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Working Capital Management

This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for Working Capital Management.

JNU, JaipurFirst Edition 2013

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JNU makes reasonable endeavours to ensure content is current and accurate. JNU reserves the right to alter the content whenever the need arises, and to vary it at any time without prior notice.

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Index

ContentI. ...................................................................... II

List of FiguresII. .........................................................VI

List of TablesIII. ........................................................ VII

AbbreviationsIV. .....................................................VIII

Case StudyV. .............................................................. 117

BibliographyVI. ........................................................ 122

Self Assessment AnswersVII. ................................... 125

Book at a Glance

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Contents

Chapter I ....................................................................................................................................................... 1Working Capital Analysis............................................................................................................................ 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction ............................................................................................................................................. 21.2 Meaning of Working Capital .................................................................................................................... 2 1.2.1 Importance of Adequate Working Capital ............................................................................... 3 1.2.2 Optimum Working Capital ....................................................................................................... 41.3 Determinants of Working Capital ............................................................................................................ 41.4 Issues in the Working Capital Management............................................................................................. 5 1.4.1 Current Assets to Fixed Assets Ratio ....................................................................................... 5 1.4.2 Liquidity versus Profitability ................................................................................................... 61.5 Estimating Working Capital Needs .......................................................................................................... 61.6 Operating or Working Capital Cycle........................................................................................................ 61.7 Concept of Working Capital ................................................................................................................... 71.8 Requirements of Working Capital ........................................................................................................... 71.9 Classification of Working Capital ........................................................................................................... 81.10 Significance of Working Capital Management ..................................................................................... 91.11 Factors Influencing Working Capital Requirements ............................................................................. 91.12 Principles of Working Capital Management ....................................................................................... 101.13 Structure of Working Capital ................................................................................................................11Summary ..................................................................................................................................................... 13References ................................................................................................................................................... 13Recommended Reading ............................................................................................................................. 14Self Assessment ........................................................................................................................................... 15

Chapter II ................................................................................................................................................... 17Cash Management ..................................................................................................................................... 17Aim .............................................................................................................................................................. 17Objectives .................................................................................................................................................... 17Learning outcome ........................................................................................................................................ 172.1 Introduction ............................................................................................................................................ 182.2 General Principles of Cash Management: .............................................................................................. 192.3 Functions of Cash Management ............................................................................................................. 202.4 Motives of Holding Cash ....................................................................................................................... 212.5 Financing of Cash Shortage and Cost of Running Out of Cash ............................................................ 222.6 Financing Current Assets ....................................................................................................................... 23Summary ..................................................................................................................................................... 25References ................................................................................................................................................... 25Recommended Reading ............................................................................................................................. 25Self Assessment ........................................................................................................................................... 26

Chapter III .................................................................................................................................................. 28Cash Flow and Financial Planning ........................................................................................................... 28Aim .............................................................................................................................................................. 28Objectives .................................................................................................................................................... 28Learning outcome ........................................................................................................................................ 283.1 Introduction ............................................................................................................................................ 293.2 Depreciation ........................................................................................................................................... 293.3 Classifying Inflows and Outflows of Cash ............................................................................................ 303.4 Preparing the Statement of Cash Flows ................................................................................................. 313.5 Cash Planning: Cash Budgets ................................................................................................................ 32

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3.5.1 The Sales Forecast ................................................................................................................. 32 3.5.2 Preparing the Cash Budget .................................................................................................... 333.6 Net Cash Flow, Ending Cash, Financing, and Excess Cash .................................................................. 353.7 Cash Forecasting .................................................................................................................................... 36Summary ..................................................................................................................................................... 38References ................................................................................................................................................... 38RecommendedReading .............................................................................................................................. 39Self Assessment ........................................................................................................................................... 40

Chapter IV .................................................................................................................................................. 42Liquidity and Working Capital Financing .............................................................................................. 42Aim .............................................................................................................................................................. 42Objectives .................................................................................................................................................... 42Learning outcome ........................................................................................................................................ 424.1 Introduction ............................................................................................................................................ 434.2 Traditional Measures .............................................................................................................................. 43 4.2.1 An Alternative Method ........................................................................................................... 434.3 Liquidity Ratios ..................................................................................................................................... 44 4.3.1 Types of Liquidity Ratio ........................................................................................................ 444.4 Net Working Capital .............................................................................................................................. 45 4.4.1 Business Uses of Working Capital ......................................................................................... 454.5 Permanent and Cyclical Working Capital .............................................................................................. 464.6 Forms of Working Capital Financing ..................................................................................................... 47 4.6.1 Line of Credit ......................................................................................................................... 47 4.6.2 Accounts Receivable Financing ............................................................................................. 47 4.6.3 Factoring ................................................................................................................................ 484.7 Inventory Financing ............................................................................................................................... 484.8 Term Loan .............................................................................................................................................. 494.9 Sources of Working Capital for Small Businesses ................................................................................. 504.10 Underwriting Issues in Working Capital Financing ............................................................................. 51Summary ..................................................................................................................................................... 52References ................................................................................................................................................... 52Recommended reading .............................................................................................................................. 53Self Assessment ........................................................................................................................................... 54

Chapter V .................................................................................................................................................... 56Cash Management and Financial Flexibility ........................................................................................... 56Aim .............................................................................................................................................................. 56Objectives .................................................................................................................................................... 56Learning outcome ........................................................................................................................................ 565.1 Introduction ............................................................................................................................................ 575.2 Corporate Cash Management ................................................................................................................. 575.3 Value-Based Strategy in Working Capital Management ........................................................................ 605.4 Value-Based Strategy in Cash Management .......................................................................................... 615.5 Cash Balance Forecasting ...................................................................................................................... 645.6 Precautionary Cash Management - Safety Stock Approach .................................................................. 65Summary ..................................................................................................................................................... 66References ................................................................................................................................................... 66Recommended Reading ............................................................................................................................. 67Self Assessment ........................................................................................................................................... 68

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Chapter VI .................................................................................................................................................. 70Inventory Management ............................................................................................................................. 70Aim .............................................................................................................................................................. 70Objectives .................................................................................................................................................... 70Learning outcome ........................................................................................................................................ 706.1 Introduction ............................................................................................................................................ 716.2 Functions of Inventory ........................................................................................................................... 726.3 Classification of Inventory Systems ...................................................................................................... 72 6.3.1 Lot Size Reorder Point Policy ............................................................................................... 72 6.3.2 Fixed Order Interval Scheduling Policy ................................................................................ 73 6.3.3 Optional Replenishment Policy ............................................................................................. 746.4 Other Types of Inventory Systems ......................................................................................................... 746.5 Selective Inventory Management .......................................................................................................... 74 6.5.1 ABC Analysis ......................................................................................................................... 75 6.5.2 VED Analysis......................................................................................................................... 76 6.5.3 FSN Analysis ......................................................................................................................... 766.6 Exchange Curve and Aggregate Inventory Planning ............................................................................. 766.7 Deterministic Inventory Models ............................................................................................................ 77Summary ..................................................................................................................................................... 78References ................................................................................................................................................... 78Recommended Reading ............................................................................................................................. 79Self Assessment ........................................................................................................................................... 80

Chapter VII ................................................................................................................................................ 82Capital and Money Market ....................................................................................................................... 82Aim .............................................................................................................................................................. 82Objectives .................................................................................................................................................... 82Learning outcome ........................................................................................................................................ 827.1 Introduction ............................................................................................................................................ 837.2 Financial Market .................................................................................................................................... 837.3 Capital Market Efficiency ...................................................................................................................... 84 7.3.1 Forms of Capital Market Efficiency ...................................................................................... 857.4 Capital Market Operations ..................................................................................................................... 867.5 Money Market ........................................................................................................................................ 86 7.5.1 Characteristics of Money Market .......................................................................................... 87 7.5.2 Functions of Money Market .................................................................................................. 87 7.5.3 Importance of Money Market ................................................................................................ 887.6 Indian Money Market Instruments ......................................................................................................... 897.7 Drawbacks of Indian Money Market ..................................................................................................... 917.8 Reforms in Indian Money Market .......................................................................................................... 92Summary ..................................................................................................................................................... 93References ................................................................................................................................................... 93Recommended Reading ............................................................................................................................. 94Self Assessment ........................................................................................................................................... 95

Chapter VIII ............................................................................................................................................... 97Receivable Management ............................................................................................................................ 97Aim .............................................................................................................................................................. 97Objectives .................................................................................................................................................... 97Learning outcome ........................................................................................................................................ 978.1 Introduction ........................................................................................................................................... 988.2 Receivable Management ........................................................................................................................ 988.3 Cost of Maintaining Receivables ......................................................................................................... 1018.4 Factors Affecting the Size of Receivables ........................................................................................... 1028.5 Principles of Credit Management ........................................................................................................ 103

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8.6 Objectives of Receivable Management ............................................................................................... 1048.7 Aspects of Credit Policy ....................................................................................................................... 1058.8 Determination of Credit Policy ............................................................................................................ 106 8.8.1 Credit Terms ......................................................................................................................... 106 8.8.2 Credit Standards ................................................................................................................... 108 8.8.3 Collection Policy .................................................................................................................. 1088.9 Collection of Accounts Receivables .................................................................................................... 109 8.9.1 Types of Collection Efforts .................................................................................................. 109 8.9.2 Degree of Collection Efforts ................................................................................................ 109 8.9.3 Collection Follow-Up System ..............................................................................................1108.10 Credit Control .....................................................................................................................................1108.11 Control of Receivables ........................................................................................................................111 8.11.1 Payment Pattern Approach ..................................................................................................111Summary ....................................................................................................................................................113References ..................................................................................................................................................114Recommended Reading ............................................................................................................................114Self Assessment ..........................................................................................................................................115

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List of Figures

Fig. 1.1 The angles of working capital management ..................................................................................... 2Fig. 1.2 Permanent and temporary working capital ....................................................................................... 3Fig. 1.3 Alternative current assets policies .................................................................................................... 5Fig. 3.1 The firm’s cash flow ....................................................................................................................... 30Fig. 3.2 The short-term financial planning process ..................................................................................... 32Fig. 4.1 Cash flow and the working capital cycle ........................................................................................ 46Fig. 5.1 Liquid assets influence on value of the corporation ....................................................................... 58Fig. 5.2 Reasons for holding cash by companies and their relation to the risk ........................................... 60Fig. 5.3 BAT model ...................................................................................................................................... 62Fig. 5.4 Beranek model ................................................................................................................................ 63Fig. 5.5 Miller –Orr model ........................................................................................................................... 63Fig. 5.6 Stone model .................................................................................................................................... 64Fig. 6.1 Typical inventory balances for EOQ- reorder point policy............................................................. 73Fig. 6.2 Fixed reorder cycle policy. ............................................................................................................. 73Fig. 6.3 Typical inventory balances in policy. ............................................................................................. 74Fig. 6.4 ABC analysis .................................................................................................................................. 75Fig. 7.1 The financial system ....................................................................................................................... 84Fig. 8.1 Flowchart showing the purpose of maintaining receivables ........................................................ 101

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List of Tables

Table 3.1 The general format of the cash budget ......................................................................................... 33Table 3.2 A schedule of projected cash receipts for Coulson Industries ($000) .......................................... 34Table 3.3 A sensitivity analysis of Coulson industries cash budget ............................................................. 35

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Abbreviations

JIT - Just In TimeEOQ - Economic order quantityMACRS - ModifiedacceleratedcostrecoverysystemOCF - operatingcashflowFCF - freecashflowNFAI - NetfixedassetinvestmentNCAI - Net current asset investmentA/R - accounts receivableR&D - receipts and disbursementsANI - adjusted net incomeEBIT - Earnings Before Interest, TaxesPBS - Pro forma balance sheetARM - Accrual reversal methodFCFF - freecashflowstofirmNWC - net working capital growthCA - Current AssetsCL - Current LiabilitiesCCI - Controller of Capital IssuesCP - Commercial paperAPY - Annual Percentage YieldAPR - Annual Percentage RateMMMFs - Money Market Mutual FundDFHI - Discount and Finance House of IndiaLAF - Liquidity Adjustment Facility

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Chapter I

Working Capital Analysis

Aim

The aim of this chapter is to:

definethegoalofworkingcapitalmanagement•

elucidate the concept of work capital•

explain the importance of working capital•

Objectives

The objectives of this chapter are to:

explain the types of working capital•

explicate the issues in the working capital management•

elucidate the determinants of working capital•

Learning outcome

At the end of this chapter, you will be able to:

understandthecurrentassetstofixedassetsratio•

identify the working capital cycle•

recognisethesignificanceofworkingcapitalmanagement•


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1.1 Introduction WorkingCapitalManagementinvolvesmanagingthebalancebetweenfirm’sshort-termassetsanditsshort-termliabilities.Thegoalofworkingcapitalmanagementistoensurethatthefirmisabletocontinueitsoperationsandthatithassufficientcashflowtosatisfybothmaturingshort-termdebtsandupcomingoperationalexpenses.Theinteraction between current assets and current liabilities is, therefore, the main theme of the theory of working capital management.

There aremany aspects ofworking capitalmanagementwhichmakes it an important function of financialmanagement.

Time:Workingcapitalmanagementrequiresmuchofthefinancemanager’stime.•Investment: Working capital represents a large portion of the total investment in assets.•Credibility:Workingcapitalmanagementhasgreatsignificanceforallfirms,butitisverycriticalforsmall•firms.Growth:Theneedforworkingcapitalisdirectlyrelatedtothefirm’sgrowth.•

1.2 Meaning of Working CapitalThe concept of working capital can also be explained through two angles.


Value Time

Gross Working Capital

Net Working Capital

Permanent Temporary

OR

Fig. 1.1 The angles of working capital management

ValueFromthevaluepointofview,workingcapitalcanbedefinedasgrossworkingcapitalornetworkingcapital.Grossworkingcapitalreferstothefirm’sinvestmentincurrentassets.Currentassetsarethoseassetswhichcanbeconverted into cash within an accounting year. Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash balances, etc.

Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year. Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends payable and Short-term loans. A positive working capital means that the company is able to payoff its short-term liabilities. A negative working capital means that the company currently is unable to meet its short-term liabilities.

TimeFrom the point of view of time, the term working capital can be divided into two categories viz., permanent and temporary.

Permanent working capital refers to the hard core working capital. It is that minimum level of investment in the current assets that is carried by the business at all times to carry out minimum level of its activities.

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Temporary working capital refers to that part of the total working capital, which is required by a business over and above the permanent working capital. It is also called variable working capital. Since the volume of temporary working capitalkeepsonfluctuatingfromtimetotimeaccordingtothebusinessactivities,itmaybefinancedfromshort-termsources.Thefollowingdiagramsshowpermanentandtemporaryorfluctuatingorvariableworkingcapital:

Fig. 1.2 Permanent and temporary working capital

Bothkindsofworkingcapital,i.e.permanentandfluctuating(temporary)arenecessarytofacilitateproductionandsales through the operating cycle.

1.2.1 Importance of Adequate Working CapitalManagementofworkingcapitalisanessentialtaskofthefinancemanager.Hehastoensurethattheamountofworking capital available with his concern is neither too large nor too small for its requirements.

A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company hastopayhugeamountasinterestonsuchfunds.Ifthefirmhasinadequateworkingcapital,suchfirmrunstheriskofinsolvency.Paucityofworkingcapitalmayleadtoasituationwherethefirmmaynotbeabletomeetitsliabilities. Various studies conducted by the Bureau of Public Enterprises have shown that one reason for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over-capitalisation. Overcapitalisation implies that a company has too large funds for its requirements,resultinginalowrateofreturnasituationwhichimpliesalessthanoptimaluseofresources.Afirmhas, therefore, to be very careful in estimating its working capital requirements. Maintaining an adequate working capitalisnotjustimportantintheshort-term.Sufficientliquiditymustbemaintainedinordertoensurethesurvivalof the business in the long-term as well. When business makes investment decisions, they must not only consider thefinancialoutlayinvolvedwithacquiringthenewmachineorthenewbuilding,etc.,butmustalsotakeaccountof the additional current assets that are usually required with any expansion of activity. For e.g.:

Increased production leads to hold additional stocks of raw materials and work in progress.•An increased sale usually means that the level of debtors will increase.•Ageneralincreaseinthefirm’sscaleofoperationstendstoimplyaneedforgreaterlevelsofworkingcapital.•

Aquestionthenariseswhatanoptimumamountworkingcapitalisforafirm?Wecansaythatafirmshouldneitherhavetoohighanamountofworkingcapitalnorshouldthesamebetoolow.Itisthejobofthefinancemanagertoestimate the requirements of working capital carefully and determine the optimum level of investment in working capital.


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1.2.2 Optimum Working CapitalIf a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. It is understood that a currentratioof2(two)foramanufacturingfirmimpliesthatthefirmhasanoptimumamountofworkingcapital.This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position, if liquid current assets are equal to current liabilities. Bankers,financialinstitutions,financialanalysts,investorsandotherpeopleinterestedinfinancialstatementshave,for years, considered the current ratio at, ‘two’ and the acid test ratio at, ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate.

However, it should be remembered that optimum working capital can be determined only with reference to the particularcircumstancesofaspecificsituation.Thus,inacompanywheretheinventoriesareeasilysaleableandthesundrydebtorsareasgoodasliquidcash,thecurrentratiomaybelowerthan2andyetthefirmmaybesound.

Innutshell,afirmshouldhaveadequateworkingcapitaltorunitsbusinessoperations.Bothexcessiveaswellasinadequate working capital positions are dangerous.

1.3 Determinants of Working CapitalWorking capital management is concerned with:-

Maintaining adequate working capital (management of the level of individual current assets and the current •liabilities)Financing of the working capital•

Forthepointa)above,afinancemanagerneedstoplanandcomputetheworkingcapitalrequirementsforitsbusiness.Oncetherequirementhasbeencomputed,heneedstoensurethatitisfinancedproperly.Thiswholeexerciseisnothing but Working Capital Management.

Soundfinancialandstatisticaltechniques,supportedbyjudgementshouldbeusedtopredictthequantumofworkingcapital required at different times. Some of the items/factors which need to be considered while planning for working capital requirement are:

Cash: Identify the cash balance which allows for the business to meet day-to-day expenses, but reduces cash •holding costs.Inventory: Identify the level of inventory which allows for uninterrupted production but reduces the investment •inrawmaterialsandhenceincreasescashflow.ThetechniqueslikeJustInTime(JIT)andEconomicOrderQuantity (EOQ) are used for this.Debtors: Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any •impactoncashflowsandthecashconversioncyclewillbeoffsetbyincreasedrevenueandhenceReturnonCapital (or vice versa). The tools like discounts and allowances are used for this.Short-termfinancingoptions:Inventoryisideallyfinancedbycreditgrantedbythesupplier;dependentonthe•cash conversion cycle, it may however, be necessary to utilise a bank loan (or overdraft), or to “convert debtors tocash”through“factoring”inordertofinanceworkingcapitalrequirements.Nature of business: For e.g., in a business of restaurant, most of the sales are in cash. Therefore, the need for •working capital is very less.Market and demand conditions: For e.g., if an item demand far exceeds its production, the working capital •requirementwouldbelessasinvestmentinfinishedgoodinventorywouldbeveryless.Technology and manufacturing policies: For e.g., in some businesses, the demand for goods is seasonal. In •that case, a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season.

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Operatingefficiency:Acompanycanreducetheworkingcapitalrequirementbyeliminatingwaste,improving•coordination, etc.Price level changes: For e.g., rising prices necessitate the use of more funds for maintaining an existing level •of activity. For the same level of current assets, higher cash outlays are required. Therefore, the effect of rising prices is that a higher amount of working capital is required.

1.4 Issues in the Working Capital ManagementWorking capital management entails the control and monitoring of all components of working capital, i.e., cash, marketable securities, debtors (receivables) and stocks (inventories) and creditors (payables). Finance manager has topayparticularattentiontothelevelsofcurrentassetsandtheirfinancing.Todecidethelevelsandfinancingofcurrent assets, the risk return trade off must be taken into account.

1.4.1 Current Assets to Fixed Assets RatioThefinancemanagerisrequiredtodeterminetheoptimumlevelofcurrentassets,sothattheshareholders’valueismaximised.Afirmneedsfixedandcurrentassetstosupportaparticularlevelofoutput.Asthefirm’soutputandsalesincreases, the need for current assets also increases. Generally, current assets do not increase in direct proportion tooutput;currentassetsmayincreaseatadecreasingratewithoutput.Astheoutputincreases,thefirmstartsusingitscurrentassetsmoreefficiently.

Thelevelofthecurrentassetscanbemeasuredbycreatingarelationshipbetweencurrentassetsandfixedassets.Dividingcurrentassetsbyfixedassetsgivescurrentassets/fixedassetsratio.Assumingaconstantleveloffixedassets,ahighercurrentassets/fixedassetsratioindicatesaconservativecurrentassetspolicyandalowercurrentassets/fixedassetsratiomeansanaggressivecurrentassetspolicyassumingallfactorstobeconstant.

A conservative policy implies greater liquidity and lower risk, whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. Thecurrentassetspolicyofmostofthefirmsmayfallbetweenthesetwoextremepolicies.

The following diagram shows alternative current assets policies:

Fig. 1.3 Alternative current assets policies


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1.4.2 Liquidity versus ProfitabilityRiskreturntradeoff−Afirmmayfollowaconservative,aggressiveormoderatepolicyasdiscussedabove.However,these policies involve risk, return trade off. A conservative policy means lower return and risk. An aggressive policy produces higher returns and risks.

Thetwoimportantaimsoftheworkingcapitalmanagementareprofitabilityandsolvency.Aliquidfirmhaslessrisk of insolvency, that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost associatedwithmaintainingasoundliquidityposition.However,tohavehigherprofitabilitythefirmmayhavetosacrificesolvencyandmaintainarelativelylowlevelofcurrentassets.Thiswillimprovefirm’sprofitabilityasfewer funds will be tied up in idle current assets, but its solvency would be threatened and exposed to greater risk of cash shortage and stock outs.

1.5 Estimating Working Capital NeedsOperating cycle is one of the most reliable methods of computation of working capital. However, other methods likeratioofsalesandratiooffixedinvestmentmayalsobeusedtodeterminetheworkingcapitalrequirements.Thesemethodsarebrieflyexplainedasfollows:

Current assets holding period: To estimate working capital needs based on the average holding period of •current assets and relating them to costs based on the company’s experience in the previous year. This method is essentially based on the Operating Cycle Concept.Ratio of sales: To estimate working capital needs as a ratio of sales on the assumption that current assets change •with changes in sales.Ratiooffixedinvestments:Toestimateworkingcapitalrequirementsasapercentageoffixedinvestments.•

A number of factors will, however, be impacting the choice of method of estimating Working Capital. Factors such asseasonalfluctuations,accuratesalesforecast,investmentcostandvariabilityinsalespricewouldgenerallybeconsidered.Theproductioncycleandcreditandcollectionpoliciesofthefirmwillhaveanimpactonworkingcapitalrequirements. Therefore, they should be given due weightage in projecting working capital requirements.

1.6 Operating or Working Capital CycleA useful tool for managing working capital is the operating cycle. The operating cycle analyses the accounts receivable, inventory and accounts payable cycles in terms of number of days. For example:

Accounts receivable are analysed by the average number of days it takes to collect an account.•Inventory is analysed by the average number of days it takes to turn over the sale of a product (from the point •it comes in the store to the point it is converted to cash or an account receivable).Accounts payable are analysed by the average number of days it takes to pay a supplier invoice.•

Working capital cycle indicates the length of time between a company’s payment to procure materials, entering it intostockandreceivingcashfromthesalesoffinishedgoods.Itcanbedeterminedbyaddingthenumberofdaysrequired for each stage in the cycle. For example, a company holds raw materials on an average for 60 days, it gets creditfromthesupplierfor15days,productionprocessneeds15days,finishedgoodsareheldfor30daysand30 days credit is extended to debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total working capital cycle.

Mostbusinessescannotfinance theoperatingcycle (accounts receivabledays+ inventorydays)withaccountspayablefinancingalone.Consequently,workingcapitalfinancingisneeded.Thisshortfallistypicallycoveredbythenetprofitsgeneratedinternallyorbyexternallyborrowedfundsorbyacombinationofthetwo.

The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within a business. Good management of working capital will generate cashwhichwillhelptoimproveprofitsandreducerisks.Thecostofprovidingcredittocustomersandholdingstockscanrepresentasubstantialproportionofafirm’stotalprofits.

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1.7 Concept of Working Capital There are two concepts of working capital. These are:

Gross Working Capital (Total Current Assets) Thegrossworkingcapital,simplycalledasworkingcapitalreferstothefirm’sinvestmentincurrentassets.Currentassets are the assets, which can be converted into cash within an accounting year or operating cycle. Thus, gross working capital, is the total of all current assets. It includes:

Inventories (Raw materials and Components, Work-in-Progress, Finished Goods, etc.) •Trade Debtors •Loans and Advance •Cash and Bank Balances •Bills Receivables •Short-term Investment•

Net Working Capital (Total Current Assets – Total Current Liabilities)Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year. Net working capital may be positive or negative. A positive net working capital will arise when current assets exceed current liabilities and a negative net working capital will arise when current liabilities exceed current assets, i.e., there is no working capital,butthereisaworkingcapitaldeficit.Itincludes:

Trade Creditors •Bills Payable •Accrued or Outstanding Expenses •Trade Advances •Short-term Borrowings (Commercial Banks and Others) •Provisions •Bank Overdraft •

Working capital represents the amount of current assets that have not been supplied by current, short-term creditors. Gross working capital refers to the amount of funds invested in current assets that are employed in the business process while, Net working capital refers to the difference between current assets and current liabilities.

Working capital is the excess of current assets that has been supplied by the long-term creditors and the stockholders. The two concepts of working capital, gross working capital and net working capital are exclusive. Both are equally importantfor theefficientmanagementofworkingcapital.Thegrossworkingcapitalfocusesattentionontwoaspects,howinvestmentcanbeoptimisedincurrentassetsandhowcurrentassentsshouldbefinanced?Networkingcapitalconceptisqualitative.Itindicatestheliquiditypositionofthefirmandsuggeststheextenttowhichworkingcapitalneedsmaybefinancedbypermanentsourcesoffunds.

1.8 Requirements of Working Capital Therearenosetrulesorformulatodeterminetheworkingcapitalrequirementsofthefirms.Alargenumberoffactorsinfluencetheworkingcapitalneedofthefirms.Allfactorsareofdifferentimportanceandalsoimportancechangeforthefirmovertime.Therefore,ananalysisoftherelevantfactorsshouldbemadeinordertodeterminethetotalinvestmentinworkingcapital.Generally,thefollowingfactorsinfluencetheworkingcapitalrequirementsofthefirm:

Nature and size of the business •Seasonalfluctuations•Production policy •


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Taxation •Depreciation policy •Reserve policy •Dividend policy •Credit policy: •Growth and expansion •Price level changes •Operatingefficiency•Profitmarginandprofitappropriation•

1.9 Classification of Working Capital The quantitative concept of working capital is known as gross working capital while that under qualitative concept isknownasnetworkingcapital.Workingcapitalcanbeclassifiedinvariousways.Theimportantclassificationsare as given below: Conceptual classificationThere are two concepts of working capital, viz., quantitative and qualitative. The quantitative concept takes into account as the current assets while the qualitative concept takes into account the excess of current assets over current liabilities.Deficitofworkingcapitalexistswheretheamountofcurrentliabilitiesexceedstheamountofcurrentassets. The above can be summarised as follows:

Gross working capital = Total current assets •Net working capital = Excess of current assets over current liabilities •Workingcapitaldeficit=Excessofcurrentliabilitiesovercurrentassets.•

Classification on the basis of financial reportsTheinformationofworkingcapitalcanbecollectedfromBalanceSheetorProfitandLossAccount;assuchtheworkingcapitalmaybeclassifiedasfollows:

CashWorkingCapital–This iscalculated from the informationcontained inprofitand lossaccount.This•conceptofworkingcapitalhasassumedagreatsignificanceinrecentyearsasitshowstheadequacyofcashflowinbusiness.Balance Sheet Working Capital – The data for balance sheet working capital is collected from the balance •sheet. On this basis, the working capital can also be divided in three more types, viz., gross working capital, networkingcapitalandworkingcapitaldeficit.

Classification on the basis of variabilityGrossworkingcapitalcanbedividedintwocategories,viz.,(i)permanentorfixedworkingcapitaland(ii)Temporary,seasonalorvariableworkingcapital.Suchtypeofclassificationisveryimportantforhedgingdecisions.

Temporaryworkingcapital–Temporaryworkingcapitalisalsocalledasfluctuatingorseasonalworkingcapital.•This represents additional investment needed during prosperity and favourable seasons. It increases with the growth of the business. Temporary working capital is the additional assets required to meet the variations in sales above the permanent level.Permanent working capital – It is a part of total current assets which is not changed due to variation in sales. •There is always a minimum level of cash, inventories, and accounts receivables which is always maintained in the business even if sales are reduced to a minimum. Amount of such investment is called as permanent working capital. Permanent working capital is the amount of working capital that persists over time regardless offluctuationsinsales.Thisisalsocalledasregularworkingcapital.

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1.10 Significance of Working Capital Management Funds are needed in every business for carrying on day-to-day operations. Working capital funds are regarded as the lifebloodofabusinessfirm.Afirmcanexistandsurvivewithoutmakingprofitbutcannotsurvivewithoutworkingcapitalfunds.Ifafirmisnotearningprofititmaybetermedas‘sick’,but,nothavingworkingcapitalmaycauseitsbankruptcy.Eachfirmmustdecidehowtobalancetheamountofworkingcapitalitholds,againsttheriskoffailure.Workingcapitalhasacquiredagreatsignificanceandsoundpositionintherecentpastforthetwinobjectsofprofitabilityandliquidity.Inperiodofrisingcapitalcostsandscarcefunds,theworkingcapitalisoneofthemostimportant areas requiring management review.

It is rightly observed that, Constant management review is required to maintain appropriate levels in the various working capital accounts. Mainly the success of a concern depends upon proper management of working capital. Hence, working capital managementhasbeenlookeduponasthedrivingseatofafinancialmanager.Itconsumesagreatdealoftimetoincreaseprofitabilityaswellastomaintainproperliquidityatminimumrisks.Therearemanyaspectsofworkingcapitalmanagementwhichmakeitanimportantfunctionofthefinancemanager.Infact,weneedtoknowwhentolook for working capital funds, how to use them and how to measure, plan and control them.

A study of working capital management is very important for internal and external experts. Sales expansion, dividend declaration, plants expansion, new product line, increase in salaries and wages, rising price level, etc., put added strain on working capital maintenance. Failure of any enterprise is undoubtedly due to poor management and absence of management skills. Importance of working capital management stems from two reasons, viz., (i) A substantial portion of total investment is invested in current assets, and (ii) level of current assets and current liabilities will changequicklywiththevariationinsales.Thoughfixedassetsinvestmentandlong-temborrowingwillalsorespondto the changes in sales, but its response will be weak.

1.11 Factors Influencing Working Capital Requirements Numerousfactorscaninfluencethesizeandneedofworkingcapitalinaconcern.So,nosetruleorformulacanbeframed. It is rightly observed that, there is no precise way to determine the exact amount of gross or net working capital for every enterprise. The data and problem of each company should be analysed to determine the amount of workingcapital.Briefly,theoptimumlevelofcurrentassetsdependsuponthefollowingdeterminants.

Nature of business: Trading and industrial concerns require more funds for working capital. Concerns engaged •in public utility services need less working capital. For example, if a concern is engaged in electric supply, it willneedlesscurrentassets,firstlyduetocashnatureofthetransactionsandsecondlyduetosaleofservices.However,itwillinvestmoreinfixedassets.Inadditiontoit,theinvestmentvariesconcerntoconcern,dependingupon the size of business, the nature of the product, and the production technique.Conditions of supply: If the supply of inventory is prompt and adequate, less funds will be needed. But, if the •supply is seasonal or unpredictable, more funds will be invested in inventory. Investment in working capital willfluctuateincaseofseasonalnatureofsupplyofrawmaterials,sparepartsandstores.Productionpolicy:Incaseofseasonalfluctuationsinsales,productionwillfluctuateaccordinglyandultimately•therequirementofworkingcapitalwillalsofluctuate.However,salesdepartmentmayfollowapolicyofoff-season discount, so that sales and production can be distributed smoothly throughout the year and sharp variations in working capital requirements are avoided.Seasonal operations: It is not always possible to shift the burden of production and sale to slack period. For •example, in case of sugar mill, more working capital will be needed at the time of crop and manufacturing.


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Credit availability: If credit facility is available from banks and suppliers on favourable terms and conditions, •less working capital will be needed. If such facilities are not available, more working capital will be needed to avoid risk. Credit policy of enterprises-- in some enterprises, most of the sale is in cash and even it is received in advance. In other enterprises, mostly credit sales happen and payments are received only after a month or two. In former case, less working capital is needed than the latter. The credit terms depend largely on norms of the industry. In order to ensure that unnecessary funds are not tied up in book debts, the enterprise should follow a rationalised credit policy based on the credit standing of the customers and other relevant factors.Growth and expansion: The need of working capital is increasing with the growth and expansion of an enterprise. •Itisdifficulttopreciselydeterminetherelationshipbetweenvolumeofsalesandtheworkingcapitalneeds.Thecritical fact, however, is that the need for increased working capital funds does not follow growth in business activities but precedes it. It is clear that advance planning is essential for a growing concern.Price level change: With the increase in price level, more and more working capital will be needed for the same •magnitude of current assets. The effect of rising prices will be different for different enterprises.Circulation of working capital: Less working capital will be needed with the increase in circulation of working •capital and vice-versa. Circulation means time required to complete one cycle, i.e., from cash to material, frommaterialtowork-in-progress,fromwork-in-progresstofinishedgoods,fromfinishedgoodstoaccountsreceivable and from accounts receivable to cash.Volume of sale: This is directly indicated with working capital requirement, with the increase in sales more •workingcapitalisneededforfinishedgoodsanddebtors.Itsviceversaisalsotrue.Liquidityandprofitability:Thereisanegativerelationshipbetweenliquidityandprofitability.Whenworking•capitalinrelationtosalesisincreaseditwillreduceriskandprofitabilityononesideandwillincreaseliquidityon the other side.Management ability: Proper co-ordination in production and distribution of goods may reduce the requirement •of working capital, as minimum funds will be invested in absolute inventory, non-recoverable debts, etc.Externalenvironment:Withdevelopmentoffinancialinstitutions,meansofcommunication,transportfacility,•etc., needs of working capital is reduced because it can be available as and when needed.

1.12 Principles of Working Capital Management The following are the principles of working capital management:

Principlesoftheriskvariation:Riskherereferstotheinabilityoffirmtomaintainsufficientcurrentassetsto•payitsobligations.Ifworkingcapitalisvariedrelativetosales,theamountofriskthatafirmassumesisalsovariedandtheopportunityforgainorlossisincreased.Inotherwords,thereisadefiniterelationshipbetweenthedegreeofriskandtherateofreturn.Asafirmassumesmorerisk,theopportunityforgainorlossincreases.As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, amount of risk goes down, and vice-versa, the opportunity for gain is likewise adversely affected.Principle of equity position: According to this principle, the amount of working capital invested in each component •shouldbeadequatelyjustifiedbyafirm’sequityposition.Everyrupeeinvestedintheworkingcapitalshouldcontributetothenetworthofthefirm.Principleofcostofcapital:Thisprincipleemphasisesthatdifferentsourcesoffinancehavedifferentcostof•capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital results in decline in the cost of capital.Principle of maturity of payment: A company should make every effort to relate maturity of payments to its •flowofinternallygeneratedfunds.Thereshouldbetheleastdisparitybetweenthematuritiesofafirm’sshort-termdebtinstrumentsanditsflowofinternallygeneratedfunds,becauseagreaterriskisgeneratedwithgreaterdisparity. A margin of safety should, however, be provided for any short-term debt payments.

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1.13 Structure of Working CapitalThe study of structure of working capital is another name for the study of working capital cycle. In other words, it can be said that the study of structure of working capital is the study of the elements of current assets, viz., inventory, receivable, cash and bank balances and other liquid resources like short-term or temporary investments. Current liabilities usually comprise bank borrowings, trade credits, assessed tax and unpaid dividends or any other such things. The following points relate to the various elements of working capital:

InventoryInventory is a major item of current assets. The management of inventories – raw material, goods-in-process and finishedgoodsisanimportantfactorintheshort-runliquiditypositionsandlong-termprofitabilityofthecompany.Rawmaterialinventories–uncertaintiesaboutthefuturedemandforfinishedgoods,togetherwiththecostsofadjustingproductiontochangeindemandwillcauseafinancialmanagertodesiresomelevelofrawmaterialinventory.Intheabsenceofsuchinventory,thecompanycouldrespondtoincreaseddemandforfinishedgoodsonlybyincurringexplicitclericalandothertransactioncostsofordinaryrawmaterialforprocessingintofinishedgoodstomeetthatdemand. If changes in demand are frequent, these order costs may become relatively large.

Moreover, attempts to purchase hastily the needed raw material may necessitate payment of premium purchases prices to obtain quick delivery and, thus, raise cost of production. Finally, unavoidable delays in acquiring raw material may cause the production process to shut down and then re-start again raising the costs of production. Under these conditions the company cannot respond promptly to changes in demand without sustaining high costs. Hence, some level of raw materials inventory has to be held to reduce such costs. Determining its proper level requires an assessment of costs of buying and holding inventories and a comparison with the costs of maintaining insufficientlevelofinventories.

Work-in-process inventoryThis inventory is built up due to production cycle. Production cycle is the time-span between introduction of raw materialintoproductionandemergenceoffinishedproductatthecompletionofproductioncycle.Tilltheproductioncycle is completed, the stock of work-in-process has to be maintained.

Finished goods inventoryFinished goods are required for reasons similar to those causing the company to hold raw materials inventories. Customer’sdemandforfinishedgoodsisuncertainandvariable.Ifacompanycarriesnofinishedgoodsinventory,unanticipated increases in customer demand would require sudden increases in the rate of production to meet the demand. Such rapid increase in the rate of production may be very expensive to accomplish. Rather than loss of sales,becausetheadditionalfinishedgoodsarenotimmediatelyavailableorsustainhighcostsofrapidadditionalproduction,itmaybecheapertoholdafinishedgoodsinventory.Theflexibilityaffordedbysuchaninventoryallows a company to meet unanticipated customer demands at relatively lower costs than if such an inventory is not held.

Thus, to develop successfully optimum inventory policies, the management needs to know about the functions of inventory, the cost of carrying inventory, economic order quantity and safety stock. Industrial machinery is usually verycostlyanditishighlyuneconomicaltoallowittolieidle.Skilledlabouralsocannotbehiredandfiredatwill.Modern requirements are also urgent. Since requirements cannot wait and since the cost of keeping machine and men idle is higher, than the cost of storing the material, it is economical to hold inventories to the required extent. The objectives of inventory management are:

To minimise idle cost of men and machines causes by shortage of raw materials, stores and spare parts. •To keep down: •

Inventory ordering cost �Inventory carrying cost �Capital investment in inventories �Obsolescence losses �


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ReceivablesManyfirmsmakecreditsalesandasaresultthereofcarryreceivablesasacurrentasset.Thepracticeofcarryingreceivables has several advantages as follows:

Reduction of collection costs over cash collection•Reduction in the variability of sales, and •Increase in the level of near-term sales. •

While immediate collection of cash appears to be in the interest of shareholders, the cost of that policy may be very high relative to costs associated with delaying the receipt of cash by extension of credit. Imagine, for example, an electric supply company employing a person at every house constantly reading electricity meter and collecting cash from him every minute as electricity is consumed. It is far cheaper for accumulating electricity usage and bill once a month. This of course, is a decision to carry receivables on the part of the company. It may also be true that the extensionofcreditbythefirmtoitscustomersmayreducethevariabilityofsalesovertime.Customersconfinedtocash purchases may tend to purchase goods when cash is available to them. Erratic and perhaps cyclical purchasing patterns may then result unless credit can be obtained elsewhere. Even if customers do obtain credit elsewhere, they must incur additional cost of search in arranging for a loan costs that can be estimated when credit is given by asupplier.Therefore,extensionofcredittocustomersmaywellsmoothoutofthepatternofsalesandcashinflowstothefirmovertimesincecustomersneednotwaitforsomeinflowsofcashtomakeapurchase.Totheextentthatsales are smoothed, cost of adjusting production to changes in the level of sales should be reduced.

Finally,theextensionofcreditbyfirmsmayacttoincreasenear-termsales.Customersneednotwaittoaccumulatenecessary cash to purchase an item but can acquire it immediately on credit. This behaviour has the effect of shifting futuresalesclosetothepresenttime.Therefore,theextensionofcreditbyafirmandtheresultinginvestmentinreceivablesoccursbecauseitpaysafirmtodoso.Costsofcollectingrevenuesandadaptingtofluctuatingcustomerdemandsmaymakeitdesirabletooffertheconvenienceassociatedwithcredittofirm’scustomers.

Cash and interest-bearing liquid assetsCash is one of the most important tools of day-to-day operation, because it is a form of liquid capital which is available for assignment to any use. Cash is often the primary factor which decides the course of business destiny. The decision to expand a business may be determined by the availability of cash and the borrowing of funds will frequently be dictated by cash position. Cash-in-hand, however, is a non-earning asset. This leads to the question as to what the optimum level of this idle resource is. This optimum depends on various factors, such as the manufacturing cycle, the sale and collection cycle, age of the bills and on the maturing of debt. It also depends upon the liquidity of other current assets and the matter of expansion. While a liberal maintenance of cash provides asenseofsecurity,alackofsufficiencyofcashhampersday-to-dayoperations.Prudence,therefore,requiresthatno more cash should be kept on hand than the optimum required for handling miscellaneous transactions over the counter and petty disbursements, etc.

It has not become a practice with business enterprises to avoid too much redundant cash by investing a portion of their earnings in assets which are susceptible to easy conversion into cash. Such assets may include government securities, bonds, debentures and shares that are known to be readily marketable and that may be liquidated at a moment’s notice, when cash is needed.

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SummaryWorkingCapitalManagementinvolvesmanagingthebalancebetweenfirm’sshort-termassetsanditsshort-•term liabilities.The interaction between current assets and current liabilities is the main theme of the theory of working capital •management.Grossworkingcapitalreferstothefirm’sinvestmentincurrentassets.•Net working capital refers to the difference between current assets and current liabilities.•A positive working capital means that the company is able to payoff its short-term liabilities.•Permanent working capital refers to the hard core working capital. It is that minimum level of investment in •the current assets that is carried by the business.Temporary working capital refers to that part of total working capital, which is required by a business over and •above permanent working capital.Working capital management entails the control and monitoring of all components of working capital.•Thelevelofthecurrentassetscanbemeasuredbycreatingarelationshipbetweencurrentassetsandfixed•assets.Assumingaconstantleveloffixedassets,ahighercurrentassets/fixedassetsratioindicatesaconservative•currentassetspolicyandalowercurrentassets/fixedassetsratiomeansanaggressivecurrentassetspolicyassuming all factors to be constant.A conservative policy implies greater liquidity and lower risk, whereas an aggressive policy indicates higher •risk and poor liquidity.Thetwoimportantaimsoftheworkingcapitalmanagementareprofitabilityandsolvency.•Operating cycle is one of the most reliable methods of computation of working capital.•A useful tool for managing working capital is the operating cycle.•Working capital cycle indicates the length of time between a company’s payment for materials, entering into •stockandreceivingthecashfromsalesoffinishedgoods.Current assets are the assets, which can be converted into cash within an accounting year or operating cycle.•Net working capital refers to the difference between current assets and current liabilities.•Working capital is the excess of current assets that has been supplied by the long-term creditors and the •stockholders.The quantitative concept of working capital is known as gross working capital while that under qualitative •concept is known as net working capital.Cash is one of the most important tools of day-to-day operation, because it is a form of liquid capital which is •available for assignment to any use.Whilealiberalmaintenanceofcashprovidesasenseofsecurity,alackofsufficiencyofcashhampersday-to-•day operations.

ReferencesWorking Capital• [Online] Available at: <http://www.scribd.com/doc/24525667/Working-Capital-analysis> [Accessed 12 July 2013].Work capital Analysis• [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/705/13/14_chapter5.pdf> [Accessed 12 July 2013].Working capital Management• [Videoonline]Availableat<http://www.youtube.com/watch?v=KQWe-2G23kw>[Accessed 12 July 2013].Working Capital Management Principal and Approaches• [Video online] Available at <http://www.youtube.com/watch?v=zJCiEIqAxbs>[Accessed12July2013].


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Preve, L. And Allende, V.S., 2010. • Working Capital Management. Oxford University Press, USA.Sagner, J., 2010. • Essentials of Working Capital Management. Wiley.

Recommended ReadingWeide, J. H.V. and Maier, S. F., 1984. • Managing Corporate Liquidity: An Introduction to Working Capita. John Wiley & Sons Inc.Kimmel,P.D.andWeygandt,J.J.,2008.• Financial Accounting: Tools for Business Decision Making. 5th ed., Wiley.Laurens, B., 1998. • Managing capital flows. International Monetary Fund, Monetary and Exchange Affairs Department.

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Self AssessmentThegoalof_________________istoensurethatthefirmisabletocontinueitsoperationsandthatithas1. sufficientcashflowtosatisfybothmaturingshort-termdebtandupcomingoperationalexpenses.

investmenta. working capital managementb. credibilityc. gross working capitald.

_________________referstothefirm’sinvestmentincurrentassets.2. Working capitala. Cash balanceb. Current liabilitiesc. Gross working capitald.

_______________referstothedifferencebetweencurrentassetsandcurrentliabilities.3. Net working capitala. Short-term liabilitiesb. Permanent working capitalc. Fluctuating working capitald.

Whichofthefollowingisalsocalledvariableworkingcapital?4. Permanent working capitala. Temporary working capitalb. Current liabilitiesc. Gross working capitald.

Whichofthefollowingisnotafunctionoffinancialmanagement?5. Timea. Credibilityb. Growthc. Assetsd.

Whichofthefollowingisnotafactorwhichisconsideredwhileplanningforworkingcapitalrequirement?6. Credibilitya. Cashb. Inventoryc. Debtorsd.

The___________________isrequiredtodeterminetheoptimumlevelofcurrentassets,sothattheshareholders7. value is maximised.

firma. assetb. current assetc. financemanagerd.


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A_________________impliesgreaterliquidityandlowerrisk,whereasanaggressivepolicyindicateshigher8. risk and poor liquidity.

current assets policya. return trade offb. risk trade offc. conservative policyd.

Whichofthefollowingisnotamethodusedtodeterminetheworkingcapitalrequirements?9. Ratio of salesa. Ratio of variable investmentb. Ratiooffixedinvestmentc. Current assets holding periodd.

The_______________analysestheaccountsreceivable,inventoryandaccountspayablecyclesintermsof10. number of days.

working capital cyclea. operating cycleb. total current assetsc. total current liabilitiesd.

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Chapter II

Cash Management

Aim


definecashmanagement•

elucidate the principles of cash management•

explain the functions of cash management•

Objectives


explainthefinancingofcashshortage•

explicate the cost of running out of cash•

elucidatetheconceptoffinancingcurrentassets•

Learning outcome


understandthethreeapproachesoffinancingcurrentassets•

identifythecashflowstatement•

recognise the motives of holding cash•


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2.1 IntroductionCash, like the blood stream in the human body, gives vitality and strength to a business enterprise. Though, cash holds the smallest portion of total current assets. However, cash is both the beginning and end of working capital cycle - cash, inventories, receivables and cash. It is the cash, which keeps the business going. Hence, every enterprise has to hold necessary cash for its existence. Moreover, steady and healthy circulation of cash throughout the entire business operations is the basis of business solvency. Now-a-days, non-availability and high cost of money have created a serious problem for the industry. Nevertheless, cash like any other asset of a company is treated as a tool ofprofit.Further,todaytheemphasisisontherightamountofcash,attherighttime,attherightplaceandattheright cost.

In the words of R.R. Bari, “Maintenance of surplus cash by a company unless there are special reasons for doing so, is regarded as a bad sign of cash management.” Holding of cash balance has an implicit cost in the form of its opportunity cost.

Cash may be interpreted under two concepts. In narrow sense, cash is a very important business asset, but although coin and paper currency can be inspected and handled, the major part of the cash of most enterprises is in the form of bank checking accounts, which represent claims to money rather than tangible property. While in a broader sense, cash consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks. In general, nothing should be considered unrestricted cash, unless it is available to the management for disbursement of any nature. Thus, from the above quotations we may conclude that in narrow sense, cash means cash in hand and at bank but in wider sense, it is the deposits in banks, currency, cheques, bank drafts, etc., in addition to cash in hand and at bank. Cash management includes management of marketable securities also, because in modern terminology money comprises marketable securities and actual cash in hand or in bank.

Theconceptofcashmanagementisnotnewandithasacquiredagreatersignificanceinthemodernworldofbusinessduetochangesthattookplaceintheconductofbusinessandeverincreasingdifficultiesandthecostofborrowing.Apart from the fact that it is the most liquid of all the current assets, cash is the common denominator to which all current assets can be reduced because the other current assets, i.e., receivables and inventory get eventually converted intocash.Thisunderlinesthesignificanceofcashmanagement.Thetermcashmanagementreferstothemanagementof cash resource in such a way that generally accepted business objectives could be achieved. In this context, the objectivesofafirmcanbeunifiedasbringingaboutconsistencybetweenmaximumpossibleprofitabilityandliquidityofafirm.Cashmanagementmaybedefinedastheabilityofamanagementinrecognisingtheproblemsrelatedwithcashwhichmaycomeacrossinfuturecourseofaction,findingappropriatesolutionstocurbsuchproblemsiftheyarise,andfinallydelegatingthesesolutionstothecompetentauthorityforcarryingthemout.Thechoicebetweenliquidityandprofitabilitycreatesastateofconfusion.Itiscashmanagementthatcanprovidesolutiontothis dilemma. Cash management may be regarded as an art that assists in establishing equilibrium between liquidity andprofitabilitytoensureundisturbedfunctioningofafirmtowardsattainingitsbusinessobjectives.

Cash itself is not capable of generating any sort of income on its own. It rather is the prime requirement of income generatingsourcesandfunctions.Thus,afirmshouldgoforminimumpossiblebalanceofcash,yetmaintainingitsadequacyfortheobviousreasonoffirm’ssolvency.Cashmanagementdealswithmaintainingsufficientquantityofcashinsuchawaythatthequantitydenotesthelowestadequatecashfiguretomeetbusinessobligations.

Cashmanagementinvolvesmanagingcashflows(intoandoutofthefirm),withinthefirmandthecashbalancesheldbyaconcernatapointoftime.Thewords,‘managingcashandthecashbalances’asspecifiedabovedoesnotmean optimisation of cash and near cash items but also point towards providing a protective shield to the business obligations. Cash management is concerned with minimising unproductive cash balances, investing temporarily excess cash advantageously and to make the best possible arrangement for meeting planned and unexpected demands onthefirms’cash.

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2.2 General Principles of Cash ManagementHarryGrosshassuggestedcertaingeneralprinciplesofcashmanagementthat,essentiallyaddefficiencytocashmanagement.Theseprinciplesreflectingcauseandeffectrelationshiphavinguniversalapplicationsgiveascientificoutlook to the subject of cash management. While, the application of these principles in accordance with the changing conditions and business environment requiring high degree of skill and tact which places cash management in the category of art. Thus, we can say that cash management like any other subject of management is both science and art.Ithaswell-establishedprinciplescapableofbeingskilfullymodifiedaspertherequirements.Theprinciplesofmanagement are follows:

Determinable variations of cash needsA reasonable portion of funds, in the form of cash is required to be kept aside to overcome the period anticipated astheperiodofcashdeficit.Thisperiodmayeitherbeshortandtemporaryorlastforalongerdurationoftime.Normal and regular payment of cash leads to small reductions in the cash balance at periodic intervals. Making this payment to different employees on different days of a week can equalise these reductions. Another technique for balancing the level of cash is to schedule cash disbursements to creditors during that period, when accounts receivables collected amounts to a large sum but without putting the goodwill at stake.

Contingency cash requirementCertain instances which fall beyond the forecast of the management may arise. These constitute unforeseen calamities, whicharetoodifficulttobeprovidedfor,inthenormalcourseofthebusiness.Suchcontingenciesalwaysdemandforspecial cash requirements that was not estimated and provided for in the cash budget. Rejections of wholesale product, large amount of bad debts, strikes, lockouts, etc., are a few among these contingencies. Only a prior experience and investigation of other similar companies prove helpful as a customary practice. A practical procedure is to protect thebusinessfromsuchcalamitieslikebad-debtlosses,fire,etc.,bywayofinsurancecoverage.

Availability of external cashAnother factor that is of great importance to the cash management is the availability of funds from outside sources. There resourcesaid inprovidingcredit facility to thefirm,whichmaterialised thefirm’sobjectivesofholdingminimumcashbalance.Assuch,ifafirmsucceedsinacquiringsufficientfundsfromexternalsourceslikebanksorprivatefinanciers,shareholders,governmentagencies,etc.,theneedformaintainingcashreservesdiminishes.

Maximising cash receiptsEveryfinancialmanageraimsatmakingthebestpossibleuseofcashreceipts.Again,cashreceiptsiftackledprudently,results in minimising cash requirements of a concern. For this purpose, the comparative cost of granting cash discounts to customers and the policy of charging interest expense for borrowing must be evaluated on continuous basis to determine the futility of either of the alternatives or both of them during that particular period for maximising cash receipts. Yet, the under mentioned techniques proved helpful in this context:

Concentration banking: Under this system, a company establishes banking centres for collection of cash in •different areas. Thereby, the company instructs its customers of adjoining areas to send their payments to those centres. The collection amount is then deposited with the local bank by these centres as early as possible. Whereby, thecollectedfundsaretransferredtothecompany’scentralbankaccountsoperatedbytheheadoffice.Localboxsystem:Underthissystem,acompanyrentsoutthelocalpostofficesboxesofdifferentcitiesand•the customers are asked to forward their remittances to it. These remittances are picked by the authorised lock bankfromtheseboxestobetransferredtothecompany’scentralbankoperatedbytheheadoffice.Reviewing credit procedures: It aids in determining the impact of slow payers and bad debtors on cash. The •accounts of slow paying customers should be reviewed to determine the volume of cash tied up. Besides this, evaluation of credit policy must also be conducted for introducing essential amendments. As a matter of fact, too strictacreditpolicyinvolvesrejectionsofsales.Thus,curtailingthecashinflow.Ontheotherhand,toolenientacreditpolicywouldincreasethenumberofslowpaymentsandbaddebtsagaindecreasingthecashinflows.Minimisingcreditperiod:Shorteningthetermsallowedtothecustomerswoulddefinitelyacceleratethecash•inflowside-by-siderevisingthediscountofferedwouldpreventthecustomersfromusingthecreditforfinancingtheirownoperationsprofitably.


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Others: Introducing various procedures for special handling of large to very large remittances or foreign •remittances such as, personal pick up of large sums of cash using airmail, special delivery and similar techniques to accelerate such collections.

Minimising cash disbursementsThemotiveofminimisingcashpayments is theultimatebenefitderived frommaximisingcash receipts.Cashdisbursement can be brought under control by preventing fraudulent practices, serving time draft to creditors of large sums, making staggered payments to creditors and for payrolls, etc.

Maximising cash utilisationSurplus of cash is a luxury. Moreover, proper and optimum utilisation of cash always makes way for achievement ofthemotiveofmaximisingcashreceiptsandminimisingcashpayments.Attimes,aconcernfindsitselfwithfundsinexcessofitsrequirement,whichlayidlewithoutbringinganyreturntoit.Atthesametime,theconcernfindsit unwise to dispose it, as the concern shall soon need it. In such conditions, efforts should be made in investing these funds in some interest bearing securities. There are certain basic strategies suggested by Gitman, which prove evidently helpful in managing cash if employed by the cash management. They are:

Payaccountspayablesaslateaspossiblewithoutdamagingthefirm’screditrating,buttakeadvantageofthe•favourable cash discount, if any.Turnover, the inventories as quickly as possible, avoiding stock outs that might result in shutting down the •productions line or loss of sales.

Collect accounts receivables as early as possible without losing future loss sales because of high-pressure collections techniques.Cashdiscounts,iftheyareeconomicallyjustifiable,maybeusedtoaccomplishthisobjective.

2.3 Functions of Cash ManagementCash management is concerned with minimising unproductive cash balances, investing temporarily excess cash advantageously and to make the best possible arrangements for meeting planned and unexpected demands on the firm’scash.CashManagementmustaimtoreducetherequiredlevelofcash,butminimisetheriskofbeingunableto discharge claims against the company as they arise. All these aims and motives of cash management largely dependupontheefficientandeffectivefunctioningofcashmanagement.Cashmanagementfunctionscanbestudiedunderfiveheads,namely,cashplanning,managingcashflow,controllingcashflow,optimisingthecashlevelandinvesting idle cash. All these functions are discussed below in details:

Cash planningGood planning is the very foundation of attaining success. For any management decision, planning is the foremost requirement. Planning is basically an intellectual process, a mental pre-disposition to do things in an orderly way, to think before acting and to act in the light of facts rather than of a guess. Cash planning is a technique, which comprises of planning for and controlling of cash. It is a management process of forecasting the future needs of cash, itsavailableresourcesandvarioususesforaspecifiedperiod.Cashplanning,thus,dealsatlengthwithformulationof necessary cash policies and procedures in order to carry on business continuously and on sound lines. Good cash planning aims at providing cash, not only for regular, but also for irregular and abnormal requirements.

Managing cash flowsTheheadingsimplysuggestsanideaofmanagingproperlytheflowofcashcominginsidethebusiness,i.e.,cashinflowandcashmovingoutofthebusiness,i.e.,cashoutflow.Thesetwoaresaidtobeproperlymanagedonly,ifafirmsucceedsinacceleratingtherateofcashinflowtogetherwithminimisingthecashoutflow.Asobservedexpediting collections, avoiding unnecessary inventories, improving control over payments, etc., contribute to better management of cash. Whereby, a business can conserve cash and thereof would require lesser cash balance for its operations.

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Controlling the cash flowsAs forecasting is not an exact science because it is based on certain assumptions. Therefore, cash planning will inevitably be at variance with the results actually obtained. For this reason, control becomes an unavoidable function of cash management. Moreover, cash controlling becomes essential as it increases the availability of usable cash fromwithintheenterprise.Asitisobviousthatgreaterthespeedofcashflowcycle,greaterwouldbethenumberoftimesafirmcanconvertitsgoodsandservicesintocashandsolesserwillbethecashrequirementtofinancethe desired volume of business during that period. Furthermore, every enterprise is in possession of some hidden cash, which if traced out substantially decreases the cash requirement of the enterprise.

Optimising the cash levelAfinancialmanagershouldconcentrateonmaintainingsound liquidityposition, i.e.,cash level.Allhiseffortsrelating to planning, managing and controlling cash should be diverted towards maintaining an optimum level of cash. The foremost need of maintaining optimum level of cash is to meet the necessary requirements and to settle the obligations well in time. Optimisation of cash level may be related to establishing equilibrium between risk and therelatedprofitexpectedtobeearnedbythecompany.

Investing idle cashIdlecashorsurpluscashreferstotheexcessofcashinflowsovercashoutflows,whichdonothaveanyspecificoperationsoranyotherpurposetosolvecurrently.Generally,afirmisrequiredtoholdcashformeetingworkingneeds facing contingencies and to maintain as well as develop goodwill of bankers. The problem of investing this excessamountofcasharisessimplybecauseitcontributesnothingtowardsprofitabilityofthefirmasidlecashprecisely earns no returns. Further, permanent disposal of such cash is not possible, as the concern may again need thiscashafterashortwhile.But,ifsuchcashisdepositedwiththebank,itdefinitelywouldearnanominalrateofinterest paid by the bank. A much better returns than the bank interest can be expected if a company deploys idle cash in marketable securities. There are yet another group of enterprises that neither invest in marketable securities nor are willing to get interest. They prefer to deposit excess cash for improving relations with banks by helping them in meeting bank requirements for compensating balances for services and loans.

2.4 Motives of Holding CashEverybusinesstransactionwhethercarriedoncreditoroncashbasisultimatelyresultsineithercashinfloworcashoutflows.Thepivotalpointinpresentdayfinancialmanagementistomaximisecashgenerationandtominimisecashoutflowsinrelationtothecashinflows.Keynespostulatedthreemotivesforholdingcash:

Transaction Motive,•Precautionary Motive, and•Speculative Motive.•

To which one more motive for holding cash has been added:Compensation Motive•

Transaction motiveIt refers toholdingofcash formeeting routinecash requirementsandfinancing transactionscarriedonby thebusiness in the normal course of action. This motive requires cash for payment of various obligations like purchase of raw materials, the payment of usage and salaries, dividend, income tax, various other operating expenses, etc. However,thereexistsregularandcounterinflowofcashinthebusinessbywayofreturnoninvestments,sales,etc.However,cashreceiptsandcashpaymentsdonotperfectlysynchronisewitheachother.Therefore,afirmrequiresan additional cash balance during the periods when payments are in excess of cash receipts. Thus, transaction motive stresses on holding cash to meet anticipated obligations that are not counter balanced by cash receipts due to disparity of timings.


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Precautionary motiveUnder precautionary motive, the need to hold cash arises for meeting any unforeseen, unpredicted contingencies or unexpected disbursements. Such motives provide a cushion to withstand unexpected cash requirements arising spontaneouslyatshortnoticeduetovariouscauses.Inthisregard,twofactorslargelyinfluencetheprecautionarycash balance, degree of predictability and availability of short-term credit. If a cash management succeeds in estimating the cash requirements adequately, it escapes from maintaining big cash balance for emergency. Likewise, ifamanagementiscapableandefficientenoughtoborrowtherequiredcashfromshort-termcreditorssmallbalancewould be held and vice-versa.

Speculative motiveThespeculativemotivefindsitsoriginoutofthedesireofanenterprisetoavailitselfthebenefitsoftheopportunitiesarising at unexpected moments that do not happen to exist in the normal course of business. This motive represents apositiveandaggressiveapproach.Reasonablecashreserveismaintainedbyconcernsforexploitingprofitableopportunities like bulk purchase of raw materials at discounted prices, purchasing securities when interest rates are expected to fall, postpone purchase of raw material if decline in prices is anticipated, etc.

Compensation motiveSuch motives require holding cash balance in case the concern enters into some loan agreement with the bank. Bank provides a great variety of services to its customers. For some of such services, it charges commission or fee. While for otheranindirectcompensationisdemandedbyitbyaskingitscustomerstokeepaminimumbankbalancesufficientto earn a return equal to cost of services provided by it. Such balances are termed as compensating balances.

2.5 Financing of Cash Shortage and Cost of Running Out of CashAsituationarises,whenthecashoutflowsofafirmexceedsitsinflowsduringacertainperiod.Suchsituationcreatescashshortageinafirm.Shortageofcashishighlyundesirableinallsortsofbusinessholdingsforthereasonofdreadful consequences that it bears. A management is deemed to be over-cautious and highly careful while dealing withtheproblemofcashshortageevenifcashinflowsareanticipatedinthenearfuture;elseaconcernmayevenreachthestageoffinalliquidation.Cashflowstatementshouldbepreparedtoacknowledgetherepercussionsoftransactions involving the movement of cash.

Ascashflowstatementismadetoshowtheimpactofvarioustransactionsonthecashpositionofafirm,ittakesinto consideration only such transactions that have relationship with cash.

In case of temporary shortage of cash, a concern is required to procure essential cash immediately for the anticipated short duration, so as the curb it at the very stage instead of sustaining the long-term implication later on. The immediate source to fall back upon remains the bank credit. In fact, bank credit is a means to meet cash shortages aswellassourceoffinancingthecurrentassets.Thevariousmethodsfromwhichafirmcanprocurefundsduringtheperiodwhenitsoutflowsexceedtheinflowsarestatedbelow:

Using bank credit tine•Raising loans from institutions and creditors other than banks•Liquidity marketable securities•Resorting to bills discounting schemes•Disposingoffsurplusfixedassets•Shedding the quantity of raw materials•Unloadingfinishedgoodsevenatloss•By delaying payments•

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Itisrecommendedbythefinancialexpertsthatacashmanagementshouldnotstartsearchingforexternalfinanceatthe very instance when the cash shortage is anticipated. At the initial stage, a management should take appropriate steps to avoid or minimise the undesirable situation of emerging cash shortage by exercising effective control over internal resources. In this respect, the matters of special consideration that can be gainfully employed by the concern for overpowering the situation of cash shortage are:

Increasing efforts to speedup collection•Reduction in purchase of inventories•Increasing cash sales•Selling-off redundant assets•Selling short-term investments•Deferment of capital expenditure•Postponing and delaying payments•

These considerations are nothing but mere use of tact and skill to overcome a shortage of cash. They are much economical than any other resources (internal or external) for they cost neither interest nor any expenses. Even if an external resource has to be found, this might be seen as a bridging operation pending the ability to bring on stream analternativeinternalsource.Whenafirmbecomesawareoftheapproachingshortageofcash,itshouldconcentrateits efforts towards the eradication of such situation. The sooner the shortage is provided for, the better it is. Every concern escapes itself from lending into such a situation as it makes way for numerous costs because of running outofcash.Afirmbearsnotonlytheburdenofunnecessarycosts,butissubjectedtovarioustypesofpressurespertaining to its dealings. All these factors adversely affect the morale of management, causes damages to the hard-earnedreputationandfinancialcredit-worthiness,etc.Afirmisforcedtoborrowfundsathighratesofinteresthasto accept higher price demand of suppliers, loses cash discount on payments, enters into further negotiations with banksandotherfinancialinstitutionsonaccountofslowpayment.

2.6 Financing Current AssetsCurrentassetsofenterprisesmaybefinancedeitherbyshort-termsourcesorlong-termsourcesorbycombinationofboth.Themainsourcesconstitutinglong-termfinancingareshares,debentures,anddebtsformbanksandfinancialinstitutions.Thelong-termsourceoffinanceprovidessupportforasmallpartofcurrentasset-requirementswhichis called the working capital margin. Working capital margin is used here to express the difference between current assetsandcurrentliabilities.Short-termfinancingofcurrentassetsincludessourcesofshort-termcredit,whichafirmis mostly required to arrange in advance. Short-term bank loans, commercial papers, etc., are a few of its components. Currentliabilitieslikeaccrualsandprovisions,tradecredit,short-termbankfinance,short-termdepositsandthelikewarrantingthecurrentassetsarealsoreferredtoashort-termtermsourcesoffinance.Spontaneousfinancingcanalsofinancecurrentassets,whichincludescreditors,billspayableandoutstandingreceipts.Aproductfirmwouldalwaysoptforutilisingspontaneoussourcesfullysinceitisfreeofcost.Concernsthatcannomorebefinancedbyspontaneoussourcesoffinancinghastodecidebetweenshort-termandlong-termsourceoffinancealongwithrelevantproportionofthetwo.Therearethreeapproachesoffinancingcurrentassetsthatarepopularlyused:

Matching approachAsthenameitselfsuggests,afinancinginstrumentwouldoffsetthecurrentassetunderconsideration,beingfinancinginstrument bearing approximately same maturity. In simple words, under this approach a match is established betweentheexpectedlivesofcurrentasset tobefinancedwiththesourceoffundraisedtofinancethecurrentassets.Forthisreason,afirmwouldselectlong-termfinancingtofinanceorpermanentcurrentassetstofinancetemporaryorvariablecurrentassets.Thus,aten-yearloanmayberaisedforfinancingmachinerybearingexpectedlifeoftenyears.Similarly,one-monthstockcanbefinancedbymeansofone-monthbankloan.Thisisalsotermedas hedging approach.


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Conservative approachConservative approach takes an edge over and above matching approach, as it is practically not possible to plan an exactmatchinallcases.Afirmissaidtobefollowingaconservativeapproachwhenitdependsmoreonlong-termfinancialsourcesformeetingitsfinancialneeds.Underthisfinancingpolicy,thefixedassets,permanentcurrentassetsandevenapartoftemporarycurrentassetsareprovidedwithlong-termsourcesoffinanceandthismakesitlessrisky.Anotheradvantageoffollowingthisapproachisthatintheabsenceoftemporarycurrentassets,afirmcan invest surplus funds into marketable securities and store liquidity.

Aggressive approachAsagainstconservativeapproach,afirmissaidtobefollowingaggressivefinancingpolicywhendependsrelativelymoreonshort-termsourcesthanwarrantedbythematchingplan.Underthisapproach,thetermfinanceincludesnotonlyitstemporarycurrentassetsbutalsoapartofpermanentcurrentassetswithshort-termsourcesoffinance.Innutshell, itmaybeconcluded that forfinancingofcurrent assets, afirmshoulddecideupon two importantconstraints;firstly,thetypeoffinancingpolicytobeselected(whethershort-termorlong-termandsecondly,therelativeproportionofmodesoffinancing.Thisdecisionistotallybasedontrade-offbetweenriskandreturn,as,short-termfinancingislesscostlybutrisky,long-termfinancingislessriskybutcostly.

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SummarySteady and healthy circulation of cash throughout the entire business operations is the basis of business •solvency.Cash consists of legal tender, cheques, bank drafts, money orders and demand deposits in banks.•Cash management includes management of marketable securities also, because in modern terminology money •comprises marketable securities and actual cash in hand or in bank.The term cash management refers to the management of cash resource in such a way that generally accepted •business objectives could be achieved.Cash management may be regarded as an art that assists in establishing equilibrium between liquidity and •profitabilitytoensureundisturbedfunctioningofafirmtowardsattainingitsbusinessobjectives.Cashmanagementinvolvesmanagingcashflows(intoandoutofthefirm),withinthefirmandthecashbalances•held by a concern at a point of time.Normal and regular payment of cash leads to small reductions in the cash balance at periodic intervals.•Another technique for balancing the level of cash is to schedule cash disbursements to creditors during that •period when accounts receivables collected amounts to a large sum but without putting the goodwill at stake.Everyfinancialmanageraimsatmakingthebestpossibleuseofcashreceipts.•Themotiveofminimisingcashpaymentsistheultimatebenefitderivedfrommaximisingcashreceipts.•Cash planning is a technique, which comprises of planning for and controlling of cash.•Idlecashorsurpluscashreferstotheexcessofcashinflowsovercashoutflows,whichdonothaveanyspecific•operations or any other purpose to solve currently.Itisrecommendedbythefinancialexpertsthatacashmanagementshouldnotstartsearchingforexternalfinance•at the very instance when the cash shortage is anticipated.Short-termfinancingofcurrentassetsincludessourcesofshort-termcredit,whichafirmismostlyrequiredto•arrange in advance.Afirmissaidtobefollowingconservativeapproachwhenitdependsmoreonlong-termfinancialsourcesfor•meetingitsfinancialneeds.Conservative approach takes an edge over and above matching approach, as it is practically not possible to plan •an exact match in all cases.

ReferencesAnalysis of Cash Management• [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_chapter%207.pdf> [Accessed 12 July 2013].Cash management• [Online] Available at: <http://www.investopedia.com/terms/c/cash-management.asp> [Accessed 12 July 2013].Financial Management - Lecture 05• [Videoonline]Availableat:<http://www.youtube.com/watch?v=aiduHQMrd88>[Accessed 12 July 2013].Financial Management: Lecture 4 • [Videoonline]Availableat:<http://www.youtube.com/watch?v=ZRE1glkq9zA>[Accessed 12 July 2013].Ward, M. A. and Sagner, J., 2003. • Essentials of Managing Corporate Cash Wiley.Jones, E. B. and Jones, E. B., 2001. • Cash Management.R&L Education.

Recommended ReadingCooper, R., 2004. • Corporate Treasury and Cash Management (Finance and Capital Markets). Palgrave Macmillan.Linzer, R.S. and Linzer, A.O., 2007. • CashFlowStrategies:InnovationinNonprofitFinancialManagement.Jossey-Bass.Driscoll, M.C., 1983. • CashManagement:CorporateStrategies. John Wiley & Sons Inc.


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Self AssessmentWhichofthefollowingisnotapartofworkingcapitalcycle?1.

Casha. Inventoryb. Receivablec. Accounts d.

____________consistsoflegaltender,cheques,bankdrafts,moneyordersanddemanddepositsinbanks.2. Inventorya. Accountsb. Receivablec. Cashd.

_______________includesmanagementofmarketablesecuritiesalso,becauseinmodernterminologymoney3. comprises marketable securities and actual cash in hand or in bank.

Cash managementa. Receivable managementb. Inventory managementc. Financial managementd.

Whichofthefollowingstatementisnotaprincipleofcashmanagement?4. Determinable variations of cash needsa. Contingency cash requirementb. Availability of internal cashc. Maximising cash receiptsd.

Under________________system,acompanyestablishesbankingcentresforcollectionofcashindifferent5. areas.

local box systema. concentration bankingb. minimising creditc. reviewing creditd.

Under_________________system,acompanyrentsoutthelocalpostofficesboxesofdifferentcitiesandthe6. customers are asked to forward their remittances to it.

local box systema. concentration bankingb. minimising creditc. reviewing creditd.

Themotiveof____________________istheultimatebenefitderivedfrommaximisingcashreceipts.7. cash utilisationa. concentration bankingb. minimising cash paymentsc. credit periodd.

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______________________isatechnique,whichcomprisesofplanningforandcontrollingofcash.8. Cash planninga. Cash managementb. Forecastingc. Cashflowd.

Whichofthefollowingincreasestheavailabilityofusablecashfromwithintheenterprise?9. Cash controllinga. Cashflowb. Cash forecastingc. Cashfinanced.

__________referstotheexcessofcashinflowsovercashoutflows,whichdonothaveanyspecificoperations10. or any other purpose to solve currently.

Cash investmenta. Forecastb. Idle cashc. Profitabilityd.


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Chapter III

Cash Flow and Financial Planning

Aim


definecashflow•

elucidatedepreciationinfinancialmanagement•

classifytheinflowsandoutflowsofcash•

Objectives


explainthestatementofcashflow•

explicatethefinancialplanningprocess•

elucidate cash planning•

Learning outcome


understand the preparation of cash budget•

identifythenetcashflow•

recognise the do’s and don’ts of cash forecasting•

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3.1 IntroductionCashflowistheprimaryfocusoffinancialmanagement.Thegoalistwofold,tomeetthefirm’sfinancialobligationsandtogeneratepositivecashflowforitsowners.Financialplanningfocusesonthefirm’scashandprofits—bothofwhicharekeyelementsofcontinuedfinancialsuccess,andevensurvival.Thischapteroutlineshowthefirmanalysesitscashflows,includingtheeffectofdepreciation,andtheuseofcashbudgetsandproformastatementsastoolsoffinancialplanning.

Cashflow,thelifebloodofthefirm,istheprimaryfocusofthefinancialmanagerbothinmanagingday-to-dayfinancesandinplanningandmakingstrategicdecisionsaimedatcreationofshareholdervalue.Animportantfactoraffectingafirm’scashflowisdepreciation(andanyothernon-cashcharges).Fromastrictfinancialperspective,firmsoftenfocusonbothoperatingcashflow,whichisusedinmanagerialdecisionmakingandfreecashflow,whichiscloselywatchedbyparticipantsinthecapitalmarket.Webeginouranalysisofcashflowbyconsideringthekeyaspectsofdepreciation,whichiscloselyrelatedtothefirm’scashflow.

3.2 DepreciationBusinessfirmsarepermittedfortaxandfinancialreportingpurposestochargeaportionofthecostsoffixedassetssystematically against annual revenues. This allocation of historical costs over a period of time is called depreciation. For tax purposes, the depreciation of business assets is regulated by the Internal Revenue Code. Because the objectives offinancialreportingaresometimesdifferentfromthoseoftaxlegislation,firmsoftenusedifferentdepreciationmethodsforfinancialreportingthanthoserequiredfortaxpurposes.Taxlawsareusedtoaccomplisheconomicgoals, such as providing incentives for business investment in certain types of assets, whereas the objectives of financialreportingareofcoursequitedifferent.

Keepingtwodifferentsetsofrecordsforthesetwodifferentpurposesislegal.DepreciationfortaxpurposesisdeterminedbyusingtheModifiedAcceleratedCostRecoverySystem(MACRS);avarietyofdepreciationmethodsareavailableforfinancialreportingpurposes.Beforewediscussthemethodsofdepreciatinganasset,youmustunderstand the depreciable value of an asset and the depreciable life of an asset.

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

Depreciable life of an assetThetimeperiod,overwhichanassetisdepreciated,itsdepreciablelifecansignificantlyaffectthepatternofcashflows.Theshorterthedepreciablelife,themorequicklythecashflowcreatedbythedepreciationwrite-offwillbereceived.

Depreciation methodsForfinancialreportingpurposes,avarietyofdepreciationmethodslikestraight-line,double-decliningbalance,andsum-of-the-years can be used.

Developing the statement of cash flowsThestatementofcashflowssummarisesthefirm’scashflowoveragivenperiodoftime.Beforediscussingthestatementanditsinterpretation,wewillreviewthecashflowthroughthefirmandtheclassificationofinflowsandoutflowsofcash.

The firm’s cash flowsFigure3.1illustratesthefirm’scashflows.Notethatmarketablesecuritiesareconsideredthesameascashbecauseof their highly liquid nature. Both cash and marketable securities represent a reservoir of liquidity, that is, increased bycashinflowsanddecreasedbycashoutflows.Also,notethatthefirm’scashflowscanbedividedinto:

Operatingflows•Investmentflows•Financingflows•


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Theoperatingflowsarecashinflowsandoutflowsdirectlyrelatedtosaleandproductionofthefirm’sproductsandservices.Investmentflowsarecashflowsassociatedwithpurchaseandsaleofbothfixedassetsandbusinessinterests.

Clearly,purchasetransactionswouldresultincashoutflows,whereassalestransactionswouldgeneratecashinflows.Thefinancingflowsresultfromdebtandequityfinancingtransactions.Incurring(orrepaying)eithershort-termorlong-termdebtwouldresultinacorrespondingcashinflow(oroutflow).Similarly,thesaleofstockwouldresultinacash inflow; thepaymentofcashdividendsor repurchaseofstockwouldresult inafinancingoutflow. Incombination,thefirm’soperating,investment,andfinancingcashflowsduringagivenperiodaffectthefirm’scashand marketable securities balances.

3.3 Classifying Inflows and Outflows of CashThestatementofcashflowsineffectsummarisestheinflowsandoutflowsofcashduringagivenperiod.

Work inProcess

OverheadExpenses

BusinessInterests

AccountsPayable

RawMaterials

AccruedWagesLabor

Fixed Assets

Debt(Short-Term and

Long-Term)

Repayment

Payment of Cash Dividends

Repurchase of Stock

Sale of Stock

Borrowing

Sale

Purchase

Sale

Purchase

Equity

FinishedGoods

Operating (incl.Depreciation) andInterest Expense

Cashand

MarketableSecurities

TaxesPayment

Depreciation

Paymentof CreditPurchases

Payment of Accruals

Cash Sales

Collection of Credit Sales

Refund

Sales

AccountsReceivable

swolF tnemtsevnI )2(swolF gnitarepO )1(

(3) Financing Flows

Fig. 3.1 The firm’s cash flow

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3.4 Preparing the Statement of Cash FlowsThestatementofcashflowsforagivenperiodisdevelopedusingtheincomestatementfortheperiod,alongwiththe beginning and end-of-period balance sheets.

Interpreting the statementThestatementofcashflowsallowsthefinancialmanagerandotherinterestedpartiestoanalysethefirm’scashflow.Themanagershouldpayspecialattentionbothtothemajorcategoriesofcashflowandtotheindividualitemsofcashinflowandoutflowtoassesswhetheranydevelopmentshaveoccurredthatarecontrarytothecompany’sfinancialpolicies.Inaddition,thestatementcanbeusedtoevaluateprogresstowardsprojectedgoalsortoisolateinefficiencies.Forexample,increasesinaccountsreceivableorinventoriesresultinginmajorcashoutflowsmaysignalcreditorinventoryproblems,respectively.Thefinancialmanageralsocanprepareastatementofcashflowsdevelopedfromprojectedfinancialstatements.Thisapproachcanbeusedtodeterminewhetherplannedactionsaredesirableinviewoftheresultingcashflows.

Operating cash flowAfirm’sOperatingCashFlow(OCF)isthecashflowitgeneratesfromitsnormaloperations,producingandsellingitsoutputofgoodsorservices.AvarietyofdefinitionsofOCFcanbefoundinthefinancialliterature.We’vealreadybeenintroducedtothesimpleaccountingdefinitionofcashflowfromoperationsinequation.

OCF= EBI-Taxes + Depreciation

Free cash flowThefirm’sFreeCashFlow(FCF)representstheamountofcashflowavailabletoinvestors,theprovidersofdebt(creditors)andequity(owners)afterthefirmhasmetalloperatingneedsandpaidforinvestmentsinnetfixedassetsand net current assets. It is called “free” not because it is “without cost” but because it is “available” to investors. It representsthesummationofthenetamountofcashflowavailabletocreditorsandownersduringtheperiod.Freecashflowcanbedefinedbyequation:

FCF=OCF-Netfixedassetinvestment(NFAI)-Netcurrentassetinvestment(NCAI)

The financial planning processFinancial planning is an important aspect of thefirm’s operations because it provides roadmaps for guiding,coordinating,andcontrollingthefirm’sactionstoachieveitsobjectives.Twokeyaspectsofthefinancialplanningprocessarecashplanningandprofitplanning.Cashplanninginvolvespreparationofthefirm’scashbudget.Profitplanning involves preparation of pro forma statements. Both the cash budget and the pro forma statements are useful forinternalfinancialplanning;theyalsoareroutinelyrequiredbyexistingandprospectivelenders.

Thefinancialplanningprocessbeginswithlong-term,orstrategic,financialplans.Theseinturnguidetheformulationofshort-term,oroperating,plansandbudgets.Generally,theshort-termplansandbudgetsimplementthefirm’slong-termstrategicobjectives.Althoughtheremainderofthischapterplacesprimaryemphasisonshort-termfinancialplansandbudgets,afewpreliminarycommentsonlong-termfinancialplansareinorder.

Long-term (strategic) financial plansLong-term(strategic)financialplanslayoutacompany’splannedfinancialactionsandtheanticipatedimpactofthoseactionsoverperiodsrangingfrom2to10years.Five-yearstrategicplans,whicharerevisedassignificantnewinformationbecomesavailable,arecommon.Generally,firmsthataresubjecttohighdegreesofoperatinguncertainty, relatively short production cycles, or both, tend to use shorter planning horizons.

Long-termfinancial plans are part of an integrated strategy that, alongwith production andmarketing plans,guidesthefirmtowardstrategicgoals.Thoselong-termplansconsiderproposedoutlaysforfixedassets,researchand development activities, marketing and product development actions, capital structure, and major sources of financing.Alsoincludedwouldbeterminationofexistingprojects,productlines,orlinesofbusiness;repaymentorretirementofoutstandingdebts;andanyplannedacquisitions.Suchplanstendtobesupportedbyaseriesofannualbudgetsandprofitplans.


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Short-term (operating) financial plansShort-term (operating)financial plans specify short-termfinancial actions and the anticipated impact of thoseactions.Theseplansmostoftencovera1to2-yearperiod.Keyinputsincludethesalesforecastandvariousformsof operating and

Pro FormaIncome

Statement

Pro FormaBalance Sheet

Current-Period

BalanceSheet

CashBudget

ProductionPlans

SalesForecast

Long-TermFinancing

Plan

Fixed AssetOutlayPlan

Information Needed

Output for Analysis

Fig. 3.2 The short-term financial planning process

financialdata.Keyoutputsincludeanumberofoperatingbudgets,thecashbudget,andproformafinancialstatements.Theentireshort-termfinancialplanningprocessisoutlinedinFig.3.2.

Short-termfinancialplanningbeginswiththesalesforecast.Fromit,productionplansaredevelopedthattakeintoaccount lead (preparation) times and include estimates of the required raw materials. Using the production plans, the firmcanestimatedirectlabourrequirements,factoryoverheadoutlays,andoperatingexpenses.Oncetheseestimateshavebeenmade,thefirm’sproformaincomestatementandcashbudgetcanbeprepared.Withthebasicinputs(proformaincomestatement,cashbudget,fixedassetoutlayplan,long-termfinancingplan,andcurrent-periodbalancesheet),theproformabalancesheetcanfinallybedeveloped.

3.5 Cash Planning: Cash BudgetsThecashbudget,orcashforecast,isastatementofthefirm’splannedinflowsandoutflowsofcash.Itisusedbythefirmtoestimateitsshort-termcashrequirements,withparticularattentiontoplanningforsurpluscashandforcashshortages. Typically, the cash budget is designed to cover a 1-year period, divided into smaller time intervals. The numberandtypeofintervalsdependonthenatureofthebusiness.Themoreseasonalanduncertainafirm’scashflows,thegreaterthenumberofintervals.Becausemanyfirmsareconfrontedwithaseasonalcashflowpattern,thecashbudgetisquiteoftenpresentedonamonthlybasis.Firmswithstablepatternsofcashflowmayusequarterlyor annual time intervals.

3.5.1 The Sales ForecastThekeyinputtotheshort-termfinancialplanningprocessisthefirm’ssalesforecast.Thispredictionofthefirm’ssales over a given period is ordinarily prepared by the marketing department. On the basis of the sales forecast, the financialmanagerestimatesthemonthlycashflowsthatwillresultfromprojectedsalesreceiptsandfromoutlays

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relatedtoproduction,inventoryandsales.Themanageralsodeterminestheleveloffixedassetsrequiredandtheamountoffinancing,ifany,neededtosupporttheforecastlevelofsalesandproduction.Inpractice,obtaininggooddataisthemostdifficultaspectofforecasting.Thesalesforecastmaybebasedonananalysisofexternaldata,internal data, or a combination of the two.

Anexternalforecastisbasedontherelationshipsobservedbetweenthefirm’ssalesandcertainkeyexternaleconomicindicatorssuchastheGrossDomesticProduct(GDP),newhousingstarts,consumerconfidence,anddisposablepersonal income.Forecastscontaining these indicatorsare readilyavailable.Because thefirm’ssalesareoftenclosely related to some aspect of overall national economic activity, a forecast of economic activity should provide insights into future sales.

Internalforecastsarebasedonabuildup,orconsensus,ofsalesforecaststhroughthefirm’sownsaleschannels.Typically,thefirm’ssalespeopleinthefieldareaskedtoestimatehowmanyunitsofeachtypeofproducttheyexpect to sell in the coming year. These forecasts are collected and totalled by the sales manager, who may adjust thefiguresusingtheknowledgeofspecificmarketsorofthesalesperson’sforecastingability.Finally,adjustmentsmay be made for additional internal factors, such as production capabilities.

Firmsgenerallyuseacombinationofexternalandinternalforecastdatatomakethefinalsalesforecast.Theinternaldata provides insights into sales expectations, and the external data provides a means of adjusting these expectations totakeintoaccountgeneraleconomicfactors.Thenatureofthefirm’sproductalsooftenaffectsthemixandtypesof forecasting methods used.

3.5.2 Preparing the Cash BudgetThe general format of the cash budget is presented in Table 3.1.

Jan. Feb.

.....

.........

Nov. Dec.

Cash receipts $XXX $XXG $XXM $XXT

Less: Cash disbursements XXA XXH XXN XXU

Netcashflow $XXB $XXI $XXO $XXV

Add: Beginning cash XXC XXD XXJ XXP XXQ

Ending cash $XXD $XXJ

...........

$XXQ $XXW

Less: Minimum cash balance XXE XXK XXR XXY

Requiredtotalfinancing XXL $XXS

Excess cash balance $XXF $XXZ

Table 3.1 The general format of the cash budget

Cash ReceiptsCashreceiptsincludeallofafirm’sinflowsofcashinagivenfinancialperiod.Themostcommoncomponentsofcash receipts are cash sales, collections of accounts receivable, and other cash receipts.

Example:Coulson Industries, a defence contractor, is developing a cash budget for October, November, and December. Coulson’s sales in August and September were $100,000 and $200,000, respectively. Sales of $400,000, $300,000


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and $200,000 have been forecast for October, November and December, respectively. Historically, 20% of the firm’ssaleshavebeenforcash,50%havegeneratedaccountsreceivablecollectedafter1month,andtheremaining30% have generated accounts receivable collected after 2 months. Bad-debt expenses (uncollectible accounts) have beennegligible.InDecember,thefirmwillreceivea$30,000dividendfromstockinasubsidiary.Thescheduleofexpected cash receipts for the company is presented in Table 3.8. It contains the following items:

Forecast sales: This initial entry is merely informational. It is provided as an aid in calculating other sales-•related items.Cash sales: The cash sales shown for each month represent 20% of the total sales forecast for that month.•Collections of A/R: These entries represent the collection of accounts receivable (A/R) resulting from sales in •earlier months.Lagged1month:Thesefiguresrepresentsalesmadeintheprecedingmonththatgeneratedaccountsreceivable•collected in the current month. Because 50% of the current month’s sales are collected 1 month later, the collections of A/R with a 1-month lag shown for September represent 50% of the sales in August, collections for October represent 50% of September sales, and so on.Lagged2months:Thesefigures represent salesmade2months earlier that generated accounts receivable•collected in the current month. Because 30% of sales are collected 2 months later, the collections with a 2-month lag shown for October represent 30% of the sales in August, and so on.Other cash receipts: These are cash receipts expected from sources other than sales. Interest received, dividends •received, proceeds from the sale of equipment, stock and bond sale proceeds, and lease receipts may show up here.

Forecast sales Aug. $100 Sept. $200 Oct. $400 Nov. $300 Dec. $200

Cash sales (0.20) $20 $40 $80 $60 $40

Collections of A/R:

Lagged 1 month (0.50) 50 100 200 150

Lagged 2 month (0.50) 30 60 120

Other cash receipts 30

Total cash receipts $210 $320 $340

Table 3.2 A schedule of projected cash receipts for Coulson Industries ($000)

Cash disbursementsCashdisbursementsincludealloutlaysofcashbythefirmduringagivenfinancialperiod.Themostcommoncashdisbursements are:

Cash purchases•Fixed-asset outlays•Payments of accounts payable•Interest payments•Rent (and lease) payments•Cash dividend payments•Wages and salaries•Principal payments (loans)•Tax payments•Repurchases or retirements of stock•

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It is important to recognise that depreciation and other noncash charges are NOT included in the cash budget, becausetheymerelyrepresentascheduledwrite-offofanearliercashoutflow.Theimpactofdepreciation,aswenotedearlier,isreflectedinthereducedcashoutflowfortaxpayments.

3.6 Net Cash Flow, Ending Cash, Financing, and Excess CashThefirm’snetcashflowisfoundbysubtractingthecashdisbursementsfromcashreceiptsineachperiod.Then,weaddbeginningcashtothefirm’snetcashflowtodeterminetheendingcashforeachperiod.Finally,wesubtractthedesiredminimumcashbalancefromendingcashtofindtherequiredtotalfinancingortheexcesscashbalance.Iftheendingcashislessthantheminimumcashbalance,financingisrequired.Suchfinancingistypicallyviewedas short-term and is therefore represented by notes payable. If the ending cash is greater than the minimum cash balance, excess cash exists. Any excess cash is assumed to be invested in a liquid, short-term, interest-paying vehicle, that is, in marketable securities.

Evaluating the cash budgetThe cash budget indicates whether a cash shortage or surplus is expected in each of the months covered by the forecast. Eachmonth’sfigureisbasedontheinternallyimposedrequirementofaminimumcashbalanceandrepresentsthetotal balance at the end of the month.

Coping with uncertainty in the cash budgetAside from careful estimation of cash budget inputs, there are two ways of coping with the uncertainty of the cash budget. One is to prepare several cash budgets based on pessimistic and optimistic forecasts. From this range of cash flows,thefinancialmanagercandeterminetheamountoffinancingnecessarytocoverthemostadversesituation.Theuseofseveralcashbudgets,basedondifferingassumptions,alsoshouldgivethefinancialmanagerasenseofthe riskiness of various alternatives. This sensitivity analysis, or ‘what if’ approach, is often used to analyse cash flowsunderavarietyofcircumstances.Computersandelectronicspreadsheetssimplifytheprocessofperformingsensitivity analysis.

Table 3.3 presents the summary of Coulson Industries’ cash budget prepared for each month of concern using pessimistic, most likely and optimistic estimates of total cash receipts and disbursements. The most likely estimate is based on the expected outcomes presented earlier.

rebmeceDrebmevoNrebotcO

Pessi- Most Opti- Pessi- Most Opti- Pessi- Most Opti-mistic likely mistic mistic likely mistic mistic likely mistic

Total cashreceipts $160 $210 $285 $210 $320 $ 410 $275 $340 $422

Less: Total cashdisbursements 200 213 248 380 418 467 280 305 320

Net cash flow ($ 40) ($ 3) $ 37 ($170) ($ 98) ($ 57) ($ 5) $ 35 $102Add: Beginning

cash 50 50 50 10 47 87 ( 160) ( 51) 30Ending cash $ 10 $ 47 $ 87 ($160) ($ 51) $ 30 ($165) ($ 16) $132Less: Minimum

cash balance 25 25 25 25 25 25 25 25 25Required total

financing $ 15 — — $185 $ 76 — $190 $ 41 —Excess cash

balance — $ 22 $ 62 — — $ 5 — — $107

Table 3.3 A sensitivity analysis of Coulson industries cash budget


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3.7 Cash ForecastingAcashflowforecastaimstopredictacompany’sfuturefinancialliquidityoveraspecificperiodoftime,usingtriedandtestedfinancialmodels.Whilecashnormallyreferstotheliquidassetsinacompany’sbankaccount,theforecast usually estimates its treasury position, which is cash plus short-term investments minus short-term debts. Thecashflowitselfreferstothechangeinthecashortreasurypositionfromoneperiodtothenext.Thecashflowforecast is an important way to value assets, work out budgets, and determine appropriate capital structures. It will provideagoodindicatorofacompany’sfinancialhealthforpotentialinvestors.

Severalmethodsaregenerallyused to forecastcashflow—onedirect,and three indirect.Thedirectmethod ismost suitable for short-term forecasts of anywhere from 30 days up to a year, since it is based on actual data from which the projections are extrapolated. The data used are the company’s cash receipts and disbursements (R&D). Receiptsprimarilyincludeaccountsfromrecentsales,salesofotherassets,proceedsoffinancing,etc.Disbursementsinclude salaries, payments for recent purchases, dividends, and debt servicing. Many of the R&D entries are based on projected future sales.

Alltheothermethodsuseacompany’sprojectedincomestatementsandbalancesheetsastheirbasis.ThefirstmethodisAdjustedNetIncome(ANI),whichfirstexaminestheoperatingincome(EBITorEBITDA),andthenlooksatchangesonthebalancesheetsuchasreceivables,payables,andinventorytoforecastcashflow.TheProforma Balance Sheet (PBS) method looks at the projected book cash account, if projections for all other balance sheetaccountsarecorrect,thenthecashflowwillalsobecorrect.Boththesemethodscanbeusedtomakeshort-term (up to 12 months) and long-term (multiple year) forecasts. Since they use the monthly or quarterly intervals ofacompany’sfinancialplan,theymustbeadjustedtoaccountforthedifferencesbetweenthebookcashandtheactualbankbalance,andthesemaybesignificantlydifferent.

The third method uses the Accrual Reversal Method (ARM), which reverses large accruals (revenues and expenses that are recognised when they are earned or incurred, disregarding the actual receipt or dispersal of cash) and calculates the cash effects based on statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily. It can also be used to extend the R&D method beyond the 30-day horizon because it eliminates the inherent cumulative errors. This is the most complicated of all methods and is best suited for medium-term forecasts.

AdvantagesCashflowprojectionsofferausefulindicatorofacompany’sfinancialhealth.•Cashflowforecastsenableyou topredict thepeaksand troughs inyourcashbalance,helpingyou toplan•borrowings, and they tell you how much surplus cash you may have at a given time. Most banks insist on forecasts before considering a loan.

DisadvantagesAcashflowforecastnevertellsthewholestoryaboutacompany’sfinancialsituationandshouldnotberelied•on as the sole indicator.

Dos and Don’tsDos

Use the most appropriate method, depending on how long you want your forecasting horizon to be.•Rememberthatacashflowforecastcanonlydeterminetheshort-termsustainabilityofacompany.•The longer the forecast horizon, the higher the chance of an inaccurate projection.•Bearinmindthattheforecastisdynamic—youwillneedtoadjustitfrequentlydependingonbusinessactivity,•payment patterns and supplier demands.

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Don’tsDon’trelysolelyonacashflowforecasttodetermineacompany’sfinancialstability—lookattheotherfinancial•statements and forecasts, such as an income statement and a balance sheet, to see what’s actually going on.Don’tforgettoincorporatewarningsignalsintoyourcashflowforecast.Forexample,ifpredictedcashlevels•come close to your overdraft limits, this should sound an alarm and trigger action to bring cash back to an acceptable level.


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SummaryCashflowistheprimaryfocusoffinancialmanagement.•Financialplanningfocusesonthefirm’scashandprofits—bothofwhicharekeyelementsofcontinuedfinancial•success, and even survival.Animportantfactoraffectingafirm’scashflowisdepreciation.•Depreciationfortaxpurposesisdeterminedbyusingthemodifiedacceleratedcostrecoverysystem.•Thetimeperiod,overwhichanassetisdepreciated,itsdepreciablelifecansignificantlyaffectthepatternof•cashflows.Bothcashandmarketablesecuritiesrepresentareservoirof liquidity that is increasedbycashinflowsand•decreasedbycashoutflows.Theoperatingflowsarecashinflowsandoutflowsdirectlyrelatedtosaleandproductionofthefirm’sproducts•and services.Investmentflowsarecashflowsassociatedwithpurchaseandsaleofbothfixedassetsandbusinessinterests.•Thefinancingflowsresultfromdebtandequityfinancingtransactions.•Thestatementofcashflowsallowsthefinancialmanagerandotherinterestedpartiestoanalysethefirm’scash•flow.Afirm’soperatingcashflow(OCF)isthecashflowitgeneratesfromitsnormaloperations,producingand•selling its output of goods or services.Both thecashbudgetand theproformastatementsareuseful for internalfinancialplanning; theyalsoare•routinely required by existing and prospective lenders.Long-termfinancialplansarepartofanintegratedstrategythat,alongwithproductionandmarketingplans,•guidesthefirmtowardstrategicgoals.Short-term(operating)financialplansspecifyshort-termfinancialactionsandtheanticipatedimpactofthose•actions.Internal forecasts are based on a build up, or consensus, of sales forecasts through thefirm’s own sales•channels.Firmsgenerallyuseacombinationofexternalandinternalforecastdatatomakethefinalsalesforecast.•The internal data provide insight into sales expectations, and the external data provide a means of adjusting •these expectations to take into account general economic factors.Cashreceiptsincludeallofafirm’sinflowsofcashinagivenfinancialperiod.•Cashdisbursementsincludealloutlaysofcashbythefirmduringagivenfinancialperiod.•Thefirm’snetcashflowisfoundbysubtractingthecashdisbursementsfromcashreceiptsineachperiod.•Acashflowforecastaimstopredictacompany’sfuturefinancialliquidityoveraspecificperiodoftime,using•triedandtestedfinancialmodels.Thecashflowforecastisanimportantwaytovalueassets,workoutbudgetsanddetermineappropriatecapital•structures.TheProformaBalanceSheet(PBS)methodlooksattheprojectedbookcashaccount—iftheprojectionsfor•allotherbalancesheetaccountarecorrect,thenthecashflowwillalsobecorrect.

ReferencesPreparing aCashFlowForecast• [Online]Available at: <http://www.qfinance.com/contentFiles/QF02/g1xqynvv/12/1/preparing-a-cash-flow-forecast.pdf>[Accessed12July2013].Cashflowandfinancialplanning• [Pdf] Available at: <http://wps.aw.com/wps/media/objects/222/227412/ebook/ch03/chapter03.pdf> [Accessed 12 July 2013].CFALevelICashFlowStatement• [Videoonline]Availableat:<http://www.youtube.com/watch?v=hkcOqTNPiTo>[Accessed 12 July 2013].

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Chap 17 Lecture: Statement of Cash Flows.• [Video online] Available at: <http://www.youtube.com/watch?v=M7xhaJVx-WE>[Accessed12July2013].Ramsey, D., 2009. • The TotalMoneyMakeover:AProvenPlan forFinancial Fitness. 3rd ed., Thomas Nelson.Jury, T., 2012. • CashFlowAnalysisandForecasting. Wiley.

RecommendedReadingTracy, J.A. and Tracy, T., 2011. • CashFlowForDummies. For DummiesO’Berry, D., 2006. • SmallBusinessCashFlow:Strategies forMakingYourBusiness aFinancial Success. Wiley.CPF Board, 2013• . CFP Board Financial Planning Competency Handbook. Wiley.


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Self Assessment______________istheprimaryfocusoffinancialmanagement.1.

Businessfirma. Cashflowb. Financial planningc. Capital marketd.

______________areusedtoaccomplisheconomicgoals,suchasprovidingincentivesforbusinessinvestment2. in certain types of assets.

Tax lawsa. MACRSb. Cashprofitsc. Tax purposesd.

Whichofthefollowingisnotoneofthedivisionsofcashflow?3. Operatingflowsa. Investmentflowsb. Purchaseflowsc. Financingflowsd.

Thestatementof_____________allowsthefinancialmanagerandotherinterestedpartiestoanalysethefirm’s4. cashflow.

businessfirma. cashflowsb. financialplanningc. capital marketd.

_____________________representsthesummationofthenetamountofcashflowavailabletocreditorsand5. owners during the period.

OCFa. EBIb. NCAIc. FCFd.

Twokeyaspectsofthefinancialplanningprocessarecashplanningand____________planning.6. processa. lossb. receivablec. profitd.

___________________planninginvolvespreparationofproformastatements.7. Processa. Lossb. Receivablec. Profitd.

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Whichofthefollowingstatementisfalse?8. Long-term(strategic)financialplanslayoutacompany’splannedfinancialactionsandtheanticipatedimpacta. of those actions over periods ranging from 2 to 10 years.Thefinancialplanningprocessbeginswithlong-term,orstrategic,financialplans.b. Long-termfinancialplansarepartofanintegratedstrategythat,alongwithproductionandmarketingplans,c. guidesthefirmtowardstrategicgoals.Long-term(operating)financialplansspecifyshort-termfinancialactionsand theanticipated impactofd. those actions.

The_______________isastatementofthefirm’splannedinflowsandoutflowsofcash.9. cash budgeta. short-termfinancialplanningb. long-termfinancialplanningc. sale forecastd.

An/A_______________isbasedontherelationshipsobservedbetweenthefirm’ssalesandcertainkeyexternal10. economic indicators, such as the Gross Domestic Product (GDP).

internal forecasta. external forecastb. finalforecastc. cashflowd.


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Chapter IV

Liquidity and Working Capital Financing

Aim


definetraditionalmeasuresofliquidity•

elucidate the liquidity ratios•

explain the types of liquidity ratio•

Objectives


explain net working capital•

explicate the business uses of working capital•

elucidate permanent working capital•

Learning outcome


understand the cyclical working capital•

identifytheworkingcapitalfinancing•

recognisetheformsofworkingcapitalfinancing•

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4.1 IntroductionLiquidity refers to the ability of a company to meet its immediate obligations without any trouble or strain. The obligations for a business may consist of items, such as accounts payable for the suppliers of raw materials, taxes payable,utilitiespayableandotheraccruedexpenses.Howdoesacompanypayalltheseobligations?Itisthroughcash.

Wherefromanorganisationgetstherequiredcashformeetingalltheseobligations?Itgetscashfromtheexistingcash balance in hand, bank account balances and realisation of cash by converting the current assets such as account receivable, note receivable and inventories into cash. The above explanation shows that liquidity contributes to profitability.Sowhatwillhappentotheorganisationwhoseperformancesuffersfromapoorliquidityposition?Thismeansthatthisorganisationisfindingithardtomeetitspaymentobligationstooutsiders,suchassuppliers/vendors of material.

If this situation continues, the vendors will not supply the required materials for the production activities and may even blacklist the company. Poor liquidity position thus can bring upon many challenges, which could even result in liquidation, if not addressed properly.

4.2 Traditional MeasuresBusiness entities have so far relied on two major measures to gauge their liquidity position. One is current ratio and the other one is liquidity or quick ratio (popularly known as the acid-test ratio). The current ratio is computed bydividingthetotalofcurrentassetsbythetotalofcurrentliabilities.Here,currentassetsaredefinedasassetsthat are convertible into cash in one year or one operating cycle, whichever is higher. Examples include cash in hand, cash at bank, short-term marketable securities, accounts receivable, notes receivable, inventories and pre-paid expenses. Current liabilities are those obligations that are to be settled in one year or one operating cycle, whichever is longer.

A current ratio of 2:1 is considered to be satisfactory in theory. This indicates that the company has twice the amount of money invested in current assets than that of the amount required for meeting its current liabilities. However, practicality suggests that the judgement on whether a company’s liquidity position is good or bad should be based on the industry standards or benchmark.

Here, quick ratio is a better measure of the actual liquidity position of a company compared to the current ratio. The majorflawinusingcurrentratioisthatitusesinventoriesandpre-paidexpensesinitsdefinitionofliquidassets,while they are the least liquid assets in reality. Quick ratio removes this error by dividing the liquid assets by the currentliabilitiesofafirm.Here,quickorliquidassetsincludeallthecurrentassetsexceptinventoriesandpre-paidexpenses. A quick ratio of one is considered satisfactory in theory. Again, investors need to look at the industry standards for the right interpretation about a company’s liquidity position.

4.2.1 An Alternative MethodHowever, investors must not take a call on the liquidity position of a company just by going through the traditional liquiditymeasuresalone.Theyneedtolookattheliquiditypositionofafirmbasedonthealternativemethodtoo.Youcandothisbydividingtheexcessoflong-termfinancingoverthenetfixedassetsbythenetworkingcapitalrequirementsofafirm.Herelong-termfinancingiscomputedbyaddingtheowners’equitywiththenon-currentliabilities.Netfixedassetscanbearrivedatbydeductingaccumulateddepreciationfromthegrossfixedassets,and net working capital by subtracting the total of current liabilities from the total of current assets excluding cash balance. This method suggests the following:

Long-termfundsavailableshouldbegreaterthantheamountlockedupinnetfixedassets.•The amount of current assets [excluding cash] should exceed the amount of current liabilities of the •organisation.

Some analysts also compute absolute cash ratio where liquidity is measured by dividing the sum of cash and near-cash assets by the sum of current liabilities.


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4.3 Liquidity RatiosLiquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations. This is done by comparing a company’s most liquid assets (or, those that can be easily converted to cash), its short-term liabilities.In general, the greater the coverage of liquid assets to short-term liabilities, the better, as it is a clear signal that a company can pay its debts that are due in the near future and still fund its ongoing operations. On the other hand, acompanywithalowcoveragerateshouldraisearedflagforinvestorsasitmaybeasignthatthecompanywillhavedifficultyrunningitsoperationsandmeetingitsobligations.Thebiggestdifferencebetweeneachratioisthetype of assets used in the calculation. While each ratio includes current assets, the more conservative ratios will exclude some current assets as they aren’t as easily converted to cash.

4.3.1 Types of Liquidity RatioThe types of liquidity ratios are:Current ratioThecurrentratioisapopularfinancialratiousedtotestacompany’sliquidity(alsoreferredtoasitscurrentorworking capital position) by deriving the proportion of current assets available to cover current liabilities. The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Formula:

Quick ratioThequickratioorthequickassetsratioortheacid-testratioisaliquidityindicatorthatfurtherrefinesthecurrentratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficulttoturnintocash.Therefore,ahigherratiomeansamoreliquidcurrentposition.

Formula:

Cash ratioThecashratioisanindicatorofacompany’sliquiditythatfurtherrefinesboththecurrentratioandthequickratioby measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.

Formula:

Cash conversion cycleThis liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The Cash Conversion Cycle (CCC) measures the number of days a company’s cash istiedupintheproductionandsalesprocessofitsoperationsandthebenefititgetsfrompaymenttermsfromitscreditors. The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known as the “cash” or “operating” cycle.

Formula: Cash conversion Cycle= DIO+DSO-DPO

Where:DIO= Days Inventory OutstandingDSO- Days Sales OutstandingDPO= Days Payable Outstanding

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4.4 Net Working CapitalNet Working Capital (which is also known as “Working Capital” or the initials “NWC”) is a measurement of the operating liquidity available for a company to use in developing and growing its business. The working capital can be calculated very simply by subtracting a company’s total current liabilities from its total current assets.Through this formula, a working capital amount can be determined to be either positive or negative. Naturally, this will rely largely on the amount of debt owed by the company. It should not come as a surprise that, having plenty of working capital tends to help companies achieve more success. This follows because working capital allows companies to grow smoothly and make necessary improvements to their corporate operations.

Ontheotherhand,companiesthatareoperatingwithnegativeworkingcapitalmaynothavethefinancialsupportorflexibilitytogrowand/orimprove,evenwhensuchdevelopmentswouldbeindicated.Hence,workingcapitalcanbean indicator of the overall strength of a company. There are three main indicators used in calculating working capital. Elements of the “current assets” side of the equation will include accounts receivable, as well as any inventory of goods on hand. “Current liabilities” will include accounts payable.

A positive change in a company’s working capital will generally indicate one of two developments. Either the company has increased its current assets by receiving cash (or some other form of assets), or it has minimised its liabilities – often by paying off short-term creditors.

4.4.1 Business Uses of Working CapitalJustasworkingcapitalhasseveralmeanings,firmsuse it inmanyways.Most fundamentally,workingcapitalinvestment is the lifebloodof a company.Without it, afirmcannot stay inbusiness.Thus, thefirst, andmostcritical, use of working capital is providing the ongoing investment in short-term assets that a company needs to operate. A business requires a minimum cash balance to meet basic day-to-day expenses and to provide a reserve for unexpected costs. It also needs working capital for prepaid business costs, such as licenses, insurance policies or security deposits.

Furthermore,allbusinessesinvestinsomeamountofinventory,fromalawfirm’sstockofofficesuppliestothelargeinventoriesneededbyretailandwholesaleenterprises.Withoutsomeamountofworkingcapitalfinance,businessescouldnotopenandoperate.Asecondpurposeofworkingcapitalisaddressingseasonalorcyclicalfinancingneeds.Here,workingcapitalfinancesupportsthebuildupofshort-termassetsneededtogeneraterevenue,butwhichcome before the receipt of cash. For example, a toy manufacturer must produce and ship its products for the holiday shopping season several months before it receives cash payment from stores. Since most businesses do not receive prepaymentforgoodsandservices,theyneedtofinancethesepurchase,production,sales,andcollectioncostspriorto receiving payment from customers.

Fig.4.1illustratesthisshort-termcashflowandfinancingcycle.Anotherwaytoviewthisfunctionofworkingcapitalisprovidingliquidity.Adequateandappropriateworkingcapitalfinancingensuresthatafirmhassufficientcashflowtopayitsbillsasitawaitsthefullcollectionofrevenue.Whenworkingcapitalisnotsufficientlyorappropriatelyfinanced,afirmcanrunoutofcashandfacebankruptcy.Aprofitablefirmwithcompetitivegoodsorservicescanstillbeforcedintobankruptcy,ifithasnotadequatelyfinanceditsworkingcapitalneedsandrunsoutofcash.Workingcapitalisalsoneededtosustainafirm’sgrowth.Asabusinessgrows,itneedslargerinvestmentsin inventory, accounts receivable, personnel, and other items to realise increased sales.


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Newfacilitiesandequipmentsarenottheonlyassetsrequiredforgrowth;firmsalsomustfinancetheworkingcapitalneededtosupportsalesgrowth.Afinaluseofworkingcapitalistoundertakeactivitiestoimprovebusinessoperations and remain competitive, such as product development, ongoing product and process improvements, and cultivatingnewmarkets.Withfirmsfacingheightenedcompetition,theseimprovementsoftenneedtobeintegratedinto operations on a continuous basis. Consequently, they are more likely to be incurred as small repeated costs than aslargeinfrequentinvestments.Thisisespeciallytrueforsmallfirmsthatcannotaffordthecostandrisksoflargefixedinvestmentsinresearchanddevelopmentprojectsornewfacilities.Ongoinginvestmentsinproductandprocessimprovementandmarketexpansion,therefore,oftenmustbeaddressedthroughworkingcapitalfinancing.

AR converted

to cash

Collectaccounts

receivablesales order

Deliver goods or services

Goods or Services converted to Accounts

Receivable

produce goods or services

cash converted to prepaid expenses and inventory

cash

Fig. 4.1 Cash flow and the working capital cycle

4.5 Permanent and Cyclical Working CapitalFirms need both a long-term (or permanent) investment in working capital and a short-term or cyclical one. The permanent working capital investment provides an ongoing positive net working capital position, that is, a level of currentassetsthatexceedscurrentliabilities.Thisallowsthefirmtooperatewithacomfortablefinancialmarginsince short-term assets exceed short-term obligations and minimises the risk of being unable to pay its employees, vendors,lenders,orthegovernment(fortaxes).Tohavepositivenetworkingcapital,acompanymustfinancepartof its working capital on a long-term basis. Since total assets equal total liabilities and owner’s equity, when current assetsexceedcurrentliabilities,thisexcessisfinancedbythelong-termdebtorequities.Sincethedemandforgoodsandservicesvariesoverthecourseofayear,firmsneedtofinancebothinventoriesandothercoststopreparefortheir peak sales period and accounts receivable until cash is collected.

Cyclicalworkingcapitalisbestfinancedbyshort-termdebtsincetheseasonalbuildupofassetstoaddressseasonaldemand will be reduced and converted to cash to repay borrowed funds within a short predictable period. By matching thetermofliabilitiestothetermoftheunderlyingassets,short-termfinancinghelpsafirmmanageinflationandotherfinancialrisks.Short-termfinancingisalsopreferablesinceitisusuallyeasiertoobtainandpricedlowerthanlong-term debt.

Workingcapitalfinancingisakeyfinancingneedandchallengeforsmallfirms.Smallbusinesseshavelessaccessto long-term sources of capital than large businesses, including limited access to equity capital markets and fewer sourcesoflong-termdebt.Thus,manysmallfirmsareheavilydependentonshort-termdebt,muchofwhichistiedto working capital.

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However,limitedequityandrelianceonshort-termdebtincreasesthedemandonafirm’scashflow,reducesliquidity,andincreasesfinancialleverage—allofwhichheightenthefinancialrisksofextendingcredit.Consequently,smallfirmsmayhavetroubleraisingshort-termdebtwhileatthesametimefacingobstaclestosecuringthelonger-termdebtnecessarytoimprovetheirfinancialpositionandliquidity,andlessentheircreditrisk.Developmentfinancehas an important role in addressing this problem, either by offering working capital loans when private loans are not availableorbyprovidingdebttermsthatreduceafirm’sfinancialrisksandhelpitaccessprivateworkingcapitalfinancing.Inparticular,practitionerscanhelpbusinessesfinancepermanentworkingcapitaltoreducetheirshort-termfinancialpressures.

4.6 Forms of Working Capital FinancingWorkingcapitalfinancingcomesinmanyforms,eachofwhichhasuniquetermsandofferscertainadvantagesanddisadvantagestotheborrower.Thissectionintroducesthefivemajorformsofdebtusedtofinanceworkingcapitaland discusses the relative advantages of each one.

The purpose of this information is to provide insights into the different ways in which debt can be structured and preparepractitionerstochooseandstructureadebttoolbestsuitedtoafirm’sfinancialsituationandneeds.

4.6.1 Line of CreditA line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any time duringtheloanperiod.Thisarrangementallowsacompanyflexibilitytoborrowfundswhentheneedarisesfortheexact amount required. Interest is paid only on the amount borrowed, typically on a monthly basis. A line of credit canbeeitherunsecured,ifnospecificcollateralispledgedforrepayment,orsecuredbyspecificassetssuchasaccounts receivable or inventory. The standard term for a line of credit is 1 year with renewal subject to the lender’s annual review and approval. Since a line of credit is designed to address cyclical working capital needs and not to financelong-termassets,lendersusuallyrequirefullrepaymentofthelineofcreditduringtheannualloanperiodand prior to its renewal. This repayment is sometimes referred to as the annual cleanup.

Two other costs, beyond interest payments, are associated with borrowing through a line of credit. Lenders require afeeforprovidingthelineofcredit,basedontheline’screditlimit,whichispaidwhetherornotthefirmusestheline. This fee, usually in the range of 25 to 100 basis points, covers the bank’s costs for underwriting and setting up theloanaccountintheeventthatafirmdoesnotusethelineandthebankearnsnointerestincome.

A second cost is the requirement for a borrower to maintain a compensating balance account with the bank. Under this arrangement, a borrower must have a deposit account with a minimum balance equal to a percentage of the line ofcredit,perhaps10%to20%.Ifafirmnormallymaintainsthisbalanceinitscashaccounts,thennoadditionalcostsareimposedbythisrequirement.However,whenafirmmustincreaseitsbankdepositstomeetthecompensatingbalance requirement, then it is incurring an additional cost. In effect, the compensating balance reduces the business’s net loan proceeds and increases its effective interest rate.

The advantages of a line of credit are twofold. First, it allows a company to minimise the principal borrowed and the resulting interest payments. Second, it is simpler to establish and entails fewer transaction and legal costs, particularly when it is unsecured. The disadvantages of a line of credit include the potential for higher borrowing costswhenalargecompensatingbalanceisrequiredanditslimitationtofinancingcyclicalworkingcapitalneeds.With full repayment required each year and annual extensions subject to lender approval, a line of credit cannot financemedium-termorlong-termworkingcapitalinvestments.

4.6.2 Accounts Receivable FinancingSome businesses lack the credit quality to borrow on an unsecured basis and must instead pledge collateral to obtain aloan.Loanssecuredbyaccountsreceivableareacommonformofdebtusedtofinanceworkingcapital.Underaccounts receivable debt, the maximum loan amount is tied to a percentage of the borrower’s accounts receivable. Whenaccountsreceivableincrease,theallowableloanprincipalalsorises.However,thefirmmustusecustomerpayments on these receivables to reduce the loan balance. The borrowing ratio depends on the credit quality of the


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firm’scustomersandtheageoftheaccountsreceivable.Afirmwithfinanciallystrongcustomersshouldbeableto obtain a loan equal to 80% of its accounts receivable. With weaker credit customers, the loan may be limited to 50% to 60% of accounts receivable. Additionally, a lender may exclude receivables beyond a certain age (e.g., 60 or 90 days) in the base used to calculate the loan limit. Older receivables are considered indicative of a customer withfinancialproblemsandlesslikelytopay.

Sinceaccountsreceivablearepledgedascollateral,whenafirmdoesnotrepaytheloan,thelenderwillcollectthe receivables directly from the customer and apply it to loan payments. The bank receives a copy of all invoices along with an assignment that gives it the legal right to collect payment and apply it to the loan. In some accounts receivable loans, customers make payments directly to a bank-controlled account (a lock box).

Firmsgainseveralbenefitswithaccountsreceivablefinancing.Withtheloanlimittiedtototalaccountsreceivable,borrowing capacity grows automatically as sales grow. This automatic matching of credit increases to sales growth providesareadymeanstofinanceexpandedsales,whichisespeciallyvaluabletofast-growingfirms.Italsoprovidesagoodborrowingalternativeforbusinesseswithoutthefinancialstrengthtoobtainanunsecuredlineofcredit.Accountsreceivablefinancingallowssmallbusinesseswithcreditworthycustomerstousethestrongercreditoftheircustomerstohelpborrowfunds.Onedisadvantageofaccountsreceivablefinancingisthehighercostsassociatedwith managing the collateral, for which lenders may charge a higher interest rate or fees. Since accounts receivable financingrequirespledgingcollateral,itlimitsafirm’sabilitytousethiscollateralforanyotherborrowing.Thismaybeaconcernifaccountsreceivablearethefirm’sprimaryasset.

4.6.3 FactoringFactoringentailsthesaleofaccountsreceivabletoanotherfirm,calledthefactor,whothencollectspaymentfromthe customer. Through factoring, a business can shift the costs of collection and the risk of non payment to a third party. In a factoring arrangement, a company and the factor work out a credit limit and average collection period for each customer. As the company makes new sales to a customer, it provides an invoice to the factor. The customer pays the factor directly, and the factor then pays the company based on the agreed upon average collection period, less a slight discount that covers the factor’s collection costs and credit risks.

In addition to absorbing collection risks, a factor may advance payment for a large share of the invoice, typically 70%to80%,providingthecompanywithimmediatecashflowfromsales.Inthiscase,thefactorchargesaninterestrateonthisadvanceandthendeductstheadvanceamountfromitsfinalpaymenttothefirmwhenaninvoiceiscollected.

Factoringhasseveraladvantagesforafirmoverstraightaccountsreceivablefinancing.First,itsavesthecostofestablishing and administering its own collection system. Second, a factor can often collect accounts receivable at a lower cost than a small business, due to economies of scale, and transfer some of these savings to the company. Third,factoringisaformofcollectioninsurancethatprovidesanenterprisewithmorepredictablecashflowfromsales.Ontheotherhand,factoringcostsmaybehigherthanadirectloan,especiallywhenthefirm’scustomershavepoor credit that lead the factor to charge a high fee. Furthermore, once the collection function shifts to a third party, the business loses control over this part of the customer relationship, which may affect overall customer relations, especially when the factor’s collection practices differ from those of the company.

4.7 Inventory FinancingAswithaccountsreceivableloans,inventoryfinancingisasecuredloan,inthiscasewithinventoryascollateral.However,inventoryfinancingismoredifficulttosecuresinceinventoryisriskiercollateralthanaccountsreceivable.Some inventory becomes obsolete and loses value quickly, and other types of inventory, like partially manufactured goods, have little or no resale value. Firms with an inventory of standardised goods with predictable prices, such asautomobilesorappliances,willbemoresuccessfulatsecuringinventoryfinancingthanbusinesseswithalargeamount of work in process or highly seasonal or perishable goods. Loan amounts also vary with the quality of the inventory pledged as collateral, usually ranging from 50% to 80%. For most businesses, inventory loans yield loan proceedsatalowershareofpledgedassetsthanaccountsreceivablefinancing.Wheninventoryisalargeshareofafirm’scurrentassets,however,inventoryfinancingisacriticaloptiontofinanceworkingcapital.

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Lenders need to control the inventory pledged as collateral to ensure that it is not sold before their loan is repaid. Two primary methods are used to obtain this control:

Warehouse storage•Directassignmentbyproductserialoridentificationnumbers•

Under one warehouse arrangement, pledged inventory is stored in a public warehouse and controlled by an independent party (the warehouse operator). A warehouse receipt is issued when the inventory is stored, and the goods are released only upon the instructions of the receipt-holder. When the inventory is pledged, the lender has control of the receipt and can prevent release of the goods until the loan is repaid. Since public warehouse storage isinconvenientforfirmsthatneedon-siteaccesstotheirinventory,analternativearrangement,knownasafieldwarehouse, can be established. Here, an independent public warehouse company assumes control over the pledged inventoryatthefirm’ssite.Ineffect,thefirmleasesspacetothewarehouseoperatorratherthantransferringgoodsto an off-site location. As with a public warehouse, the lender controls the warehouse receipt and will not release the inventory until the loan is repaid. Direct assignment by serial number is a simpler method to control inventory used for manufactured goods that are tagged with a unique serial number. The lender receives an assignment or trust receipt for the pledged inventory that lists all serial numbers for the collateral. The company houses and controls its inventory and can arrange for product sales. However, a release of the assignment or return of the trust receipt is required before the collateral is delivered and ownership transferred to the buyer. This release occurs with partial or full loan repayment.

While inventoryfinancing involves higher transaction and administrative costs thanother loan instruments, itisanimportantfinancingtoolforcompanieswithlargeinventoryassets.Whenacompanyhaslimitedaccountsreceivableandlacksthefinancialpositiontoobtainalineofcredit,inventoryfinancingmaybetheonlyavailabletype of working capital debt.

Moreover,thisformoffinancingcanbecosteffectivewheninventoryqualityishighandyieldsagoodloan-to-value ratio and interest rate.

4.8 Term LoanWhilethefourpriordebtinstrumentsaddresscyclicalworkingcapitalneeds,termloanscanfinancemedium-termnoncyclical working capital. A term loan is a form of medium-term debt in which principal is repaid over several years,typicallyin3to7years.Sincelendersprefernottobearinterestraterisks,termloansusuallyhaveafloatinginterest rate set between the prime rate and prime plus 300 basis points, depending on the borrower’s credit risk. Sometimes,abankwillagreetoaninterestratecaporfixedrateloan,butitusuallychargesafeeorhigherinterestrate for these features.

Termloanshaveafixedrepaymentschedulethatcantakeseveralforms.Levelprincipalpaymentsovertheloanterm are most common. In this case, the company pays the same principal amount each month plus interest on the outstanding loan balance. A second option is a level loan payment in which the total payment amount is the same, every month but the share allocated to interest and principle varies with each payment. Finally, some term loans arepartiallyamortisingandhaveaballoonpaymentatmaturity.Termloanscanbeeitherunsecuredorsecured;abusinesswithastrongbalancesheetandagoodprofitandcashflowhistorymightobtainanunsecuredtermloan,butmanysmallfirmswillberequiredtopledgeassets.Moreover,sinceloanrepaymentextendsoverseveralyears,lendersincludefinancialcovenantsintheirloanagreementstoguardagainstdeteriorationinthefirm’sfinancialpositionovertheloanterm.Typicalfinancialcovenantsincludeminimumnetworth,minimumnetworkingcapital(or current ratio), and maximum debt-to-equity ratios. Finally, lenders often require the borrower to maintain a compensating balance account equal to 10% to 20% of the loan amount.

The major advantage of term loans is their ability to fund long-term working capital needs. As discussed at the beginningofthechapter,businessesbenefitfromhavingacomfortablepositivenetworkingcapitalmargin,whichlowers the pressure to meet all short-term obligations and reduces bankruptcy risk. Term loans provide the medium-termfinancingtoinvestinthecash,accountsreceivable,andinventorybalancesneededtocreateexcessworking


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capital.Theyalsoarewellsuitedtofinancetheexpandedworkingcapitalneededforsalesgrowth.Furthermore,atermloanisrepaidoverseveralyears,whichreducesthecashflowneededtoservicethedebt.However,thebenefitsoflongertermfinancingdonotcomewithoutcosts,mostnotablyhigherinterestratesandlessfinancialflexibility.Since a longer repayment period poses more risks to lenders, term loans carry a higher interest rate than short-term loans.

Whenprovidedwithafloatinginterestrate,termloansexposefirmstogreaterinterestraterisksincethechancesofaspike in interest rates increase for a longer repayment period. Due to restrictive covenants and collateral requirements, atermloanimposesconsiderablefinancialconstraintsonabusiness.Moreover,thesefinancialconstraintsareinplace for several years and cannot be quickly reversed, as with a 1-year line of credit. Despite these costs, term loanscanbeofgreatvaluetosmallfirms,providingawaytosupplementtheirlimitedsupplyofequityandlong-term debt with medium-term capital.

4.9 Sources of Working Capital for Small BusinessesCommercialbanksarethelargestfinancingsourceforexternalbusinessdebt,includingworkingcapitalloans,andthey offer a large range of debt products. With banking consolidation, commercial banks are multistate institutions that increasingly focus on lending to small business with large borrowing needs that pose limited risks.

Consequently, alternate sources of working capital debt become more important. Savings banks and thrift lenders are increasingly providing small business loans, and, in some regions, they are small business and commercial real estate lenders.

Although savings banks offer fewer products and may be less familiar with unconventional economic development loans,theyaremorelikelytoprovidesmallerloansandmorepersonalisedservice.Commercialfinancecompaniesareimportantworkingcapitallenders.Asnon-regulatedfinancialinstitutions,theycanmakehigh-riskloans.Somefinancecompaniesspecialiseinservingspecificindustries,whichallowsthemtoassesstheirriskandcreditworthinessin a bettermanner and extend loans that general lenderswould notmake.Another approachusedbyfinancecompanies is asset-based lending in which a lender carefully evaluates and lends against asset collateral value, placinglessemphasisonthefirm’soverallbalancesheetandfinancialratios.Anasset-basedlendingapproachcanimproveloanavailabilityandtermsforsmallfirmswithgoodqualityassetsbutweakeroverallcredit.Commercialfinancecompaniesalsoaremorelikelytoofferfactoringthanbanks.Tradecreditextendedbyvendorsisafourthalternativeforsmallfirms.Whiletradecreditdoesnotfinancepermanentorlong-termworkingcapital,ithelpstoaddress short-term borrowing needs.

Extending payment periods and increasing credit limits with major suppliers is a fast and cost-effective way to financesomeworkingcapitalneedsthatcanbepartofafirm’soverallplantomanageseasonalborrowingneeds.

Venturecapitalfirmsalsofinanceworkingcapital,especiallypermanentworkingcapitaltosupportrapidgrowth.While venture capitalists typically provide equityfinancing, some alsoprovidedebt capital.Agrowing set ofmezzanine funds, often managed by venture capitalists, supply medium-term subordinate debt and take warrants thatincreasetheirpotentialreturns.Thistypeoffinancingisappropriatetofinancelong-termworkingcapitalneedsand is a lower-cost alternative to raising equity. However, the availability of venture capital and mezzanine debt islimitedtofast-growingfirms,ofteninindustriesandmarketsviewedasofferingthepotentialforhighreturns.Governmentandnon-profitrevolvingloanfundsalsosupplyworkingcapitalloans.Whilesmallintotalcapital,thesefundshelpfirmstoaccessconventionalbankdebtbyprovidingsubordinateloans,offeringsmallerloans,andservingfirmsthatdonotqualifyforconventionalworkingcapitalcredit.

Manyentrepreneursandsmallfirmsalsorelyonpersonalcreditsourcestofinanceworkingcapital,especiallycreditcards and second mortgage loans on the business owner’s home. These sources are easy to come by and involve few transaction costs, but they have certain limits. First, they provide only modest amounts of capital. Second, credit card debtisexpensivewithinterestratesof18%orhigher,whichreducescashflowforotherbusinesspurposes.Third,personalcreditlinksthebusinessowner’spersonalassetstothefirm’ssuccess,puttingimportanthouseholdassets,such as the owner’s home, at risk. Finally, credit cards and second mortgage loans are not viable for entrepreneurs who do not own a home or lack a formal credit history.

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Immigrantorlow-incomebusinessowners,inparticular,areleastabletousepersonalcredittofinanceabusiness.Given these many limitations, it is desirable to move entrepreneurs from informal and personal credit sources into formalbusinessworkingcapitalloansthatarestructuredtoaddressthecreditneedsoftheirfirms. 4.10 Underwriting Issues in Working Capital FinancingSincerepaymentiscloselylinkedtoshort-termcashflow,especiallyforcyclicalworkingcapitalloans,financepractitioners need to scrutinise these projections in detail. Borrowers will need to provide monthly or quarterly cash flowprojectionsforthenext1to2yearstofacilitatethisanalysis.Moreover,thisrequirementhelpstoassesshowcarefullythefirmplansandmonitorscashflowandhelpstoidentifyweaknessesinthesekeymanagementareas.Detailedmonthlyprojectionscanalsouncoverwaystoimprovecashflowthatmayreduceborrowingneedsandimprovethefirm’scapacitytorepayandqualifyforaloan.Forexample,afirmmaybeabletoreduceitsinventory,offer incentives for more rapid payment of invoices, or improve supplier credit terms. For working capital loans, lenders will pay special attention to liquidity ratios and the quality of current assets since these factors are most critical to loan repayment.

Finally, the underwriting analysis needs to evaluate the applicant’s need for permanent versus cyclical working capital debt.Smallbusinesseswithlimitedlong-termcapitalareunderheavypressuretomeetshort-termcashflowneeds.Adding short-term working capital loans does not address this problem and may make matters worse. Thus, it is importanttoanalysewhythefirmisseekingdebt,whatpurposetheloanwillserve,andhowtheserelatetoshort-term cyclical needs versus long-term permanent working capital needs. In some cases, practitioners need to revise theborrower’sloanrequestandstructuredebtthatbetterreflectsthefirm’sneeds.Thismightentailproposingatermloan in place of a line of credit when the business needs permanent working capital or combining short-term and medium-term debt instruments to create a good balance between cyclical and permanent working capital debt.

Thesealternativescanimproveafirm’scashflowandliquiditytopartiallyoffsetthegreaterrepaymentriskthatresults from extending loan repayment. Loan guarantees and subordinate debt can reduce this additional risk and help convinceconventionallenderstobothsupplycreditandprovideitontermsthatfitaborrower’sfinancialneeds.


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SummaryLiquidity refers to the ability of a company to meet its immediate obligations without any trouble or strain.•The current ratio is computed by dividing the total of current assets by the total of current liabilities.•Acompanywithalowcoveragerateshouldraisearedflagforinvestorsasitmaybeasignthatthecompany•willhavedifficultyrunningitsoperations,aswellasmeetingitsobligations.Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations.•Acompanywithalowcoveragerateshouldraisearedflagforinvestorsasitmaybeasignthatthecompany•willhavedifficultymeetingrunningitsoperations,aswellasmeetingitsobligations.The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, •whicharemoredifficulttoturnintocash.Thecashratioisanindicatorofacompany’sliquiditythatfurtherrefinesboththecurrentratioandthequick•ratiobymeasuringtheamountofcash;cashequivalentsorinvestedfundsthereareincurrentassetstocovercurrent liabilities.The Cash Conversion Cycle (CCC) measures the number of days a company’s cash is tied up in the production •andsalesprocessofitsoperationsandthebenefititgetsfrompaymenttermsfromitscreditors.The working capital can be calculated very simply by subtracting a company’s total current liabilities from its •total current assets.A business requires a minimum cash balance to meet basic day-to-day expenses and to provide a reserve for •unexpected costs.The permanent working capital investment provides an ongoing positive net working capital position.•Tohavepositivenetworking capital, a companymustfinancepart of itsworking capital on a long-term•basis.Cyclicalworkingcapitalisbestfinancedbyshort-termdebtsincetheseasonalbuildupofassetstoaddress•seasonal demand will be reduced.A line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any •time during the loan period.The disadvantages of a line of credit include the potential for higher borrowing costs when a large compensating •balanceisrequiredanditslimitationtofinancingcyclicalworkingcapitalneeds.Accountsreceivablefinancingallowssmallbusinesseswithcreditworthycustomerstousethestrongercredit•of their customers to help borrow funds.Factoringentailsthesaleofaccountsreceivabletoanotherfirm,calledthefactor,whothencollectspayment•from the customer.A warehouse receipt is issued when the inventory is stored, and the goods are released only upon the instructions •of the receipt-holder.The major advantage of term loans is their ability to fund long-term working capital needs.•Termloansprovidethemedium-termfinancingtoinvestinthecash,accountsreceivable,andinventorybalances•needed to create excess working capital.Duetorestrictivecovenantsandcollateralrequirements,atermloanimposesconsiderablefinancialconstraints•on a business.

ReferencesWorking Capital Finance• [Pdf]Availableat:<http://www.sagepub.com/upm-data/5005_Seidman_Chapter_5.pdf> [Accessed 12 July 2013].The right measure of liquidity• [Pdf] Available at: <http://www.thehindubusinessline.com/features/investment-world/young-investor/the-right-measure-of-liquidity/article2354246.ece> [Accessed 12 July 2013].

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Finance,leverage,liquidity,solvency,andtheMacroeconomy• [Video online] Available at: <http://www.youtube.com/watch?v=g_mb1QRrpIg>[Accessed12July2013].CFA Level IWorking CapitalManagement• [Video online] Available at: <http://www.youtube.com/watch?v=7orxxjow1I4>[Accessed12July2013].Matz, L., 2011. • Liquidity Risk Measurement and Management. Xlibris.Soprano, A., 2013. • Liquidity Management: A Funding Risk Handbook.Wiley.

Recommended readingChoudhry, M., 2012. • The Principles of Banking. Wiley.Banks, E., 2004. • Liquidity Risk: Managing Asset and Funding Risks. Palgrave Macmillan.Blum, L., 1995. • FreeMoneyforSmallBusinessesandEntrepreneur. 4th ed., Wiley.


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Self Assessment_________________referstotheabilityofacompanytomeetitsimmediateobligationswithoutanytrouble1. or strain.

Profitabilitya. Liquidityb. Entitiesc. Current ratiod.

_____________________aredefinedasassetsthatareconvertibleintocashinoneyearoroneoperatingcycle,2. whichever is higher.

Current assetsa. Quick ratiosb. Liquid assetsc. Current ratiosd.

________________attempttomeasureacompany’sabilitytopayoffitsshort-termdebtobligations.3. Quick ratiosa. Current ratiosb. Liquidity ratiosc. Liquidity assetsd.

Whichofthefollowingisnotoneofthetypesofliquidityratio?4. Current ratioa. Quick ratiob. Asset ratioc. Cash ratiod.

The_________________measuresthenumberofdaysacompany’scashistiedupintheproductionandsales5. processofitsoperationsandthebenefititgetsfrompaymenttermsfromitscreditors.

DIOSa. DSOb. CCCc. DPOd.

___________________isameasurementoftheoperatingliquidityavailableforacompanytouseindeveloping6. and growing its business.

Liquidity a. Flexibilityb. DPOc. Net working capitald.

A________________isanopen-endedloanwithaborrowinglimitthatthebusinesscandrawagainstorrepay7. at any time during the loan period.

second costa. firstcostb. line of creditc. interest paymentd.

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Afirmwith financially strong customers should be able to obtain a loan equal to 80%of its accounts8. ______________.

benefita. receivableb. inventoryc. financingd.

_________________entailsthesaleofaccountsreceivabletoanotherfirm,calledthefactor,whothencollects9. payment from the customer.

Factoringa. Credit riskb. Inventoryfinancingc. Lendersd.

Aterm______________isaformofmedium-termdebtinwhichprincipalisrepaidoverseveralyears,typically10. in 3 to 7 years.

loana. working capitalb. net working capitalc. inventory capitald.


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Chapter V

Cash Management and Financial Flexibility

Aim


definefinancialflexibility•

elucidate corporate cash management•

explain liquidity management•

Objectives


explainprofitability•

explicate liquid assets•

elucidate value-based strategy•

Learning outcome


understand net working capital•

identifycurrentassetfinancing•

recognise the various models in value-based strategies of cash management•

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5.1 IntroductionInrecentyears,financialflexibilityisreceivingagrowinginterestamongresearchersandhasbecomeoneofthemostimportantdeterminantsincapitalstructuredecisionsofafinancialexecutive.Classicalcapitalstructuretheories,such as the trade-off and the pecking order theory, fail to explain the puzzling corporate behaviour regarding capital structuredecisionsoffirms.Overtheyears,atheoreticalframeworkhasbeenestablishedthatremainstobethecriticalmissinglinkforanempiricallyviabletheoryinexplainingfirmbehaviourwithrespecttocapitalstructuredecisions.

Thetermfinancialflexibilityisdefineddifferentlyinthefinancialliteratureandrequiresacleardefinitioninordertouseitsfullexplanatorypower.Someauthorsseefinancialflexibilityinpreservingtheborrowingcapacityandthusconsideringonlydebt.However,financialflexibilitytheorymayalsoexplainwhyfirmstendtohoardhighamountsof cash even though high economic costs, such as taxes, are normally associated with cash holdings. Thus, not onlyfreedebtcapacityprovidesacompanywithfinancialflexibility,butalsocash.Theoverallgoalofestablishingfinancialflexibilityforafirmforbothsourcingscenariosisthesame.Tobeabletomobilisefinancialresourcesincase of unanticipated shocks, e.g., earnings shortfalls, crises, investment opportunities, etc.

Thefinancial crisis resulting from consumer defaults on subprimemortgages had remarkable effects on theU.S.financialsectorandlateronthewholeeconomy.Thesupplyofexternalcapitalwasradicallyrestrictedandcompanies were forced to rely on internal sources. The changing economic circumstances resulting from the current financialcrisiscreatesanexemplaryopportunitytoexaminetheeffectofdifferentsourcesoffinancialflexibilityandinvestigatehowfirmsusedifferentfundsinordertoattainfinancialflexibilityandwhateconomicsignificancein terms of real decisions they have.

5.2 Corporate Cash ManagementCorporatecashmanagementdependsondemandsforcashinafirm.Theaimofcashmanagementissuchthatlimitingcashlevelsinthefirmmaximisesownerwealth.Cashlevelsmustbemaintained,soastooptimisethebalancebetweencostsofholdingcashandthecostsofinsufficientcash.Thetypeandthesizeofthesecostsarepartlyspecifictothefinancialstrategyofthefirm.Inaddition,cashmanagementinfluencesfirmvalue,becauseitscash investment levels entail the rise of alternative costs, which are affected by net working capital levels. Both the riseandfallofnetworkingcapitallevelsrequirethebalancingoffuturefreecashflows,andinturn,resultinfirmvaluation changes.

Liquiditymanagementrequiresthatasufficientbalanceofcashandotherworkingcapitalassets-receivablesandinventories should be ensured. If the level of liquid assets is not adequate, it enhances the company’s operating risk –lossofliquidity.Maintenanceofworkingcapitalassetsgeneratescosts,thusaffectingthecompany’sprofitability.Theproblemofthispaperishowliquiditycanbecombinedwithprofitability.

If the level of liquid assets is too low, then a company may encounter problems with timely repayment of its liabilities, while discouraging clients by an excessively restrictive approach to recovery of receivables or shortages in the offered range of goods. Therefore, the level of liquid assets cannot be too low.

Inaddition,cashmanagementinfluencesfirmvalue,becauseitscashinvestmentlevelsentailtheriseofalternativecosts, which are affected by net working capital levels. Both the rise and fall of net working capital levels require thebalancingoffuturefreecashflows,andinturn,resultinfirmvaluationchanges.

Liquiditymanagementrequiresthatasufficientbalanceofcashandotherworkingcapitalassets-receivablesandinventories should be ensured. If the level of liquid assets is not adequate, it enhances the company’s operating risk –lossofliquidity.Maintenanceofworkingcapitalassetsgeneratescosts,thusaffectingthecompany’sprofitability.Theproblemofthispaperishowliquiditycanbecombinedwithprofitability.Ifthelevelofliquidassetsistoolow,then a company may encounter problems with timely repayment of its liabilities, while discouraging clients by an excessively restrictive approach to recovery of receivables or shortages in the offered range of goods. Therefore, the level of liquid assets cannot be too low.


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Atthesametime,surplus liquidassetsmaynegativelyaffect thecompany’sprofitability.This isbecauseuponexceeding the ‘necessary’ level of liquid assets, their surpluses, when the market risk remains stable, become a source of ineffective utilisation of resources.

Along with an increased risk of the company’s daily operations, you should increase the level of liquid assets to exceed the required levels as this will protect your company against negative consequences of unavailable liquid assets.Itispossibletomeasureprofitabilityofliquiditymanagementdecisionintwoways.Firstly,itispossibletocheckhowitaffectsthenetprofitanditsrelationtoequity,totalassets,oranotheritemofassets.Secondly,itispossibletoassessprofitabilityinrelationtovalueofthecompany.

IndividualelementsinfluencingliquiditymanagementdecisionsaffectthelevelofFreeCashFlowstoFirm(FCFF)and thus the value of the company. Let us assume that the company is faced with a decision regarding the level of liquid assets. As we know, a higher debtors turnover ratio and inventory turnover ratio (resulting from a more liberal approach to granting a trade credit for the purchasers and offering a shorter turnaround on clients’ orders) will be accompanied by more sales (larger cash revenues) but also higher costs.

Influence on FCFF

Influence on k

Influence on t

Trade credit policychanges influence:

costs?NWC

Trade credit policychanges influence cost ofcapital

Trade credit policychanges influenceperiod of life of theenterprise.

)(11

CapexNWCkNOPATEVAk

FCFFV

n

ttt

p

Fig. 5.1 Liquid assets influence on value of the corporation

Where:FCFF=FreeCashFlowstoFirm;NWC=NetWorkingCapitalgrowth;k=costofthecapitalfinancingthecorporation;andt=theforecastedlifetimeofthecorporationandtimetogeneratesingleFCFF.

ProfitabilitymeasuredbyROEindicatesthat‘medium’liquiditylevelisoptimal.Similarresultswillbeachievedifestimatinginfluenceonthecompany’svalue.Again,theoptimalvariantwasonethatassumeda‘medium’liquiditylevel as applying such level of liquidity ensures potentially the highest increase in the company‘s value measured by∆V.

If the level of liquid assets is too low, it downsizes the sales thus discouraging clients with an overly restrictive trade credit policy. On the other hand, excessive exposure to liquid assets under the ‘high’ level of liquid assets variant generated higher sales revenues than under the ‘medium’ variant, but at the same time the positive result of increase in the sales volumes has been offset by high level of generated costs.

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Iftheadvantagesofholdingcashatachosenlevelaregreaterthantheinfluenceofthealternativecostsofholdingcash,therebyincreasingnetworkingcapital,thenfirm’svaluewillalsoincrease.Thenetworkingcapital(currentassets less current liabilities) results from lack of synchronisation of the formal rising receipts and the real cash receipts from each sale. Net working capital also results from divergence during time of rising costs and time, from therealoutflowofcashwhenafirmpaysitsaccountspayable.

NWC=CA-CL=AAR+ZAP+G-AAP

where, NWC = Net Working Capital, CA = Current Assets, CL = Current Liabilities, AAR = Accounts Receivables, ZAP=Inventory,G=CashandCashEquivalents,AAP=AccountsPayables.

Whenmarkingfreecashflows,cashpossessionandincreasednetworkingcapitalisthedirectresultofamountsofcash allocated for investment in net working capital allocation. If an increase of net working capital is positive, then weallocatemoremoneyfornetworkingcapitalpurposesandtherebydecreasefuturefreecashflow.Itisimportanttodeterminehowchangesincashlevelschangeafirm’svalue.

Accordingly,weuseequation,basedonthepremisethatafirm’svalueisthesumofitsdiscountedfuturefreecashflowstothefirm.

where, Vp = Firm Value Growth, FCFFt = Future Free Cash Flow to Firm Growth inPeriod t, k = Discount Rate2.

Future Free Cash Flow, we have as:FCFFt = (CRt - FCWD-VCt-NCE)X(1-T)+NCE-∆NWCt- Capext

where, CRt = Cash Revenues on Sales, FCWD = Fixed Costs, VCt = Variable Costs in Time t, NCE = Non-cash Expenses (i.e., Depreciation), T = Effective Tax Rate, DNWC = Net Working Capital Growth, Capex = Operational Investments Growth.

Changes in precautionary cash levels affect the net working capital levels and as well the level of operating costs ofcashmanagementinafirm.Companiesinvestincashreservesforthreebasicreasons.

First,firmsareguidedbytransactionalandintentionalmotivesresultingfromtheneedtoensuresufficientcapitaltocoverpaymentscustomarilymadebythecompany.Afirmretainstransactionalcashtoensureregularpaymentstovendorsforitscostsofmaterialsandrawmaterialsforproduction.Aswell,afirmretainsintentionalcashfortax, social insurance and other known non-transactional payment purposes.

Second,firmshaveprecautionarymotivestoinvestincashreservesinordertoprotectthecompanyfromthepotentialnegative consequences of risk, which are unexpected, negative cash balances that can occur as a result of delays in accounts receivable collection or delays in receiving other expected monies.

Third,companieshavespeculativemotivestoretaincashreserves.Speculativecashmakesitpossibleforthefirmtousethepositivepartoftheriskequationtoitsbenefit.Companiesholdspeculativecashtoretainthepossibilityof purchasing assets at exceptionally attractive prices.


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TRANSACTIONAL& INTENTIONAL

CASH

SPECULATIVE

CASH

PRECAUTIONARY

CASH

OPERATIONAL RISK FINANCIAL

RISK

Fig. 5.2 Reasons for holding cash by companies and their relation to the risk

5.3 Value-Based Strategy in Working Capital ManagementThe issue discussed here attempts to address the question of which net working capital management strategy should beappliedtobringthebestresultsforaspecifictypeofbusiness.Financialdecisionsofacompanyalwaysfocusonselectingtheanticipatedlevelofbenefitsinconditionsofriskanduncertainty.Decisionsregardingnetworkingcapital management strategy, whether focused on assets (strategy of investing in the net working capital) or liabilities (strategyoffinancingthenetworkingcapital),affectfreecashflowsand,alsothecostofcapital-financingthecompany.Theprincipleofseparatingfinancialdecisionsfromoperatingdecisions,i.e.,separatingconsequencesof operations from changes in the capital structure, calls for a need to take the net working capital management decisionfirstfocusingonassets(itaffectsfreecashflowstothecompany)andthenonliabilities(itaffectsthestructureandcostofcapitalusedforfinancingthecompany).Managementofnetworkingcapitalaimedatcreationofvalueofthecompany.Ifthebenefitsofmaintainingnetworkingcapitalattheleveldeterminedbythecompanyoutweighthenegativeinfluenceofthealternativecostofsuchmaintenance,thenanincreaseinnetworthofthecompany will be reported.

Interestingfromourpointofview,determinedbytheneedtoobtainthemainobjectiveofthecompany’sfinancialmanagement, is how a change in the net working capital level may impact the value of the company.

Networkingcapitalis,mostgenerally,theportionofcurrentassetsfinancedwithpermanentfunds.Thenetworkingcapital is a difference between current assets and current liabilities or a difference between permanent liabilities and permanent assets. It is a consequence of dichotomy between the formal origination of the sales revenue and theactualinflowoffundsfromrecoveryofreceivablesanddifferenttimeswhencostsareoriginatedandwhenthefundscoveringtheliabilitiesareactuallypaidout.Whenestimatingfreecashflows,maintainingandincreasingnetworking capital means, that the funds earmarked for raising that capital are tied. If the increase is positive, it means everhigherexposureoffunds,whichreducesfreecashflowsforthecorporation.Anincreaseinproductionusuallymeans the need to boost inventories, receivables, and cash assets. A portion of this increase will be most probably financedwithcurrentliabilities(whicharealsousuallyautomaticallyupalongwithincreasedproductionvolumes).Theremainingpart(indicatedasanincreaseinnetworkingcapital)willneedanalternativesourceoffinancing.

Currentassetfinancingpoliciesaredrivenbythemanneroffinancingcurrentassets.Anychangestotheselectedcurrentassetfinancingpolicyaffectthecostofcapitalbutdonotimpacttheleveloffreecashflows.Thecompanycan choose one of the three policies:

Anaggressivepolicywherebyamajorportionofthecompany’sfixeddemandandtheentiretyofitsvolatile•demandforfinancingcurrentassetsissatisfiedwithshort-termfinancing.Amoderatepolicyaimingtoadjusttheperiodwhenfinancingisneededtotheperiodwhenthecompanyrequires•givenassets.Asaresultofsuchapproach,afixedportionofcurrentassetsisfinancedwithlong-termfunds,whilethevolatileportionoftheseassetsisfinancedwithshort-termfunds.Aconservativepolicywherebybothfixedandvolatilelevelsofcurrentassetsaremaintainedwithlong-term•financing.

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The aggressive policy will most probably mean the highest increase in the net worth of the company. However, this resultisnotthatobvious.Thisisbecauseanincreaseinfinancingwithanexternalshort-termcapitalandadecreaseinfinancingwithanexternallong-termcapital(namelyshiftingfromconservativetoaggressivepolicyoffinancingcurrentassets)meansenhancedrisklevel.Suchincreasedrisklevelshouldbereflectedinanincreasedcostofowncapital.Thisstemsfromincreasedcostsoffinancialdifficulties.

Theaggressivepolicyoffinancingcurrentassetsistheleastfavourable,consideringanincreasedcostofowncapital.Policies regarding investments in current assets are applied by the company as measures determining amounts and structure of current assets. There are three major policies available:

An aggressive policy, whereby the level of tangible assets is minimised and a restrictive approach to merchant •lending is applied. Minimising current assets results on the one hand, in savings which later translate to higher freecashflows.Ontheotherhand,insufficientlevelofcurrentassetsincreasestheoperationalrisk.Toolowinventoriesmayinterrupttheproductionandsalesprocess.Insufficientlevelofreceivableswillmostoftenleadto a restrictive merchant lending policy and, consequently, potentially lower sales revenue than in the case of a liberalmerchantlendingpolicy.Insufficienttransactionalcashlevelsmaydisruptsettlementofliabilitiesandas a result negatively affect the company’s reputation.A moderate policy, whereby the level of current assets, and in particular inventories and cash, is held on an •average levelA conservative policy, whereby a high level of current assets (and especially inventories and cash) is maintained •at the company and ensuring a high level of receivables by using a liberal trade creditors’ recovery policy

If the company aims at maximising V, it should select the aggressive policy. However, similarly as in the preceding item, it is worth considering the relation between the risk increase and the cost of own capital (and probably also external capital). The more aggressive the current asset investment policy, the higher will be the risk. Higher risk, on the other hand, should be accompanied by higher costs of own capital and probably also external capital.

Changesofthepolicy,fromconservativetoaggressive,causeanincreaseinthecostofcapitalfinancingthecompany’soperationsduetoenhancementofrisk.Itispossiblethatinspecificcircumstances,therisksmaydrivethecostofcapital to such a high degree that the aggressive policy will be unfavourable.

Inthediscussedexamples,thecompanyshouldselectaconservativecurrentassetfinancingstrategyandanaggressivecurrentassetinvestmentpolicy.Theprimaryobjectiveoffinancingthecompany’soperationsistomaximisethecompany’snetworth.Itcanbeestimatedamongothersbytotallingall thefuturefreecashflowsgeneratedbythe company, discounted with the cost of capital. Decisions regarding management of net working capital should also serve the purpose of achieving the primary objective, which is maximising the company’s net worth. These decisionsmayimpactboththeleveloffreecashflowsandthecostofcapitalusedforfinancingthecompany’soperations. The module discusses probably changes of the capital cost rate, resulting from changes in selection of the net working capital management policy and, consequently, the anticipated impact of such decisions on the company’s net worth.

5.4 Value-Based Strategy in Cash ManagementThe most liquid current assets are cash balances. The purpose of cash management is to determine the level of cash resources at the company, so that it increases the wealth of the company owners. In other words, the objective is to maintain such level of cash resources at the company that is optimal from the point of view of trade-off between thecostsofmaintainingcashbalancesagainstthecostsofholdinginsufficientcashbalances.Thetypeandamountofthesecostsispartiallydrivenbytheparticularfinancialpolicyappliedbythecompany.

Basedonobservationofcurrentinflowsandoutflowsofthecompany,itmaybenoticedthattherearefourbasicsituationsatthecompanyintermsofoperationalcashflows:

Whenfutureinflowsandoutflowsareforeseeableandinflowsexceedoutflows•Whenfutureinflowsandoutflowsareforeseeableandoutflowsexceedinflows•


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Whenfuture inflowsandoutflowsare foreseeablebut it is impossible todeterminewhichare inexcessof•whichWhenfutureinflowsandoutflowsarenotforeseeable•

Dependingonthetypeandvolumesofinflowsandoutflowsatthecompany,itispossibletoselectoneofthefourmodelsofcashflowmanagement.Itiscertainlynotnecessaryforonlyoneoftheabovesituationstoprevailatthecompany.Thesamebusinessmayhaveperiodswheninflowsexceedoutflowsonapermanentbasis,aswellasperiods when a reversed trend is noted or it is not possible to determine the trend. It is similar in case of projecting futureinflowsandoutflows.Itispossiblethatinsomeperiodsoftime,inflowsandoutflowscanbeprojectedwithoutanymajordifficulty,whileinotherperiodssuchprojectionisveryhardorcompletelyimpossible.

Usinginformationaboutfuturecashinflowsandoutflows,weareabletoapply,forexample,theBaumolmodelortheBeranekmodel.Ifweanticipatethatcashinflowsaregreaterthanoutflows,weareabletousetheBeranekmodeltodeterminecashflowmanagementwithinafirm.Ontheotherhand,ifwepredictthatcashoutflowsaregreaterthaninflowsweuseBaumolmodel.Whenwecannotforecastlong-termcashflows,foraperiodlongerthanapproximately14days,weareabletousetheStonemodeltodeterminecashflowmanagement.However,whenwecannotpredictfuturecashinflowsandoutflowsatall,theMiller-Orrmodelcanbeusedtodeterminecashflowmanagement.

AccordingtotheBATmodelassumptions,thecompanyreceivesbothregularandperiodiccashinflows,whileitspendscashinanongoingmanner,atafixedrate.Atthetimeofreceivingfunds,thecompanyearmarksasufficientportionofthesefundstocoveritsoutflows.Thisisperformeduntilthenextinflowofcash.Thismodelcanberecommendedinasituationwhenfutureinflowsandoutflowsrelatedtooperationsofthecompanycanbeforeseenand,atthesametime,operationaloutflowsexceedinflows.TheBATmodelcomprisestwotypesofassets:cashand(external)marketablesecurities,whichgenerateprofitintheformofinterestduringeachperiod.

cash

time

2C

C*

0

Fig. 5.3 BAT model

The BAT model has been developed for two reasons: in order to specify the optimal cash balance at the company and to suggest how the company managers should proceed to ensure optimal cash management.

The company which decides to follow recommendations regarding cash management, arising from the BAT model, determines an optimal cash level.

It stems from the BAT model that when cash is spent, the company should secure cash from non-operational sources of cash. Most often, this means that it should sell (external) securities, close the held deposit, and/or raise a short-term loan. The total amount of raised funds should be in each event twice as high as an average cash balance. The ratio of the total demand for cash in a given period and one transfer provides information on how many such operations must be performed during the year. It is clear that if conditions, which enable application of the BAT model, have existed at the company for less than one year, then shorter periods should be taken into account.

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cash

time

2C

C*

0

Fig. 5.4 Beranek model

The basic assumption of the Miller-Orr model is that changes in cash balance at the company are unforeseeable. The company managers react automatically when cash balance equals either the upper or lower level. This model ispresentedinthefigure.

cash level

U*

C*

L

Upper Limit

Lower Limit

time

Target Cash Level

Fig. 5.5 Miller –Orr model

Reacting to the situation when the cash balance at the company reaches the upper or lower limit, the management board buys or sells (external) short-term securities, opens or closes short-term deposits and/or repays or raises a short-term loan in order to restore the target cash balance Cmo

*.

ThismodelisusedtraditionallyinsuchamannerthatthemanagementboardofthecompanyfirstspecifiesthelowerlimitofcashLthatitfindsacceptable.Thisvalueisspecifiedsubjectivelybasedonexperienceofthecompanymanagers. As in a sense it is a minimum level of cash balance, it depends on such factors as availability of the company’saccesstoexternalfinancingsources.Ifintheopinionofthemanagementboardmembers,thisaccessiseasy and relatively inexpensive, liquidity at the company is lower and L can be set on a relatively low level.

The Miller-Orr model assumes that the target cash balance C* depends on the (alternative) costs of holding funds, costsofcashshortages(transfer)andvariantsofcashflowsduringtheconsideredperiod(thisperiodmustequaltheperiodforwhichaninterestratehasbeenset).Thelevelofvarianceofcashflowsduringtheanalysedperiodisbest determined based on historic data.

The target cash balance according to the Miller-Orr model is calculated based on the formula for C* mo.

In this model, after setting the target cash balance Cmo* the upper limit U* is determined as a difference between

triple target cash balance and double lower control limit.


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TheStonemodelisamodificationoftheMiller-Orrmodelfortheconditionswhenthecompanycanforecastcashinflowsandoutflowsinafew-dayperspective.SimilarlytotheMiller-Orrmodel,ittakesintoaccountcontrollimitsand surpassing these limits is a signal for reaction. In case of the Stone model, however, there are two types of limits, external and internal, but the main difference is that in case of the Stone model, such signal does not mean an automatic correction of cash balance as in the Miller-Orr model.

cash level

H1U*

C*

LH0

upper limit

target cash level

lower limitcash reductiontime

Fig. 5.6 Stone model

If the cash balance exceeds the upper external limit H1 or the lower external limit H0, the management board analyses futurecashinflowsbyprojectingfuturecashbalancebycalculatingtheSlevel.

If the S level (determining the cash balance after n days from the moment of surpassing either of the external control limits) continues to surpass any of the internal limits, the management board should prevent variations from the targetbalancebypurchaseordisposalofsecuritiesintheamountsufficientforthecashbalanceatthecompanytobe restored to its optimal level, .

This model shows that the cash balance has been growing as from the beginning of the analysed period. At some point, it exceeded the upper internal limit U*. Then it exceeded the external control limit H1. At the time of exceeding the externalcontrollimit,themanagementboardofthecompanyforecastfutureinflowsandoutflows.Astheforecastindicated that the cash balance would continue to exceed the internal control limit (the grey line), the management board decided to adjust this level to the anticipated C*. After the appropriate adjustment, the cash balance started to decrease after a few days and it surpassed the lower external control limit. Another forecast was prepared and it turned out that for several days the cash balance would remain below the lower internal control limit. Therefore, the cash balance was reduced down to

5.5 Cash Balance ForecastingMaintaining the appropriate cash balance requires not only ongoing monitoring of the currently held current assets and liabilities that mature in the forthcoming future, but also those that should be anticipated in the future. Therefore, itisnecessarytoplanfuturecashinflowsandoutflows.

Cash forecast is performed based on cash budget. This tool contains a forecast of recovered receivables, expenditure on inventories and repayment of liabilities. It provides information about the cash balance, as cash balance is a resultofinflowsfromsales(paymentofreceivables)andoutflowsduetopurchaseofmaterialsandothercostsofthe company.

Cash budget is most often prepared several periods in advance subject to the company’s information capabilities and needs. The most popular version of a cash budget is one prepared for six monthly periods. However, there are no reasons why cash budgets should not be prepared for six weeks or six biweekly periods. In any case, the rolling wave planning is used, which requires that subsequent periods be added to the budget on an ongoing and regular basis sothatatanyonetimethecompanyhasaforecastforthefixednumberofforecastperiods(namely,ifthebudgetis prepared for 8 biweekly periods, then it should be adequately extended when required so that a sixteen-week

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budget is available at any time). This requirement ensures for the budget to be constantly valid and applicable. For somecompanies,itisabsolutelynecessarytodetermineinflowsandoutflowsforindividualweeksandsometimesevendays.Themoredetailedthecontrolofcashinflowsandoutflows,themoreprobablethepreciseandcorrectcontrolofcashflowlevels.

When developing a cash budget, it is a matter of top priority to hold a forecast of the company’s sales revenues. Preparingsuchforecastistheprimaryandhardesttask.Next,thedemandarisingfromtheheldfixedassetsandinventories, resulting from production of goods for sale is forecast. This information is combined with information on delays in recovery of receivables. Also, tax due dates, interest due dates, and other factors are taken into account.

5.6 Precautionary Cash Management - Safety Stock ApproachCurrent models for determining cash management, for example Baumol, Beranek, Miller-Orr or Stone models, assign no minimal cash level, and are based on the manager’s intuition. In addition, these models are based inventory managements models. In this study, we address the potential for adaptation of these methods of determining safety stocktodetermineminimalcashlevelsinthefirm.Safetystockisaresultofinformationabouttheriskofinventories.To calculate safety stock, we use a result of information about the risk of inventories. To calculate safety stock we use:

where: zb = Safety Stock, C = Cost of Inventories (in percentage), Q = One Order Quantity, v = Cost of Inventories (Price),P=YearlyDemandforInventories,s=StandardDeviationofInventorySpending,Kbz = Cost of Inventories Lack. It is also possible to apply the following equation to determine minimal cash level:

where:LCL = Low Cash Level (Precautionary Cash Level), k = Cost of Capital, G* = Average Size of One Cash Transferwhicharethebasisofstandarddeviationcalculation,P=theSumofallCashInflowsandOutflowsinthePeriod,s=StandardDeviationofDailyNetCashInflows/Outflows,Kbsp=CostofCashLack.

Part of the information necessary to determine LCL, still requires the manager‘s intuition. For example, costs of lack of cash, contains not only costs known from accountant records, but also other costs, such as opportunity costs. Precautionarycashreservesare,firstofalltheresultofanxietiesbeforenegativeresultsofrisk.Itsmeasureisthestandard deviation.

SpeculativeCashBalanceManagement-OptionApproachAllfirmsdonotnecessarilyholdspeculativecashbalances.Speculative cash is held in order to utilise the positive part of the risk equation. Firms want to retain opportunities thatresultfrompricevolatility.Forexample,intheordinarypracticeofPolishfirms,weseethatspeculativecashbalancescanbeusefultobenefitfromtransactionsinforeignexchanges.Itcanbeprofitableforfirmstopurchasenecessary products or services in foreign exchange at prices cheaper than its average purchase price. Such purchase ispossible,ifthefirmmaintainsspeculativecashbalances.

Speculativecashbalancesgivethefirmtheabilitytouseoftheirpurchasingpoweranytime.Suchcashsuperiorityover other assets shows option value of speculative cash balances.


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SummaryThetermfinancialflexibilityisdefineddifferentlyinthefinancialliteratureandrequiresacleardefinitionin•order to use its full explanatory power.Thechangingeconomiccircumstancesresultingfromthecurrentfinancialcrisiscreatesanexemplaryopportunity•toexaminetheeffectofdifferentsourcesoffinancialflexibility.Corporatecashmanagementdependsondemandsforcashinafirm.•Liquiditymanagementrequiresthatasufficientbalanceofcashandotherworkingcapitalassets-receivables•and inventories – should be ensured.Individualelementsinfluencingliquiditymanagementdecisionsaffecttheleveloffreecashflowstofirm.•ProfitabilitymeasuredbyROEindicatesthat‘medium’liquiditylevelisoptimal.•If the level of liquid assets is too low, it downsizes the sales thus discouraging clients with an overly restrictive •trade credit policy.Iftheadvantagesofholdingcashatachosenlevelaregreaterthantheinfluenceofthealternativecostsof•holdingcash,therebyincreasingnetworkingcapital,thenfirm’svaluewillalsoincrease.The net working capital (current assets less current liabilities) results from lack of synchronisation of the formal •rising receipts.If an increase of net working capital is positive, then we allocate more money for net working capital purposes •andtherebydecreasefuturefreecashflow.Changes in precautionary cash levels affect the net working capital levels and as well the level of operating •costsofcashmanagementinafirm.Speculativecashmakesitpossibleforthefirmtousethepositivepartoftheriskequationtoitsbenefit.•Financialdecisionsofacompanyalwaysfocusonselectingtheanticipatedlevelofbenefitsinconditionsof•risk and uncertainty.Ifthebenefitsofmaintainingnetworkingcapitalattheleveldeterminedbythecompanyoutweighthenegative•influenceofthealternativecostofsuchmaintenance.The net working capital is a difference between current assets and current liabilities or a difference between •permanent liabilities and permanent assets.Whenestimatingfreecashflows,maintainingandincreasingnetworkingcapitalmeansthatthefundsearmarked•for raising that capital are tied.Currentassetfinancingpoliciesaredrivenbythemanneroffinancingcurrentassets.•Insufficienttransactionalcashlevelsmaydisruptsettlementofliabilitiesandasaresultnegativelyaffectthe•company’s reputation.Changesofthepolicy,fromconservativetoaggressive,causeanincreaseinthecostofcapitalfinancingthe•company’s operations due to enhancement of risk.Dependingonthetypeandvolumesofinflowsandoutflowsatthecompany,itispossibletoselectoneofthe•fourmodelsofcashflowmanagement.Thelevelofvarianceofcashflowsduringtheanalysedperiodisbestdeterminedbasedonhistoricdata.•The most popular version of a cash budget is one prepared for six monthly periods.•Six-month budgets are most frequently prepared based on monthly time bands.•

ReferencesBalances of Cash And The Firm Value• [Pdf] Available at: <http://www.euba.sk/department-for-research-and-doctoral-studies/economic-review/preview-file/er1_2009_michalski-10131.pdf>[Accessed12July2013].Analysis of Cash Management• [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_chapter%207.pdf> [Accessed 12 July 2013].Bragg. S.M., 2012. • Corporate Cash Management. Accounting Tools.

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Tennent, J., 2012. • Guide to Cash Management. Wiley.Financial Management.• [Video online]Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>[Accessed 12 July 2013]Financial Management.• [Video online]Available at: <http://www.youtube.com/watch?v=oCH1Ll7riDQ>[Accessed 12 July 2013]

Recommended ReadingCooper, R., 2004. • Corporate Treasury and Cash Management. Palgrave Macmillan.Jones, E.V. and Jones, E.B., 2001. • Cash Management. R&L Education.Driscoll, M.C., 1983• .CashManagement:CorporateStrategiesforProfit. John Wiley & Sons Inc.


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Self Assessment__________________managementdependsondemandsforcashinafirm.1.

Corporate casha. Cashb. Financialc. Flexibilityd.

Ifthelevelof______________isnotadequate,itenhancesthecompany’soperatingrisk–lossofliquidity.2. cashflowa. cashinflowb. capital assetsc. liquid assetsd.

Whichofthefollowingstatementsistrue?3. Cashmanagementinfluencesfirmvalue,becauseitscashinvestmentlevelsentailtheriseofalternativea. costs.If the level of liquid assets is not adequate, it enhances the company’s operating risk – loss of liquidity.b. Maintenanceofworkingcapitalassetsgeneratescosts,thusaffectingthecompany’sprofitability.c. If the level of liquid assets is high, then a company may encounter problems with timely repayment of its d. liabilities.

_____________________cashmakesitpossibleforthefirmtousethepositivepartoftheriskequationtoits4. benefit.

Flowa. Speculativeb. Flexibilityc. Financiald.

The____________________isadifferencebetweencurrentassetsandcurrentliabilitiesoradifferencebetween5. permanent liabilities and permanent assets.

net working capitala. financialflexibilityb. freecashflowc. capital assetd.

Themostliquidcurrentassetsare_______________.6. cashflowsa. flexibilityb. cash balancesc. liquidflowd.

Accordingtothe_______________assumptions,thecompanyreceivesbothregularandperiodiccashinflows,7. whileitspendscashinanongoingmanner,atafixedrate.

Beranek’s modela. BET modelb. Miller- Orr modelc. Stone modeld.

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The basic assumption of the _______________ is that changes in cash balance at the company are8. unforeseeable.

Beranek’s modela. BET modelb. Miller- Orr modelc. Stone modeld.

The_________________isamodificationoftheMiller-Orrmodelfortheconditionswhenthecompanycan9. forecastcashinflowsandoutflowsinafew-dayperspective.

BET modela. Stone modelb. Beranek’s modelc. Miller- Orr modeld.

________________toolcontainsaforecastofrecoveredreceivables,expenditureoninventoriesandrepayment10. of liabilities.

Cash budgeta. Cash balanceb. Cash forecastc. Cashoutflowd.


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Chapter VI

Inventory Management

Aim


defineinventorymanagement•

elucidate the importance of inventory management•

explain the functions of inventory management•

Objectives


classify inventory system •

explicate the types of inventory system•

elucidate selective inventory management•

Learning outcome


understand the VED analysis•

identify the aggregate inventory planning•

recognise the inventories model•

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6.1 IntroductionInventorymaybedefinedasusablebut idle resource. If resource issomephysicaland tangibleobjectsuchasmaterials, then it is generally termed as stock. Thus, stock and inventory are synonymous terms though inventory has wider implications. Broadly speaking, the problem of inventory management is one of maintaining, for a given financial investment,anadequatesupplyofsomethingtomeetanexpecteddemandpattern.Thiscouldberawmaterials,workinprogress,finishedproductsorthesparesandotherindirectmaterials.

Inventory can be one of the indicators of the management effectiveness on the materials management front. Inventory turnover ratio (annual demand/average inventory) is an index of business performance. A soundly managed organisation will have higher inventory turnover ratio and vice-versa.

Inventory management deals with the determination of optimal policies and procedures for procurement of commodities.Sinceitisquitedifficulttoimaginearealworksituationinwhichtherequiredmaterialwillbemadeavailable at the point of use instantaneously, hence maintaining, inventories becomes almost necessary. Thus, inventories could be visualised as `necessary evil’.

Inventory related costs Aninventorysystemmaybedefinedasoneinwhichthefollowingcostsaresignificant:

Cost of carrying inventory: This is expressed in Rs. /item held in stock/unit time. This is the opportunity cost of •blocking material in the non-productive form as inventories. Some of the cost elements that comprise carrying costsare-costofblocking,capital(interestrate);costofinsurances;storagecost;costduetoobsolescence,pilferage, deterioration, etc. It is generally expressed as a fraction of value of the goods stocked per year. For example, if the fraction of carrying charge is 20% per year and a material worth Rs. 1,000 is kept in inventory for one year, the unit carrying cost will be Rs. 200/item/year. It is obvious that for items that are perishable in nature, the attributed carrying cost will be higher.Cost of incurring shortages: It is the opportunity cost of not having an item in stock when one is demanded. It •may be due to lost sales or backlogging. In the backlogging (or back ordering) case, the order is not lost but is backlogged, to be cleared as soon as the item is available on stock. In lost sales case, the order is lost. In both cases,therearetangibleandintangiblecostsofnotmeetingthedemandontime.Itmayincludelostdemand;penaltycost;emergencyreplenishment;lossofgood-will,etc.ThisisgenerallyexpressedasRs./itemshort/unit time.Cost of replenishing inventory: This is the amount of money and efforts expended in procurement or acquisition •of stock. It is generally called ordering cost. This cost is usually assumed to be independent of the quantity ordered,becausethefixedcostcomponentisgenerallymoresignificantthanthevariablecomponent.Thus,itis expressed as Rs. /order.

These three types of costs are the most commonly incorporated in inventory analysis, though there may be other costparametersrelevantinsuchananalysissuchasinflation,pricediscounts,etc.

Importance of Inventory ManagementScientificinventorymanagementisanextremelyimportantproblemareainthematerialsmanagementfunction.Materials account for more than half the total cost of any business and organisations maintain huge amount of stocks, muchofthiscouldbereducedbyfollowingscientificprinciples.Inventorymanagementishighlyamenabletocontrol.In the Indian industries there is a substantial potential for cost reduction due to inventory control. Inventory being a symptom of poor performance we could reduce inventories by proper design of procurement policies by reduction in the uncertainty of lead times by variety reduction and in many other ways.


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6.2 Functions of InventoryAs mentioned earlier, inventory is a necessary evil. Necessary, because it aims at absorbing the uncertainties of demand and supply by ‘decoupling’ the demand and supply sub-systems. Thus, an organisation maybe carrying inventory for the following reasons:

Demand and lead time uncertainties necessitate building of safety stock (buffer stocks) so as to enable various •sub-systems to operate somewhat in a decoupled manner. It is obvious that the larger the uncertainty of demand andsupply;thelargerwillhavetobetheamountofbufferstocktobecarriedforaprescribedservicelevel.b) Time lag in deliveries also necessitates building of inventories. If the replenishment lead times are positive, then stocks are needed for system operation.Cycle stocks may be maintained to get the economics of scale, so that total system cost due to ordering, carrying •inventory and backlogging are minimised. Technological requirements of batch processing also build up cycle stocks. Stocksmaybuildupaspipelineinventoryorwork-in-processinventoryduetofinitenessofproductionand•transportation rates. This includes materials actually being worked on or moving between work centres or being in transit to distribution centres and customers.When the demand is seasonal, it may become economical to build inventory during periods of low demand to •ease the strain of peak period demand. Inventory may also be built up for other reasons such as, quantity discounts being offered by suppliers, discount •sales, anticipated increase in material price, possibility of future non-availability, etc.

Different functional managers of an organisation may view the inventory from different viewpoints leading to conflicting objectives.This calls for an integrated systems approach to planning of inventories, so that theseconflictingobjectivescanbescrutinisedtoenablethesystemtooperateatminimumtotalinventoryrelatedcosts-both explicit such as purchase price, as well as implicit such as carrying, shortage, transportation and inspection costs. Concepts and techniques useful in analysis these problems to arrive at sound policy decisions are the focal point of presentation in this unit.

6.3 Classification of Inventory SystemsTheinventorysystemcanbeclassifiedasfollows:

6.3.1 Lot Size Reorder Point PolicyUnder this operating policy, the inventory status is continuously reviewed and as soon as the inventory level falls toaprescribedvaluecalled‘reorderpoint’.AfreshreplenishmentorderoffixedquantitycalledEconomicOrderQuantity (EOQ) is initiated. Thus, the order size is constant and is economically determined. This is one of the very classical types of inventory policies and a lot of mathematical analysis has appeared on this type of policy. Fig.6.1showsthetypicalstockbalanceunderthistypeofinventorypolicy.Thesolidlineinthisfigurerepresentstheactualinventoryheldinpracticalsituationwithafiniteleadtime,theleadtimebeingdefinedasthetimedelaybetween the placing of a replenishment order and its subsequent receipt. The broken line indicates the inventory that would be held in the ideal situation, if no lead time existed. Lot size and reorder point are the two decision variables involved in the design of the policy.

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INV

ENTO

RY L

EVEL

REPLENISHMENT ORDER PLACED

REPLENISHMENT ORDER RECEIVED

LEAD TIME

RE-ORDER POINT

STOCKOUT

TIME

Fig. 6.1 Typical inventory balances for EOQ- reorder point policy.

6.3.2 Fixed Order Interval Scheduling PolicyUnder this policy, the time between consecutive replenishment orders is constant. There is a maximum stock level(s) prescribedandtheinventorystatusisreviewedperiodicallywithafixedinterval(T).Ateachreview,anorderofsize Q is placed which takes the stock on hand plus an order equal to the maximum stock level. Thus, order quantity could vary from period to period. This policy ensures that when the level of stock on hand is high at review, a smaller sizereplenishmentorderisplaced.Fig.6.1showsthetypicalstockbalancesunderthisfixedreordercyclepolicy.S, the maximum stock level and T the review period are the decision variables under this policy.

$

INV

ENTO

RY L

EVEL

TIME

STOCKOUTREPLENISHMENT ORDER PLACED

REPLENISHMENT ORDER RECEIVED

REVIEW ORDER

LEAD TIME

Fig. 6.2 Fixed reorder cycle policy.


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6.3.3 Optional Replenishment PolicyThis is very popularly known as the (s, S) policy. Fig. 6.3 shows the typical stock balance under this policy. The status of stock is periodically reviewed and maximum stock level (S) and minimum stock level (s) are prescribed.

$

$REVIEWTAKESPLACE- ON REPLENISHMENT ORDERED

REVIEWTAKESPLACE- AND REPLENISHMENT ORDERED

REVIEW PERIOD

TIME

LEAD TIME

STOCKOUT

INV

ENTO

RY L

EVEL

Fig. 6.3 Typical inventory balances in policy.

If at the time of review, the stock on hand, is less than or equal to s, an order of size Q is placed so that stock on hand plus on order equals the maximum stock level S. If stock on hand at review is higher than s, no order is placed and the situation is reviewed at the time of next review period. S, s and T (review period) are the decision variables in the design of such inventory policy.

6.4 Other Types of Inventory SystemsThere may be other policies which may be special cases of the policies mentioned above or may be a combination of these policies. As a special case of (s, S) policy we may have (S-1, S) policy or one-for-one order policy, when the maximum stock level may be up to S and whenever there is demand for one unit, a replenishment of one unit is ordered. Such a policy may be quite useful for slow moving expensive items. We may use a combination of lot-sizereorderpointpolicyandfixedintervalorderschedulingpolicy.Yet,anothervariationofinventorypolicycouldbe multiple reorder point policy, where more than one reorder points may be established. Other types of inventory systems may be static inventory systems when a single purchase decision is to be made which should be adequate during the entire project duration. Such decisions are not repetitive in nature. Other initial provisioning decisions may be with respect to repairable assemblies such as engines, gearboxes, etc. in a bus which may have to be overhauled andforwhichwehavetofindadequatenumberofspareenginestobeprovidedinitially.

The right choice of an inventorypolicydependsupon the nature of the problem;usagevalueof an itemandother situationalparameters.Wemustfirst selectanoperatingpolicy,beforedeterminingoptimalvaluesof itsparameters.

6.5 Selective Inventory ManagementOneofthemajoroperatingdifficultiesinthescientificinventorycontrolisanextremelylargevarietyofitemsstockedby various organisations. These may vary from 10,000 to 100,000 different types of stocked items and it is neither feasiblenordesirabletoapplyrigorousscientificprinciplesofinventorycontrolinalltheseitems.

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Suchan indiscriminateapproachmaymakecostof inventorycontrolmore than itsbenefitsand thereforemayprove to be counter-productive. Therefore, inventory control has to be exercised selectively. Depending upon the value, criticality and usage frequency of an item we may have to decide on an appropriate type of inventory policy. The selective inventory management thus plays a crucial role so that we can put our limited control efforts more judiciouslytothemoresignificantgroupofitems.Inselectivemanagementwegroupitemsinfewdiscretecategoriesdependinguponvalue;criticalityandusagefrequency.SuchanalysesarepopularlyknownasABC,VEDandFSNAnalysisrespectively.Thistypeofgroupingmaywellformthestartingpointinintroducingscientificinventorymanagement in an organisation.

6.5.1 ABC AnalysisThisisbasedonaveryuniversalPareto’sLawthatinanylargenumberwehave`significantfew’and`insignificantmany’. For example, only 20% of the items may be accounting for the 80% of the total material cost annually. These arethesignificantfewwhichrequireutmostattention.

C

B

A

Perc

ent o

f ave

rage

inve

ntor

y in

vest

men

t

Percent of number of inventory items

100

90

75

50

25

00 10 25 50 75 100

Fig. 6.4 ABC analysis

Fig. 6.4 shows a typical ABC analysis showing percentage of number of inventory items and percentage of average inventory investment (annual usage value). Annual usage value is the demand multiplied by unit price thus giving monetaryworthofannualconsumption.Itcanbeseenfromthisfigurethat10%itemsareclaiming75%oftheannualusagevalueandthusconstitutethe‘significantfew’.ThesearecalledA-classitems.Another15%itemsaccount for another 15% annual usage value and are called B-class items. A vast majority of 75% items account for only10%expenditureonmaterialconsumptionandconstitute‘insignificantmany’andarecalledC-classitems.Toprepare an ABC type curve we may follow the following simple procedure:

Arrange items in the descending order of the annual usage value. Annual usage value = Annual demand x Unit •price.Identifycutoffpointsonthecurvewhenthereisaperceptiblesuddenchangeo1slopeoralternativelyfindcut•off points at top 10% next 20% or so but do not interpret these too literally- rather as a general indicator.


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A very simple empirical way to classify items may be adopted as follows:

Average annual usage value X=

A-Class items 6XC-Class items 0.5X

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

6.5.2 VED AnalysisThis analysis attempts to classify items into three categories depending upon the consequences of material stock out when demanded. As stated earlier, the cost of shortage may vary depending upon the seriousness of such a situation. AccordinglytheitemsareclassifiedintoV(Vital),E(Essential)andD(Desirable)categories.Vitalitemsarethemost critical having extremely high opportunity cost of shortage and must be available in stock when demanded. Essential items are quite critical with substantial cost associated with shortage and should be available in stock by and large. Desirable group of items do not have very serious consequences, if not available when demanded, but can be stocked items.

Obviously the % risk of shortage with the vital’ group of items has to be quite small, thus calling for a high level of service. With Essential’ category we can take a relatively higher risk of shortage and for `Desirable’ category even higher. Since even a C-class item may be vital or an A-class item may be `Desirable,’ we should carry out a two-wayclassificationofitemsgroupingthemin9distinctgroupsasA-V,A-E,AD,B-V,B-E,B-D,C-V,C-EandC.D.Then, we are able to argue on the aimed at service-level for each of these nine categories and plan for inventories accordingly.

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

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

(TI).(TO)=K=constantValueofconstantKisgivenby

K=

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Where, Di = Annual requirement of ith item,V, = Unit price for ith item, i = 1....N

Thus, a plot between (TI) and (TO) is a rectangular hyperbola and is called as `exchange curve’ or `optimal policy’ curve. A typical exchange curve for a situation, where the ordering cost is not explicitly known. It shows that any point on the exchange curve is an optimal trade-off between investment in inventories and total number of orders.

Uses of exchange curveExchange curve is an effective instrument for aggregate inventory analysis to quickly determine the rationality (or otherwise)ofourexistingstockprovisioningpolicies.WefirstplottheexchangecurvebycomputingthevalueofKfor a chosen group of items. Then, we determine the total number of orders (TO) and total investment in inventories (TI) under current practice.

6.7 Deterministic Inventory ModelsIn this section, we discuss some elementary inventory models with deterministic demand and lead time situations. The purpose is to provide an illustration of the mathematical analysis of inventory systems. The most classical of the inventorymodelswasfirstproposedbyHarrisin1915andfurtherdevelopedbyWilsonin1928.Itisverypopularlyknown as EOQ (Economic Order Quantity) model or ‘Wilson’s Lot Size formula’.

When dealing with stocked items, the two important decisions to be made are, how much to order and when to order. EOQ attempts to provide answer to former, while the Reorder Point (RoP) provides the answer to the latter.

The following assumptions are made in the standard Wilson lot size formula to obtain EOQ:Demand is continuous at a constant rate•Theprocesscontinuesinfinitely.•No constraints are imposed on quantities ordered, storage capacity, budget etc.•Replenishment is instantaneous (the entire order quantity is received all at one•

time as soon as the order is released).All costs are time-invariant.•No shortages are allowed•Quantity discounts are not available.•The inventory status under EOQ-RoP policy is continuously reviewed.•


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SummaryInventory management deals with the determination of optimal policies and procedures for procurement of •commodities.Demand and lead time uncertainties necessitate building of safety stock (buffer stocks), so as to enable various •sub-systems to operate somewhat in a decoupled manner.Inventory can be one of the indicators of the management effectiveness on the materials management front.•Inventory turnover ratio (annual demand/average inventory) is an index of business performance.•It is the opportunity cost of not having an item in stock, when one is demanded. •In the backlogging (or back ordering) case, the order is not lost but is backlogged, to be cleared as soon as the •item is available on stock.Therightchoiceofaninventorypolicydependsuponthenatureoftheproblem;usagevalueofanitemand•other situational parameters.Annual usage value is the demand multiplied by unit price, thus giving monetary worth of annual •consumption.Exchange curve (or optimal policy curve) is an effective technique to look at the inventories at an aggregate •level in the organisation.Exchange curve is an effective instrument for aggregate inventory analysis to quickly determine the rationality •(or otherwise) of our existing stock provisioning policies.Themostclassicalof the inventorymodelswasfirstproposedbyHarris in1915andfurtherdevelopedby•Wilson in 1928.When dealing with stocked items, the two important decisions to be made are-how much to order and when to •order.If the total investment in inventories (TI) is prescribed then a rational inventory policy must aim at minimising •(TO).Essential items are quite critical with substantial cost associated with shortage and should be available in stock •by and large.Vital items are the most critical having extremely high opportunity cost of shortage and must be available in •stock when demanded.The selective inventory management plays a crucial role, so that we can put our limited control efforts more •judiciouslytothemoresignificantgroupofitems.Inselectivemanagement,wegroupitemsinfewdiscretecategoriesdependinguponvalue;criticalityandusage•frequency.Therightchoiceofaninventorypolicydependsuponthenatureoftheproblem;usagevalueofanitemand•other situational parameters.When the demand is seasonal, it may become economical to build inventory during periods of low demand to •ease the strain of peak period demand.

ReferencesTheImportanceofInventoryManagement• [Online]Availableat:<http://www.southernfulfillment.com/articles/order-fulfillment/inventory-management/the_importance_of_inventory_management.htm>[Accessed12July2013].InventoryManagement• [Online] Available at: <http://www.termpaperwarehouse.com/essay-on/4-3-1-Template-Managers-Report/158537> [Accessed 12 July 2013].Muller, M., 2011. • EssentialsofInventoryManagement. 2nd ed., AMACOM.Bragg, S.M., 2011. • InventoryBestPractices 2nd ed., Wiley.

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Inventory Management Best Practices• [Video online] Available at: <http://www.youtube.com/watch?v=C8Z3IApWCNQ>[Accessed12July2013].InventoryManagement - An Introduction.• [Video online] Available at: <http://www.youtube.com/watch?v=qkZQxXJuqKo>[Accessed12July2013].

Recommended ReadingSilver, E. A., Pyke, D. F. and Peterson, R., • InventoryManagementandProductionPlanningandScheduling, 3rd ed., Wiley.Schreibfeder, J., 2003. • AchievingEffectiveInventoryManagement, 5th ed., Effective Inventory Management, Inc.Bose, D.C., 2006. • InventoryManagement. PHI Learning Pvt. Ltd.


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Self AssessmentWhichofthefollowingisanindexofbusinessperformance?1.

Financial managementa. Financial investmentb. Inventory managementc. Inventory turnover ratiod.

_________________dealswith the determination of optimal policies andprocedures for procurement of2. commodities.

Financial managementa. Financial investmentb. Inventory managementc. Inventory turnover ratiod.

__________________istheopportunitycostofnothavinganiteminstock,whenoneisdemanded.3. Cost of replenishing inventorya. Cost of incurring shortagesb. Cost of carrying inventoryc. Cost of incorporated inventoryd.

______________________ is theamountofmoneyandeffortsexpended inprocurementoracquisitionof4. stock.

Inventory amounta. Cost of replenishing inventoryb. Cost of incurring shortagesc. Cost of carrying inventoryd.

Whichofthefollowingisalsocalledasorderingcost?5. Fixed costa. Cost of incurring shortageb. Cost of carrying inventoryc. Cost of replenishing inventoryd.

Whichofthefollowingisalsoknownas(S,s)policy?6. Selective inventory policy a. Fixed order interval scheduling policyb. Lot size reorder point policyc. Optional replenishment policyd.

Inselectivemanagement,wegroupitemsinfewdiscretecategoriesdependingupon_________;criticalityand7. usage frequency.

casha. analysisb. inventoryc. situationd.

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_________________value is the demandmultiplied by unit price thus givingmonetaryworth of annual8. consumption.

Casha. Consumptionb. Annual usagec. Analyticald.

________________analysisattemptstoclassifyitemsintothreecategoriesdependingupontheconsequences9. of material stock out when demanded.

VEDa. FSNb. ABCc. ECAd.

_________________ is an effective instrument for aggregate inventory analysis to quickly determine the10. rationality (or otherwise) of our existing stock provisioning policies.

Inventory modela. Exchange curveb. Inventory planningc. Inventory managementd.


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Chapter VII

Capital and Money Market

Aim


definefinancialmarket•

elucidatethetypesoffinancialmarkets•

explain the functions of capital market•

Objectives


explaining capital market operations •

explicatetheformsofcapitalmarketefficiency•

elucidate the term selective inventory management•

Learning outcome


understand the importance of money market•

identify the Indian money market system•

recognise the drawbacks of Indian money market•

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7.1 IntroductionTheeconomicdevelopmentofanationisreflectedbytheprogressofthevariouseconomicunits,broadlyclassifiedinto corporate sector, Government and household sector. While performing their activities, these units are placed in surplus/deficit/balancedbudgetarysituations.

Therearesomepeoplewithsurplusfundsandsomeotherswithadeficit.Afinancialsystemorfinancialsectorfunctionsasanintermediaryandfacilitatestheflowoffundsfromtheareasofsurplustotheareasofdeficit.Afinancialsystemisacompositionofvariousinstitutions,markets,regulationsandlaws,practices,moneymanager,analysts, transactions and claims and liabilities.

7.2 Financial MarketAfinancialmarketcanbedefinedasthemarketinwhichfinancialassetsarecreatedortransferred.Asagainstarealtransactionthatinvolvesexchangeofmoneyforrealgoodsorservices,afinancialtransactioninvolvescreationortransferoffinancialassets.Financialassetsorfinancialinstrumentsrepresentaclaimtothepaymentofasumofmoney sometime in the future /or periodic payment in the form of interest or dividend.

Afinancialmarketcanbecategorisedasmoneymarket,capitalmarket,forexmarketandderivativemarket:Money market: The money market is a wholesale debt market for low-risk, highly-liquid, short-term instruments. •Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostlybygovernment,banksandfinancialinstitutions.Capitalmarket:Thecapitalmarketisdesignedtofinancethelong-terminvestments.Thetransactionstaking•placeinthismarketwillbeforperiodsoverayear.HerbertK.Dougalldefinesthetermcapitalmarketas“acomplex of institutions and mechanisms whereby, intermediate term funds (loans up to 10 years maturity) and long lean funds (longer maturity loans and corporate stocks) are pooled and made available to business, Government and individuals and where instruments that are already outstanding are transferred.” The capital market is a medium through which small and scattered savings of investors are directed into productive activities of corporate entities. It also provides the essential attributes of liquidity, marketability and safety of investments to the investors.Forex market: The Forex market deals with the multicurrency requirements, which are met by the exchange of •currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.Credit market: Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans •to corporate and individuals.Derivative markets: The derivatives market is meant as the market, where exchange of derivatives takes place. •Derivatives are one type of securities, whose price is derived from the underlying assets. Value of these derivatives isdeterminedbythefluctuationsintheunderlyingassets.Theseunderlyingassetsaremostcommonlystocks,bonds, currencies, interest rates, commodities and market indices.


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Financial System

Financial Instrument

Money Market Instrument

Primary Market

Secondary Market

Capital Market

Money Market

Derivative Market

Credit Market

Forex Market

Capital Market Instrument

Hybrid Instrument

Financial Market Financial Intermediaries

Fig. 7.1 The financial system

7.3 Capital Market EfficiencyCapital market facilitates the buying and selling of securities, such as shares and bonds or debentures. They perform two valuable functions, liquidity and pricing securities.

LiquidityLiquidity means the convenience and speed of transforming assets into cash, or transferring assets from one person to another without any loss of value. Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person without any decline in value. Capital market makes securities liquid. They facilitate the buying and selling of securities by a large number of investors continuously and instantaneously without incurring significantcosts.Theyhelptoreduce,ifnoteliminate,transactioncosts.Forensuringtheliquidity,capitalmarketsdo require certain investors who are always ready to buy or sell securities. These market makers enhance liquidity and reduce transaction costs.

Pricing securitiesHowarethepricesofsecuritiesdetermined?Arethesepricesfair?Inthecapitalmarkets,hundredofinvestorsmakeseveral deals a day. The screen-based trading makes these deals known to all in the capital market. Thus, a large number of buyers and sellers interact in the capital markets. The demand and supply forces help in determining theprices.Sinceallinformationispubliclyavailable,andsincenosingleinvestorislargeenoughtoinfluencethesecurity prices, the capital markets provide a measure of fair price of securities.

Afinancialmanagerborrowsandlends(invests)fundsonthecapitalmarket.Capitalmarketsfacilitatetheallocationoffundsbetweensaversandborrowers.Thisallocationwillbeoptimum,ifthecapitalmarketshaveanefficientpricing mechanism.

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7.3.1 Forms of Capital Market EfficiencyThefinancetheoryreferstothreeformsofcapitalmarketefficiency:Weak form of market efficiencyThesecuritypricesreflectallthepastinformationaboutthepricemovementsintheweak-formofefficiency,itis,therefore, not possible for any investor to predict future security price by analysing historical prices, and achieve a performance (return) better than the stock market index such as Bombay Stock Exchange Share Price Index or the Economic Times Share Price Index. It is so because the capital market has no money, and the stock market index has already incorporated past information about the security prices in the current market price.

Howdoesoneknowthatthecapitalmarketisefficientinitsweakform?Toanswerthisquestion,itisnecessarytofindoutthecorrelationbetweenthe‘securitypricesovertime’.Inanefficientcapitalmarket,thereshouldnotexistasignificantcorrelationbetweenthesecuritypricesovertime.Mostempiricaltestshaveshownthatthereexistsserialindependencebetweenthesecuritypricesovertime.Hence,theweakformofefficiencyisreferredtoastherandomwalkhypothesis.Analternativemethodtotestingtheweaklyefficientmarkethypothesisistoformulatethetrading strategies using the security prices and compare their performance with the stock market performance.

Semi-strong form of market efficiencyInsemi-strongformofefficiency,assetpricesalreadyreflectallinformationthatispubliclyavailable,i.e.,earnings,dividends, analyst forecasts, expectations of the future, etc. Most tests show that material public announcements areaccompaniedbyanimmediatechangeinprice.Inasemi-strongefficientmarket,themarket’sreactiontonewand material information should be both instantaneous and unbiased, i.e., without any systematic pattern of over or under-reaction. In addition, the market should only react to the extent that new information differs from what had beenexpected.Semi-strongefficiencyalsomeansthatmostfinancialanalysisworkorfundamentalanalysis,basedon using public information, should not work.

Opportunities may occasionally exist that produce above normal or excess returns. However, after the information orstrategiesbecomeknowntothepublic,theyshouldnolongerproduceexcessreturns;forexample,theJanuaryeffect in small stocks has vanished. Also, a talented investment analyst might still be able to beat the market, provided that he/she is able to consistently interpret information better than his or her competitor.

Implicationsofsemi-strongformofmarketefficiencyareasdetailedbelow:Stock prices are expected to increase over time, but future returns are expected to be consistent with the •systematic risk.InvestmentsinfinancialassetsareexpectedtobeZERONetPresentValue.Thismeansthatyoushouldexpect•to earn an average future return, which is, determined by the systematic risk of the investments.

What ifnooneperformedsecurityanalysis?Then, thefirstperson thatbecomesananalystwillfindcountlessmispricedassetsandtradingrulesthatearnexcessorabnormalreturns.Suchprofitableopportunitieswouldcertainlyleadtomanymoreindividualsenteringtheanalystfield.Competitionwillquicklybegintoeliminatemostofthemispriced assets.

Duetointensecompetition,itwillbecomedifficulttoearnabnormalreturns.Themarginalbenefitofanalysiswilljust equal the marginal cost of analysis for the average analyst or investor. It, thus, follows that individuals should be exceedingly suspicious of anyone that advertises some investment technique that earns abnormal returns. If the method really works, then any rational person would keep the technique undisclosed. This holds for the weak-form marketefficiencyaswell,asmanyattempttosellmethodsfortechnicalanalysis.

Strong-form of market efficiencyIn the strong-formof efficiency, the security prices reflect all published and unpublished, public and privateinformation,thisis,asignificantlystrongassertion,andempiricalstudieshavenotborneoutthevalidityoftheefficientmarkethypothesisinthestrongformofefficiency,peoplewithprivateorinsideinformationhavebeenable to outperform the market.


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7.4 Capital Market OperationsCapital market operations consist mainly of primary market operations and secondary market operations. Primary market or new issue market deals with the issue of new securities to the investors and facilitates the corporate sector inraisingfunds.Theprimarymarketismadeupoftwocomponents,wherefirmsgopublicforthefirsttimethroughinitialpublicofferingsandwherefirmswhichhavealreadytradedraiseadditionalcapitalthroughseasonedequityofferings.

Initial capital is raised by issuing only ordinary and preference shares, whereas further capital can be raised by •selling debentures as well.In order to effectively control the activities in the new issue market and to ensure that investments in the country •are made in a planned manner and in accordance with the priorities laid down in the plans, the Government has instituted the Controller of Capital Issues (CCI) under the Capital Issues (Control) Act, 1947.CCI laid stringent controls on pubic and right issues and in their pricing. As a result, capital issues were generally •underpriced. But when Capital Issues (Control) Act was repealed and free pricing was introduced by SEBI in 1992 the market saw a plethora of issues.Heftypremiumswerechargedbytheissuingcompaniesastherewasnorestrictiononfixingofpremiums.•Manyfly-by-nightcompaniesalsoaccessedcapitalmarket.•But in many cases, investors lost heavily as the post issue listings were quoted far below issue prices.•It is estimated that around 1000 companies which came out with issues and collected about Rs. 3000 crores in •1995 and 1996 have disappeared completely.

With a view to protect the interest of investors, Malegam Committee recommended the introduction of book building asanalternativedevicetotheexistingsystemoffixedpricinganditwasadoptedbySEBIin1996.Bookbuildinghelpstofindabetterpriceforanissuetobemade.Underthismethod,theissuingcompanywillmentionanindicativeprice at which securities will be offered and gives the investors an opportunity to bid collectively. Then, a consensus pricewillbearrivedatandallotmentwillbefinalisedattheagreedprice.

Buy-back of shares is a device which facilitates capital restructuring of a company. It helps in arresting wide fluctuationinsharepricesandpavesthewayforefficientallocationofresources.Earlier,buy-backofshareswasprohibited in India by the Companies Act, 1956, however, buy- back was allowed in India through an amendment ordinance in 1998. Now, Indian companies are free to buy its own shares and other securities up to 25 per cent of their net worth out of its free reserves, or securities premium account, or proceeds of an earlier issue other than a freshissuemadespecificallyforbuy-backpurposes.Inanotherdevelopment,companiesaregiventheoptiontoissue shares of any denomination without a uniform par value.

7.5 Money MarketMoney market means market where money or its equivalent can be traded. Money is synonymous to liquidity. Money marketconsistsoffinancialinstitutionsanddealersinmoneyorcreditwhowishtogenerateliquidity.Itisbetterknown as a place where large institutions and Government manage their short-term cash needs. For generation of liquidity,short-termborrowingandlendingisdonebythesefinancialinstitutionsanddealers.Duetohighlyliquidnature of securities and their short-term maturities, money market is treated as a safe place.

Definitionsofmoneymarkethelptoidentifythebasiccharacteristicsofamoneymarket.Variousfinancialinstrumentsare used for transactions in a money market. There is perfect mobility of funds in a money market. The transactions in a money market are of short -term nature.

AccordingtotheRBI,“Themoneymarketisthecentrefordealingmainlyofshortcharacter,inmonetaryassets;it meets the short-term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short-termsurplus investiblefundsat thedisposaloffinancialandother institutionsand individualsarebidbyborrowers, again comprising institutions and individuals and also by the government.”

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According to Nadler and Shipman, “A money market is a mechanical device through which short-term funds are loanedandborrowedthroughwhichalargepartofthefinancialtransactionsofaparticularcountryorworldaredegraded. A money market is distinct from but supplementary to the commercial banking system.”

7.5.1 Characteristics of Money MarketThe important characteristics of money market are as follows:Short-term Credit MarketIn the money market, funds are made available for a short period only. The funds are borrowed or lent for one day, a week or for three to six months or in exceptional cases for the period of more than six months but less than one year.

Funds against different types of instrumentsThe funds are usually borrowed against different types of securities which are called as near-money. The important instruments against which funds are borrowed are trade bills or bills of exchange, promissory notes, banker’s acceptance, treasury bills or suitable commercial papers of maturity up to six months.

Composition of sub-marketsIn the money market, funds are borrowed against various securities. The transactions of borrowing of funds against a particular security are carried out in a particular part which is called as a sub-part or a sub-market of the money market, i.e., transactions of borrowing against bills of exchange are carried out in a bill market, there are following important sub-markets in the money market, which are:

Call money market•Acceptance market•Bill market•Treasury Bill market•Collateral Loans market•

No definite locationThemoneymarkethasnodefinitelocationwhereborrowersandlendersmeet.Negotiationsbetweenborrowersandlenders may be carried on through telephone, telegraphs and through mails or any other arrangement. Thus, money market is an arrangement that brings about a direct or indirect contract between the borrower and the lender.

Specific institutionsSomefinancialinstitutionsdealinshort-termfinanceandlong-termfinanceonceatthesametime.But,therearecertain agencies which deal only in the short-term credit. For example, discount houses and acceptance houses.

Purpose of loansThemoneymarketprovidesshort-termloansforvariouspurposessuchasloanformeetingshort-termfinancialneeds of industry, commerce, trade, agriculture, Government developmental activities and for meeting short-term financialneedsofstockexchangebrokers,etc.

Settlement of financial transactionsFromthedefinitiongivenbyMaddenandNadler,onecansaythatamoneymarketisanagencythroughwhichmanyfinancialtransactionsofthecountryaresettled.Incaseofdevelopedmoneymarket,manyfinancialtransactionsofthe world are settled. This conveys the importance of money markets in the world economy.

7.5.2 Functions of Money MarketMoneymarketisanimportantpartoftheeconomy.Itplaysverysignificantfunctions.Asmentionedabove,itisbasically a market for short-term monetary transactions. Thus, it has to provide facility for adjusting liquidity to thebanks,businesscorporations,Non-BankingFinancialinstitutions(NBFs)andotherfinancialinstitutionsalongwith investors.


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The major functions of money market are given below:To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money •for short-term monetary transactionsTo promote economic growth. Money market can do this by making funds available to various units in the •economy such as agriculture, small scale industries, etc.Toprovidehelptotradeandindustry.Moneymarketprovidesadequatefinancetotradeandindustry.Similarly,•it also provides facility of discounting bills of exchange for trade and industryTo help in implementing monetary policy. It provides a mechanism for an effective implementation of the •monetary policyTo help in capital formation. Money market makes available investment avenues for short term period. It helps •in generating savings and investments in the economy

Moneymarketprovidesnon-inflationarysourcesoffinancetoGovernment.Itispossiblebyissuingtreasurybillsin order to raise short loans. However, this does not lead to increases in the prices Apart from these, money market isanarrangementwhichaccommodatesbanksandfinancialinstitutionsdealinginshort-termmonetaryactivities,such as the demand for and supply of money.

7.5.3 Importance of Money MarketAdevelopedmoneymarketplaysanimportantroleinthefinancialsystemofacountrybysupplyingshort-termfunds adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Therefore, a developed money market is highly indispensable for the rapid development of the economy. A developed moneymarkethelpsthesmoothfunctioningofthefinancialsysteminanyeconomyinthefollowingways:Development of trade and industryMoneymarket isan importantsourceoffinancing tradeand industry.Themoneymarket, throughdiscountingoperationsandcommercialpapers,financestheshort-termworkingcapitalrequirementsoftradeandindustryandfacilities the development of industry and trade both – national and international.

Development of capital marketTheshort-termratesofinterestandtheconditionsthatprevailinthemoneymarketinfluencethelong-terminterestas well as the resource mobilisation in capital market. Hence, the development of capital depends upon the existence of a development of capital money market.

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

Effective central bank controlA developed money market helps the effective functioning of a central bank. It facilitates effective implementation of the monetary policy of a central bank. The central bank, through the money market, pumps new money into the economyinslumpandsiphonsifoffinboom.Thecentralbank,thus,regulatestheflowofmoneysoastopromoteeconomic growth with stability.

Formulation of suitable monetary policyConditions prevailing in a money market serve as a true indicator of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising the monetary policy then and there depending upon the monetary conditions prevailing in the market.

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Non-inflationary source of finance to GovernmentAdevelopedmoneymarkethelpstheGovernmenttoraiseshort-termfundsthroughthetreasurybillsfloatedinthemarket. In the absence of a developed money market, the Government would be forced to print and issue more money orborrowfromtheCentralBank.Bothwayswouldleadtoanincreaseinpricesandtheconsequentinflationarytrend in the economy.

7.6 Indian Money Market InstrumentsInvestment in money market is done through money market instruments. Money market instrument meets short-term requirements of the borrowers and provides liquidity to the lenders. Common money market instruments are as follows:Treasury Bills (T-Bills)Treasury Bills, one of the safest money market instruments, are short-term borrowing instruments of the Central Government of the country issued through the Central Bank (RBI in India).

They are zero risk instruments, and hence the returns are not so attractive. It is available both in primary market •aswellassecondarymarket.Itisapromisetopayasaidsumafteraspecifiedperiod.T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three •month, six-month, and one-year maturity periods.The Central Government issues T-Bills at a price less than their face value (par value). They are issued with •a promise to pay full face value on maturity. So, when the T-Bills mature, the Government pays the holder its face value.The difference between the purchase price and the maturity value is the interest income earned by the purchaser •of the instrument.T-Bills are issued through a bidding process at auctions. The bid can be prepared either competitively or non-•competitively.Inthesecondtypeofbidding,returnrequiredisnotspecifiedandtheonedeterminedattheauctionisreceived•onmaturity.Whereas,incaseofcompetitivebidding,thereturnrequiredonmaturityisspecifiedinthebid.IncasethereturnspecifiedistoohighthentheT-Billmightnotbeissuedtothebidder.At present, the Government of India issues three types of treasury bills through auctions, namely, 91-day, 182 •day and 364-day. There are no treasury bills issued by State Governments.TreasurybillsareavailableforaminimumamountofRs.25Kandinitsmultiples.While91-dayT-billsare•auctioned every week on Wednesdays, 182-day and 364-day T-bills are auctioned every alternate week on Wednesdays.The Reserve Bank of India issues a quarterly calendar of T-bill auctions which is available at the banks’ website. •It also announces the exact dates of auction, the amount to be auctioned and payment dates by issuing press releases prior to every auction. Payment by allottees at the auction is required to be made by debit to their/ custodian’s current account.T-bills auctions are held on the Negotiated Dealing System (NDS) and the members electronically submit their •bids on the system. NDS is an electronic platform for facilitating dealing in Government securities and money market instruments.RBI issues these instruments to absorb liquidity from the market by contracting the money supply. In banking •terms, this is called Reverse Repurchase (Reverse Repo).Ontheotherhand,whenRBIpurchasesbacktheseinstrumentsataspecifieddatementionedatthetimeof•transaction, liquidity is infused in the market. This is called Repo (Repurchase) transaction.

Repurchase AgreementsRepurchase transactions, called Repo or Reverse Repo are transactions or short-term loans in which two parties •agree to sell and repurchase the same security. They are usually used for overnight borrowing.Repo/Reverse Repo transactions can be done only between the parties approved by RBI and in RBI approved •securities, viz., GOI and State Govt. Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds, etc.


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Underrepurchaseagreement,thesellersellsspecifiedsecuritieswithanagreementtorepurchasethesameat•a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date at a predetermined price. Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities.Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the •transaction.The lender or buyer in a Repo is entitled to receive compensation for use of funds provided to the counterparty. •Effectively, the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller.The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties •independentlyofthecouponrateorratesoftheunderlyingsecuritiesandisinfluencedbyoverallmoneymarketconditions.

Commercial Paper (CP)Commercial paper is a low-cost alternative to bank loans. It is a short-term unsecured promissory note issued •bycorporateandfinancialinstitutionsatadiscountedvalueonfacevalue.Theyareusuallyissuedwithfixedmaturitybetweenoneto270daysandforfinancingofaccountsreceivables,•inventories, and meeting short-term liabilities. Say, for example, a company has receivables of Rs 1 lakh with credit period 6 months. It will not be able to liquidate its receivables before 6 months.The company is in need of funds. It can issue commercial papers in form of unsecured promissory notes at •discount of 10% on face value of Rs 1 lakh to be matured after 6 months. The company has strong credit rating andfindsbuyerseasily.ThecompanyisabletoliquidateitsreceivablesimmediatelyandthebuyerisabletoearninterestofRs10K•over a period of 6 months.TheyyieldhigherreturnsascomparedtoT-Billsastheyarelesssecureincomparisontothesebills;however•chances of default are almost negligible but are not zero risk instruments.Commercialpaperbeinganinstrumentnotbackedbyanycollateral,onlyfirmswithhighqualitycreditratings•willfindbuyerseasilywithoutofferinganysubstantialdiscounts.Theyareissuedbycorporatestoimpartflexibilityinraisingworkingcapitalresourcesatmarketdetermined•rates. Commercial Papers are actively traded in the secondary market since they are issued in the form of promissory •notes and are freely transferable in demat form.

Certificate of DepositIt is a short-term borrowing more like a bank term deposit account. It is a promissory note issued by a bank in •formofacertificateentitlingthebearertoreceiveinterest.The certificate bears thematurity date, the fixed rate of interest and the value. It can be issued in any•denomination.Theyarestampedandtransferredbyendorsement.Itstermgenerallyrangesfromthreemonthstofiveyears•and restricts the holders to withdraw funds on demand.However, on payment of certain penalty the money can be withdrawn on demand also.•ThereturnsoncertificateofdepositsarehigherthanT-Billsbecauseitassumeshigherlevelofrisk.•WhilebuyingCertificateofDeposit,returnmethodshouldbeseen.ReturnscanbebasedonAnnualPercentage•Yield (APY) or Annual Percentage Rate (APR).In APY, interest earned is based on compounded interest calculation. However, in APR method, simple interest •calculation is done to generate the return. Accordingly, if the interest is paid annually, equal return is generated bybothAPYandAPRmethods.However,ifinterestispaidmorethanonceinayear,itisbeneficialtooptAPY over APR.

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Banker’s AcceptanceItisashort-termcreditinvestmentcreatedbyanon-financialfirmandguaranteedbyabanktomakepayment.•It is simply a bill of exchange drawn by a person and accepted by a bank. It is a buyer’s promise to pay to the selleracertainspecifiedamountatcertaindate.The same is guaranteed by the banker of the buyer in exchange for a claim on the goods as collateral.•The person drawing the bill must have a good credit rating otherwise the banker’s acceptance will not be •tradable.The most common term for these instruments is 90 days. However, they can very from 30 days to180 days.•Forcorporations,itactsasanegotiabletimedraftforfinancingimports,exportsandothertransactionsingoods•and is highly useful when the credit worthiness of the foreign trade party is unknown.The seller need not hold it until maturity and can sell off the same in secondary market at discount from the •face value to liquidate its receivables.

7.7 Drawbacks of Indian Money MarketThough the Indian money market is considered as the advanced money market among developing countries, it still suffersfrommanydrawbacksordefects.Thesedefectslimittheefficiencyofourmarket.Someoftheimportantdrawbacks of the Indian money market are:Absence of integrationThe Indian money market is broadly divided into the organised and unorganised sectors. The former comprises thelegalfinancialinstitutionsbackedbytheRBI.Theunorganisedsegmentofitincludesvariousinstitutionssuchas indigenous bankers, village money lenders, traders, etc. There is lack of proper integration between these two segments.

Multiple rate of interestIn the Indian money market, especially the banks, there exist too many rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors.

Insufficient funds or resourcesTheIndianeconomywithitsseasonalstructurefacesfrequentshortageoffinancialrecourse.Lowerincome,lowersavings, and lack of banking habits among people are some of the reasons for it.

Shortage of investment instrumentsIntheIndianmoneymarket,variousinvestmentinstrumentssuchasTreasuryBills,CommercialBills,Certificateof Deposits, Commercial Papers, etc. are used. But taking into account, the size of the population and market these instruments are inadequate.

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

Lack of organised banking systemInIndia,eventhoughwehaveabignetworkofcommercialbanks;stillthebankingsystemsuffersfrommajorweaknessessuchastheNPA,hugelosses,andpoorefficiency.Theabsenceoftheorganisedbankingsystemismajor problem for Indian money market.

Less number of dealersThere are lesser number of dealers in the short-term assets who can act as mediators between the Government and the banking system. This leads to the slow contact between the end lender and end borrowers.


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7.8 Reforms in Indian Money MarketIndian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in 1984 to review the Indian monetary system. Later, Narayanan Vaghul working group and Narasimham Committee was also set up. As pertherecommendationsofthesestudygroupsandwiththefinancialsectorreformsinitiatedintheearly1990s,the Government has adopted following major reforms in the Indian money market.

Deregulation of the interest rate: In recent period, the Government has adopted an interest rate policy of •liberal nature. It lifted the ceiling rates of the call money market, short-term deposits, bills rediscounting, etc. Commercial banks are advised to see the interest rate change that takes place within the limit. There was a further deregulation of interest rates during the economic reforms. Currently, interest rates are determined by the working of market forces except for a few regulations.Money Market Mutual Fund (MMMFs): In order to provide additional short-term investment revenue, the RBI •encouraged and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell units to corporate and individuals. The upper limit of 50-crore investment has also been lifted. Financial institutions such as the IDBI and the UTI have set up such funds.

Establishment of the DFI: The Discount and Finance House of India (DFHI) was set up in April 1988 to �impart liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has played an important role in stabilizing the Indian money market.Liquidity Adjustment Facility (LAF): Through the LAF, the RBI remains in the money market on a continue �basis through the repo transaction. LAF adjusts liquidity in the market through absorption and or injection offinancialresources.Electronictransactions:Inordertoimparttransparencyandefficiencyinthemoneymarkettransactionthe �electronic dealing system has been started. It covers all deals in the money market. Similarly, it is useful for the RBI to watchdog the money market.Establishment of the CCIL: The Clearing Corporation of India limited (CCIL) was set up in April 2001. �The CCIL clears all transactions in Government securities, and repose reported on the negotiated dealing system.Development of new market instruments: The Government has consistently tried to introduce new short-term �investmentinstruments.Examples:TreasuryBillsofvariousdurations,Commercialpapers,CertificatesofDeposits, MMMFs, etc. have been introduced in the Indian money market.

ThesearemajorreformsundertakeninthemoneymarketinIndia.Apartfromthese,thestampdutyreforms,floatingrate bonds, etc. are some other prominent reforms in the money market in India. Thus, at the end we can conclude that the Indian money market is developing at a good speed.

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SummaryAfinancialsystemisacompositionofvariousinstitutions,markets,regulationsandlaws,practices,money•manager, analysts, transactions and claims and liabilities.Afinancialmarketcanbedefinedasthemarketinwhichfinancialassetsarecreatedortransferred.•Financialassetsorfinancialinstrumentsrepresentaclaimtothepaymentofasumofmoneysometimeinthe•future and/or periodic payment in the form of interest or dividend.Thecapitalmarketisdesignedtofinancethelong-terminvestments.•The capital market is a medium through which small and scattered savings of investors are directed into productive •activities of corporate entities.The forex market deals with the multi-currency requirements, which are met by the exchange of currencies.•Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate •and individuals.Derivatives are one type of securities whose price is derived from the underlying assets.•Capital market facilitates the buying and selling of securities, such as shares and bonds or debentures.•Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person •without any decline in value.For ensuring the liquidity, capital markets do require certain investors who are always ready to buy or sell •securities.Capital markers facilitate the allocation of funds between savers and borrowers.•Thesecuritypricesreflectallthepastinformationaboutthepricemovementsintheweak-formofefficiency.•Capital market operations consist mainly of primary market operations and secondary market operations.•Money market means market where money or its equivalent can be traded. Money is synonymous to •liquidity.A money market is a mechanical device through which short-term funds are loaned and borrowed through which •alargepartofthefinancialtransactionsofaparticularcountryorworldaredegraded.The important instruments against which funds are borrowed are trade bills or bills of exchange, promissory •notes, banker’s acceptance, treasury bills or suitable commercial papers of maturity up to six months.To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money •for short-term monetary transactions.Moneymarketprovidesnon-inflationarysourcesoffinancetoGovernment.•Adevelopedmoneymarketplaysanimportantroleinthefinancialsystemofacountrybysupplyingshort-term•funds adequately and quickly to trade and industry.The money market provides the commercial banks with facilities for temporarily employing their surplus funds •in easily realisable assets.

ReferencesMoney Market and its Instruments• [Pdf]Availableat:<http://www.caalley.com/art/Money_Market_and_Money_Market_Instruments.pdf>[Accessed12July2013].Financial system• [Online]Available at: < http://www.slideshare.net/chotu30/financial-system-11563132>[Accessed 12 July 2013].Ritter, L.S. and Silber, W.L., 2008• . Principles of Money, Banking & Financial Markets. 12th ed. Prentice Hall.Thau, A., • The Bond Book, 3rd ed., McGraw-Hill.


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Money Markets and Capital Markets• [Videoonline]Availableat:<http://www.youtube.com/watch?v=nv0a0GEc-4s> [Accessed 12 July 2013].Financial Markets and Products• [Videoonline]Availableat:<http://www.youtube.com/watch?v=y_ti1PXDnLE>[Accessed 12 July 2013].

Recommended ReadingKidwell,D.S.,Blackwell,D.W.,Whidbee,D.A.andSias,R.W.,2011.• Financial Institutions, Markets, and Money. 11th ed. Financial Institutions, Markets, and Money, Wiley.Mishkin, F.S. and Eakins, S., 2011. • Financial Markets and Institutions. 7th ed., Prentice Hall.Levinson, M., 2009. • Guide to Financial Markets. Guide to Financial Markets. 5th ed., Bloomberg Press.

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Self AssessmentWhichofthefollowingisnotoneoftheeconomicunits?1.

Corporate sectora. Private sectorb. Government sectorc. House hold sectord.

A_________________canbedefinedasthemarketinwhichfinancialassetsarecreatedortransferred.2. financialmanagementa. inventory managementb. cashflowc. financialmarketd.

Whichofthefollowingisnotoneofthecategorisationoffinancialmarket?3. Derivative marketa. Capital marketb. Monetary marketc. Forex marketd.

The____________________dealswiththemulticurrencyrequirements,whicharemetbytheexchangeof4. currencies.

Forex marketa. Credit marketb. Capita marketc. Money marketd.

The__________________ismeantasthemarketwhereexchangeofderivativestakesplace.5. Underlying assetsa. Money marketsb. Derivatives marketc. Capital marketd.

___________________meanstheconvenienceandspeedoftransformingassetsintocash,ortransferringassets6. from one person to another without any loss of value.

Liquiditya. Pricingb. Derivativec. Creditd.

Whichofthefollowingisnotoneoftheformsofcapitalmarketefficiency?7. Weakformofmarketefficiencya. Semi strong primary market operationsb. Semi-strongformofmarketefficiencyc. Strong-formofmarketefficiencyd.


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___________________meansmarketwheremoneyor itsequivalentcanbe traded.Money issynonymof8. liquidity.

Capital marketa. Money marketb. Derivative marketc. Market operationsd.

Whichofthefollowingisnotoneofthecharacteristicsofmoneymarket?9. Long term credit marketa. Nodefinitelocationb. Purpose of loansc. Settlementoffinancialtransactiond.

Whichofthefollowingisnotoneofthefunctionsofmoneymarket?10. To maintain momentary equilibriuma. To promote economic growthb. To provide help to Trade and Industryc. To help in implementing Monetary Policyd.

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Chapter VIII

Receivable Management

Aim


definemanagementofreceivables•

elucidate the receivable management•

explain the instruments indicating receivables•

Objectives


explain the cost of maintaining receivables •

explicate the factors affecting the size of receivables•

elucidate the principles of credit management•

Learning outcome


understand the objectives of receivable management•

identify the aspects of credit management•

recognise various credit periods•


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8.1 Introduction Management of trade credit is commonly known as management of receivables. Receivables are one of the three primary components of working capital, the other being inventory and cash. Receivables occupy second important placeafterinventoriesandtherebyconstituteasubstantialportionofcurrentassetsinseveralfirms.Thecapitalinvested in receivables is almost of the same amount as that invested in cash and inventories. Receivables thus, form about one third of current assets in India. Trade credit is an important market tool, as it acts like a bridge for mobilisationofgoodsfromproductiontodistributionstagesinthefieldofmarketing.Receivablesprovideprotectionto sales from competitions. It acts no less than a magnet in attracting potential customers to buy the product at terms andconditionsfavourabletothemaswellastothefirm.Receivablesmanagementdemandsdueconsiderationforafinancialexecutivenotonlybecausecostandriskareassociatedwiththisinvestment,butalsoforthereasonthateachrupeecancontributetoafirm’snetworth.

When goods and services are sold under an agreement permitting the customer to pay for them at a later date, the amountduefromthecustomerisrecordedasaccountsreceivables;so,receivablesareassetaccountsrepresentingamountsowedtothefirmasaresultofthecreditsaleofgoodsandservicesintheordinarycourseofbusiness.Thevalue of these claims is carried on to the assets side of the balance sheet under titles such as accounts receivable, tradereceivablesorcustomerreceivables.Thistermcanbedefinedas“debtowedtothefirmbycustomersarisingfrom sale of goods or services in ordinary course of business.”

According to Robert N. Anthony, “Accounts receivables are amounts owed to the business enterprise, usually by itscustomers.Sometimesitisbrokendownintotradeaccountsreceivables;theformerreferstoamountsowedbycustomers, and the latter refers to amounts owed by employees and others.”

8.2 Receivable ManagementGenerally, when a concern does not receive cash payment in respect of ordinary sale of its products or services immediatelyinordertoallowthemareasonableperiodoftimetopayforthegoodstheyhavereceived.Thefirmis said to have granted trade credit. Trade credit thus, gives rise to certain receivables or book debts expected to becollectedbythefirminthenearfuture.Inotherwords,saleofgoodsoncreditconvertsfinishedgoodsofasellingfirmintoreceivablesorbookdebts.Ontheirmaturity,thesereceivablesarerealisedandcashisgenerated.AccordingtoPrasannaChandra,“Thebalanceinthereceivablesaccountswouldbe;averagedailycreditsalesxaverage collection period.”

The book debts or receivables arising out of credit have three dimensions:It involves an element of risk, which should be carefully assessed. Unlike cash sales, credit sales are not risk-•less as the cash payment remains un-received.It is based on economics value. The economic value in goods and services passes to the buyer immediately •when the sale is made in return for an equivalent economic value expected by the seller from him to be received later on. Itimpliesfuturity,asthepaymentforthegoodsandservicesreceivedbythebuyerismadebyhimtothefirm•on a future date.

Thecustomerwhorepresentsthefirm’sclaimorassets,fromwhomreceivablesorbook-debtsaretobecollectedinthenear future, are known as debtors or trade debtors. A receivable originally comes into existence at the very instance, when the sale is affected. But, the funds generated as a result of these sales can be of no use until the receivables are actuallycollectedinthenormalcourseofthebusiness.Receivablesmayberepresentedbyacceptance;billsornotesdue from others at an assignable date in the due course of the business. As sale of goods is a contract, receivables too get affected in accordance with the law of contract, e.g., both the parties (buyer and seller) must have the capacity to contract, proper consideration and mutual assent must be present to pass the title of goods and above all contract of sale to be enforceable must be in writing. Moreover, extensive care is needed to be exercised for differentiating true sales form what may appear to be as sales like bailment, sales contracts, consignments, etc. Receivables, as are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied up in trade debtors. Hence, a great deal of careful analysis and proper management is exercised for effective and efficientmanagementofreceivablestoensureapositivecontributiontowardsincreaseinturnoverandprofits.

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When goods and services are sold under an agreement permitting the customer to pay for them at a later date, the amountduefromthecustomerisrecordedasaccountsreceivables;so,receivablesareassetaccountsrepresentingamountsowedtothefirmasaresultofthecreditsaleofgoodsandservicesintheordinarycourseofbusiness.Thevalue of these claims is carried on to the assets side of the balance sheet under titles such as accounts receivable, tradereceivablesorcustomerreceivables.Thistermcanbedefinedas“debtowedtothefirmbycustomersarisingfrom sale of goods or services in ordinary course of business.”

According to Robert N. Anthony, “Accounts receivables are amounts owed to the business enterprise, usually by itscustomers.Sometimes,itisbrokendownintotradeaccountsreceivables;theformerreferstoamountsowedbycustomers, and the latter refers to amounts owed by employees and others.”

Generally, when a concern does not receive cash payment in respect of ordinary sale of its products or services immediately,inordertoallowthemareasonableperiodoftimetopayforthegoodstheyhavereceived.Thefirmis said to have granted trade credit. Trade credit thus, gives rise to certain receivables or book debts expected to becollectedbythefirminthenearfuture.Inotherwords,saleofgoodsoncreditconvertsfinishedgoodsofasellingfirmintoreceivablesorbookdebts,ontheirmaturitythesereceivablesarerealisedandcashisgenerated.AccordingtoPrasannaChandra,“Thebalanceinthereceivablesaccountswouldbe;averagedailycreditsalesxaverage collection period.”

The book debts or receivables arising out of credit have three dimensions:It involves an element of risk, which should be carefully assessed. Unlike cash sales, credit sales are not risk •less as the cash payment remains un-received.It is based on economics value. The economic value in goods and services passes to the buyer immediately, •when the sale is made in return for an equivalent economic value expected by the seller from him to be received later on. Itimpliesfuturity,asthepaymentforthegoodsandservicesreceivedbythebuyerismadebyhimtothefirm•on a future date.

Thecustomerwhorepresentsthefirm’sclaimsorassets,fromwhomreceivablesorbook-debtsaretobecollectedin the near future, are known as debtors or trade debtors. A receivable originally comes into existence at the very instance when the sale is affected. But the funds generated as a result of these sales can be of no use until the receivables are actually collected in the normal course of the business.

Receivablesmayberepresentedbyacceptance;billsornotesandthelikeduefromothersatanassignabledateinthe due course of the business. As sale of goods is a contract, receivables too get affected in accordance with the law of contract, e.g., both the parties (buyer and seller) must have the capacity to contract, proper consideration and mutual assent must be present to pass the title of goods and above all contract of sale to be enforceable must be in writing. Moreover, extensive care is needed to be exercised for differentiating true sales from what may appear to be as sales like bailment, sales contracts, consignments, etc.

Receivables are forms of investment in any enterprise manufacturing and selling goods on credit basis, large sums of funds are tied up in trade debtors. Hence, a great deal of careful analysis and proper management is exercised foreffectiveandefficientmanagementofreceivablestoensureapositivecontributiontowardsincreaseinturnoverandprofits.

Instruments indicating receivablesHarry Gross has suggested three general instruments in a concern that provide proof of receivables relationship. Theyarebrieflydiscussedbelow:Open book accountThis is an entry in the ledger of a creditor, which indicates a credit transaction. There is no evidence of the existence of a debt under the sales of goods.


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Negotiable promissory noteItisanunconditionalwrittenpromisesignedbythemakertopayadefinitesumofmoneytothebearer,ortoorderatafixedordeterminabletime.Promissorynotesareused,whilegrantinganextensionoftimeforcollectionofreceivables, and debtors are unlikely to dishonour its terms.

Increase in profitAs receivables will increase the sales, the sales expansion would favourably raise the marginal contribution proportionately more than the additional costs associated with such an increase. This in turn would ultimately enhancethelevelofprofitoftheconcern.

Meeting competitionA concern offering sale of goods on credit basis always falls in the top priority list of people willing to buy those goods.Therefore,afirmmayresortgrantingofcreditfacilitytoitscustomersinordertoprotectsalesfromlosingit to competitors. Receivables act as a means for attracting potential customers and retaining the older ones at the same time by weaning them away from the competitors.

Augment customer’s resourcesReceivables are valuable to the customers on the ground that it augments their resources. It is favoured particularly bythosecustomers,whofinditexpensiveandcumbersometoborrowfromotherresources.Thus,notonlythepresentcustomersbutalsothepotentialcreditorsareattractedtobuythefirm’sproductattermsandconditionsfavourable to them.

Speedy distributionReceivables play a very important role in accelerating the velocity of distributions. As a middleman would act quickly enough in mobilising his quota of goods from the productions place, for distribution without any hassle of immediate cash payment, as he can pay the full amount after affecting his sales. Similarly, the customers would hurry for purchasing their needful even if they are not in a position to pay cash instantly. It is for these, the receivables are regarded as a bridge for the movement of goods from production to distribution to the ultimate consumer.

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Start

Stop

Credit Sales

More Liquidity

Credit Sales

Retaining Present

Customers

Attracting Potential Creditors

Expansion of Sales

HigherProfitLevel

Quick Distribution

of Goods

Potentiality to face

Competition

Fig. 8.1 Flowchart showing the purpose of maintaining receivables

8.3 Cost of Maintaining ReceivablesReceivablesareatypeofinvestmentmadebyafirm.Likeotherinvestments,receivablestoofeatureadrawback,which are required to be maintained for long that it known as credit sanction. Credit sanction means tie-up of funds withnopurposecostingcertainamounttothefirm.Suchcostsassociatedwithmaintainingreceivablesaredetailedbelow: Administrative costIfafirmliberalisesitscreditpolicyforeithermaximizingsalesorminimizingerosionofsales,itincurstwotypesof costs:

Credit Investigation and Supervision Costs•As a result of lenient credit policy, there happens to be a substantial increase in the number of debtors. As a result,thefirmisrequiredtoanalyseandsupervisealargevolumeofaccountsatthecostofexpensesrelatedwith acquiring credit information either through outside specialist agencies or from its own staff.Collection Costs•Afirmwillhavetointensifyitscollectioneffortstocollecttheoutstandingbillsespeciallyincaseofcustomerswhoarefinanciallylesssound.Itincludesadditionalexpensesofcreditdepartmentincurredonthecreationandmaintenance of staff, accounting records, stationary, postage and other related items.

Capital costThereisnodenyingthatmaintenanceofreceivablesbyafirmleadstoblockageofitsfinancialresourcesduetothetie log that exists between the date of sale of goods to the customer and the date of payment made by the customer. But,thebitterfactremainsthatthefirmhastomakeseveralpaymentstotheemployees,suppliersofrawmaterialsandthelikeevenduringtheperiodoftimelag.Asaconsequence,afirmisliabletomakearrangementsformeetingsuchadditionalobligationsfromsourcesotherthansales.Thus,afirminthecourseofexpandingsalesthroughreceivables makes way for additional capital costs.


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Production and selling costThese costs are directly proportionate to the increase in sales volume. In other words, production and selling costs increasewiththeveryexpansioninthequantumofsales.Inthisrespect,afirmconfrontstwosituations;firstlywhen the sales expansion takes place within the range of existing production capacity. In that case, only variable costs relating to the production and sale would increase. Secondly, when the production capacity is added due to expansion of sales in excess of existing production capacity. In such a case, incremental production and selling costswouldincreasebothvariableandfixedcosts.

Delinquency costThis type of cost arises on account of delay in payment on customer’s part or the failure of the customers to make payments of the receivables as and when they fall due after the expiry of the credit period. Such debts are treated as doubtful debts. They involve:

Blockingoffirm’sfundsforanextendedperiodoftime,•Costs associated with the collection of overheads, reminders, legal expenses and on initiating other collection •efforts.

Default costSimilar to delinquency cost is default cost. Delinquency cost arises as a result of customers’ delay in payments of cashorhisinabilitytomakethefullpaymentfromthefirmofthereceivablesduetohim.Defaultcostemergesaresultofcompletefailureofadefaulter(customer)topayanythingtothefirminreturnofthegoodspurchasedbyhimoncredit.Whendespitealltheefforts,thefirmfailstorealisetheamountduetoitsdebtorsbecauseofhiscompleteinabilitytopayforthesame.Thefirmtreatssuchdebtsasbaddebts,whicharetobewrittenoff,asitcannot be recovered in any case.

8.4 Factors Affecting the Size of ReceivablesThe size of receivables is determined by a number of factors for receivables being a major component of current assets. As most of them vary from business to business in accordance with the nature and type of business, therefore, to discuss all of them would prove irrelevant and time-consuming. Some main and common factors determining the level of receivables are discussed below:

Stability of salesStability of sales refers to the elements of continuity and consistency in the sales. In other words, the seasonal nature of sales violates the continuity of sales in between the year. So, the sale of such a business in a particular season wouldbelargeneedingalargeasizeofreceivables.Similarly,ifafirmsuppliesgoodsoninstalmentbasis,itwillrequire a large investment in receivables.

Terms of saleAfirmmayaffectitssaleseitheroncashbasisoroncreditbasis.Asamatteroffact,creditisthesoulofabusiness.Italsoleadstohigherprofitlevelthroughexpansionofsales.Thehigherthevolumeofsalesmadeoncredit,thehigher will be the volume of receivables and vice-versa.

The volume of credit salesIt plays the most important role in determination of the level of receivables. As the terms of trade remains more orlesssimilartomostoftheindustries.So,afirmdealingwithahighlevelofsaleswillhavelargevolumeofreceivables.

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Credit policyForafirmpractisinglenientorrelativelyliberalcreditpolicyitssizeofreceivableswillbecomparativelylargethanthefirmwithmorerigidorstringentcreditpolicy.Itisbecauseoftwoprominentreasons:

Alenientcreditpolicyleadstogreaterdefaultsinpaymentsbyfinanciallyweakcustomersresultinginbigger•volume of receivablesAlenientcreditpolicyencouragesthefinanciallysoundcustomerstodelaypaymentsagainresultinginthe•increase in the size of receivables.

Terms of saleThe period for which credit is granted to a customer duly brings about increase or decrease in receivables. The shorter the credit period, the lesser is the amount of receivables as short-term credit ties the funds for a short period only. Therefore, a company does not require holding unnecessary investments by way of receivables.

Cash discountCash discount on one hand attracts the customers for payments before the lapse of credit period. In this system, a tempting offer of lesser payments is proposed to the customer, if he succeeds in paying within the stipulated period. On the other hand, it reduces the working capital requirements of the concern. Thus, decreasing the receivables management.

Collection policyThe policy, practice and procedure adopted by a business enterprise in granting credit, deciding as to the amount ofcreditandtheprocedureselectedforthecollectionofthesamealsogreatlyinfluencethelevelofreceivablesofa concern. The more lenient or liberal to credit and collection policies, the more receivables are required for the purpose of investment.

Collection collectedIfanenterpriseisefficientenoughinen-cashingthepaymentattachedtothereceivableswithinthestipulatedperiodgranted to the customer. Then, it will opt for keeping the level of receivables low. Whereas, enterprise experiencing undue delay in collection of payments will always have to maintain large receivables.

Bills discounting and endorsementIfthefirmoptsfordiscountingitsbillswiththebankorendorsingthebillstothethirdpartyformeetingitsobligations,it would lower the level of receivables required in conducting business.

Quality of customerIfacompanydealsspecificallywithfinanciallysoundandcreditworthycustomers,thenitwoulddefinitelyreceiveallthepaymentsinduetime.Asaresult,thefirmcancomfortablydowithalesseramountofreceivablesthanincase,whereacompanydealswithcustomershavingfinanciallyweakerpositions.

8.5 Principles of Credit ManagementJosephL.Woodisoftheopinion,“Thepurposeofanycommercialenterpriseistheearningofprofit,creditinitselfisutilisedtoincreasesales,butsalesmustreturnaprofit.”Theprimaryobjectiveofmanagementorreceivablesshould not be limited to expansion of sales but should involve maximisation of overall returns on investment. So, receivablesmanagementshouldnotbeconfinedtomerecollectionorreceivableswithintheshortestpossibleperiod,butisrequiredtofocusdueattentiontothebenefit-costtrade-offrelatingtonumerousreceivablesmanagement.

Inordertoaddprofitability,soundnessandeffectivenesstoreceivablesmanagement,anenterprisemustmakeitapointtofollowcertainwell-establishedanddulyrecognisedprinciplesofcreditmanagement.”Thefirstoftheseprinciplesrelatetotheallocationofauthoritypertainingtocreditandcollectionsofsomespecificmanagement.Thesecond principle puts stress on the selection of proper credit terms. The third principle emphasises a thorough credit investigation before a decision on granting a credit is taken. And the last principle touches upon the establishment of sound collection policies and procedures.”


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In the light of this quotation, the principles of receivables management can be stated as:Allocation or authorityTheefficiencyofacreditmanagementinformulationandexecutionofcreditandcollectionpolicieslargelydependupon the location of credit department in the organisational structure of the concern. The aspect of authority allocationcanbeviewedundertwoconcepts.Asperthefirstconcept,itisplacedunderthedirectresponsibilityofchieffinanceofficerforitbeingafunctionprimarilyfinancedbynature.Further,creditandcollectionpolicieslaydirectinfluenceonthesolvencyofthefirm.“Forthesereasons,thecreditandcollectionfunctionshouldbeplacedunderthedirectsupervisionoftheindividualswhoareresponsibleforthefirm’sfinancialposition.”“Thereareotherswhosuggestthatbusinessfirmsshouldstrictlyenforceupontheirsalesdepartmentstheprinciplesthatsalesare insolate until the value thereof is realised.

Those favouring this aspect plead to place the authority of allocation under the direct charge of the marketing executive or the sales department. To conclude, the reasonability to administer credit and collections policies may beassignedeithertoafinancialexecutiveortomarketingexecutiveortobothofthemjointlydependingupontheorganisationalstructureandtheobjectivesofthefirm.”

Selection of proper credit termsThe receivables management of an enterprise is required to determine the terms and conditions on the basis of which trade credit can be sanctioned to the customers. The nature of the credit policy of an enterprise is decided on the basisofcomponentsofthecreditpolicy.Thesecomponentsinclude;creditperiod,cashdiscountandcashdiscountperiod.Inpractice,thecreditpolicyoffirms,varywithintherangeoflenientandstringent.Afirmthattendstograntlongperiodcreditsanditsdebtorsincludeeventhosecustomerswhosefinancialpositionisdoubtful.Suchafirmissaidtobefollowinglenientcreditpolicy.Contrarytothis,afirmprovidingcreditsalesforarelativelyshortperiodoftimeonhighlyselectivebasisonlytothosecustomerswhoarefinanciallystrongandhaveproventheircredit worthiness is said to be following a stringent credit policy.

Credit investigationAfirmif itdesires tomaintaineffectiveandefficientreceivablesmanagementofreceivablesmustundertakeathorough investigation before deciding to grant credit to a customer. The investigation is required to be carried onwithrespecttothecreditworthinessandfinancialsoundnessofthedebtors,soastopreventthereceivablesfor falling into the category of bad debts later on at the time of collection. Credit investigation is not only carried onbeforehand.Butinthecaseoffirmspracticingliberalcreditpolicy,suchinvestigationmayberequiredtobeconducted when debtors fail to make payments of receivables due from him, even after the expiry of credit sale, so as to save doubtful debts from becoming bad debts.

Sound collection policies and proceduresReceivables management is linked with a good degree of risk. As a few debtors are slow payers and some are non-payers.How-so-everefficientandeffectiveareceivablesmanagementmaybe,theelementofriskcannotbeavoidedaltogether,butcanbeminimisedtoagreatextent.Itisforthisreason;theessenceofsoundcollectionpoliciesand procedures arise. A sound collection policy aims at accelerating collection from slow payers and reducing bad debts losses. As good collection polices ensure prompt and regular collection by adopting collection procedures in a clear-cut sequence.

8.6 Objectives of Receivable ManagementTheobjectiveofreceivablesmanagementistopromotesalesandprofituntilthatisreachedwherethereturnoninvestmentinfurtherfindingofreceivableislessthanthecostoffundsraisedtofinancethatadditionalcredit(i.e.,costofcapital).Theprimaryaimofreceivablesmanagementinminimisingthevalueofthefirmwhilemaintainingareasonablebalancebetweenrisk(intheformofliquidity)andprofitability.Themainpurposeofmaintainingreceivables is not sales maximisation or minimisation of risks involved by way of bad debts. Had the main objective been growth of sales, the concern would have opened credit sales for all sorts of customers. Contrary to this, if the aimhadbeenminimisationofriskofbaddebts,thefirmwouldnothavemadeanycreditsaleatall.Thatmeans,afirmshouldindulgeinsalesexpansionbywayofreceivablesonlyuntiltheextenttowhichtheriskremainswithinan acceptably manageable limit.

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All in all, the basic target of management of receivables is to enhance the overall return on the optimum level of investmentmadebythefirminreceivables.Theoptimuminvestmentisdeterminedbycomparingthebenefitstobe derived from a particular level of investment with the cost of maintaining that level. The costs involve not only the funds tied up in receivables, but also losses from accounts that do not pay. The latter arises from extending credit too leniently.

A brief inference of objectives of management of receivables may be given as under: To attain not maximum possible, but optimum volume of sales.•To exercise control over the cost of credit and maintain it on a minimum possible •level.•To keep investments at an optimum level in the form of receivables.•To plan and maintain a short average collection period.•

Granting of credit and its proper and effective management is not possible without involvement of any cost. These costs are credit administrative expenses bad debts losses, opportunity costs, etc. As mentioned before, these costs cannot be possibly eliminated altogether but should essentially be regulated and controlled. Elimination of such costs simplymeansreducingthecostofzero,i.e.,nocreditgrantispermittedtothedebtors.Inthatcase,firmwouldnodoubtescapefromincurringthecosts,yettheotherfaceofcoinwouldreflectthattheprofitsforegoneonaccountofexpectedriseinsalesvolumemadeoncreditamountswillbemuchmorethanthecostseliminated.Thus,afirmwould fail to materialise the objective of increasing overall return of investment. The period goal of receivables managementistostrikeagoldenmeanamongrisk,liquidityandprofitabilityturnsouttobeeffectivemarketingtool. It helps in capturing sales volume by winning new customers besides retaining to old ones.

8.7 Aspects of Credit PolicyThe discharge of the credit function in a company embraces a number of activities for which the policies have to be clearly laid down. Such a step will ensure consistency in credit decisions and actions. A credit policy thus, establishes guidelines that govern grant or reject credit to a customer, what should be the level of credit granted to a customer, etc. A credit policy can be said to have a direct effect on the volume of investment a company desires to make in receivables.

Acompanyfallspreytomanyfactorspertainingtoitscreditpolicy.Inadditiontospecificindustrialattributeslikethetrendofindustry,patternofdemand,paceoftechnologychanges,factorslikefinancialstrengthofacompany,marketing organisation, growth of its product, etc., also influence the credit policy of an enterprise.Certainconsiderations demand greater attention while formulating the credit policy like a product of lower price should be sold to customer bearing greater credit risk. Credit of smaller amounts results, in greater turnover of credit collection.Newcustomersshouldbe least favouredfor largecreditsales.Theprofitmarginofacompanyhasdirectrelationshipwiththedegreeorrisk.Theyaresaidtobeinter-woven.Since,everyincreaseinprofitmarginwould be counterbalanced by increase in the element of risk. As observed by Harry Gross, “Two very important considerations involved in incurring additional credit risks are, the market for a company’s product and its capacity to satisfy that market. If the demand for the seller’s product is greater than its capacity to produce, then it would be more selective in granting credit to its customers. Conversely, if the supply of the product exceeds the demand, the seller would be more likely to lower credit standards with greater risks.”

Such a conditionwould appear in case of a companyhaving excess capacity coupledwith high profitabilityandincreasedsalesvolume.Creditpolicyofeverycompanyisatlargeinfluencedbytwoconflictingobjectivesirrespectiveofthenativeandtypeofcompany.Theyareliquidityandprofitability.Liquiditycanbedirectlylinkedtobookdebts.Liquiditypositionofafirmcanbeeasilyimprovedwithoutaffectingprofitabilitybyreducingtheduration of the period for which the credit is granted and further by collecting the realised value of receivables as soonastheyfailsdue.Toimproveprofitability,onecanresorttolenientcreditpolicyasaboosterofsales,buttheimplications are: -

Changes of extending credit to those with weak credit rating.•Unduly long credit terms.•


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Tendencytoexpandcredittosuitcustomer’sneeds;and•Lack of attention to over dues accounts.•

8.8 Determination of Credit PolicyTheevaluationofachangeinafirm’screditpolicyinvolvesanalysisof:

Opportunity cost of lost contribution.•Credit administration cost and risk of bad debt losses.•

Optimumcreditpolicydoesnotmeanthepointatwhichbalancebetweenliquidityandprofitabilitycanbemaintained.Instead,anoptimumcreditpolicyisonethatmaximisesthefirm’sisachievedwhenmarginalrateofreturni.e.incremental rate of return on investment becomes equal to marginal cost of capital, i.e., incremental cost of funds usedtofinancetheinvestment.Theincrementalrateofreturnisobtainedbydividingincrementalinvestmentinreceivables.Theincrementalcostoffundsistherateofreturnexpectedbyfirmgrantingthecredit.Thisrateofreturnisnotequaltoborrowingrate.Asincaseoffirmfollowingloosecreditpolicy,higherrateofreturnmeanshigher risks to invest in A/c’s receivables due to slow paying and defaulting accounts.

Tosumup,inordertoachievethegoalofmaximisingthevalueofthefirmtheevaluationofinvestmentinreceivablesaccounts should involve the following four steps:

Estimationofincrementaloperatingprofit,•Estimation of incremental investment in accounts receivables,•Estimation of the incremental rate of return of investment,•Comparison of incremental rate of return with the required rate of return.•

Itisratheradifficulttasktoestablishanoptimumcreditpolicyasthebestcombinationofvariablesofcreditpolicyisquitedifficulttoobtain.Theimportantvariablesofcreditpolicyshouldbeidentifiedbeforeestablishinganoptimumcredit policy. The three important decisions variables of credit policy are:

8.8.1 Credit TermsCredittermsrefertothestipulationsrecognisedbythefirmsformakingcreditsaleofthegoodstoitsbuyers.Inotherwords,credittermsliterallymeanthetermsofpaymentsofthereceivables.Afirmisrequiredtoconsidervarious aspects of credit. Customers, approval of credit period, acceptance of sales discounts, provisions regarding the instruments of security for credit to be accepted are a few considerations which need due care and attention. Theselectionofcreditcustomerscanbemadeonthebasisoffirms’capacitytoabsorbthebaddebtlossesduringagivenperiodoftime.However,afirmmayoptfordeterminingthecredittermsinaccordancewiththeestablishedpractices in the light of its needs. The amount of funds tied up in the receivables is directly related to the limits of credit granted to customers. These limits should never be ascertained on the basis of the subjects’ own requirements. They should be based upon the debt paying power of customers and his ledger record of the orders and payments. There are two important components of credit terms which are detailed below:Credit periodAccording to Martin H. Seiden, “Credit period is the duration of time for which trade credit is extended. During this time, the overdue amount must be paid by the customers.” The credit period lays its multi-faced effect on many aspects,thevolumeofinvestmentinreceivables;itsindirectinfluencecanbeseenonthenetworthofthecompany.A long period credit term may boost sales, but it also increases investment in receivables and lowers the quality of trade credit. While determining a credit period, a company is bound to take into consideration various factors like buyer’srateofstockturnover,competitors’approach,thenatureofcommodity,marginofprofitandavailabilityof funds, etc.

Theperiodofcreditdiffersfromindustrytoindustry.Inpractice,thefirmsofsameindustrygrantvariedcreditperiodstodifferentindividuals.asmostofsuchfirmsdecideupontheperiodofcredittobeallowedtoacustomeronthebasisofhisfinancialpositioninadditiontothenatureofcommodity,qualityinvolvedintransaction,thedifferenceintheeconomicstatusofcustomersthatmayconsiderablyinfluencethecreditperiod.

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Thegeneralwayofexpressingcreditperiodofafirmistocoinitintermsofnetdate,thatis,ifafirm’scredittermsare “Net 30”, it means that the customer is expected to repay his credit obligation within 30 days. Generally, a free credit period granted, to pay for the goods purchased on accounts tends to be tailored in relation to the period required for the business and in turn, to resale the goods and to collect payments for them.

Afirmmaytightenitscreditperiod,ifitconfrontsfaultcasestoooftenandfearsoccurrenceofbaddebtlosses.Ontheotherside,itmaylengthenthecreditperiodforenhancingoperatingprofitthroughsalesexpansion.Anyhow,thenetoperatingprofitwouldincrease,onlyifthecostofextendingcreditperiodwillbelessthantheincrementaloperatingprofit.But the increase in sales alonewith extended credit periodwould increase the investment inreceivables too because of the following two reasons:

Incremental sales result into incremental receivables,i. The average collection period will get extended, as the customers will be granted more time to repay credit ii. obligation.

Determiningtheoptionsofcreditperiod,therefore,involveslocatingtheperiodwheremarginalprofitandincreasedsales are exactly off set by the cost of carrying the higher amount of accounts receivables.

Cash discount termsThecashdiscountisgrantedbythefirmtoitsdebtors,inordertoinducethemtomakethepaymentearlierthanthe expiry of credit period allowed to them. Granting discount means reduction in prices entitled to the debtors, so as to encourage them for early payment before the time stipulated, i.e., the credit period. According to Theodore N. Beckman,

“Cash discount is a premium on payment of debts before due date and not a compensation for the so called prompt payment.”Grantofcashdiscountbeneficialtothedebtorisprofitabletothecreditoraswell.Acustomerofthefirm,i.e., debtor would be realised from his obligation to pay soon at discounted prices. On the other hand, it increases theturnoverrateofworkingcapitalandenablesthecreditorfirmtooperateagreatervolumeofworkingcapital.Italso prevents debtors from using trade credit as a source of working capital.

Cash discount is expressed as a percentage of sales. A cash discount term is accompanied by (a) the rate of cash discount, (b) the cash discount period, and (c) the net credit period. For instance, a credit term may be given as “1/10 Net 30” that means a debtor is granted 1 percent discount, if he settles his accounts with the creditor before the tenth day starting from the day after the date of the invoice. But in case the debtor does not opt for discount, he is bound to terminate his obligation within the credit period of thirty days.


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Change in cash discount can either have positive or negative implication and at times both. Any increase in cash discount would directly increase the volume of credits sale. As the cash discount reduces the price of commodity for sale, the demand for the product ultimately increases leading to more sales. On the other hand, cash discount lures the debtors for prompt payment, so that they can relish the discount facility available to them. This in turn reduces the average collection period and bad debt expenses thereby, bringing about a decline in the level of investment in receivables.Ultimately,theprofitswouldincrease.Increaseindiscountratecannegativelyaffecttheprofitmarginper unit of sale due to reduction of prices. A situation exactly reverse of the one stated above will occur in case of decline in cash discount.

AspointedoutbyN.K.Agarwal,“wemarketproductsthroughestablisheddealers.Ifsometimespaymentisnotreceived within the credit period, it is just not possible to deny discount as it would spoil business relations.” Yet, the management of business enterprises should always take note of the point that cash discount, as a percentage ofinvoiceprices,mustnotbehighastohaveanuneconomicbearingonthefinancialpositionoftheconcern.Itshould be seen in this connection that terms of sales include net credit period, so that cash discount may continue toretainitssignificanceandmightbepreventedfrombeingtreatedbythebuyersjustlikequantitydiscount.Tomake cash discount an effective tool of credit control, a business enterprise should also see that it is allowed to onlythosecustomerswhomakepaymentsatduedate.Andfinally,thecredittermsofanenterpriseonthereceiptof securities while granting credit to its customers. Credit sales may be secured by furnishing instruments such as trade acceptance, promissory notes or bank guarantees.

8.8.2 Credit StandardsCreditstandardsrefertotheminimumcriteriaadoptedbyafirmforthepurposeofshortlistingitscustomersforextension of credit during a period of time. Credit- rating, credit reference and average payments provide a quantitative basisforestablishingandenforcingcreditstandards.Thenatureofcreditstandardfollowedbyafirmcanbedirectlylinked to changes in sales and receivables. In the opinion of Van Home, “There is the cost of additional investment in receivables, resulting from increased sales and a slower average collection period.”

Aliberalcreditstandardalwaystendstopushupthesalesbyluringcustomersintodealings.Thefirm,asaconsequencewould have to expand receivables investment along with sustaining costs of administering credit and bad-debt losses. A liberal extension of credit may cause certain customers to be less conscientious in paying their bills on time. Onthecontrary,strictcreditstandardswouldmeanextendingcredittofinanciallysoundcustomersonly.Thissavesthefirmfrombaddebtlossesandthefirmhastospendlesserbyawayofadministrativecreditcost.But,thisreducesinvestmentinreceivablesbesidesdepressingsales.Inthisway,profitsacrificedbythefirmonaccountoflosingsalesamountsismorethanthecostssavedbythefirm.

Prudently,afirmshouldoptforloweringitscreditstandardsonlyuptothatlevel,whereprofitabilityarisingthroughexpansion in sales exceeds various costs associated with it. That way, optimum credit standards can be determined and maintained by inducing trade-off between incremental returns and incremental costs.

8.8.3 Collection PolicyCollectionpolicyreferstotheproceduresadoptedbyafirm(creditor)incollectingtheamountsfromitsdebtors,whensuchamountbecomesdueaftertheexpiryofcreditperiod.R.K.MishraStates,“Acollectionpolicyshouldalways emphasise promptness, regularity and systematisation in collection efforts. It will have a psychological effectuponthecustomers,inthat;itwillmakethemrealisetheobligationofthesellertowardstheobligationsgranted.” “The requirements of collection policy arises on account of the defaulters, i.e., the customers not making the payments of receivables in time. Some turns out to be, slow payers and some others, non-payers. A collection policy shall be formulated with a whole and sole aim of accelerating collection from bad-debt losses by ensuring prompt and regular collections.

Regularcollectionononehandindicatescollectionefficiencythroughcontrolofbaddebtsandcollectioncostsas well as by inducing velocity to working capital turnover. On the other hand, it keeps debtors alert in respect of prompt payments of their dues. A credit policy is needed to be framed in the context of various considerations like

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short-term operations, determinations of level of authority, control procedures, etc. Credit policy of an enterprise shall be reviewed and evaluated periodically and if necessary amendments shall be made to suit the changing requirements of the business.

It should be designed in such a way that it co-ordinates activities of concerned departments to achieve the overall objective of the business enterprises. Finally, poor implementation of good credit policy will not produce optimal results.

8.9 Collection of Accounts ReceivablesDespiteafirm’sbestprecautionaryeffortsinescapingthebadanddoubtfuldebts,therealwaysexistsacertainnumber of unpaid accounts on the due date. Three well-known causes of failure of such payments on the part of debtors(i.e.,firm’scustomer)canbecitedas:

It may happen at times that the due date of payment slips from debtor’s mind and he delays in making good •the payments at the right time.Itmayincidentallyoccuratthetimeofgrantofcreditthatafirmfailstoaccessandinterpretthecharacter,•capacity, capital, collateral and conditions correctly and appropriately.Theremayariseaconsiderablechangeinthefinancialpositionofadebtorafterthecredithasbeengrantedto•himbythefirm.

Alltheabovestatedreasonscompelafirmtoformulateacollectionprogrammetoobtainrecoveryorreceivablesfrom delinquent account. Such programme may consist of following steps:

Monitoring the state of receivables.•Dispatch of letters to customers whose due date is near.•Telegraphic and telephone advice to customers around the due date.•Threat of legal action to overdue accounts, and•Legal actions against overdue accounts.•

8.9.1 Types of Collection EffortsA well-established collection policy always attempts at enlisting clear-cut guidelines in order of a sequence, that too in precise terms for collection overdue from the customers. As a cord of suggestion, the sequence adopted must becapableofbringingeffectivenessandefficiencyincollectionpolicy.Forinstance,ifthecreditperiodgrantedtothecustomerlapsesandhedoesnotpay.Thefirmshouldbeginwithapoliteletterofreminderreflectingdemandofpayment.Thismaybefollowedbytelegramortelephoneorevenapersonalvisitbyfirm’srepresentative.Afterthat,afirmmayproceedforlegalaction,iftheamountofreceivableswillremainsunpaid.Itshouldbenotedthatas an account becomes more and more overdue, the collection efforts become more personal and strict. But before initiatinganylegalaction,thefinancialpositionofthedebtormustbeconsidered.Alegalactionagainstacustomer,whobearsawearfinancialconditionwouldbeofnogoodtothefirm,insteadwillcausecustomers’bankruptcyreducing the chance of even a marginal amount of payment. Thus, a concern should face such a situation with patience and try to settle the account by accepting a reduced payment.

8.9.2 Degree of Collection EffortsThe efforts on collection policy can be better explained by categorising the collection efforts of a company as strict, liberal and lenient. Strict collection policy is characterised by debtor’s payment on or before the due date. As a result,manytimesdebtorbenefitshimselfwithcashdiscount.Whereas,alenientpolicyisfeaturedbydefaultersinpayments of receivables, forfeiture of cash discount, etc.

A rigorous collection policy shortens the average collection period, pulls down sales and bad-debt percentage along with increasing collection expenses. A relaxed collection programme would push up sales and bad-debts percentage, lengthen the average of collection period and reduce collection expenses but enhances credit administrative cost.


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Aconcernmustmakeuseoffinancialdefaultandriskanalysis;itiswillingtofavourliberalcreditpolicy.Similarly,afirmcanhelpbeingcautiouswhileadoptingstrictcollectionpolicyfor,itmayoffendtiecustomersforcingthemto switch over to the competitors.

Betweenthetwoextremesofrigorousandsoftcollectionpolicies,therealsoexistsflexiblecollectionpolicy,whichinvolves reminding the customers through correspondence before the due date. Optimum collection policy may be achievedbycomparingcostsandbenefits,whichwillbeconsistentwiththegoalofattainingmaximumvalueofthefirm.

8.9.3 Collection Follow-Up SystemTheelementofregularityisalwaysdesiredincollectionefforts,whichprimarilydependsupontwopre-requisites;thedevelopment of a suitable system of collection and the establishment of a congenial collection follow-up system.

As far as development and adoption of suitable collection period is concerned, it varies from industry to industry orattimesfromfirmtofirm.Thereforeacongenialcollectionfollow-upsystemcanbeestablishedthroughvariouspractices. Some of them are mentioned below:Accounts receivable reportThis device is regarded as highly useful in timely collections of receivables from debtors. It makes a successful attempt atkeepingakeeneyeoveralmostalloutstandingaccountsofthefirm.Hence,enablingafirmtoinitiateappropriateand timely measure against defaulters as per the guidelines framed by the collection policy of a concern,

Ledger plan or card tickler systemIn order to establish a sound collection follow-up system, ledger plan of the collection follow-up system is based on the creditor‘s ledger record. The card tickler system involves maintenance of cards in the name of each delinquent fileddatewiseinapropersequence.Thecardspecifiesinformationregardingtheamount,termsduedate,collectionactions taken so far, etc., at length in detail.

Computer and credit managementOf late, the use of computers has also come in vogue for the purpose or credit management. Computer helps a great deal in availing essential up-to-date information. For a quick access to various sorts of information, all information previously placed on receivable ledger can be placed on punched cards or tapes. Computer can also provide report on summary of all billings, payments, discount taken, amount still owned, etc. In addition to this, complete report ondelinquentaccountscanbeobtainedalongwithtimelyandaccurateinformationregardingthefiveCsofthecustomer.

Further, special reports can be prepared for a particular span of period supplemented with categorisation and comparison of customer as well as adopted credit policies.

8.10 Credit ControlCredit control is a complex process, which costs both time and administrative costs. Broadly, speaking, the function of credit control incorporates the following elements:Checking customers credit worthinessThis step relates to applicant’s ability to pay for the goods or services opted by him. The decision pertaining to credit grantanditsvolumelargelydependsuponthisassessment.Theassessmentcanbedoneonthebasisoffinancialsoundness, general behaviour, past records, business habits and traits. Trade reference, banker’s records available with the geriatric, etc. are a few of certain elements that provide relevant information for conducting this assessment.

Prompt invoicing and follow-upThis is an executive action involving prompt issue of invoice and equally close follow-up action. A continuous personal attention is required for reviewing amounts of bills receivables. Methods are selected among the various possible alternatives available to ensure that the time period is the least between realisation of payments and converting it into bank’s credit account.

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Credit insuranceThis point pertains to credit exports. As credit sales do not fall under any credit insurance policy coverage in India, it is export credit guarantee department, which formulates appropriate rules and issues credit insurance policies for exports on payments of a nominal premium. These facilities are of high importance for credit control of exports.

Financial statementsFinancial statement is an important document that presents desirable sources of information to the seller regarding thefinancialpositionofcustomerforcreditcontrol.For thecompaniescarryingoutseasonalbusiness, interimstatementsinsteadoffinancialstatementsarepreferred.Foracquiringauthenticatedinformation,auditedfinancialstatementsshouldbefavouredratherthanunauditedfiguresenclosingpossibilityoffraud.

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

8.11 Control of ReceivablesControl of receivables largely depends upon the system of credit control practiced by a business enterprise. It becomes a part of organisation’s obligation to obtain full and relevant information complete in all respects before deciding upon the right customer for the right amount of credit grant. Whenever an order is placed by an applicant, financialpositionandcreditworthinessbecomeessential.Onlyafterensuringthedegreeofsafety,anordershouldbe accepted and delivered.

Afirmisexpectedtopreparesalesinvoiceandcreditnotesasearlyaspossible;sidebyside,itshouldalsoensurethattheyaredispatchedatspecifiedregularintervalsforeffectivecontrolofreceivables.Itisalwaysconsideredgoodonthepartofthefirmtokeepaseparateledgerfortheaccountsofbadanddoubtfuldebtors.Suchsegregationnotonly helps in easy assessment of the position of bad and doubtful debtors in relation to the total debtor’s position. A considerable amount of reduction in debtors can be achieved by offering cash discount to the customers.

Even in case of export sales, segregation of credit sales into separate ledger adds effectiveness to control of receivables. Sometimeslargecontracts,payablebyinstalments,involvecreditforseveralyears.Thepricefixedinthesecasesshouldbesufficientlyhighnotonlytocoverexportcreditinsurance,butalsotocoverasatisfactoryrateofintereston the diminishing balances of debt expected to the outstanding during the credit period.

Therearetwomethodsofcontrollingaccountsreceivables,whicharetraditionalinnature;dayssalesoutstandingandageingschedule.Thoughtheyarepopularlyused,theysufferfromaseriousdeficiency.Boththesemethodsare based on aggregation of sales and receivables due to which the changes in the pattern of payment cannot be easilydetected.Inordertoovercomethisdrawbackoftraditionalmethods,afirmcanmakeuseofpaymentspatternapproach.

8.11.1 Payment Pattern ApproachThe payment pattern approach is the key issue in controlling accounts receivables as it focuses on payment behaviour. This approach is pioneered by B.R. Stone. W.G. Lewellen and R.W. Johnson. Pattern of payments are expressed mostly in terms of proportions and at times as percentage. In general:

Pi=P0+ PO+ P2+ P3+ ........................ ...Pn

Here, Pi represents the proportion of credit sales paid in T month and “n” is the payment horizon. And also,

Po+ P2+ P3+•..........................Pn=1


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This is the payment pattern which is related to receivables pattern given as where, ‘Ri’ represents the receivables collected at the end of T months and ‘n-V denotes the horizon. Aggregating the receivables and payments, we obtain:

Ri=1-(P0+ PO+ P2+ P3+ .........Pn +Pi

A conversion matrix is prepared to show the credit sales in each month relating it to the pattern of collection associated with it. The payment pattern approach is dependent of sales level. It simply involves matching collections and receivables to sales in the month or origin. As a result, this approach is free from the limitation observed in traditional methods. Moreover, this method is capable of presenting payment pattern on monthly basis as against combined sales and payment patterns. The main drawback, which we come across in this method, is that conversion matrix cannot bepreparedonlyonthebasisofpublishedfinancialstatementsliketraditionalmethods;italsorequiresinternalfinancialdata.Stillpaymentpatterndoesnotrequireasthedataasrequiredincaseofageingschedulemethod.

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SummaryManagement of trade credit is commonly known as management of receivables.•Receivables are one of the three primary components of working capital, the other being inventory and cash.•Trade credit is an important market tool, as it acts like a bridge for mobilization of goods from production to •distributionstagesinthefieldofmarketing.Receivables, as are forms of investment in any enterprise manufacturing and selling goods on credit basis, large •sums of funds are tied up in trade debtors.Thecustomerwhorepresentsthefirm’sclaimorassets,fromwhomreceivablesorbook-debtsaretobecollected•in the near future, are known as debtors or trade debtors.As sale of goods is a contract, receivables too get affected in accordance with the law of contract.•A concern offering sale of goods on credit basis always falls in the top priority list of people willing to buy •those goods.Receivables act as a bridge attracting potential customers and retaining the older ones at the same time by •weaningthemawayfirmthecompetitors.Receivables are valuable to the customers on the ground that it augments their resources.•Receivables play a very important role in accelerating the velocity of distributions.•Creditsanctionmeanstieupoffundswithnopurposetosolveyetcostingcertainamounttothefirm.•Delinquency cost arises as a result of customers’ delay in payments of cash or his inability to make the full •paymentfromthefirmofthereceivablesduetohim.The size of receivables is determined by a number of factors for receivables being a major component of current •assets.Stability of sales refers to the elements of continuity and consistency in the sales.•The primary objective of management or receivables should not be limited to expansion of sales but should •involve maximisation of overall returns on investment.The receivables management of an enterprise is required to determine the terms and conditions on the basis of •which trade credit can be sanctioned to the customers are of vital importance for an enterprise.A sound collection policy aims at accelerating collection from a slow payer and reducing bad debts losses.•As good collection polices ensure prompt and regular collection by adopting collection procedures in a clear-•cut sequence.The main purpose of maintain receivables is not sales maximisation or minimisation of risk involved by way •of bad debts.Thegoalofreceivablesmanagementistostrikeagoldenmeanamongrisk,liquidityandprofitability.Itisan•effective marketing tool.The discharge of the credit function in a company embraces a number of activities for which the policies have •to be clearly laid down.Credit period is the duration of time for which trade credit is extended. During this time, the overdue amount •must be paid by the customers.Collectionpolicyreferstotheproceduresadoptedbyafirm(creditor)tocollecttheamountfromitsdebtors•when such amount becomes due after the expiry of credit period.A credit policy is needed to be framed in the context of various considerations like short-term operations, •determinations of level of authority, control procedures, etc.Credit control is a complex process, which costs both time and administrative costs.•


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ReferencesAnalysis of Receivable Management• [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf>[Accessed12July2013].ImpactofreceivablesmanagementonworkingcapitalandProfitability• [Pdf] Available at: < http://shodhganga.inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf>[Accessed12July2013].Salek, J.G., 2005. • AccountsReceivableManagementBestPractices. Wiley.Brigham, E.F. and Ehrhardt, M.C., 2010. • Financial Management: Theory & Practice, 13th ed., Cengage Learning.AccountsReceivable andUncollectibleAccounts• [Video online] Available at: <http://www.youtube.com/watch?v=Gg2_BO61sVk>[Accessed12July2013].AccountsReceviableLecture• [videoonline]Availableat:<http://www.youtube.com/watch?v=DkFsfdNG93w>[Accessed 12 July 2013].

Recommended ReadingSagner, J., 2010. • Essentials of Working Capital Management. Wiley.Madura, J., 2011. • International Financial Management. 11th ed., Cengage Learning.Bukics, R.L. and Loven, W.T., 1987. • TheHandbookofCreditandAccountsReceivable. Probus Pub Co.

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Self AssessmentWhatismanagementoftradecreditalsoknownas?1.

Managementoffinancea. Management of cashb. Management of receivablesc. Managementofcashflowd.

__________________provideprotectiontosalesfromcompetitions.2. Receivablesa. Trade creditb. Debt owedc. Traded.

Whichofthefollowingisnotoneofthedimensionsofbook-debtsorreceivablesarisingoutofcredit?3. It involves an element of risk.a. It is based on daily trade sales.b. It is based on economics value.c. It implies futurity.d.

_______________________areamountsowedtothebusinessenterprise,usuallybyitscustomers.4. Accounts receivablesa. Trade creditb. Open book accountc. Assets accountd.

__________________meanstieupoffundswithnopurposetosolveyetcostingcertainamounttothefirm.5. Administrative costa. Credit investigationb. Supervision costc. Credit sanctiond.

____________________costsaredirectlyproportionatetotheincreaseinsalesvolume.6. Delinquency a. Capitalb. Production and sellingc. Defaultd.

Whichofthefollowingisnotthefactorthatdeterminesthelevelofreceivables?7. Stability of salesa. The volume of credit salesb. Credit policyc. Trade policyd.


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Thepurposeofany_________________istheearningofprofit,creditinitselfisutilisedtoincreasesale,but8. salesmustreturnaprofit.

commercial enterprisea. financialmanagementb. credit managementc. collection policyd.

A_______________policyaimsatacceleratingcollectionformslowpayerandreducingbaddebtslosses.9. currenta. creditb. sound collectionc. collectiond.

__________________referstothestipulationsrecognisedbythefirmsformakingcreditsaleofthegoodsto10. its buyers.

Credit perioda. Credit discountb. Credit termsc. Cash discountd.

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Case Study I

iPhone Inventory Management

IntroductionWhen Steve Jobs announced the new revolutionary mobile communication in his Macworld presentation, iPhone was judged as a triumph of design and functionality, not to mention its X-factor. Similar to other hot electronic products, such as Xbox, PS3, Wii, etc., – analysts expected big shortages when the iPhones would go for sale across counters, but that didn’t happen, instead iPhone turned out to be the triumph of inventory management along its supply chain.

Selling 270,000 iPhones in 30 hours of transaction, a million units in 3 months, and 3.75 million units in 6 months showthemeticulousplanningofitsinventorycontrolandmanagementalongitsentiresupplychain.Keytothissuccess was:

Choosing right suppliers and partners•Establishing synchronisation in the value delivery chain•

Choosing Right Suppliers and PartnersChoosing the hardware suppliers from USA, China, Taiwan, Japan, etc., worked out in Apple’s favour. They •were able to manufacture the iPhone initially at $200-220 per set including distribution cost. They sold over a millionunitsat$499-599shootingtheirprofitsto$6.22billion.Applethenwasabletobringdownthepricesbyalmost40%andyetgeneratehugeprofitsbyincreasingthevolumeto3.75millionunits,throughstablesupply chain management in 6 monthsSelecting AT&T for distribution was a strategic move. The buyers were committed a 3-minute activation time, •and customers were offered across-the-counter activation for those who buy them at the AT&T storesFedex Express was another strategic partner who ensured smooth distribution of products from China to US, •and to distribute those products to individual stores on time, just few hours before the launch time of 6 PMThey partnered with Yahoo!, Google, Flicker, etc., for the applications that were relevant to the US market•

Establishing Synchronisation in the Inventory ChainA value inventory chain consists of suppliers, production, distribution, partners, etc. Typically every single step •where some value is added from production to consumption of the product.First, the communication layer was synchronised, and all the partners and suppliers shared a single version of •the truth. The market research data was shared with its suppliers along with its management’s goal in terms of the number of units to be sold each month. This enabled the partners to plan their capacity and production well in advance.The assemblers of the product in China had manufactured the expected quantities well before the launch dates. •The distributors had it sent to US a whole week before the products were to be sold. The goods were sent to the retailers few hours before the lunch break so that stores could close and reopen at 6 PM to prepare for sales till midnight.Retailers had also made some changes with respect to merchandising the products. iPhones were sold near the •entrance area of the shop.

Bringing together all these components .and synchronising helped a historical launch of this product resulted in exceedingtheexpectedsalesduringthefirstfewdaysofthelaunch.

(Source:iPhone:Abestcasestudyofefficientinventorymanagement[Online]Availableat:<http://scienceofbusiness.wordpress.com/2009/08/26/iphone-a-best-case-study-of-efficient-inventory-management/> [Accessed 16 July2013]).


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QuestionsWhatwasthereasonofsuccessofiPhonemobile?1. AnswerThe key to the success of iPhone was:

Choosing right suppliers and partners•Establishing synchronisation in the value delivery chain•

Whatdoesvalueinventorychainconsistsof?2. AnswerThe value inventory chain consists of suppliers, production, distribution, partners, etc.

Howwassynchronisationintheinventorychainestablished?3. AnswerThe synchronisation in the inventory chain was established as:

First, the communication layer was synchronised, and all the partners and suppliers shared a single version •of the truth. The market research data was shared with its suppliers along with its management’s goal in terms of the number of units to be sold each month. This enabled the partners to plan their capacity and production well in advance.The assemblers of the product in China had manufactured the expected quantities well before the launch •dates. The distributors had it sent to US a whole week before the products were to be sold. The goods were sent to the retailers few hours before the lunch break so that stores could close and reopen at 6 PM to prepare for sales till midnight.Retailers had also made some changes with respect to merchandising the products. iPhones were sold near •the entrance area of the shop.

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Case Study II

Indian Capital Market

Company ProfileAmajorfinancialservicescompanybasedinJapan,providingknowledgeandITsolutionsforfinancialbusinessworldwide. Anshinsoft has been a very key strategic outsourcing partner for design and development of a comprehensiveback-officeITsolution.

Business SituationIndian capital market systems have evolved to be at par with the advanced systems of the world in the last 10 years. Business process, functionality, monitoring/regulating mechanisms, hardware, software, etc., are all revamped to compete with the global leaders. With the internal systems and monitoring mechanism properly in place, the time is ripe for India to join itself to the global capital market network. At present, India stands in the door step of full convertibility of the Indian Rupee in capital account. Cross border trading in the securities market is a very bright possibility in the near future.

One major customer of the IT solution provider, a leading securities broker based in Japan, has shown keen interest in venturing into the Indian Capital Market. The company has asked Anshinsoft to provide a very high level overview of the Indian Secondary market.

Technical SituationsThe IT solution provider has been looking for credible market research in the Indian capital market space, keeping in mind that their end-customer has shown keen interest in venturing into the Indian market in near future. Getting anoverviewofthemarketisextremelyimportant–sinceeventuallythebrokeragefirmwouldliketousethesameback-officesolutionwhileoperatingintheIndianmarket.Theinitialoverviewdocumentisasteppingstonetowardslarge scale gap analysis of their existing solution.

SolutionAnshinsoft delivered a very high level overview of the Indian Secondary Market with emphasis on the following areas:

Keysecondarymarketintermediaries•Trading and settlement systems •Settlement cycle•Legal framework of the securities market•Typicalactivityflowanddownloadablereportsforabrokerfirm•KeyIndianvendorsinthesecuritiesmarketproductspace•

BenefitsEven though lots of information and market research documents are available in today’s world, the company specificallyselectedAnshinsofttoprepareareportthatobjectivelyanswerswhattheyhavebeenlookingfor.TheywereextremelysatisfiedwiththereportthatAnshinsoftpreparednotonlydiditcoverthemajorareasoftheIndiansecondarymarket,butitalsoprovidedinformationthatarespecifictotheIndianmarketinparticularsothattheycouldspottheoperationaldifferencesquiteearly.Also,beingthelong-termbackofficesolutiondevelopmentpartnerof the same company, Anshinsoft could highlight important gaps in their existing solution having known the fact that they would eventually customise and deploy the solution for Indian operations as well. The report encouraged their senior management to conduct a detailed gap analysis of the existing solution, where Anshinsoft will be one of the key partners.


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Services UsedAnshinsoft solely relied on the experience and expertise of its own business analysts and market experts to prepare the report. Public market data available in the internet was included for reference purpose.

(Source:SecuritiesTradingBackOfficeSolutionsOverview[Online]Availableat:<http://www.anshinsoft.com/files/Back_Office_Solutions_Case_Study.pdf>[Accessed7August2013]).

QuestionsHowisthecurrentscenarioofIndiancapitalmarketsystemexplained?1. WhoisshowingkeeninterestinventuringintotheIndiancapitalmarket?2. WhatisthehighleveloverviewoftheIndiansecondarymarketmentionedabove?3.

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Case Study III

Accounts Receivables Management and Medical Billing

The CustomerAn Urgent Care practice in Maryland

The ChallengeO2I was initially approached by the clinic to take care of Account Receivables Management. The client was also facing a problem on the billing side like:

The billing was not completed within 24 hours•Steep decrease in collections•Poor quality of work done by in-house billers•

TheClientwantedtohandoverthebillingsidetousin2monthsifhegetssatisfiedwithourabilityontheARManagement (we did a good job and the owner of the clinic handed over the billing part as promised).

We had to use a new software namely AdvancedMD for carrying out the operations. We got cross-trained over phone on the practice management software.

The Project:To provide Full Service Billing.•To handle average of 700 claims every month•

The SolutionThe following measures were taken to improve collections and productivity:

A dedicated account manager and team were deputed to handle the clients account•The team consisted of full-time employees for medical billing, medical coding and an AR expert•Evolved a medical billing process and an AR process to make sure that billing takes place within 24 hours•Follow-up on denied claims•Address issues with insurance company and get them resolved•Maintain knowledge base of issues and solutions•

The ResultsBy outsourcing their medical billing functions to O2I, the CLIENT was able to:

Witness that the average AR days were brought down from 34 to 23 days within 6 months•Witness that the collection percentage increased from 53% to 61% within 6 months•Havesignificantimprovementinthecashflowasaresultofincreaseincollectionratios•Concentrateonpatientcareandseemorepatients,withtheavailabilityofmoretime,andaclutterfreeoffice•Decreaserelianceonemployeesandeliminatefluctuationsassociatedwithbackloggedclaimsandemployee•turnoverIncreaseoperatingefficiencyandreduceadministrativecosts•

(Source: CaseStudyonAccountsReceivablesManagement&MedicalBilling [Online] Available at: <http://www.outsource2india.com/Healthcare/success_stories/ar-management-billing.asp>[Accessed16July,2013]).

QuestionsWhatwastheproblemfacedbyO2I?1. Whatwerethemeasurestakentoimprovecollectionsandproductivity?2. Whatwasthesoftwareusedtocarryouttheaccountreceivablemanagementproject?3.


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Bibliography

ReferencesAccountsReceivable andUncollectibleAccounts.• [Video online] Available at: http://www.youtube.com/watch?v=Gg2_BO61sVk>[Accessed12July2013].AccountsReceviableLecture.• [videoonline]Availableat:<http://www.youtube.com/watch?v=DkFsfdNG93w>[Accessed 12 July 2013].Analysis of Cash Management.• [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/723/12/12_chapter%207.pdf> [Accessed 12 July 2013].Analysis of Receivable Management.• [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf>[Accessed12July2013].Balances of Cash And The Firm Value.• [Pdf] Available at: <http://www.euba.sk/department-for-research-and-doctoral-studies/economic-review/preview-file/er1_2009_michalski-10131.pdf>[Accessed12July2013].Bragg, S.M., 2011. • InventoryBestPractices. 2nd ed., Wiley.Bragg. S.M., 2012. • Corporate Cash Management. Accounting Tools.Brigham, E.F. and Ehrhardt, M.C., 2010. • Financial Management: Theory & Practice. 13th ed., Cengage Learning.Cashflowandfinancialplanning.• [Pdf] Available at: <http://wps.aw.com/wps/media/objects/222/227412/ebook/ch03/chapter03.pdf> [Accessed 12 July 2013].Cash management.• [Online] Available at: <http://www.investopedia.com/terms/c/cash-management.asp> [Accessed 12 July 2013].CFALevelICashFlowStatement.• [Videoonline]Availableat:<http://www.youtube.com/watch?v=hkcOqTNPiTo>[Accessed 12 July 2013].Chap 17 Lecture: Statement of Cash Flows.• [Video online] Available at: <http://www.youtube.com/watch?v=M7xhaJVx-WE>[Accessed12July2013].Financial Management - Lecture 05.• [Video online] Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>[Accessed12July2013].Financial Management.• [Video online]Available at: <http://www.youtube.com/watch?v=aiduHQMrd88>[Accessed 12 July 2013].Financial Management.• [Video online]Available at: <http://www.youtube.com/watch?v=oCH1Ll7riDQ>[Accessed 12 July 2013].Financial Management: Lecture 4.• [Videoonline]Availableat:<http://www.youtube.com/watch?v=ZRE1glkq9zA>[Accessed 12 July 2013].Financial Markets and Products.• [Videoonline]Availableat:<http://www.youtube.com/watch?v=y_ti1PXDnLE>[Accessed 12 July 2013].Financial system.• [Online]Available at: <http://www.slideshare.net/chotu30/financial-system-11563132>[Accessed 12 July 2013].ImpactofreceivablesmanagementonworkingcapitalandProfitability• [Pdf] Available at: < http://shodhganga.inflibnet.ac.in/bitstream/10603/723/11/11_chapter%206.pdf>[Accessed12July2013].InventoryManagement - An Introduction.• [Video online] Available at: <http://www.youtube.com/watch?v=qkZQxXJuqKo>[Accessed12July2013].InventoryManagement.• [Online] Available at: <http://www.termpaperwarehouse.com/essay-on/4-3-1-Template-Managers-Report/158537 > [Accessed 12 July 2013].Inventory Management Best Practices.• [Video online] Available at: <http://www.youtube.com/watch?v=C8Z3IApWCNQ>[Accessed12July2013].Jones, E.B. and Jones, E.B., 2001. • Cash Management. R&L Education.Jury, T., 2012. • CashFlowAnalysisandForecasting, Wiley.

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Money Market and its Instruments.• [Pdf]Availableat:<http://www.caalley.com/art/Money_Market_and_Money_Market_Instruments.pdf>[Accessed12July2013].Money Markets and Capital Markets.• [Videoonline]Availableat:<http://www.youtube.com/watch?v=nv0a0GEc-4s> [Accessed 12 July 2013].Muller, M., 2011. • EssentialsofInventoryManagement. 2nd ed., AMACOM.Preparing aCashFlowForecast.• [Online]Available at: <http://www.qfinance.com/contentFiles/QF02/g1xqynvv/12/1/preparing-a-cash-flow-forecast.pdf>[Accessed12July2013].Preve, L. And Allende, V.S., 2010. • Working Capital Management. Oxford University Press, USA.Ramsey, D., 2009. • The TotalMoneyMakeover:AProvenPlan forFinancial Fitness. 3rd ed., Thomas Nelson.Ritter, L.S. and Silber, W.L., 2008• . Principles of Money, Banking & Financial Markets. 12th ed., Prentice Hall.Sagner, J., 2010. • Essentials of Working Capital Management. Wiley.Salek, J.G., 2005. • AccountsReceivableManagementBestPractices. Wiley.Tennent, J., 2012. • Guide to Cash Management. Wiley.Thau, A., • The Bond Book. 3rd ed., McGraw-Hill.TheImportanceofInventoryManagement• .[Online]Availableat:<http://www.southernfulfillment.com/articles/order-fulfillment/inventory-management/the_importance_of_inventory_management.htm>[Accessed12July2013].Ward, M.A. and Sagner, J., 2003. • Essentials of Managing Corporate Cash. Wiley.Work capital Analysis.• [Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/705/13/14_chapter5.pdf> [Accessed 12 July 2013].WORKINGCAPITAL.• [Online] Available at: <http://www.scribd.com/doc/24525667/Working-Capital-analysis> [Accessed 12 July 2013].Working capital Management.• [Videoonline]Availableat<http://www.youtube.com/watch?v=KQWe-2G23kw>[Accessed 12 July 2013].Working Capital Management Principal and Approaches.• [Video online] Available at <http://www.youtube.com/watch?v=zJCiEIqAxbs>[Accessed12July2013].

Recommended ReadingBukics, R.L. and Loven, W.T., 1987. • TheHandbookofCreditandAccountsReceivable Probus Pub Co.Cooper, R., 2004. • Corporate Treasury and Cash Management (Finance and Capital Markets). Palgrave Macmillan.CPF Board, 2013• . CFP Board Financial Planning Competency Handbook. Wiley.Driscoll, M.C., 1983• .CashManagement:CorporateStrategiesforProfit. John Wiley & Sons Inc.Jones, E.V. and Jones, E.B., 2001. • Cash Management. R&L Education.Kidwell,D.S.,Blackwell,D.W.,Whidbee,D.A.andSias,R.W.,2011.• Financial Institutions, Markets, and Money. 11th ed., Financial Institutions, Markets, and Money. Wiley.Kimmel,P.D.andWeygandt,J.J.,2008.• Financial Accounting: Tools for Business Decision Making. 5th ed., Wiley.Laurens, B., 1998. • Managing capital flows. International Monetary Fund, Monetary and Exchange Affairs Department.Levinson, M., 2009. • Guide to Financial Markets. Guide to Financial Markets. 5th ed., Bloomberg Press.Linzer, R.S. and Linzer, A.O., 2007. • CashFlowStrategies:InnovationinNonprofitFinancialManagement. Jossey-Bass.Madura, J., 2011. • International Financial Management. 11th ed., Cengage Learning.


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Mishkin, F.S. and Eakins, S., 2011. • Financial Markets and Institutions. 7th ed., Prentice Hall.O’Berry, D., 2006. • SmallBusinessCashFlow:Strategies forMakingYourBusiness aFinancial Success. Wiley.Sagner, J., 2010. • Essentials of Working Capital Management. Wiley.Schreibfeder, J., 2003. • AchievingEffectiveInventoryManagement. 5th ed., Effective Inventory Management, Inc.Silver, E.A., Pyke, D.F. and Peterson, R., • InventoryManagementandProductionPlanningandScheduling. 3rd ed., Wiley.Tracy, J.A. and Tracy, T., 2011. • CashFlowForDummies. For DummiesWeide, J.H.V. and Maier, S.F., 1984. • Managing Corporate Liquidity: An Introduction to Working Capital. John Wiley & Sons Inc.

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Self Assessment Answers

Chapter Ib1. d2. a3. b4. d5. a6. d7. d8. b9. a10.

Chapter IId1. d2. a3. c4. b5. a6. c7. a8. a9. c10.

Chapter IIIb1. a2. c3. b4. d5. d6. d7. d8. a9. b10.

Chapter IVb1. a2. c3. c4. c5. d6. d7. b8. a9. a10.


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Chapter Va1. d2. d3. b4. a5. c6. b7. c8. b9. c10.

Chapter VId1. c2. d3. b4. d5. d6. a7. c8. a9. b10.

Chapter VIIb1. d2. c3. a4. c5. a6. b7. d8. a9. a10.

Chapter VIIIc1. a2. b3. a4. d5. c6. d7. a8. c9. c10.

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