Financial ManagementBMS 5th Sem July’11NM College

Syllabus

Section Details of Subject Lectures

I Introduction:

Meaning & Scope of Financial Management

Functions & Objectives of Financial Management

Changing Role of Financial Managers

Working Capital Management:

Definition-GWC & NWC (Explain Core Assets & Non Core Assets)

Components of Working Capital

Factors determining Working Capital

Receivables Management:

Meaning and Importance

Credit Policy Variables

Case Study on Credit Evaluation

Methods of Credit Evaluation

o Traditional and Numerical Credit Scoring

Monitoring the Debtors – Techniques

o DSO, Aging Schedule, Collection Matrix

Cash Management:

Motives of Holding Cash

Strategies of Cash Management

Cash Budget - Meaning and Objectives

Budgeting of Receipts and Payments – Trading, Non Trading & Capital

Preparation of monthly Budget and finding out Closing Cash Balance

(Excl. Financial Statements to be made from Working Capital Estimation)

14

II Cost of Capital And Capital Structure:

Types of Capital

Debt

Equity

12

Retained Earnings

Preference

Cost of Capital for Each Type of Capital

Weighted Coat of Capital

Marginal Cost of Capital (w.r.t Expansion)

Designing Capital Structure Alternatives

Types of Leverages (Combined,Operative,Financial)

III Capital Budgeting:

Introduction, Types of Capital, Sources of Capital

Evaluation of Capital Expenditure Proposal from Given Cash Flow,

Concept of Present Value

Techniques of Appraisal of Investment Proposal

Payback Period Method, Average Rate of Return Method

Net Present Value Method

Profitability Index Method

12

IV Business Restructuring:

Importance

Financial Implication

Valuation

Types of Business Restructuring:

Merger

Amalgamation

De-Merger

Other Restructurings

(Elementary Accounting Problems-Testing Fundamental Knowledge only)

Long Term and Short Term Sources of Finance:

Traditional and Modern Instruments of Finance Including Securitizations

12

Total Lectures 50

Financial management

Introduction:

Funds Management is of crucial importance for any venture. Financial Management concerns itself with acquisition of and optimum use of funds. For efficient operation of any business it is necessary that funds are available when needed and are put to effective use to obtain best results. Basically Financial Management ensures that funds are raised at most economic cost and are put to use in optimum way to yield best result. Financial Management plays a role in inflow, outflow and the distribution of funds.

The three fold decision management in Financial Management consist of

Investment decision

Financial decision and

Dividend decision

Investment decision would need Capital Budgeting to assess the funds involvement in investing capital into the venture.

Financial decision would consist of decision making in the mode of raising finance for the investment- by equity/ own funds; debt – borrowed funds or a combination of both. This woul depend on several factors like gestation period, profitability – to name a few.

Dividend decision would involve deliberation and decision as to the distribution of earnings by way of dividends or retention of earnings in the business or a combination of both.

Financial Functions :

Financial functions in an organisation would cover the following activities,

I. Process of acquisition of funds

II. Process of utilisation of funds

III. Technique of management of funds

IV. Partaking as integral part of management in decision making

V. Fore casting financial estimates of revenue and capital expenditure and income

VI. Financial planning and control

VII. Correlate with other functions of management

VIII. Dealing with budgeting, reporting and accounting

The Nature and Scope of Finance Management:

The Nature and Scope of Finance Management can be summarised as below:

Objective of the Organisation

Maximisation of Wealth

Investment Decisions Financial Decisions

Estimating Requirement of Funds

Project Selection Locating Sources of Funds

Assessment of Risk & Returns Optimise Capital Structure

Determining Cost of Capital Decision on Dividends

Working Capital Management

Lease / Hire Decisions

Merger and Acquisition

The financial decisions include assessment of fund requirement for the venture / project. After such assessment the various mix and match combination of sources that would best suit the project would be decided. The sources would be equity / preference Share Capital, Debentures, Bank Loans, Deposits from Public etc. Proper assessment of long and short herm finance requirements and debt equity ratio would enable arriving at a proper decision on suitable Capital Structure for the organisation.

Deployment of Funds in fixed assets and current assets is also important. Decision on investment into fixed assets would be taken by capital budgeting and investment in inventory would be made, considering production levels, optimum stock levels to ensure unhindered production without holding excess inventory, locking up funds.

Dividend decision would involve consideration of return on capital and retention of funds including issue of bonus shares. ESOP decisions would similarly be made regarding employee incentives.

Cash management would ensure that adequate cash is kept to meet the business requirements and excessive cash is invested profitably.

Regular submission and study of Management Information Reports would ensure periodical reviews for corrective action.

Constant efforts would be on to negotiate with Bankers, investors ,FIs and public by providing information on performance of the company and for raising funds at economic rates.

Finance Manager would be constantly aware as to the impact of stock markets on the company’s shares and take appropriate action.

Functions of Financial Manager:

Functions of Financial Manager can be broadly classified into executive financial functions and incidental financial functions.

A.Executive Financial Functions include,

1.Formation of Asset Management Policy: Formation of Asset Management Policy is an important function necessary for successful financial management. It is interlinked with functioning of other departments as well. The Asset Management Policy would include decisions on types and coverage of insurance of its assets. He has to ascertain how much of cash will be tied up in various non cash assets. This would involve the participation of other departments. Production department to decide its need for inventory of inputs, marketing to decide the inventory of finished products, Sales department to decide on terms of credit to customers, purchase department to negotiate for best credit terms etc.

2.Determining allocation of profits earned: Management should decide, based on its need for working capital asto distribution of Profit after taxes. This would be based on,

Payment of dividends to s hareholders. The dividend policy would influence the share price in the market.

Giving the employees ESOP as a measure of profit sharing plan. This would boost the loyalty of the employees.

Retain the earnings in the business to enable expansion of business.

3.Estimating requirement for funds and controlling cash flows:

It is an important duty of the finance manager to ensure timely availability of funds to ensure smooth flow of operations. At the same time holding idle surplus funds should be avoided as it affects profitability. The delicate balance between liquidity and profitability should be maintained. Holding of excess cash prevents alternate deployment of cash that would earn revenue. Inadequate cash balance, on the other hand would lead to delayed payments and affect the image of the company in the market.

4.Assessing the future needs and explore new sources of funding:

Assessing the future needs and explore new sources of funding would prevent any bottlenecks in smooth operations of the organisation. Finance manager should be able to forecast the needs of the management and explore the possibility of new sources of funding. Based on his assessment of how much funding would be required for how long a duration, he should als.o plan how it will be repaid. The additional funding could be by way of bank loans, debentures, acceptance of deposits and issue of fresh equity. He should be constantly on the look out for new sources of financing and negotiate for better terms of borrowing.

Finance manager, based on his assessment of the need for finance also plan whether finance should be borrowed for short term or long term.

5.Checking the performance of the company:

Finance Manager should be the watch dog on the performance of the company from profitability point of view. Higher production and larger sales will be of no purpose if they would result in losses. He should bring out Management Information Reports regularly and submit the same to management for discussion and corrective action in time to ensure efficient overall performance of the company.

B. Incidental Functions:

In addition to the executive functions stated above Finance Manager has to perform the incidental routine functions to eneble smooth functioning of the company. They are,

I. Supervision of cash receipts and payments and ensure safe custody of the cash balance.

II. Safe custody of the securities, insurance policies and other documents of value.

III. Taking care of the routine functions of Finance department.

IV. Record keeping and submission of periodical reports.

V. Assisting finance executives in performing their role.

The western perception of a Finance Manager’s function comprises of:

Provision of capital as required by the company

Active interaction and Investor Relations

Planning Short term financing needs

Taking care of banking and custodian functions

Taking care of Credit and receivables

Profitable investments

Adequate insurance at economic rates

Planning & control

Reporting and interpreting

Evaluation & Consulting

Tax administration

government Reporting

Protection of Assets and

Economic Appraisal

As stated earlier, wealth maximisation is the goal of any organisation and finance manager plays a key role in this activity. While in this context, students should clearly understand the distinction between profit and profitability. Profits on account of abnormal gains, or losses due to abnormal losses (Fire damages etc) will affect the profits for the period, but the profitability will not be affected by such abnormal gains or losses.

The goal of wealth maximisation is achieved by,

i. Maximising Sales/ Revenue/ Earnings

ii. Maximising Profit

iii. Maximising Return on Sales / Investments

iv. Maximising Corporate Wealth

v. Maximising Shareholder Value

vi. Maximising Social Wealth

vii. Enjoying public confidence , social acceptability and Recognition

Maximising Sales/ Revenue/ Earnings

Finance Manager would aim at maximising sales revenuewhich in turn would improve the Return on Investment.

Maximising Profit

All the management decisions, Investment decisions, finacing policy decisions and dividend policy decisions should aim towards maximising profit and any decision affecting profits adversely should be avoided.

Maximising Return on Sales / Investments

Finance Management should aim at maximisation of earnings by maximising the output at minimum input cost and maximise the return on sales. ROI should be maximised. This is achieved by maximising the return on sales.

Maximising Corporate Wealth

Maximising corporate wealth enhances the overall value of the organisation.

Maximising Shareholder Value

The prime objective of Finance Management is to maximise shareholder’s value. This is achieved by timely declaration of reasonable dividends and effective deployment of shareholder’s funds. This would increase the return of investment and enhance the confidence of the investors.

The role of a finance manager being important to management, it would look forward to the following qualities in a successful Finance Manager.

i. Good Personality: A Finance Manager should have a pleasing personality, physically with mental alertness and attitude.

ii. Intelligence: He should be having a sharp perception, analytical ability and intelligent and alert mind.

iii. Initiative: He should be self driven and act without awaiting / looking for guidance.

iv. Innovative: He should be creative, imaginative and have a mind for research.

v. Self Confidence: he should have leadership skill and capable of getting best out of teamwork.

vi. Communicative Skill: He should have communicative skill and be able to perceive the problems of his teammates and capable of helping to assist them solve their problems.

vii. Decision Making Skill: With his strong perception, analytical approach and skill, he should be capable of taking decision and responsibility.

viii. Honesty: He should be of unquestionable honesty , inculcating the same in his entire team.

ix. Administrative Skill: With his leadership skill, he should be able to lead, without dominating.

x. Discipline: With effective leadership, he should be an example of self discipline and be able to impose discipline in the organisation.

xi. Patience: He should not be hasty. With a mature mind, he should be open to the different views, before taking his decisions.

xii. Sound Knowledge: He should have a sound knowledge in his field and be constantly upgrading his knowledge with current developments in his area of functioning.

Finance Management and inter relationship with other departments:

purchase

Production

Marketing

Advertising

Financial Management Accounting

After Sales / Customer Care

Human Relations Department

Research & Development

Financial Management is not an isolated function. It is integrated with almost all other important functions required to achieve the main objective of the company. The most important of them being,

Co-ordination with Production Function:

Production function should closely co-ordinate with Finance to determine the optimum mix of the products to be made. This would, apart from the market demand and other factors, would depend on , profit margin of the product, feasibility of production, need for additional capacity to be invested and turnover cycle of production to profit. PERT reviews should be regularly discussed with production department for possible improvement in production process.

Co-ordination with Purchase Function:

Finance department should coordinate with purchase department to determine the raw material requirements, which is of prime importance. This would be a major demand on working capital. Size of inventory required, frequency of the orders, determination of minimum, maximum level of stocks, their storage, seasonal availability, terms of purchase, size of the orders and a variety of factors should be considered before planning the funds requirements for purchases. Best credit terms should be selected as it would ease strain on liquidity.

Co-ordination with Marketing Function:

Finance Managers should involve in creative discussion with various departments with over all objective of the company and suggest methods to the departments, which would be driven by their departments efficiency and goal achievement. In particular constant interaction with marketing function which would need finance for

I. Market research activities

II. Salary and incentives to the sales staff and field workers

III. Incentives and commission for dealers to remain competitive to rivals

IV. Recruitment of staff in marketing

V. Training of sales staff / dealers in promoting their marketing skills

VI. Development of new product

VII. Improving sales ,contributing to increased inflow of funds

VIII. Advertising in media – audio & visual

IX. Sales promotion and exploring potential areas for sales

X. Sample distribution and improvement of sales network

XI. Test marketing of new products/ in new areas

XII. Improve the packaging

XIII. Creation of Brand Image

Co-ordination with H R D Function:

Co-ordination with H R D Function is needed to interact and meet their requirement of finance for

I. Select and recruit competent staff

II. Training and development of employees

III. Retention of competent staff

IV. Payment of salaries and wages

V. Payment of bonus, perquisites like medical, LTA, accommodation, club membership etc.

VI. Providing an organised increment scheme to employees at all levels

VII. Providing welfare measures

Co-ordination with Research & Development Function:

Co-ordination with Research & Development Function is needed to interact and meet their requirement of finance for

I. New (and existing) Product development and design development

II. Market research activities to assess market share of the product and explore new areas of expansion

III. Innovations

The aim of the Financial Management should always be to clearly focus on optimisation of Shareholder’s wealth by increasing earnings per share, dividend per share and getting the best market price per share. As in the case of any business undertaking the motive should be to optimise the revenue at the least possible cost.

Co-ordination with AdvertisementFunction:

Co-ordination with AdvertisementFunction is needed to interact and meet their requirement of finance for

I. Media planning

II. Advertisement research

III. Penetration of new areas with advertising

IV. Improve ‘Brand Recall Image’ of the product through visual media

V. Conducting demos and roadshows

VI. Projecting a ‘consumer friendly image of the company

Co-ordination with Accounting and Finance Department Function:

Co-ordination with Accounting and Finance Department Function is needed to interact and meet their requirement of finance for

I. Payment of salaries

II. Provision of automated equipments like computers to facilitate easy and efficient Data Processing System

III. Installation of finance and accounting software relevant to the business

IV. Training the staff in up to date relevant skills for efficient performance

Co-ordination with After Sales Service:

Co-ordination with After Sales Service activities is needed to ensure customer confidence and goodwill as a satisfied customer would eventually be the spokesman of the company’s product and be an effective means for sales promotion. Finance would be needed for

I. Free door to door delivery, installation and training on use of the product.

II. Setting up grievance cell

III. Institute a system of regular customer feed back

The finance manager should assist the management to start with optimisation of earnings (Profits) and move over to optimisation of wealth. He is reportable to the General Manager with CEO/Managing Director and the Board with Share holders as the ultimate authority to be accountable to.

Equity Vs Debt Mix:

An intelligent mix of debt and equity mix could dramatically increase the Return on Investment for the investor.Consider, for example the following two methods of investment for a company:

Sources of Finance

Source of Funding

Situation

Option #1 Option #2

` `

Equity Share Capital

10% Preference Share Capital

Loans & Debentures @ 12%

Total Capital Employed

Net Profit Before Interest & Tax

2000000

-

-

400000

600000

1000000

2000000 2000000

600000 600000

In the first case the entire capital is raised by issue of equity shares. In the second case, 20% of the fundsare raised by equity capital, 30% by way of preference shares and remaining 50% raised from debt funding by way of loans and debentures bearing 10% interest per annum. The impact of the two options on Return to Investors (Equity Share Holders) would vary considerably as shown below:

Return on Equity

Particulars

Situation

Option #1 Option #2

` `

Net Profit Before Interest Tax

Interest on Loans & Debentures

Net Profit Before Tax

Income Tax (With Edu. Cess) @30.9%

Net Profit After Tax

Preference Share Dividend @10%

Funds for Equity Share Holders

Return on Investment (Equity Share Holders)

600000

-

600000

120000

600000

185400

414600

480000

148320

331680

- 60000

414600

20.7%

271680

67.9%

In the first situation the ROI is (414600 / 2000000) 20.7%.

In the second situation the ROI is (271689 / 400000) 67.9%.

The ROI is much more in second situation with lesser equity base. The option of Debt:Equity mix however would depend on several factors.

Role of a Finance Manager in India:

As against the role of Finance Manager in traditional days, when it was confined to raising of funds and managing the documentation formalities it has assumed increased dimensions in the present times. A modern day finance manager is concerned not only with raising of funds, but is equally concerned with the deployment of funds and managing it to optimise the wealth of the shareholders.

In the light of globalisation and international players entering the fray, the current day finance manager should be alert to competition and live up to the expectation of the organisation in optimising profitability and wealth amidst competition. The important changes in current day business making the task of finance managers more challenging are,

I. The advent of liberalisation of economy

II. Free pricing of securities through book building route allowed by SEBI.

III. Introduction of FEMA replacing draconian FERA.

IV. MRTP Act replaced by Competition Act

V. Freedom to companies to determine Face Value of their securities

VI. Changes in SEBI in Capital Markets

VII. Convertibility of Indian Rupee

VIII. Liberalising the regulation on FDI

IX. Relaxation of Interest rate restrictions

X. Rupee becoming a stronger currency

The current day finance manager should also be aware of various risks confronted by business to enable and equip himself with risk management measures.

I. Credit Risk

II. Interest Rate Risk

III. Business Risk

IV. Inflation Risk

V. Industry Risk (Example: Jute packaging)

VI. Liquidity Risk

VII. Systematic / Unsystematic Risk

VIII.

Working Capital Management

What Does Working Capital Management Mean?

Working Capital Management is a managerial accounting strategy focusing on keeping efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.

Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.

Working Capital is of several types1. Gross working capital

Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital. In simple words, it is total cash and cash equivalent on hand. But remember, we do not account of current liabilities in gross working capital. (EG:Stocks of Raw Materials, WIP, Finished Goods, Receivables, Prepaid Expenses, Accrued income, Advances paid, cash and bank balances).

2. Net Working Capital

Net working capital is the excess of current assets over current liabilities.

Net Working Capital = Total Current Assets – Total Current Liabilities 

This amount shows that if we deduct total current liabilities from total current assets, then balance amount can be used for repayment of long term debts at any time. It also measure of both a company's efficiency and its short-term financial health.

When current assets are more than the current liabilities, working capital is positive. If current liabilities are more than the current assets, working capital is negative.

When current assets are equal to current liabilities, it is a ‘zero working capital’.3. Permanent Working Capital

Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business. It also shows  the minimum amount of all current assets that is required at all times to ensure a minimum level of uninterrupted business operations.Permanent working capital is of two types: Initial Working Capital and Regular Working Capital. Initial Working Capital is the working capital required at the time of inception of the company. Initially, credit facility from bank and creditors may be difficult to come by. Initial Working Capital is required to prime the process of production until the regular activities start generating cash.

Regular Working Capital refers to the excess of current assets over current liabilities which keeps the business running.

4. Temporary Working Capital

Sometime, it may possible that we have to pay fixed liabilities, at that time we need working capital which is more than permanent working capital, then this excess amount will be temporary working capital. In normal working of business, we don’t need such capital.

5. Variable Working Capital

a. Seasonal Working Capital: Sometimes, the need for working cpital increases during certain periods / seasons of the year due to the nature of the business – Fruit juice extraction plants, food processing industry etc. During peak season more working capital will be needed and during off season, lesser working capita would be required. E.g Service Industries like tourism and travel, school reopening, monsoon etc.

b. Special Working Capital: To meet unforeseen eventualities like fire, storm, strikes etc, a company may need a temporary additional working capital to tide over the emergency for smooth continuity of operations. This is termed as Special Working Capital.

c. Peak Working Capital: The requirements of working capital may not be uniform theoughout the year. It may hit the peak during the year in some months when seasonal supply of materials (harvest time etc) , seasonal demand ( School uniforms, books, summer sales of cool drinks , warm clothings, construction activities, sale of Air conditioners etc.) will call for increased working capital needs.

Working capital as shown in the balance sheet on two financial years may not show the movement of working capital during the period. The movement of funds or funds flow will not be known from these figures. To know the movement of working capital is necessary as this alone will enable the Financial Manager to know when working capital need would be at its peak and when it would be slack. This knowledge would empower him to use surplus funds effectively.

These are known as balance sheet concept and operating cycle concept of working capital management.

I. Balance sheet concept

There are two interpretations of working capital under the balance sheet concept.

a. Excess of current assets over current liabilities (Net working capital)

b. Gross or total current assets.

The definition is meaningful only as an indication of the firm’s current solvency in repaying its

creditors. When firms speak of shortage of working capital they in fact possibly imply scarcity

of cash resources.

II. Operating cycle concept

A company’s operating cycle typically consists of three primary activities:

1. Purchasing resources :The firm has to maintain cash balance to pay the

bills as they come due Producing the product .

2. Inventory of Materials: In addition, the company must invest in

inventories to fill customer orders promptly distributing (selling) the

product.

3. Receivables Management : The company invests in accounts receivable

to extend credit to customers.

Operating cycle is equal to the length of inventory and receivable conversion periods.

The period of operating cycle would be the duration taken to convert the cash investments

(cash outflows) in material, labour and receivables (to mention a few) to cash inflows by way

of sales and other revenue. The lesser the period of such conversion, shorter the operating

cycle and more efficient the working capital management. The working capital turnaround

should be as fast as possible.

The operating cycle can briefly be summarised as below:

Cash on hand

Raw materials

Work in progress (inclusive of inputs of production cost)

Finished Goods (Conversion to Products ready for sale)

Receivables (in respect of credit sales

Cash on hand

The working capital funds are used for production and sales and after collection of receivables

get converted to funds again. The more often this cycle is completed, the more is the revenue

for the company.

The operating Cycle follows the following sequence:

Cash input is converted to raw materials

Raw material is converted to work in progress

Work in progress is converted to finished goods

Sale of finished goods to the extent of cash sales, releases funds immediately. Credit sales

generates receivables.

Receivables on collection becomes cash.

The operating Cycle (O C)is calculated as follows:

I. Initial capital input as Advance Money

II. Raw Material Inventory Holding Period

III. Work in Progress

IV. Finished Goods

V. Debtors

VI. Creditors

Formula for computing Operating Cycle: OC = A + R + W + F +D – C

Where OC is the period of the operating cycle.

A is the advance paid for purchases of Raw Materials

R is the period of holding the raw materials

W is the Work in Prigress duration

F is the period of holding the finished Goods

D is the Credit period to Debtors

C is the Credit period to Creditors

Number of Operating cycles in an year will be equal to 365 divided by duration of each

Operating Cycle.

Advance Working Capital Requirement will be = Total operating cost / Nr. Of Operating Cycles

in the year.

Factors Determining of Working Capital Needs:

1. Nature of Business: Service industries in general need lesser working capital

than manufacturing industries as their working capital turnover is several times

faster. Operating cycles in a financial year is more in service companies than

manufacturing companies as they do not hold huge amounts of inventory of Raw

Materials, WIP or finished goods. Merchandising businesses will carry even a higher

inventory than manufacturing industry and would need more working capital. They

will, generally having a larger Receivables too. Heavy industries, industries of

producer goods will have a working capital in lesser proportion to its Fixed capital

than industries manufacturing consumer products. Consumer durables in comparison

with FMCGs have a larger working Capital need and have a slower turnaround as

compared to FMCGs.

2. Scale of operations: A large scale chain of departmental stores will need a

larger working capital requirement than single unit supermarkets as their inventory

volume is spread over several units and locks up more working capital in inventories.

3. Production Time: Time consumed in manufacture of a product and its demand

would also influence the requirement of working capital. Faster the production and

more the sales, lesser will be the need for working capital with a faster Operating

cycle.

4. Purchase of raw materials: The nature of raw material purchase would

significantly affect the requirement of working capital. If the raw materials are

seasonal (Fruits, vegetables etc. For food processing industry), Grains during harvest

at competitive rates, scarce materials / materials in high demand, Controlled

materials etc would considerably affect the working capital requirements. Perishable

would need frequent purchase of smaller lots and may call for lesser Working Capital

with quicker turnover.

5. Manufacturing Process & Cost: If the special nature of manufacture is time

consuming and / or the cost of manufacture is high, working capital needs would be

more.

6. Working Capital turnover:

7. Manufacturing cycle: It starts with the purchase and use of raw materials and

completes with the production of finished goods. Longer the manufacturing cycle larger will

be the WC requirement; this is seen mostly in the industrial products.

8. Business fluctuation: When there is an upward swing in the economy, sales will

increase also the firm’s investment in inventories and book debts will also increase, thus it

will increase the WC requirement of the firm and vice-versa.

9. Production policy: To maintain an efficient level of production the firm’s may resort

to normal production even during the slack season. This will lead to excess production and

hence the funds will be blocked in form of inventories for a long time, hence provisions

should be made accordingly. Since the cost and risk of maintaining a constant production is

high during the slack season some firm’s may resort to producing various products to solve

their capital problems. If they do not, then they require high WC.

10. Firm’s Credit Policy: If the firm has a liberal credit policy its funds will remain

blocked for a long time in form of debtors and vice-versa. Normally industrial goods

manufacturing will have a liberal credit policy, whereas dealers of consumer goods will a

tight credit policy.

11. Availability of Credit: If the firm gets credit on liberal terms it will require less WC

since it can always pay its creditors later and vice-versa.

12. Growth and Expansion Activities: It is difficult precisely to determine the

relationship between volume of sales and need for WC. The need for WC does not follow

the growth but precedes it. Hence, if the firm is planning to increase its business activities,

it needs to plan its WC requirements during the growth period.

13. Inflation: During Inflation, cost of inputs (Men, Material & Overheads) would be higher,

resulting in more demand for Working Capital.

14. Profit Margin and Profit Appropriation: A high net profit margin contributes

towards the WC pool. Also, tax liability is unavoidable and hence provision for its payment

must be made in the WC plan, otherwise it may impose a strain on the WC.

15. Retained Earnings: Also if the firm’s policy is to retain the profits it will increase their

WC, and if they decide to pay their dividends it will weaken their WC position, as the cash

will flow out. However this can be avoided by declaring bonus shares out of past profits.

This will help the firm to maintain a good image and also not part with the money

immediately, thus not affecting the WC position.

16. Depreciation policy of the firm, through its effect on tax liability and retained

earning, has an influence on the WC. The firm may charge a high rate of depreciation,

which will reduce the tax payable and also retain more cash, as the cash does not

flow out. If the dividend policy is linked with net profits, the firm can pay fewer

dividends by providing more depreciation. Thus depreciation is an indirect way of

retaining profits and preserving the firms WC position.

17. Change in technology: The working capital requirements will vary with change

in technology as well. It could be in the following manner:

Labour oriented technology will be costlier, with higher wage bill, than mechanical

process.

Improved technology resulting in reduced machine time in manufacture would again

reduce the working capital needs.

18. Government Policies and Regulations: Government’s change in Income Tax Policy,

increasing taxation rates would reduce the retained earnings and increase the

Working Capital requirements. So will be the impact of any tariff, taxes or levies

introduces on the working capital.

Negative Working Capital (or changes)

 Can the change in non-cash working capital be negative? When current liabilities exceed the

current assets, working capital turns negative.This can be avoided by efficient management of

working capital by optimising inventory, receivales and credit terms. Working capital could also be

reduced as a deliberate strategy of an efficient finance management. Once working capital is being

managed efficiently, the working capital changes from year to year can be estimated using working

capital as a percent of revenues. For example, consider a firm that has non-cash working capital

that represent 10% of revenues and that you believe that better management of working capital

could reduce this to 6% of revenues.

Valuation of components of Working Capital:

A.CURRENT ASSETS:

I. Raw Materials:  Raw Materials are valued at cost.

II. Work in Progress: Work in Progress is to be valued at the given % of Raw Materials,Labour and Overheads. If no specific % is given, Raw Material Cost is taken at 100% and labour and overhead @ 50%

III. Finished Goods: Finished Goods are valued at cost price.

IV. Receivables: Sundry Debtors are valued at cost of goods sold to them. This is based on ‘Conservative Approach’ of not accounting of profit until the debt is recovered. However some value Receivables at sale price. This would mean that unrealised profit is included, which is not a conservative approach. Finished goods and Receivables should be valued at cost price.

V. Others: Advances paid, prepaid expenses, Income received in advance, cash and bank balances are taken at actual value.

B.CURRENT LIABILITIES:

I. Trade Creditors: Trade Creditors are valued at actual cost of purchases.

II. Bank Overdraft: Valued at actuals.

III. Outstanding Wages/ expenses: Valued at actuals.

Outstanding liability for Wages are calculated as below:

Wages accrue for every 15 days (2 Weeks).

1st of the month 15th of the month End of the month

Prepaid On due date outstanding

If wages of a month (say January) are paid at the end of the month, they are outstanding for

half month.

If wages of a month (say January) are paid at the beginning of the month, they are prepaid for

half month.

If wages of a month (say January) are paid on 15th of the month, they are neither outstan-

ding nor prepaid.

If wages of a month (say January) are paid on 10th of the next month (on 10th February), they

are outstanding for 5/6 of the month..

= 15/30 + 10/30 = 25/30 = 5/6 month.

If wages of a month (say January) are paid on 15th of the month, they are outstanding for

(5/30 = 1/6) 1/6 of a month.

This formula should be applied for calculating outstanding wages, where required.

Maximum permissible bank finance:

For calculating Maximum permissible bank finance a committee headed by Shri P.L.Tandon,

then Chairman of Punjab National Bank was appointed in 1974. This was followed by Chore

Committee in 1979. The committees recommended 3 methods for ascertaining Maximum

Permissible Bank Finance (MPBF). In the third method it was suggested that Core Current

Assets i.e. permanent current assets (that means bare minimum level of raw material, work in

progress, finished goods and stores to keep the manufacturing process going on) should be

financed from long term funds.

Tandon Committee Report on Working Capital:

Tandon committee recommended that the creditworthiness of the business enterprise needing

finance should be analysed. Based on the study the enterprise should be classified as per the risk

perceived into three types – Borrowers with low risk coverage, Borrowers of medium risk coverage

and Borrowers of high risk coverage.

The permissible borrowing limits should be fixed as under:

Borrowers with low risk coverage

MPBF = 0.75( CA – CL)

Maximum Permissible Bank Finance in such cases should be upto 75% of net current Assets i.e

(Current Assets – Current Liabilities)

Borrowers of medium risk coverage

Maximum Permissible Bank Finance in such cases should be upto 75% of current Assets less

Current Liabilities (0,75 x Current Assets) – Current Liabilities.

Borrowers of high risk coverage

Maximum Permissible Bank Finance in such cases should be upto 75% of (current Assets less Core

Current Assets) - Current Liabilities .

NOTE:

CA = Current Assets

CL = Current Liabilities excluding Bank OD

CCA = Core Current Assets. Core Current Assets are those minimum current Assets which are

always required in the business to keep it going.

RECEIVABLES MANAGEMENT

Book Debts are debts in respect of dues receivable from Trade debtors in respect of credit

sales. Receivables denote the funds locked up in credit sales of a business. Credit Sales and

therefore receivables are unavoidable in a running business. It carries with it the risk of

uncollectable or Doubtful Debts as well. This is a crucial area requiring the attention of the

Financial Manager , calling for constant monitoring and corrective action.

Receivables have costs attached to it. They are,

Cost of Collection: Follow up of the debts until they are settled involve inherent administrative

costs. Even good debts involve cost of follow up and collection of the same on due dates. In

addition to book keeping costs they may involve man hours and travel cost in follow up of

debts.

Cost of Capital: receivables lock up a part of working capital and therefore funds not available

for production. So it results in cost for additional funds to replace the funds lost in the form of

receivables with cost of raising such funds.

Cost of delinquency: Debtors may fail to pay on the due dates. This would extend the period

of the funds locked in the form of such book debts, further increasing the cost of replacement

working capital. It may also entail additional expenses such as legal costs and intensified

collection efforts. This increases the overall cost.

Cost of Default: Some customers may express their inability to service their debts, in which

case it becomes a doubtful debt and ultimately, bad debt. These unrealised bad debts are a

drain on profits.

A system must be in place to track accounts receivables. This will include balance forwards, listing of all open invoices, and generation of monthly statements to customers. An ageing of receivables will be used to collect overdue accounts enabling the Finance Manager to expedite collection measures. Measurement is another component within account receivable management. Traditional ratios, such as turnover will measure how many times you were able to convert receivables over into cash. 

Objectives of Management of Receivables:

a) To lay down a clear credit policy and communicate it to all concerned departments, in

particular - the Sales Department as it generates the Receivables, the collection

Department that follows up the dues. The customers buying on credit should be also

clearly aware of the credit policy of the company.

b) Establishment of a clear system of management of creation of receivables, presenting

the Receivables and collection of the dues.

c) Creating a machinery to evaluate the creditworthiness of the customers and setting

the credit limits.

d) Ensuring prompt raising and submission of invoices.

e) Maintenance of updated accounts of the receivables.

f) Initiate action for collection of overdues.

Credit Analysis of Customers:

I. Traditionally, customers credit is analysed on ‘5 C’s principle. This is explained

separately.

II. Financial Statements may be asked to be submitted by customer. Analysis of such

statements would give an idea of solvency, liquidity and capacity of the customer to

pay.

III. Bank References may be asked for from the customer. This would give a clear picture

of creditworthiness of the customer.

IV. Visit to the customer may give a firsthand idea of the customer’s business and give a

fair idea of the creditworthiness of the customer.

V. Trade Reference ; enquiry in the trade about the customer would provide a general

idea of the creditworthiness of the customer.

VI. Bank Guarantee/ Third Party Guarantee: Getting a Bank Guarantee or a third party

guarantee in respect of first time customers would ensure payment of dues in time.

VII. Credit bureaus can provide services on credit rating of the customer giving a reliable

information on the creditworthiness of the customer.

Method of collection of debts:

Debts can be collected by various means,

I. By centralised / decentralised collection system

II. Pay Orders/ Bank Drafts

III. Post Dated Cheques

IV. Bills of exchange

V. Letters of Credit opened in company’s favour

VI. Staff deputed for debt collection

VII. Outsourced Debt Collection Agency

VIII. Factoring

IX. Del Credre Agents and other agencies.

Control of Receivables:

Account Receivables are generally measured and controlled in three ways,

A.Expressing debts in terms of number of days sales.

= Days Sales Outstanding = Accounts Receivable

Avg. Daily Sales

Any increase in Days Sales Outstanding would call for immediate attention and corrective action.

B.Ageing Schedule: Preparation of ageing schedule of debtors, classifying them into

different periods (say 30 days, 60 days and 90 days) would highlight the impact on how long

the debt has been due, locking up the funds of the company, calling for immediate corrective

action.

C.‘ABC’ analysis of Book Debts: This is an effective approach in control of inventory and

Receivables. The debts are categorised into three heads, where,

Few customers forming a major proportion of debts are categorised as ‘A’ type.

Customers of moderate amounts due are categorised as ‘B’ type and

Large number of customers owing small amounts are categorised as ‘C’ type.

Obviously concentration on ‘A’ type would help clear a major part of receivables instead of

sparing equal efforts on all debtors irrespective of amount due by them.

Customers Credit Analysis on ‘5 C’s Principle:

Traditionally, customers credit is analysed on ‘5 C’s principle.

Character: Credit Character can be assessed by study of the customer’s income, pattern of

payments to meet his obligations, profitability of his business and his general reputation in

the market.

Capacity: The earning capacity of the customer will provide a fair idea of his credit

worthiness.

Capital: The worth of the customer can be assessed with his tangible assets, profits/ earnings

from various sources and the properties he may own.

Collateral: What the customer can offer by way of security to fall back in case of delay in

payment would also give a fair idea about his credit worthiness.

Conditions: The general condition of economy, the particular condition of the business the

customer is into and other relevant factors would provide a fair idea of his credit worthiness.

Credit appraisal of customers:

These factors help the company to analyse the custmers’ credit worthiness. Analyse the

custmers’ credit worthiness is necessary to determine the ‘Credit Risk’ on account of

customers failure to pay.

CRISIL, ICRA Limited and Credit Analysis & Research Ltd. (CARE) are few of the credit rating agencies in India.

Credit worthiness report is prepared, based on the data obtained from,

I. Competitors, neighbours of the customer and the marketing representatives.

II. Customer’s Bank, where he keeps his account and avails of the facilities.

III. Accounts of the customer and evaluation of his assets.

IV. Information gathered from other suppliers to the customer, guarantor or other

creditors.

Based on the information obtained the customers are graded into the following categories:

AAA+ Prime Category 90% +

AAA Excellent 80% to less than 90%

AA Good 60% to less than 80%

A Satisfactory 40% to less than 60%

B Risk Prone Below 40%

C High Risk Doubtful Assets

D Very High Risk Low Assets

Customers could also be classified as:

AAA 50 points and above

AA 40 to 49 points

A 30 to 39 points

B Below 30

After the assessment is done decision is made as to whether to extend credit and if

extended limits up to which credit could be extended.

Present customers and new customers are treated on different levels. The present

customers can be studied on the basis of their present payment record where as new

customers are unknown factors and are to be treated with caution.

Such credit reviews are to be done periodically and records updated.

Del Credre Agent: A del credere (Italian for belief or trust) agent, is one who, selling goods for

his principal on credit, undertakes for an additional commission to sell only to persons who are

absolutely solvent. His position is thus that of a surety who is liable to his principal should

the vendee make default.

The agreement between him and his principal need not be reduced to or evidenced by writing, for

his undertaking is not a guarantee within the Statute of Frauds. A Del Credere Agent is an agent

who not only establishes a privity of contract between his principal and the third party, but who

also guarantees to his principal the due performance of the contract by the third party. He is liable,

however, only when the third party fails to carry out his contract, e.g., by insolvency. He is not

liable to his principal if the third party refuses to carry out his contract for example, if the buyer

refuses to take delivery.

For assumption of Credit risk, the del credre agents are given extra commission called del

credre commission over and above the normal commission on sales.

Opportunity cost :Opportunity cost is the cost of any activity measured in terms of the best

alternative forgone. It is the sacrifice related to the second best choice available to someone

who has picked among several mutually exclusive choices. 

It is a key concept in economics.

I. It has been described as expressing "the basic relationship between scarcity and

choice.

II. The notion of opportunity cost plays a crucial part in ensuring that scarce resources

are used efficiently.

III. Thus, opportunity costs are not restricted to monetary or financial costs: the real

cost of output forgone, lost time, pleasure or any other benefit that

provides utility should also be considered opportunity costs.

Account receivables represents capital locked up which could have been put to alternate use.

The alternate cost of this is expressed as opportunity cost.

2007 Subprime Mortgage Crisis in US:

Indian economy is driven by savings and investments as against US economy , driven by

spending than earning. Their excess of spending over earning is financed by Banks and

Finance Companies. Home loan banking is very active in US economy. Home loans are

generally given to customers of ‘Prime’ category’ based on their creditworthiness. These

loans were later sold by the banks to SPV – Special Prime Vehicle created for this purpose.

SPV issued Collateral Debt Instruments to investors and collected money from the investors.

This money was given to banks as a consideration for purchasing the loan amount. This

helped the banks in two ways,

The liquidity of the banks improved

The banks were relieved of the burden of following up instalments and recovery of

mortgage loans as they were already sold.

The banks , flush with funds gave further loans to second level borrowers whose credit

worthiness was less than the borrowers of ‘Prime’ category. The loans were thus made to

‘Sub- Prime’ category of borrowers. Because of the higher risk, they were charged higher rate

of interest.

Again the loans were sold to SPV through ‘securitization’ and again SPV issued collateral debt

instruments to investors who invested in these instruments. These investments were to be

paid as and when future instalments were recovered. This process went on and on.....

The bubble burst when borrowers of home loans started defaulting in repayments of the

instalments. SPV in turn could not redeem their securities with their investors. On the sideline,

the insurance companies that had covered the assurance for CDIs (Collateral Debt

Instruments) could not bear the staggering claims due to defaults by borrowers and had

started defaulting in their commitments to honour the risk. The chain reaction of Sub Prime

borrowers default to SPV, SPV turning to Insurance companies, who had defaulted to meet

their claims, leading to default in redemption of CDIs (Collateral Debt Instruments) to

investors.

This led to the US Sub Prime Crisis, triggered by Home Loan repayment defaults by Sub

Prime borrowers.

This would drive home the importance of Receivables control and Receivables Management.

Method of Evaluation of Alternate Credit Policies:A.If Variable & Fixed Costs are given

Credit Policy

Period of Credit (Days/Months)

Present

Policy

Option

(I)

Option

(II)

Option

(III)

Particulars  ` ` ` `

Sales

Less Variable Cost (i)

Contribution

Less Fixed Cost (ii)

Profit – A

Total Cost : (i) + (ii)

Avg Investment in Receivables

(Based on total cost)

Cost of extending Credit:

i.__%Opportunity Cost of Capital

(calculated on Avg Investment in

Receivables)

ii.Bad Debts (as % of Sales)

iii.Credit Collection & Admin Cost

Total Cost of extending Credit –B

Net Benefit (A-B)

Incremental Net Benefit

Method of Evaluation of Alternate Credit Policies:B.If Only Variable Cost is given

Credit Policy

Period of Credit (Days/Months)

Present

Policy

Option

(I)

Option

(II)

Option

(III)

Particulars  ` ` ` `

Sales

Less Variable Cost (i)

Profit – A

Avg Investment in Receivables

(Based on Sales)

Cost of extending Credit:

i.__%Opportunity Cost of Capital

(calculated on Avg Investment in

Receivables)

ii.Bad Debts (as % of Sales)

iii.Credit Collection & Admin Cost

Total Cost of extending Credit –B

Net Benefit (A-B)

Incremental Net Benefit