so that
the payment schedule matches with the schedule of the Cash Receipts.
As far as possible, the cash receipts on purchases can be utilized,
preferable by remitting checks on the last day for utilizing such
facility. This will release the Cash within the Discount Period and the
company can also avoid the implicit rate of Interest underlying the
failure to avail Cash Discount, as this rate will be considerably high.
Under the centralized purchase system, arrangements can be made
with the suppliers for direct shipment of materials to the Company's
units located at different parts. This will reduce to some extent the
total Cost of Transportation, Handling and Storage.
100
A company never keeps all the cash in its current account for the simple
reason that the opportunity cash of Idle Cash is very high. That is why,
companies try to maintain, besides cash, other liquid assets which provide
some return but at the same time can be converted into cash within a
reasonably short time with relatively low risk.
The various forms of Liquidity in which a firm can keep its cash are:Forms of Liquidity
1.
2.
Arrangement
This form of Liquidity appears to be quite attractive as it can have
access to bank borrowing. However, constraints imposed by the Banking
Sector made it much less attractive than what it once used to be. Close
scrutiny of the quarterly budgets of the companies by banks and imposition
of penal Interest of 2 per cent over and above the normal rate of Interest on
under- or over-utilization makes 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.
101
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 years.
3.
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 period of excessive 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.
4.
short-term deposits ranging from two to three months to five or six month at
remunerative rates. However, these deposits being unsecured in Nature are
subject to considerable risk, unless the companies accepting such deposits
have excellent antecedents to their paying habits.
102
b)
Reduce the time during which payments received by the firm remain
Concentration Banking
2.
Lock-Box System
1.
Concentration Banking
In Concentration Banking, the company establishes a number of
103
2.
Lock-Box System
Another means to accelerate the flow of the funds is a lock-box
Under this arrangement, the company rents the local post office box
and authorizes its bank at each of the locations to pick up remittances in the
boxes. Customers are billed with instructions to mail their remittances in the
lock boxes. The bank picks up the mail several times a day and deposits the
checks in the company's account. The checks may be micro-filmed for
record purposes and cleared for collection. The company receives a deposit
slip and lists all the payments together with any other material in the
envelope. This procedure frees the company from handling and depositing
the checks. The main advantage of the lock-box system is that the checks are
deposited with the banks and get collected sooner than if they were
processed by the company prior to its deposit. In other words, the lag
between the time checks are received by the company and the time they are
actually deposited in the bank is reduced.
104
105
trade-off between the profits on additional sales that arise due to the credit
being extended on one hand and the cost of carrying those debtors' bad debt
losses on the other.
b)
up the Debtors and decide about a suitable Credit Policy. It involves both
laying down the credit policies and the cost of execution of such policies.
remain blocked in them because there is a time lag between the Credit sale
to customer and the receipt of Cash form them as Payment. To the extent
that the firms resources are blocked in its receivables it has to arrange
additional finance to meet its own obligations towards its creditors and
employees, like payments for purchases, salaries and other production and
administrative expenses. Whether this additional finance is met form its own
resources or from outside, it involves a cost to the firm in terms of Interest
(if financed from outside) or the opportunity costs (If Internal resources,
they could have been put to some other use).
106
2.
Administrative Cost
When a company maintains its receivables, it has to incur additional
3.
Collection Costs
These are the costs which the firm has to incur for collection of
4.
Defaulting Costs
When the customers make default in payment, not only is the
collection effort to be increased but the firm may also have to suffer losses
from the bad debts.
Inventory Model
2.
Stochastic Model
107
Inventory Model
If the future cash flows are known with certainty, the EOQ model
(used in Inventory Management) is one of the simplest models for
determining the optimal average amount of transaction cash. Here, in this
model, the opportunity (carrying) cost of holding cash is balanced against
the fixed costs associated with securities transactions to arrive at an optimal
balance.
By using the EOQ formula, the firm attempts to determine the funds
transfer size that will minimize the total cash costs, i.e. total transaction cost
and the total carrying (opportunity) costs.
108
opportunity cost [I (C/2)]. Balancing the two costs can minimize the total
costs. The optimal level of cash can be determined using the underlying
equation:
C= 2FT / I
Stochastic Models
Since the EOQ Model assumes a constant demand for Cash, this
Inventory model becomes inappropriate when the cash flows of the firms are
relatively or reasonably unpredictable, and some other models must be
applied to determine the optimal cash balances. If the cash balances fluctuate
randomly, we can apply control theory to the problem. To apply, assume that
the cash flows are stochastic and random, and then set control limits such
that when the cash balance touches the upper bound, a conversion of cash
into marketable securities is undertaken and when it approaches the lower
bound, a transfer from Marketable securities to cash is activated. And, no
transactions take place as the cash balance remains within these bounds.
Here, the question is how to fix these boundaries such that they should
depend upon both the fixed costs of a transaction and the opportunity cost of
holding cash. For determining these limits, the Miller-Orr Model is used.
This model specifies two bounds- h dollars as an upper bound and zero
dollars as a lower bound.
When the cash balances hit the lower bound (zero dollars), z dollars of
marketable securities are transferred to cash, and the new balance again
109
becomes z dollars. And, as long as the cash balance stays within the bounds,
no transaction is undertaken.
Miller-Orr Model reduces the total fixed transaction cost and the total
opportunity cost by setting these bounds. However, the average Cash
Balance recommended by the Control limit models will be higher than that
of the EOQ model, as these models assume that the cash flows are stochastic
and unpredictable.
110
MODULE TWO
END CHAPTER QUIZES
1. Which of the following investments have no default risk?
a. Inter corporate deposits
b. Treasury Bills
c. Commercial papers
d. money market mutual funds
4. Which of the following is not a motive for holding cash:a. Transaction purposes
b. Precaution against unexpected expenses
c. Extending loans to group companies
111
d. speculation purposes
5. Which of the following is not the motive for the companies to hold cash?
a. Transaction motive
b. Precautionary motive
c. Speculative motive
d. Capital investments
6. Cheques that have been deposited may not be immediately available for
use due to
a. collection float
b. payment float
c. Net float
d. Deposit float
112
113
MODULE THREE
3. MANAGEMENT OF RECEIVABLES
3.1 INTRODUCTION
Accounts receivables play an important role in constituting Current
Assets. Receivables are the direct consequences or result of credit sale.
Credit sales is an important part of a business, without it no business can
survive. Every individual customer is not willing to purchase goods in cash.
If a business has a policy of selling goods in cash only, it will not be
possible to attract the customers, so the credit sale has become very essential
and effective tool of marketing in this modern business.
When a business sells goods for cash, the business receives the
payment immediately and therefore receivables are not generated. However
when a firm sells goods or services on credit, the payments are delayed for
some times and receivables are created. Usually the credit sales are made on
open account which means that no formal acknowledgement of debt
obligations are taken from the buyers. The only documents evidencing are a
purchase order, shipping invoice or even a billing statement. The policy of
open account sales facilitates the business transactions and reduces to a great
extent the paper work required in credit sales. If a business concern sells its
goods or services only for cash so only those customers will purchase the
goods who are capable of purchasing goods for cash.
So the other customers will not purchase from the business who want
to purchase at present but interested in making payments in future. Most of
the retail traders purchase goods on credit and would like to pay after some
time. So credit sales have become an important requirement today. Credit
114
115
The present age is the age of competition various types of schemes are
applied by the business to increase its sale. To sell goods on credit and
allowing trade discount is one of the schemes. Today the other business units
are selling goods on credit, so we have to also sell our goods on credit in
order to face competition.
iii. To attract the customersIn todays environment we can only attract the public by selling goods
on credit and allowing them a reasonable period for payment.
iv. To increase the profitCredit sales always increases the total sales and decreases the cost of
production, as a result the profit of the business increases. In addition to its
cash sales is made at cheaper rate due to discount, while higher prices and
received from credit sales due to not allowing discount, which is help full in
increasing the profit.
116
The financial manager has to follow a policy which uses cash fund as
economically as possible in extending receivables without adversely
affecting the chances of increasing sales and making more profits.
Management of accounts receivable may, therefore, be defined as the
process of making decisions relating to the investment of funds in the assets
which will result in maximizing the overall return on the investment of the
firm.
117
ii.
iii.
iv.
v.
current obligations.
vi.
facilities.
vii.
x.
xi.
xii.
xv.
To minimize the cost and risk involved in trade credit planning and
control.
xvi.
3.5
ADVANTAGES
OR
BENEFITS
OF
RECEIVABLE
MANAGEMENT
The main advantages or benefits of receivable management can be
enumerated as follows :-
118
i.
Credit sales helps to attract the existing customers but also to new
iv.
v.
vi.
ii.
iv.
receivables accounts?
The following steps are involved in considering the preceding matters
in the case of receivable management:i. Credit analysis
ii. Credit standards
119
i-(a)- Collection of information about the customersBoth financial as well as qualitative type of information are needed
relating to customers. There are various sources of information available to
the enterprise to help in assessing the financial health of a customer.
(a)- Financial statementsThese are published accounts containing the Profit and Loss Account
and Balance Sheet. In the case of corporate bodies, these accounts are
available for public inspection and provide useful information.
(b)- Trade Reference-
120
(d)- Market ReportsRelevant and valuable information can also be collected from the
market reports. Such reports are prepared in such a way that they contain
meaningful data relating to the financial position and repaying ability as well
as willingness to pay in respect of several customers.
(e)- Own experience of the concernThe enterprise may use its own experience in collecting information
about the potential customers.
(f)- Other sources like Trade AssociationsCommercial Trade Directories, Public Documents etc. may also be
used for collecting information about the customers.
121
ii. Credit StandardsAn important component of credit policy is well defined credit
standards. Such credit standards provide a base of for deciding whether to
grant credit to a customer or not. Credit standards may be defined and
explained in both conservatives or strict manner and aggressive or liberal
manner. In the case of strict credit standards, credit facility is not granted to
each and every customer. Enterprise, which do not like to take risk, usually
follow strict standards. Alternatively, an enterprise may be very aggressive
in taking the risks and they may follow a very liberal credit standards. But
due to increased level of investment in receivables costs in terms of bad
debts, collection expenses and administrative expenses also rise.
Thus, profit arising due to additional sales must be compared with
possible rise in costs associated with additional investments in receivables
whenever a decision to liberalize the credit standards is being taken. So far
122
as the profitability is more than the added cost, the enterprise can lower
down i.e., liberalize the credit standards. The liberalized credit standards will
affect :
123
iii-(a)- Credit periodCredit period is the time for which an enterprise allows its customers
not to pay their bills. It is length of credit period by the end of which
enterprise expects that the customers would pay their bills. The extension of
credit period also means more investment in receivables. It also increase
credit period also means more investment in receivable. It also increase the
average collection period and losses due to bad debts.
iii-(b)- Cash DiscountAn enterprise may decide to offer a cash discount in order to encourage
prompt payment from its customers, particularly when it finds itself short of
cash resources and is facing liquidity problem. Cash discount offer does not
affect the demand because it does not amount to reduction in price. Cash
discount offer is only a mechanism. Through which some benefit is given to
those customers who are ready to pay early.
The policy of Cash discount would result in to loss of revenue to
enterprise. However average collection period becomes due to quick
124
iii-(c)- Cash Discount Period A Cash Discount Period is the time period allowed to the debtors in
which the debtors are encouraged to pay their dues and to avail the cash
discount It is with in the time period of net credit days.
iv-(a)- Types of collection efforts Some efforts are to be taken to collect payment from those customers
who do not pay within the time given. A good collection policy should
always imply clear instruction regarding the steps and efforts to be taken.
Such efforts may include dunning letters, telephone, personal visit, help
from collecting agencies and ultimately legal action.
iv-(b)- Degree of collection effortsDegree of Collection efforts in one sense refers to the policy which is
being adopted in pursuing credit policy i.e. whether conservative or
aggressive. What is needed is to maintain a balance between two types of
effect.
125
v. Control and MonitoringOnce the business concern has set credit standards, credit terms and
collection policies etc. It is important for the financial manager to control
and monitor the effectiveness of the collection for this purpose some targets
in terms of average collection period as well as ratios of bad debts to sales
may be set up by the finance manager and he may monitor the receivables
particularly the debtors with reference to there ratios.
126
amount of investment in receivables is very less under this policy and bad
debts are also less.
Have the right mental attitude to the control of credit and make sure
that it gets the priority it deserves.
2.
3.
127
4.
5.
Check out each customer thoroughly before you offer credit. Use
credit agencies, bank references, industry sources etc.
6.
7.
Continuously review these limits when you suspect tough times are
coming or if operating in a volatile sector.
8.
9.
10.
11.
12.
Monitor your debtor balances and ageing schedules, and don't let any
debts get too large or too old.
Recognize that the longer someone owes you, the greater the chance you
will never get paid. If the average age of your debtors is getting longer, or is
already very long, you may need to look for the following possible defects:
weak credit judgement
poor collection procedures
lax enforcement of credit terms
slow issue of invoices or statements
errors in invoices or statements
customer dissatisfaction.
Debtors due over 90 days (unless within agreed credit terms) should
generally demand immediate attention. Look for the warning signs of a
future bad debt. For example:longer credit terms taken with approval, particularly for smaller orders
128
The act of collecting money is one which most people dislike for many
reasons and therefore put on the long finger because they convince
themselves there is something more urgent or important that demand their
attention now. There is nothing more important than getting paid for
your product or service. A customer who does not pay is not a customer.
Here are a few ideas that may help you in collecting money from debtors:
Develop appropriate procedures for handling late payments.
Track and pursue late payers.
Get external help if your own efforts fail.
Don't feel guilty asking for money.... its yours and you are entitled to
it.
Make that call now. And keep asking until you get some satisfaction.
In difficult circumstances, take what you can now and agree terms for
the remainder. It lessens the problem.
When asking for your money, be hard on the issue - but soft on the
person. Don't give the debtor any excuses for not paying.
Make it your objective is to get the money - not to score points or get
even.
129
PRACTICAL QUESTIONS:Illustration 1:
Prakash Ltd. sells goods to its customers of A, B and C categories and
its current sales is Rs. 10,00,000 per year. If sale is made to customer of D
category for 1.5 months credit, additional sales of Rs. 10,00,000 per year can
be made. In such a case 10% bad debtors are expected. The company earns
the contribution of 15% on the sales and collection cost is expected at 4%.if
its cost of capital is 10%, should it make sales to customers of D category?
Solution:
Rs.
150000
1,00,000
50000
40000
10000
Illustration 2:
Ashoka Ltd. provides credit to its customers for 30 days. Its present
sales is Rs. 1000000 per year. The cost of capital of the company is 10% and
variable cost is 80%of sales. Company is considering to extend credit period
to 60 days, this will increase the sales by Rs. 500000 per year. The bad debt
on additional sales is expected at 8% will be fair to extend the credit period?
Solution:
Contribution on additional sales:
130
Rs.
100-80=20%on Rs.500000
Less bad debts 8% of Rs. 500000
100000
40000
60000
Balance
Less cost of capital on additional investment:
Additional investment in present sales10,00,000*80/100*30/360=Rs. 66,667
Additional investment in additional sales500000*80/100*60*360=Rs. 66667
Cost of capital=10/100(66667+66667)=
Additional profit
13333
466667
Illustration 3:
From the following data ascertain the average collection period of Jai
Prakash and brothers:
Rs.
800000
60000
10000
86000
Bills receivables
44000
6500
Solution:
Annual credit sales =Total annual sales Cash sales sales return
=800000-60000-10000=730000
Average collection period = Debtors + B/R/Annual credit sales *365
= 86000+44000/730000*365
=130000/730000*365=65 Days
Illustration 4:
Calculate average collection period of a firm :
Receivables on 1-1-2005
Rs.
45000
131
Receivables on 31-12-2005
51000
438000
Solution:
Average receivables
Illustration 5:
The debtors of the company were Rs. 180000,Rs. 21000 and Rs.
230000 Respectively on 31st March, 2003,2004 and 2005. the sales during
2003-2004was Rs. 980000 and 2004-05 Rs. 1010000. You are required to
calculate receivables turnover for two years and comment.
Solution:
Average receivables for 2003-04 =180000+210000/2 =Rs. 195000
Average receivables for 2004-05 =210000+230000/2 = Rs. 220000
Receivables turnover for 2003-04 =980000/195000=5.0 times
2004-03 =1010000/220000=4.6 times
132
MODULE THREE
END CHAPTER QUIZES
1. Which of the following costs is not associated with the extention of credit
and accounts receivables?
a. Cost of investments tied up in accounts receivables
b. collection cost
c. Cost of measure initiated to collect blocked finds beyond expiry dates
d. all are associated
2. Which of the following is not a cost linked with maintaining receivables:a. Cost of funds
b. Discount costs
c. Collection costs
d. None of the above
4. Which of the following is not used for credit evaluation:a. Ratio analysis
b. Bank references
c. Past experiences with the customers
133
134
10. Ignoring the time value of money, how much does a firm lose on a
rupees 1000 sale that has a 25% profit margin if the 20% probability default
occurs?
a. Rs. 150
b. Rs. 600
c. Rs. 650
d. Rs. 750
135
MODULE FOUR
4. MANAGEMENT OF CREDITORS
136
137
138
the amount of notes payable on the balance sheet (if they aren't classified
under 'notes payable', combine the company's short term obligations and
long term current debt). If the amount of cash and cash equivalents is much
larger than the notes payable, you shouldn't have any reason to be
concerned.
If, on the other hand, the notes payable has a higher value than the
cash, short term investments, and accounts receivable combined, you should
be seriously concerned. Unless the company operates in a business where
inventory can quickly be turned into cash, this is a serious sign of financial
weakness.
Other Current Liabilities
Depending on the company, you will see various other current
liabilities listed. Sometimes they will be lumped together under the title
"other current liabilities." Normally, you can find a detailed listing of what
these "other" liabilities are buried somewhere in the annual report or 10k.
Often, you can figure out the meaning of the entry by its name. If a business
lists "Commercial Paper" or "Bonds Payable" as a current liability, you can
be fairly confident the amount listed is what will be paid out to the
company's bond holders in the short term.
Consumer Deposits Are Liabilities to Banks
If you are looking at the balance sheet of a bank, you will want to pay
close attention to an entry under the current liabilities called "Consumer
Deposits". Often, they will be will lumped under other current liabilities.
This is the amount that customers have deposited in the bank. Since,
theoretically, all of the account holders could withdrawal all of their funds at
the same time, the bank must list the deposits as a current liability.
139
4.5 CREDITORS
A creditor is a party (e.g. person, organization, company, or
government) that has a claim to the services of a second party. It is a person
or institution to whom money is owed. The first party, in general, has
provided some property or service to the second party under the assumption
(usually enforced by contract) that the second party will return an equivalent
property or service. The second party is frequently called a debtor or
borrower. The first party is the creditor, which is the lender of property,
service or money.
The term creditor is frequently used in the financial world, especially
in reference to short term loans, long term bonds, and mortgage loans. In
law, a person who has a money judgment entered in their favor by a court is
called a judgment creditor.
140
The term creditor derives from the notion of credit. In modern America,
credit refers to a rating which indicates the likelihood a borrower will pay
back his or her loan. In earlier times, credit also referred to reputation or
trustworthiness.
141
142
143
1.
2.
By tracking who pays, and when, the distributor can see potential
problems developing and take steps to reduce or increase the allowed
amount of trade credit he extends to prospering or faltering businesses. This
limits the exposure to losses from customers going bankrupt who would
never pay for the ice cream delivered.
but
has
good
idea
about
starting
new
business.
2. Trade credit with improve the cash flows and therefore provide smoother
operation for the business.
3. Businesses can buy now and pay later which means even if they don't
have the money at first they can purchase items, sell them as a business and
then make the payments at the end of the month when the products have
been sold and a profit has been made.
144
145
The time from the purchase of raw materials until the firm
mails the payment.
Payment float time (the time it takes after the firm mails its
payment until the supplier has withdrawn spendable funds from the firms
account
Therefore, the firm should analyze credit terms to determine its best
credit strategy.
If a cash discount is offered, the firm has two optionsto take the
cash discount or to give it up.
146
% Discount
365
100% - % Discount Credit Period - Discount Period
Cost
2%
365
100% - 2% 30 10
37.24%
147
The preceding example suggest that the firm should take the cash discount
as long as it can borrow from other sources for less than 37.24%. Because
nearly all firms can borrow for less than this (even using credit cards!) they
should always take the terms 2/10 net 30.
Accruals are liabilities for services received for which payment has
yet to be made.
The most common items accrued by a firm are wages and taxes.
Accruals are liabilities for services received for which payment has
yet to be made.
The most common items accrued by a firm are wages and taxes.
148
The major type of loan made by banks to businesses is the shortterm, self-liquidating loans which are intended to carry firms through
seasonal peaks in financing needs.
As receivables and inventories are converted into cash, the loans are
then retired.
149
150
Although it may reduce the loss in the case of default, from the
viewpoint of lenders, collateral does not reduce the riskiness of default on
a loan.
151
152
153
The period of time which elapses between the point at which cash begins
to be expended on the production of a product and the collection of cash
from a customer.
The diagram below illustrates the working capital cycle for a manufacturing
firm:-
The upper portion of the diagram above shows in a simplified form the chain
of events in a manufacturing firm. Each of the boxes in the upper part of the
diagram can be seen as a tank through which funds flow. These tanks, which
are concerned with day-to-day activities, have funds constantly flowing into
and out of them.
The chain starts with the firm buying raw materials on credit.
In due course this stock will be used in production, work will be carried out
on the stock, and it will become part of the firms work in progress (WIP)
154
Work will continue on the WIP until it eventually emerges as the finished
product
As production progresses, labour costs and overheads will need to be met
Of course at some stage trade creditors will need to be paid
When the finished goods are sold on credit, debtors are increased
They will eventually pay, so that cash will be injected into the firm
Each of the areas stocks (raw materials, work in progress and finished
goods), trade debtors, cash (positive or negative) and trade creditors can be
viewed as tanks into and from which funds flow.
Working capital is clearly not the only aspect of a business that affects
the amount of cash: The business will have to make payments to government for taxation
Fixed assets will be purchased and sold
Lessors of fixed assets will be paid their rent
Shareholders (existing or new) may provide new funds in the form of cash
Some shares may be redeemed for cash
Dividends may be paid
Long-term loan creditors (existing or new) may provide loan finance, loans
will need to be repaid from time to time, and
Interest obligations will have to be met by the business.
Unlike movements in the working capital items, most of these non-working
capital cash transactions are not everyday events. Some of them are annual
events (e.g. tax payments, lease payments, dividends, interest and, possibly,
fixed asset purchases and sales). Others (e.g. new equity and loan finance
and redemption of old equity and loan finance) would typically be rarer
events.
155
The role of trade creditors in the working capital cycle is very important as
they put a huge impact on the amount of working capital, which will be
available for the business. As the trade creditors will increase, amount
availability of working capital will reduce in the business.
156
and
separate
borrowers/counterparties
operations
(group
with
of
certain
related
borrowers/counterparties);
2. applying unified methodology for identification and quantitative
assessment of credit risk which is adequate to the nature and scale
of the Bank's operations; and
3. balanced combination of centralized and decentralized decisionmaking in respect of operations related to taking credit risk.
The main tool to restrict and control the credit risk taken by the Bank is the
credit limit system. The following types of credit risk limits are put in place:
counterparty limits;
limits for independent risk-taking by the Bank's branches; and
credit risk limits by countries/industries/regions.
Credit risk limits are determined by the Credit Committee and approved
by the Bank's Management Board (in case the Credit Committee does not
have the required authority). A part of authorities for putting credit limits in
place is delegated to Branch Credit Committees (for standard credit
operations within the special limit for independent credit risk-taking by
branches), as well as to the Small Credit Committee and the Moscow Region
Credit Committee (for medium-sized and small customer lending).
Along with its internal credit risk limits, the Bank observes the
mandatory requirements established by the Bank of Russia in terms of risk
size by borrower/group of related borrowers (N6 ratio) and size of large
loans (N7).
157
The most important tool to minimize credit risks taken by the Bank is the
creation of security for credit operations. The Bank's policy in this sphere is
based on the principle of forming a reliable and liquid security portfolio,
sufficient to cover the credit risks taken by the Bank. At the same time, it does
not lift the requirement to conduct due diligence of the borrower and does not
compensate for the insufficient payment and credit capacity of the borrower or
lack of information on its business.
158
159
companies won't even look at your resume unless you have a college degree.
However, this doesn't mean that it's always the best decision. In many cases,
depending on the loan amount, it may be better to just put off the decision
until a later time or to get the money by other means.
Most people want the good life. They want the nice cars and the big
homes. They want to be able to go on luxury vacations and there's nothing
wrong with these things but if you are not in a position to do so with extra
money that you saved up, then it's probably not a good idea to owe more
money than you have to just because you want some temporary satisfaction.
Every loan you take out is a responsibility that can follow you for years,
many times decades. Therefore, before even thinking about getting a loan,
you will want to look at all other options in term of financing what you want
but at the same time, you will also want to consider delaying it. There's
nothing wrong with working a few years for example, in order to save up
some money to finish college.
160
161
Documents must conform to terms and conditions set out in the letter
of credit
Documents to be presented at a specified place
Beneficiary
The beneficiary is entitled to payment as long as he can provide the
documentary evidence required by the letter of credit. The letter of credit is a
distinct and separate transaction from the contract on which it is based. All
parties deal in documents and not in goods. The issuing bank is not liable for
performance of the underlying contract between the customer and
beneficiary. The issuing bank's obligation to the buyer, is to examine all
documents to insure that they meet all the terms and conditions of the credit.
Upon requesting demand for payment the beneficiary warrants that all
conditions of the agreement have been complied with. If the beneficiary
(seller) conforms to the letter of credit, the seller must be paid by the bank.
Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its
customer becomes absolute upon the completion of the terms and conditions
of the letter of credit. Under the provisions of the Uniform Customs and
Practice for Documentary Credits, the bank is given a reasonable amount of
time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to the seller that if
compliant documents are presented, the bank will pay the seller the amount
due and to examine the documents, and only pay if these documents comply
with the terms and conditions set out in the letter of credit.
Typically the documents requested will include a commercial invoice,
a transport document such as a bill of lading or airway bill and an insurance
162
document; but there are many others. Letters of credit deal in documents, not
goods.
Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing
bank will advise the beneficiary. Generally, the beneficiary would want to
use a local bank to insure that the letter of credit is valid. In addition, the
advising bank would be responsible for sending the documents to the issuing
bank. The advising bank has no other obligation under the letter of credit. If
the issuing bank does not pay the beneficiary, the advising bank is not
obligated to pay.
Confirming Bank
The correspondent bank may confirm the letter of credit for the
beneficiary. At the request of the issuing bank, the correspondent obligates
itself to insure payment under the letter of credit. The confirming bank
would not confirm the credit until it evaluated the country and bank where
the letter of credit originates. The confirming bank is usually the advising
bank.
163
2. Revocability
Letters of credit may be either revocable or irrevocable. A revocable
letter of credit may be revoked or modified for any reason, at any time by
the issuing bank without notification. A revocable letter of credit cannot be
confirmed. If a correspondent bank is engaged in a transaction that involves
a revocable letter of credit, it serves as the advising bank.
Once the documents have been presented and meet the terms and
conditions in the letter of credit, and the draft is honored, the letter of credit
cannot be revoked. The revocable letter of credit is not a commonly used
instrument. It is generally used to provide guidelines for shipment. If a letter
of credit is revocable it would be referenced on its face.
The irrevocable letter of credit may not be revoked or amended
without the agreement of the issuing bank, the confirming bank, and the
beneficiary. An irrevocable letter of credit from the issuing bank insures the
beneficiary that if the required documents are presented and the terms and
164
165
166
MODULE FOUR
END CHAPTER QUIZZES
1. Which of the following is/are spontaneous liability?
a. Sundry creditors
b. Salary accrued but not due
c. Provision for payment of bonus
d. All a, b and c
2. If the interest rate on long term debt is 18% p.a. and the tax rate is of the
company is 35% the cost of debt is
a. 10.70%
b. 11.70%
c. 12.85%
d. 12.70%
3. If the cost of equity is 18% and the cost of debt is 15%, what would be the
cost of capital at a tax rate of 30% and the debt equity ratio of 2:1?
a. 13.50%
b. 13.25%
c. 12.50%
d. 17.01%
167
c. 40 days
d. 25 days
5. The net operating cycle of the firm is
a. 91 days
b. 100 days
c. 117 days
d. 87 days
6. If the current assets and current liabilities are Rs. 2000 lakhs and Rs. 1200
lakhs respectively, how much amount can be borrowed on a short term basis
without reducing current ratio below 1.5?
a. Rs. 400 lakh
b. Rs. 1000 lakh
c. Rs. 1200 lakh
d. Rs. 1400 lakh
8. What is the cash conversion cycle for the firm with a receivables period of
35 days, a payables period of 40 days and an inventory period of 55 days?
168
a. 20 days
b. 50 days
c. 60 days
d. 80 days
9. If credit term is 2/10 net 30, the cost of trade credit if payment is made
after 10th day, but before 30th day of purchase is
a. 2%
b. 20%
c. 36.73%
d. 40%
10. With terms of 4/15, net 45, what is the implied interest rate foregoing a
cash discount and paying at the end of the perioda. 25.63%
b. 39.29%
c. 50%
d. 64.32%
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MODULE FIVE
5. INVENTORY MANAGEMENT
5.1 INTRODUCTION
Inventory is the main component of working capital. Inventory is also
known as stock and merchandise. The inventory means and includes the
goods and services being sold by the firm and the raw materials or other
components being used in the manufacturing of such goods and services. It
also means the stock that has been kept for sale or consumption in the
business. For the business concerns whose business is only purchase and
sale of goods, the stock of goods kept for sale is called inventory and for the
manufacturing concern the stock of raw materials, stock of work in progress
and the stock of finished goods all are included in the inventory. In addition
the other consumable material needed for production purposes known or
stores, are also included in inventory.
The raw material inventory contains items that are purchased by the
firm from suppliers and are converted into finished goods through the
manufacturing process. They are an important input of the final product. The
work in progress inventory consists of items currently being used in the
production process. They are normally partially or semi finished goods that
are at various stages of production in a multi stage production process.
Finished goods represent the final or completed products which are available
for sale. As such a large quantum of fund is necessary to finance the required
volume of inventory.
Holding finished goods inventory ensures better customer services. As
a matter of fact inventories are very important for the management as they
have direct impact on the firms profit. The financial manager has the
170
employment
rates.
(ii)
(iii)
insurance charges.
(iv)
(v)
with in an organization.
(vi)
Inventories are used in the Production process for the purpose of sale
in the business.
(ii)
(iii)
(iv)
(v)
(vi)
171
(ix)
1.
2.
price of supplies and component parts. The willingness to place large orders
may allow the firm to achieve discounts on regular prices. These discounts
will reduce the cost of goods sold and increase the profits earned on a sale.
172
3.
4.
start-up costs are incurred. These are then absorbed as production begins.
The longer the run, the smaller will be the costs to begin production of the
goods.
5.
173
174
175
176
(i)
(ii)
(iii)
stock.
(iv)
(v)
177
smooth flow of raw materials for conversion into finished product which is
meant for sale and conversion into cash.
ii. Precautionary Motives
Precaution means safety or minimum stock as commonly understood
in the industry. Inventories are held due to the usual
inability to predict
demand exactly and the consequent need to maintain some kind of a safety
margin. This occurs due to the inability to obtain instantaneous delivery of
commodities without extra costs. In other words, it necessitates holding of
inventories to guard against the risk of unpredictable change in demand and
supply forces.
iii. Speculative Motives
The speculative element is more prominent in the case of sensitive
commodities. Speculation could be due to non - availability of item as
demand exceeds supply or fear of increase price levels in future, forcing the
inventory controller to heard the stock. And also, when prices are rising or
when there are expected changes in costs, profits many be made by holding
inventories at the lower price untill the higher price obtains. In other words,
it influences the decision to increase or reduce inventory levels to take
advantages of price fluctuations.
178
The key is to know how quickly your overall stock is moving or, put
another way, how long each item of stock sit on shelves before being sold.
Obviously, average stock-holding periods will be influenced by the nature of
the business. For example, a fresh vegetable shop might turn over its entire
stock every few days while a motor factor would be much slower as it may
carry a wide range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis
whereby all the components to be assembled on a particular today, arrive at
the factory early that morning, no earlier - no later. This helps to minimize
manufacturing costs as JIT stocks take up little space, minimize stockholding and virtually eliminate the risks of obsolete or damaged stock.
Because JIT manufacturers hold stock for a very short time, they are able to
conserve substantial cash. JIT is a good model to strive for as it embraces all
the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock
movers with the objectives of establishing optimum stock levels for each
category and, thereby, minimize the cash tied up in stocks. Factors to be
considered when determining optimum stock levels include:
What are the projected sales of each product?
How widely available are raw materials, components etc.?
How long does it take for delivery by suppliers?
Can you remove slow movers from your product range without
compromising best sellers?
Remember that stock sitting on shelves for long periods of time ties up
money which is not working for you. For better stock control, try the
following:
179
management which includes their jobs, role and duties towards inventory
management and coordination with employees in the field of inventory in
management.
180
181
(ii)
production.
(iii)
(iv)
material.
So a goods inventory management policy should ensure smooth and
uninterrupted supply with out making unnecessary adjustment. The
inventory management policy must be so that it can balance the requirement
of inventory, for production as well as for customers.
182
183
ii. Modern or scientific approach The following techniques under scientific approach method are being
used to manage the inventory properly:ii.- (a) Economic Order Quantity Analysis.
ii.- (b) Re order Point.
ii.- (c) Safety Stock
ii.- (d) A.B.C. Analysis
ii.- (e) F.S.N. Analysis.
ii.- (f) H.M.L. Analysis.
ii.- (g) V.E.D. Analysis.
ii.- (a) Economic Order Quantity Analysis
Any business can obtain the material or goods in two ways which is
required by the business, the first way that it can adopt is that it can purchase
the total quantity require for the whole year only one time and can keep that
184
quantity in its godown or ware house. The second thing is that it can
purchase the required material in small quantity through out the year. The
above study explains that if the business concern purchases the total quantity
only once. It will increase the carrying cost of holding. But on the other hand
the purchase of total quantities in small units will increase the ordering cost
due to frequent order. So it is effective to place orders or that quantity and
quality of materials or goods where carrying cost and ordering cost can be
balanced to minimize the total cost of inventory. This is a cost of inventory
where. We can same money in terms of cost. This quantity of stock are
inventory is called as economic order quantity. So economic order quantity
relates to the size of the order which provides maximum economy or saving
in purchasing or acquiring any type of material.
The economic order quantity can be determined after taking into
consideration the following costs :(a) Ordering Cost The ordering costs, basically known as the acquisition of and the set
up costs, which is paid by the business concern, when the order is placed.
The ordering cost of we know the name indicates the costs which varies
depeding upon the number of orders given, issued from time to time. If
number of orders increase, the cost of order will also increase. The opposite
aspect of it that if the firm is placing ben orders then ordering cost will
comparatively small.
(b) Carrying CostThe cost which is paid to keep the inventory in stock. The carrying
cost relates to the management and maintenance of inventory. This cost can
be divided into four parts. Storage cost, servicing cost, cost of deterioration,
opportunity cost. The carrying cost and the cost of ordering although are two
185
opposites terms but collectively the level of inventory is calculated with the
help of these two costs. Storage cost basically covert expenses like
insurance, depreciation on handling plants machinery and other equipments
rent of ware house or godown. On the other hand serving cost refers to the
cost of labour handling inventory, cost of record keeping and other clerical
cost. Cost of deterioration includes theft of goods and loss by fire. Where as
opportunity cost means the loss of income or revenue which a business
concern would have earned by the investment in inventory. The economic
order quantity analysis is very much useful for the business as it is helpful in
providing all the valuable and required information regarding the quantity
which should be ordered, number of orders. Decisions regarding inventory
can be taken easily through this method.
ii.- (b) Re-order Point
When we have decided the order quantity, it is then important to
decide when the next order will be made. This problem is solved by
determining the re order lable. So re order liable or re-order point tells when
a new order for goods or material should be placed if the business has
sufficient quantity of inventory available in stock and apart from that it is
still placing the new order this will definately increase the carrying cost of
inventory. If the business is placing order stock is very low, the fear of to be
out of stock increase but the carrying cost will be low. So when inventory
reaches to a point where carrying cost and fear of shortage of stock or out of
stock tend to be equal, order should be placed. This level of stock is called or
reorder point. The reorder level depends upon the minimum stock level or
safety stocks, procurement time or lead time, daily usage of inventory.
Re- order point can be calculated as follows -
186
1-
2-
R.O.P. = S x L
When E = Safety stock
187
188
189
190
1.
Current Asset
It is assumed that the Inventories will be converted into Cash in the
Current Accounting Cycle, which is normally, one year. In some Cases, this
is not entirely true, for example, a winter may require that the wine be aged
in casks or bottles for many years. Or, a manufacturer of fine pianos may
have a production process that exceeds one year. In spite of these and
similar problems, we will view all Inventories as being Convertible into
Cash in a single year.
2.
Level of Liquidity
Inventories are viewed as a source of near Cash. For most of the
products this description is accurate. At the same time, most firms hold some
slow-moving items that may not be sold for a long time. With economic
slowdown or changes in the market for goods, the prospects for sale of the
entire product lines may be diminished. In these cases, the liquidity aspects
of Inventories become highly important to the Manager of Working Capital.
At a minimum, the analyst must recognize that inventories are the least
liquid of Current Assets. For firms with highly uncertain operating
environments, the analyst must discount the liquidity value of the
Inventories significantly.
3.
Liquidity Lags
Inventories are tied to the firm's pool of working capital in a process
creating an account payable. When the Raw Materials are processed in the
factory, the Cash to pay production expenses is transferred at future times,
191
perhaps a week, a month or so. Labor is paid on payday. The utility that
provided the electricity for manufacturing is paid after it submits the bill. Or
for goods purchased for Resale, the firm may have 30 or more days to hold
the goods before the payment is due. Whether manufactured or purchased,
the firm will hold inventories for a certain time period before the payment is
made. This Liquidity Lag offers a benefit to the firm.
b)
Storage Lag:-Once goods are available for resale, they will not be
immediately converted into Cash. First, the time must be sold. Even when
sales are moving briskly, a firm will hold Inventory as a back-up. Thus, the
firm will usually pay its suppliers, Workers, and overhead expenses before
the goods are actually sold. This lag represents a cost to the firm.
c)
Sale Lag:-Once the goods have been sold, they normally do not create
4.
Circulating Activity
Inventories are in a rotating pattern with other current assets. They get
converted into receivables which generate the much needed cash and
invested again in Inventory to continue the operating cycle.
INVENTORY COSTS
The effective Management of Inventory involves a trade off between
having too little and having too much Inventory. In achieving this trade off,
192
the Finance Manager should realize that the costs may be closely related. To
examine inventory from the cost side, four categories of costs can be
identified of which two are direct costs that are immediately connected to
buying and holding goods and the last two are indirect Costs which are
losses of Revenues that vary with different Inventory Management
Decisions.
1.
Ordering Costs
Any manufacturing organization has to purchase Materials. In that
event the ordering costs refer to the costs associated with the preparation of
purchase requisition by the user department, preparation of the purchase
order and follow up measures taken up by the purchase department,
transpiration of Materials ordered for, inspection and handling at the
warehouse for storing.
At times the Demurrage charges for not lifting the goods in time are
included as a part of the ordering costs. Sometimes some of the components
and/or Materials required for production may have facilities for
manufacturing internally. If it is found to be more economical to
manufacture such items internally, then the ordering costs refer to the costs
associated with the preparation of the requisition forms by the user
department, set-up costs to be incurred by the manufacturing department and
transport, inspection and handling at the warehouse of the user department.
By and large, ordering costs remain more or less constant irrespective
of the size of the order although transportation and inspection costs may
vary to a certain extent depending upon the order size. But this does not
193
significantly affect the behavior of the ordering costs. As the ordering costs
are considered invariant to the order size, the total ordering costs can be
reduced by increasing the size of the orders. Suppose the cost per order is
$100 and the company uses 1200 units of a material during the year. The
size of the order and the total ordering costs to be incurred by the company
are given below:-
100
150
200
No. of orders in an 12
year
$800
$600
$1200
From the above it can be easily seen that a company can reduce its
total ordering cost by increasing the order size which in turn will reduce the
number of orders. However, reduction in ordering costs is usually followed
by an increase in carrying costs.
2.
Carrying Costs
These are the expenses of storing goods. Once the goods have been
accepted, they become a part of the firm's inventories. These costs include
Insurance, Rent/Depreciation of the warehouse, and salaries of the storekeeper, his assistants and security personnel, financing costs of money
locked up in Inventories, obsolescence, spoilage and taxes. By and large, the
carrying costs are considered to be a given percentage of the value of
Inventory held in the warehouse, despite some fixed elements of costs which
comprise only a small portion of the total carrying costs. Approximately, the
carrying costs are considered to be 25% of the value of Inventories held in
194
Stock. The greater the Investment in Inventories, the greater is the carrying
costs.
In the example considered above, let us assume that the price per unit
of Material is $40 and that on an average about half of the Inventory will be
held in storage. Then, the average values of Inventory for sizes of order 100,
150 and 200 along with carrying costs @25 % of the Inventory held in
storage are given below:Size of Order (Units)
Average
Inventory
value
100
of $2000
150
200
$3000
$4000
$750
$1000
From the above calculations, it can be shown that as the order size increase,
the carrying cost also increase in a directly proportionate manner.
3.
that otherwise might have been available for other purposes. The firm has
lost the use of funds for other profit making purposes. This is its
Opportunity Cost. Whatever be the source of the funds, the inventory has a
cost in terms of its financial resources. Excess resources represent
unnecessary cost.
4.
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other words, the requisite items have run out of stock for want of timely
replenishment. These costs have both quantitative and qualitative
dimensions. These are, in the case of Raw Materials, the loss of production
due to stoppage of work, the uneconomical prices associated with 'cash'
purchases and the set-up costs which can be quantified in monetary terms
with a reasonable degree of precision. As a consequence of this, the
production department may not be able to reach its target for providing
finished goods for sale.
196
ASSUMPTIONS
The major weakness of the EOQ Model is associated with several of
its assumptions, in spite of which the model tends to yield quite good results.
The models assumptions are as follows: -
1.
vary from day to day. If the demand is stochastic that is, not known in
advance - the model must be modified through the inclusion of a safety
stock.
2.
purchase price Rs. P per unit of Material will remain unaltered irrespective
of the order size. Quite often, bulk purchase discounts or quantity discounts
197
are offered by the suppliers to induce the customers for buying in larger
quantities.
The inclusion of variable prices resulting from quantity discounts can
be handled quite easily through a modification of the original EOQ model,
redefining total costs and solving for the optimum order quantity.
3.
4.
5.
Instantaneous Delivery
If delivery is not instantaneous, which is generally the case, the
6.
Independent orders
If multiple orders result in cost savings by reducing the paperwork
and the transportation cost, the original EOQ model must be further
modified. While this modification is somewhat complicated, special EOQ
models have been developed to deal with this.
198
The second way in which Inflation affects the EOQ Model is through
increased carrying costs. As the Inflation pushes the Interest rates up, the
cost of carrying Inventory also increases. In the EOQ Model this means that
C increases, which results in a decline in the optimal economic order
quantity.
199
Set-up Costs
Inventory Carrying Costs
(2U X P)/S
Optimum Production Quantity
per annum
200
may arise whether Q*, EOQ calculated on the basis of a price without
discount will still remain valid even after reckoning with the discount. While
no general answer can be given to this question, the general approach using
the EOQ framework will prove useful in decision making - whether to avail
oneself of the discount offered and if so what should be the optimal size of
the order.
The two factors that determine the appropriate order point are the
procurement or delivery time stock which is the inventory needed during the
lead time ( i.e. the difference between the order date and the receipt of the
Inventory ordered) and the safety stock which is the minimum level of
Inventory held as a protection against shortages.
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Reorder Point
Stock
Several Factors determine how much delivery time stock and safety
stock should be held. In summary, the efficiency of replenishment system
affects amount of much delivery time needed. Since the delivery time stock
is the expected inventory usage between ordering and receiving Inventory,
efficient replenishment of Inventory would reduce the need for delivery time
stock. And the determination of level of safety stock involves a basic trade
off between the risk of stock-out, resulting in possible customer
dissatisfaction and lost sales, and the increased costs associated with
carrying additional Inventory.
From the above formula it can be easily deducted that an order for
replenishment of materials be made when the Inventory is just adequate to
meet the needs of the production during the lead time.
If the average daily usage rate of Material is 50 units and the lead
time is 7 days, then
Reorder Level =Average daily usage rate X Lead time in days
= 50 units X 7 days
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= 350 units
When the Inventory reaches 350 units an order should be placed for
material. By the time the Inventory level reaches towards the end of the
seventh day from placing the order materials and there is no confusion for
the concern.
PRACTICAL QUESTIONS:Illustration 1:
From the following information, calculate re-order level, minimum stock
level, maximum stock level, average stock levelRe-quantity
4000 units
Minimum usage per day
200 units
Maximum usage per day
300 units
Average usage per day
250 units
Minimum delivery period
4 days
Maximum delivery period
6 days
Normal delivery period
5 days
Solution:
Re-order level =maximum usage *maximum delivery period
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Illustration 2:
A factory uses three kinds of materials A,B, and C the details about them
are as given below:
A
B
C
Rs.
Rs.
Rs.
Opening stock
12000
4000
600
Purchases during the year
94000
22000
3200
Stock at the end
18000
6000
400
Calculate stock turnover of each material. Which material is fast moving
and which is slow moving?
Solution:
Material consumed = opening stock + purchases closing stock
Material
A = 12000+94000-18000 =Rs. 88000
Material
B = 4000+22000-6000 =Rs. 20000
Material
C = 600+3200-400 = Rs. 3400
Average stock =opening stock +closing stock /2
Material
A = 12000+18000/2 =30000/2 = Rs. 15000
Material
B = 4000+6000/2 = 10000/2 = Rs. 5000
Material
C = 600+400/2 = 1000/2 = Rs. 500
Inventory (stock) turnover
= Raw material consumed in the year /
Average raw material inventory
Material
A = 88000/15000 =5.87 times
Material
B = 20000/5000 =4 times
Material
C = 3400/500 = 6.8 times
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Illustration 3:A firm requires 2400 units per annum of a material. Annual storing
cost per unit is Rs. 4 and ordering cost per order is Rs. 75. What quantity
should be ordered in one time? How many orders will be placed in a year?
What will be the time interval between two orders?
Solution:Ordering cost = Rs. 75 per order (O)
Annual consumption = 2400 units (A)
Carrying cost = Rs. 4 per unit per annum ( C)
= 300 units
205
Solution:-
= 2000 units
Re order level = safety stock + lead time x usage
Daily usage = 50000 / 250
= 200 units
Safety stock = 2 x 200
= 400 units
Re order level = 400 + 5 x 200
= 1400 units.
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MODULE FIVE
END CHAPTER QUIZES
2. If the material is priced at the value that is realizable at the time of issue
such pricing method is referred to as
a. Standard price method
b. Replacement method
c. LIFO methods
d. Weighted average cost methods
3. Which of the following is not a benefit of storing inventories:a. Avoidance of lost sales
b. Availing of quantity discounts
c. Reduction of order costs
d. Reduction of carrying costs
207
6. Which of the following is/ are assumption under lying the EOQa. Constant / uniform demand
b. Constant unit price
c. Independent orders
d. All of the above
7. Which of the following costs are not associated with inventories:a. Material costs
b. Ordering costs
c. Carrying costs
d. Cost of long term debts locked in inventories
208
209
MODULE SIX
6. WORKING CAPITAL MANAGEMENT AND SMALL
BUSINESS
210
211
212
Several organizations also provide help for the small business sector,
such as the Internal Revenue Service's Small Business and Self-Employed
One-Stop Resource.
213
and taxes. In the United Kingdom and Australia, small business owners tend
to be more concerned with excessive governmental red tape.
Another problem for many small businesses is termed the
'Entrepreneurial Myth' or E-Myth. The mythic assumption is that an expert
in a given technical field will also be expert at running that kind of business.
Additional business management skills are needed to keep a business
running smoothly.
Still another problem for many small businesses is the capacity of
much larger businesses to influence or sometimes determine their chances
for success.
214
215
216
217
218
219
220
221
too. It is one of the most crucial sectors of the economy in terms of the
number of employments generated. As more than 65% of its population lives
in rural and semi rural areas, small business is one of the most viable options
for the population residing in these areas. After agriculture, small business in
India is the second largest employer of human resources. In India an
industrial undertaking that has investments in fixed assets which do not
exceed more than Rs.10 million falls under the category of small business.
The Government of India has undertaken several reforms to attract
more investors to the small business sector in India. Some of the reforms
undertaken include provision of training facilities, availability of machinery
on hire-purchase terms, special bonus for setting up small business in
backwards areas, tax deduction for small business and assistance for
marketing the products in domestic markets and exports. All small business
in India needs to get registration from Director of Industries of the respective
state government. Most states across India follow a uniform process of
registration, though there may be slight variation from state to state.
There are various reasons due to which the small scale business in
India has witnessed a spurt of growth. Chief among them are an increase in
the export potential of Indian goods, the industry is less capital intensive, the
industry has availability of manpower training facility, there is ease of
machinery and manpower procurement, goods from some of the sectors are
exclusively purchase by government and there is also reservation of
exclusive manufacture of goods in this sector.
222
The growing business trend in India indicates that the small business
sector in India is poised for much higher things. Investors in this sector must
ensure that they make use of all the resources available to reap the benefits.
223
224
In Latin America, the law of the carrot and the stick prevails. In other
words, those companies that dont pay their tax bills on time face the threat
of being shut down. According to Julin Domnguez, president of the
Chamber of Commerce of Cali, an industrial city in Colombia, people have
to get the idea into their heads that you have to pay when youre legal, and
compliance opens opportunities for companies to grow, to become more
productive and to compete.
225
SMEs
ignore
the
importance
of
technology
and
226
227
228
Thats the case for every company, where it offers goods or services;
or is small or large. The big difference is that SMEs dont apply this
approach, says Restrepo.
Restrictions on Loans
No business can possibly exist without having access to credit.
However, loans are a scarce resource for SMEs for a variety of reasons: their
informal [or underground] nature; the administrative disorder that
characterizes some SMEs; their lack of leadership; the absence of real [loan]
guarantees; and a shortage of [business] information [about small
companies].
According to Jorge Londoo, president of Bancolombia, The first
thing that every micro-enterprise must deal with is how to achieve
transparency in its supply of information while maintaining an organized
accounting system. For Londoo, who manages Colombias largest
financial institution, it is worth the effort to seek out advice about how to
diagnose the condition of your business and to implement mechanisms that
improve its financial structure.
229
amortization periods because of the way banks assess their risks, notes
Norman Correa, president of ACOPI.
The reasoning is simple: Because they are riskier, banks charge them
more, as well as cut the time they can take to repay their loans. In many
cases, these companies wind up being excluded from traditional financial
markets, notes Correa.
230
The IDB has given its Multilateral Investment Fund responsibility for
managing several programs that assist the small business sector, with
financing, technology, trade, training, innovation and modernization.
Various other organizations have become the right arm for SMEs in the
region, including the World Bank, the United Nations Industrial
Development Organization, the Andean Development Corporation and the
Organization for Economic Cooperation and Development (OECD).
Moreno, president of the IDB, notes that its goal is to enable small
companies to get involved in the globalization process. Instead of merely
subsisting and acting as [ordinary] corporations, they can develop corporate
governance policies that enable them to actively participate in Corporate
Social Responsibility programs and to take part in the Global Compact (the
initiative to encourage businesses worldwide to adopt sustainable and
socially responsible policies) that Kofi Annan, then Secretary General of the
UN, proposed in 1999.
1. Small businesses are constantly faced with problems before they can
claim success. However, the difference between a well run business and one
that is not is how they tackle their problems. They can often be faced with
financial problems. Since business has its good and challenging months you
may be swamped with bills when the tough months come. There are wages,
rent etc to be paid and you don't know where to get the money. It is therefore
advisable to always have an emergency account that can cushion you
through the tough months.
2. Incompetent employees are yet another problem faced by small
businesses. In comparison to larger companies, small businesses have a high
employee turnover. It is always a real challenge for the business owners to
231
get reliable and trustworthy employees. You may have employees who lie to
customers about specific products or services for their own selfish gain.
Unfortunately it is you who will end up "looking bad."
3. Customers can also be a source of problems for the small business. This is
because sometimes you could have an in house problem like the office
machinery lets you down and you cannot give your customer the service
they require. Many customers get easily irritated and may think you cannot
effectively run your business. They may even ask for their money back.
4. You can also be faced with problems if your suppliers do not deliver on
time or as agreed on. This can be really frustrating and nerve racking
especially if it is an order that is being waited for. Your family can also be a
part of the problem especially if they are not willing to understand why you
work so hard or late. They may begin to feel that they are secondary in your
life. It is even difficult to go on vacation because you are constantly "on
call". You should be ready to make sacrifices if you want to succeed in your
business.
5. The production problems include raw material availability, capacity
utilization, and storage problems.
6. The marketing problems arises because of dealing in only one product, cut
throat competition, adopting cost oriented method of pricing, lack of
advertisement, not branding their products etc.
6. The financial problems include investment risks, procurement of loan
from banks and their repayment, meeting day to day expenses and the like.
7. The labour problems include highly demanding employees, absenteeism
lack of skilled workers and transportation of workers.
8. Infrastructure problems also add coal to the fire. Unless and until you
have the infrastructure in its place the rest of the efforts are futile.
232
9. Personal problems like spending less time with family and for the whole
sweat exerted the rewards have not been favorable.
6.10
EFFECTIVE
SMALL
BUSINESS
WORKING
CAPITAL
MANAGEMENT
Entrepreneurs know the importance of having a sufficient working
capital in managing a business. Newly start-up businesses particularly are in
need of financing help to gain footing in the market. In fact, one of the
biggest challenges that businesses face is maintaining a sufficient financial
resource.
233
An entrepreneur must also set realistic goals. Here, we are not just
speaking about short term goals but long term goals as well. Do you have a
target goal for this month or the following months? Have you set a goal for
this year and the years to come? Setting definite goals- both short term and
long term- will enable you to make wiser decisions especially when it comes
to marketing and financing strategies.
Speaking of marketing goals, building new customer relationships and
strengthening existing customer relationships are also important steps. Make
sure that you are able to give your customers what they really want. Ensure
customer satisfaction with each of your deals. Taking care of your customer
relationships will certainly make a big difference in your performance as a
business.
Protect your cash flow by using the right tools such as business credit
cards. Credit cards for business are not just for large companies but for small
business enterprises as well. Using business credit cards to your advantage
will be a big help in keeping a steady cash resource.
Apart from business credit cards, applying for a business loan may
also be necessary especially in executing bigger projects for your business.
Having a solid credit history will surely enable you to obtain the business
loan you need without much difficulty.
234
others, the seasonality may relate to annual variations in human activity (for
example, tourism, restaurants, some forms of manufacturing).
Seasonal industries often feature large swings in labor force size, and
in many cases, precipitate mass migrations of workers.
In those countries that provide them, unemployment benefits may be
affected by a worker's seasonal status. That is, in certain cases, a seasonal
worker may not be considered "unemployed" during the off-season for the
sake of benefits or aggregated statistics, despite being functionally inactive.
235
236
237
The more permanent needs (fixed assets and the fixed element of working
capital) should be financed from fairly permanent sources (e.g. equity and
loan stocks); the fluctuating element should be financed from a short-term
source (e.g. a bank overdraft), which can be drawn on and repaid easily and
at short notice.
238
239
240
sickness, represent only 25% of the total bank credit outstanding from all
sick units. Again, of the identified SSI sick units, 92% are found to be
unviable.
241
period not less than five years and whose accumulated losses are equal to the
sum of paid up capital and free reserves.
242
a.
b.
c.
d.
e.
ii.
RBI advised banks to take urgent measures to set up Special Sick Unit
Cells to carryout periodical inspection and to undertake diagnostic studies
for techno-economic viability.
iii.
iv.
v.
243
sickness. Under this Act, the Board for Industrial and financial
Reconstruction (BIFR) came into being with vast powers aimed at
assessment and implementation of revival plans for the sick industrial
companies. However, this Act has no applicability for the sick SSI units.
However, different studies revealed that in some cases liberal policies
for the growth of the small industry sector were counter-productive in terms
of affecting the viability through unhealthy growth and inefficiency of the
units. On the other hand, the measures aimed at revival of sick industries
could not achieve a desired breakthrough in curbing the magnitude of
sickness due to their inadequacies and implementation bottlenecks.
Summary of Causes
The deliberations elaborated on the causes of industrial sickness in
Section III & IV indicate that a number of factors, both internal and external
are responsible for turning an industrial unit as sick. The major causes
pushing the industrial units towards sickness in Bangladesh have been
summed up in the following table :
Sl. # Broad Area
01. Management
a.
b.
c.
d.
e.
f.
02.
Production/
INTERNAL
Detail Causes
Lack of proper education, training, experience and business outlook
of the Sponsors/Entrepreneurs
Poor Entrepreneurial skills
Poor Management
Poor Equity base
Lack of Integrity/Division of Funds
Faulty Project Planing and Appraisal
244
Technical
b.
c.
d.
e.
f.
g.
03.
Marketing
a.
b.
c.
d.
04.
Finance
a.
b.
c.
d.
e.
05.
Personnel
a. Lack of Competence
b. Lack of Loyalty
c. Lack of Professionalism
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
EXTERNAL
Detail Causes
Frequent Policy changes
Lack of Proper Implementation of Industrial Policies
Liberal Import Policies
Poor Infrastructure / Frequent Power Disruption
Smuggling
Fiscal Anomalies
Exchange Rate Fluctuation
Lack of Co-ordination between various ministries and Govt.
Departments, etc.
Over-Saturation of particular industry type / Sector due to wrong
policy
Non-availability of Raw-material, etc.
02.
Bank &
Financial
Institutions
a.
b.
c.
d.
03.
Environment
a.
b.
c.
d.
Political Unrest
Labour Unrest
Market Recession
Delay in Project Implementation
Preventive Measures
245
Experience indicates that small industrial units fall sick much to the
occurrence of external causes while medium and large industries get
exposed to sickness largely due to internal causes. Though it would be
hardly impossible to eliminate the causes altogether, attempts should be
made to undertake measures that would reduce the magnitude of ailment in
the industrial units for healthy survival and growth. Viewed in this context,
the following measures may be suggested to prevent industrial sickness:
(i) Macro-economic Policy changes: The industrial entrepreneurs should
make their own appraisal within a predictable macro-economic environment.
For this, policy changes should not be abrupt, have to be pre-announced and
gradual.
(ii) Sub-Sectorwise Long term Policy: For each sub-sector, the long-term
policy (e.g. for a period of 5 years) should be announced by the Government
so that entrepreneurs appraisal of the policy implications do take a nearaccurate shape.
(iii) Implementation of the Announced Polices: There should be effective
co-ordination amongst the various ministries, Govt. Departments and
relevant agencies involved for proper implementation of policies related to
industrialization.
(iv) Development of Small Industry Sector: The small industry sector is
characterized by low-level of technology, low equity base, traditional
management practices, poor marketing outlets and undeveloped subcontracting arrangement. The small industries should not be left to the
market forces only. The following measures may be taken for preventing
sickness in the small scale sector :
a.
246
b.
c.
d.
e.
f.
247
b.
c.
d.
e.
f.
g.
Banks could fix up a time limit for sanction and disbursement of loan
limits for helping timely implementation of the projects/utilization of
capacity of the borrowing industrial units.
248
h.
i.
REMEDIAL MEASURES
Despite all preventions and sincerity of the policy-makers and
stakeholders, some industrial units would genuinely face sickness. In order
to provide scope for timely revival of those units, efforts should be
underway from all concerned. However, some unviable units should be
allowed to die a natural death without delay.
249
ii.
iii.
iv.
v.
250
vii.
viii.
6.15 COOPERATIVE
A cooperative (also co-operative; often referred to as a co-op) is a
business organization owned and operated by a group of individuals for their
mutual benefit. Cooperatives are defined by the International Co-operative
Alliance's Statement on the Co-operative Identity as autonomous
associations of persons united voluntarily to meet their common economic,
social, and cultural needs and aspirations through jointly-owned and
democratically-controlled enterprises. A cooperative may also be defined as
a business owned and controlled equally by the people who use its services
or by the people who work there. Cooperative enterprises are the focus of
study in the field of cooperative economics.
251
2.
Identity
Cooperatives are based on the cooperative values of "self-help, selfresponsibility, democracy and equality, equity and solidarity" and the seven
cooperative principles.
1.
252
2.
3.
4.
5.
6.
7.
253
254
255
economy most frequently as the major problems they faced the past year.
These same problem areas were cited most frequently for the near future, but
in a different order. The problem area mentioned most frequently by dairy
cooperatives for the past year was low commodity prices. Members was
also a concern. For the near future, other problem areas surfaced. Low
commodity prices were still of major concern. However, the agricultural
economy, operational difficulties, and members were also frequently
mentioned problems or issues.
Wool cooperatives identified low commodity prices and competition
as their major problems for the past and coming years, but with more future
emphasis on the agricultural economy and operational difficulties.
Cotton ginning cooperatives cited low commodity prices, weather,
and labor most frequently as problems for the past year. Low commodity
prices, increasing costs, weather, the agricultural economy, and labor were
mentioned most frequently for the near future. Weather was less of a
concern.
Low commodity prices and the agricultural economy were among the
most frequently cited problems by size of cooperative for the past year. Only
one size, cooperatives with revenues of $500 million and more, did not show
both of these problem areas among their most frequently cited concerns.
Larger-sized cooperatives cited operational problems and increasing costs
more frequently.
256
MODULE - SIX
END CHAPTER QUIZZES
1. At present, which of the following financial instruments are non-existent
in India?
a. Convertible preference shares
b. Partly convertible debentures
c. Non voting shares
d. Perpetual preference shares
257
5. Smart software limited buys in lot of 150 boxes, which is a four month
supply. The cost per box is Rs. 150 and ordering cost is Rs. 300 per order.
The inventory carrying cost is estimated at 25% of unit value per annum.
The total annual cost of the existing inventory policy is
a. Rs. 82000
b. Rs. 71212.50
c. Rs. 88500.50
d. Rs. 67890.55
ABC ltd. has total revenue of Rs. 25 lakh a year, of which 60% are credit
sale. The collection occur at an even rate and the total working days of the
firm in the year are 300. The accounts department ties up 5 days worth of
remittance checks.
On the basis of above question answer question No. 6 and 7.
7. If the internal delays are arrested this could be reduced by two days. If the
release could earn a rate of 6% p.a.. What are the annual savings for the
firm?
a. Rs. 600
258
b. Rs. 6000
c. Rs. 5000
d. Rs. 2000
9. The income for 2 months and 4 months are ---- and ---a. Rs. 18354, Rs. 44440
b. Rs. 26666, Rs. 53333
c. Rs. 12777, Rs. 32222
d. Rs. 17988, Rs. 56677
10. The income for month and one year are ---- and ---a. Rs. 80000, Rs. 160000
b. Rs. 40000, Rs. 80000
c. Rs. 60000, Rs. 120000
d. Rs. 50000, Rs. 100000
259
Module Two
1(b), 2(d), 3(d), 4(c), 5(d), 6(a), 7(a), 8(b), 9(b), 10(d)
Module Three
1(d), 2(d), 3(d), 4(d), 5(d), 6(c), 7(b), 8(a), 9(d), 10(d)
Module Four
1(d), 2(b), 3(d), 4(d), 5(d), 6(a), 7(c), 8(b), 9(c), 10(c)
Module Five
1(c), 2(b), 3(d), 4(d), 5(d), 6(d), 7(d), 8(a), 9(d), 10(d)
Module Six
1(d), 2(c), 3(d), 4(d), 5(b), 6(c), 7(a), 8(a), 9(b), 10(a)
260
BIBLIOGRAPHY
(I) Books :
1. Bansal, B. L.
2. Chandra Prasanna
: Financial Management
3. Dag Lay, V.
4. Garg, A. K.
5. Gupta, S. P.
: Financial Management
6. Kumar, R.
: Financial Management
7. Lal, G. S.
8. Maheshwari, S. N.
9. Pandey, I. M.
: Financial Management
10.Walker, W. E.
11.Kuchal, S. C.
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