Chapter One

Introduction to Working Capital Management

1.3 Determinants of Level of Working Capital.

For the purpose of profit maximization & asset maximization of any business, one of the key factors is the
determination of the optimal level of working capital. In determining the optimal; level of working capital,
followings variables should be considered:

1. Nature of Business
This is one of the main factors. Usually in trading businesses the working capital needs are higher as
most of their investment is concentrated in stock or inventory. Manufacturing businesses also need a
good amount of working capital to meet their production requirements. Whereas, those companies
that sell services and not goods, on a cash basis require least working capital because there is no
requirement on their part to maintain heavy inventories.

2. Size of Business
Size of business is another influencing factor. As size increases, the working capital requirement is
also more and vice versa.

3. Credit Terms / Credit Policy

Credit terms greatly influence working capital needs. If terms are:
 buy on credit and sell by cash, working capital is lower
 buy on credit and sell on credit, working capital is medium
 buy on cash and sell on cash, working capital is medium
 buy on cash and sell on credit, working capital is higher.

Prevailing trade practices and changing economic condition do generally exert greater influence on
the credit policy of concern.

a. A liberal credit policy if adopted more trade debtors would result and when the same is
tightened, size of debtors gets slim.
b. Credit periods also influence the size and composition of working capital. When longer
credit period is allowed to debtors as against the one extended to the firm by its creditors,
more working capital is needed and vice versa.
c. Collection policy is another influencing factor. A stringent collection policy might not only
deter away some credit customers, but also force the existing customers to be prompt in
settling dues resulting in lower level of working capital. The opposite holds well with a
liberal collection policy.
d. Collection procedure also influences the working capital needs. A decentralized collection
of dues from customers and centralized payments to suppliers shall reduce the size of
working capital. Centralized collections and centralized payments would lead to moderate
level of working capital. But with centralized collections and decentralized payments, the
working capital need would be the highest.

4. Seasonality
a. Seasonality of Production
Agriculture and food processing and preservation industries have a seasonal production.
During seasons, when production activities are in their peak, working capital need is
high.
b. Seasonality in supply of raw materials
This also affects the size of working capital. Industries that use raw materials which are
available during seasons only, have to buy and stock those raw materials. They cannot
afford to buy these items in a phased way, since either supplies would get reduced or

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 prices would be higher. Also, from the point of view of quality of raw materials, it pays to
buy in bulk during the seasons. Hence the high level of working capital needed when
season exists for raw materials.
c. Seasonality of demand for finished goods
In case of products like umbrella, rain-coats and other seasonal items, the demand is
high during peak seasons. But the production of these items has to be continuous
throughout the year to meet the high demand during peak seasons. Thus, working
capital requirement would be higher.

5. Trade Cycle
Trade cycle refers to the periodic turns in business opportunities from extremely peak levels, via a
slackening to extremely tough levels and from there, via a recovery phase to peak levels, thus
completing a business cycle. There are 4 phases of trade cycle.

a. Boom Period: more business, more production, more working capital.

b. Depression period: less business, less production, less working capital.
c. Recession period: slackening business, stock pile-up, more working capital.
d. Recovery period: recouping business, stock speedily converts to sales, less working capital.

6. Inflation
Under inflationary conditions generally working capital increases, since with rising prices demand
reduces resulting in stock pile-up and consequent increase in working capital.

7. Production cycle
The time lapse between feeding of raw material into the machine and obtaining the finished goods
out from the machine is what is described as the length of manufacturing process. It is otherwise
known as conversion time. Longer this time period, higher is the volume and value of work-in-
progress and hence higher the requirement of working capital and vice versa.

8. System of Production process

If capital intensive, high-technology automated system is adopted for production, more investment in
fixed assets and less investment in current assets are involved. Also, the conversion time is likely to
be lower, resulting in further drop in the level of working capital. On the other hand, if labor intensive
technology is adopted, less investment in fixed assets and more investment in current assets which
would lead to higher requirement of working capital?

9. Growth and expansion plans

Growth and expansion industries need more working capital than those that are static. Apart from
the above factors, dividend policy, depreciation policy, price level changes, operating efficiency and
government regulations also influence the level and the size of working capital.

10. Operating efficiency

The operating efficiency of the firm relates to the optimum utilization of all its resource at minimum
costs. The efficiency in controlling operating cost and utilizing fixed and current assets leads to
operating efficiency. The use of working capital is improved and pace of cash conversion cycle is
accelerated with operating efficiency. Better utilization improves profitability and helps the releasing
on working capital.

11. Working Capital Cycle

When the working capital cycle of a firm is long, it will require larger amount of working capital. But,
if working capital cycle is short, it will need less working capital.
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 12. Access To Money Market

If a firm has good access to capital market, it can raise loan from bank and financial institutions. It
results in minimization of need of working capital.

13. Dividend Policy

The dividend policy of the firm is an important determinant of working capital. The need for working
capital can be met with the retained earning. If a firm retains more profit and distributes lower
amount of dividend, it needs less working capital.

1.6 Working Capital Policy.

The policy is basically about how much capital the company should maintain. Should they go in for a zero-risk
arrangement, or can they try a bit of daredevilry in their working capital management? Here are the different
working capital policies, their advantages and disadvantages.

1. Conservative Approach: The main characteristics of Conservative policy are:

 High level of investment in current assets

 Support any level of sales and production
 High liquidity level
 Avoid short-term financing to reduce risk, but decreases the potential for maximum value
creation because of the high cost of long-term debt and equity financing.
 Borrowing long-term is considered less risky than borrowing short-term.
 This approach involves the use of long-term debt and equity to finance all long-term fixed
assets and permanent assets, in addition to some part of temporary current assets.
 The firm has a large amount of net working capital. It is a relatively low-risk position.
 The safety of conservative approach has a cost.
 Long-term financing is generally more expensive than short-term financing

Figure 1.1 Conservative Policy.

2. Aggressive Approach: The main characteristics of aggressive approach are:

 Low level of investment

 More short-term financing is used to finance current assets.
 Support low level of production & sales
 Borrowing short-term is considered more risky than borrowing long-term.
 Firm risk increases, due to the risk of fluctuating interest rates, but the potential for higher
returns increases because of the generally low-cost financing.
 This approach involves the use of short-term debt to finance at least the firm's temporary
assets, some or all of its permanent current assets, and possibly some of its long-term fixed
assets. (Heavy reliance on short term debt)
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  The firm has very little net working capital. It is more risky.
 May be a negative net working capital. It is very risky

Figure 1.2 Aggressive Policy.

3. Matching or Moderate or Middle‐of‐the‐ Road Policy: The main characteristics of aggressive

approach are:

 This approach tries to balance risk and return concerns.

 Temporary current assets that are only going to be on the balance sheet for a short time
should be financed with short-term debt, current liabilities. And, permanent current assets
and long-term fixed assets that are going to be on the balance sheet for a long time should be
financed from long-term debt and equity sources.
 The firm has a moderate amount of net working capital. It is a relatively amount of risk
balanced by a relatively moderate amount of expected return.
 In the real world, each firm must decide on its balance of financing sources and its approach
to working capital management based on its particular industry and the firm's risk and
return strategy.

Figure 1.3 Moderate Policy.

You may be aware that cash, inventories and receivables are all current assets that form part of working
capital. But there is a basic difference between cash and inventories on one hand and receivables on the
other. Higher level of cash and inventories means a safety buffer and therefore it is a more conservative
situation. In the case of receivables, there is no such thing as a safety buffer of receivables. A higher level of
receivables generally means that the company extends credit on more liberal terms. Aggressive working
capital policy has been identified above as risky. Then lowering inventories and cash would be aggressive but
increasing receivables would also be aggressive.

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Which Working Capital Policy should be followed?

Figure 1.4 Working Capital Policies.

Under perfect certainty, if the needs for working capital can be forecasted accurately, then aggressive policy
could be followed. Although it will be risky but at the same time the chances of profitability is high.

On the other hand, if the needs for working capital cannot be forecasted, then conservative policy should be
followed. Although the profitability will be low but liquidity & solvency will be high.

Since there is a negative trade offs between liquidity & profitability, so the best policy should be the matching
policy which can properly adjust between liquidity & profitability. In short we can describe the situation
using following criteria:

 A high CA/TA ratio combined with a low CL/TL ratio is doubly conservative.
 A low CA/TA ratio combined with a high CL/TL ratio is doubly aggressive.
 A high CA/TA ratio combined with a high CL/TL ratio is at least partially offsetting, as is a low CA/TA
ratio combined with a low CL/TA ratio.

Chapter Two
Management of Cash & Marketable Securities
2.2 Needs for Cash.
In macroeconomic theory, the needs for cash has described as liquidity preference that refers to the demand
for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The
General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by
the supply and demand for money. The demand for money as an asset was theorized to depend on the
interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such
because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest,
although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving,
interest in the Keynesian analysis is a reward for parting with liquidity.

According to Keynes, demand for liquidity or cash is determined by three motives:

1. The Transactions Motive: people prefer to have liquidity to assure basic transactions, for their
income is not constantly available. The amount of liquidity demanded is determined by the level of
income: the higher the income, the more money demanded for carrying out increased spending.
2. The Precautionary Motive: people prefer to have liquidity in the case of social unexpected
problems that need unusual costs. The amount of money demanded for this purpose increases as
income increases.

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 3. Speculative Motive: people retain liquidity to speculate that bond prices will fall. When the interest
rate decreases people demand more money to hold until the interest rate increases, which would
drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the
lower the interest rate, the more money demanded (and vice versa).

The liquidity-preference relation can be represented graphically as a schedule of the money demanded at
each different interest rate. The supply of money together with the liquidity-preference curve in theory
interact to determine the interest rate at which the quantity of money demanded equals the quantity of
money supplied (see IS/LM model).

Figure 2.1 IS-LM Model.

The IS/LM model (Investment—Saving / Liquidity preference—Money supply) is a macroeconomic tool that
demonstrates the relationship between interest rates and real output in the goods and services market and
the money market. The intersection of the IS and LM curves is the "general equilibrium" where there is
simultaneous equilibrium in both markets.

 Cash Conversion Period

The cash conversion period measures the amount of time it takes to convert your product or service into cash
inflows. There are three key components:

1. The inventory conversion period – the time taken to transform raw materials into a state where they
are ready to fulfill customers’ requirements. This is important for both manufacturing and service
industries. A manufacturer will have funds tied up in physical stocks while service organizations will
have funds tied up in work-in-progress that has not been invoiced to the customer.
2. The receivables conversion period – the time taken to convert sales into cash inflows.
3. The payable deferrable period – the time between purchase/usage of inputs e.g. materials, labor, etc.
to payment.

The net period of (1+2) – 3 gives the cash conversion period (or working capital cycle). The trick is to
minimize (1) and (2), and maximize (3), but it is essential to consider the overall needs of the business.

The chart below is an illustration of the typical receivables conversion period for many businesses.

Customer Purchase Decision &

Ordering

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 The Credit Decision

Order Fulfillment, Shipping &

Delivering

Invoicing the Customer

The Average A/C Receivables

Collection Period

Payment & Deposit

Figure 2.3 Receivables Conversion Period

The flow chart represents each event in the receivables conversion period. Completing each event takes a
certain amount of time. The total time taken is the receivables conversion period. Shortening the receivables
conversion period is an important step in accelerating your cash inflows.

2.5 Accelerating Cash Inflows.

Accelerating your cash inflows will improve your overall cash flow. The quicker you can collect cash, the
faster you can spend it in pursuit of further profit. Accelerating your cash inflows involves streamlining all the
elements of the cash conversion period:

1. The customer’s decision to buy;

2. The ordering procedure;
3. Credit decisions;
4. Fulfillment, shipping and handling;
5. Invoicing the customer;
6. The collection period;
7. Payment and deposit of funds.

1. Customer Purchase Decision and Ordering: Without a customer, there will be no cash inflow to
manage. Make sure that your business is advertising effectively and making it easy for the customer
to place an order. Use accessible, up-to-date catalogues, displays, price lists, proposals or quotations
to keep your customer informed. Provide ways to bypass the postal service. Accept orders over the
Internet, by telephone, or via fax. Make the ordering process quick, precise and easy.

2. Credit Decisions: The Bank of England estimates that only one in two companies agree their payment
terms in writing. Dun and Bradstreet has calculated that more than 90 per cent of companies grant
credit without a reference1. Inadequate credit processes can seriously damage a company’s health.

 Credit Policy: Your Company’s credit policy is important. It should not be arrived at by
default. It should be a Board decision and should determine such items as your company’s
credit criteria, the credit rating agency to be used, the person responsible for obtaining that
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 credit rating, the company’s standard payment terms, the procedure for authorizing any
exemption and the requirements for regular reporting. The policy should be written down
and kept up to date with supplements as necessary concerning any changes to the
creditworthiness of specific customers, any warnings or notes of current poor experience.
The policy should be disseminated to all sales staff, the financial controller and the Board.

 Customer Creditworthiness: Credit checks for new customers and reviews for existing
customers are important. Checking credit references, obtaining credit reports and chasing
references will cost time and resources. Start your credit decision-making process when first
meeting with new prospective customers or clients. If necessary, consider allowing small
orders to get underway quickly with a small start limit for new accounts of, say, £500. This
may be a reasonable level of risk, and may ensure that new business is not lost. With existing
customers or clients, it is best to anticipate a request for an increase in their credit limit
whenever possible. This can be accomplished by monitoring your customers’ current credit
limits and payment performance, and comparing them with your expected levels of future
business.

Ask Yourself:

 Do you methodically check the financial standing of all new customers before executing the first
order?
 Do you periodically review the financial standing of existing customers?
 Do you undertake a full recheck of the financial standing of existing customers whose purchases have
recently shown a substantial increase?
 Do you use the telephone when checking trade references? Suppliers will often tell you over the
telephone what they would not put in writing.
 Do you recognize that salesmen are by nature optimists? Use other sources of information before
increasing/establishing credit for customers.
 Is there one person in your firm who is ultimately responsible for supervising credit and for ensuring
the prompt collection of monies due and who is accountable if the credit position gets out of hand?
 Are you clear in your own mind as to how you assess credit risks and how you impose normal limits
– both in terms of total indebtedness for each customer’s account and also in terms of payment
period?
 Do you make your credit terms very clear? In a sales negotiation it is professional, not anti-selling, to
be upfront about terms for payment. On an ‘Account Application Form’ include a paragraph for the
buyer to sign, agreeing to comply with your stated payment terms and conditions of sale. On a
‘welcome letter’ restate the terms and conditions. On an ‘Order Acknowledgement’ again stress your
payment terms and conditions of sale. On ‘Invoices and Statements’ show the payment terms boldly
on the front. On invoices also show the due date e.g. ‘payment terms: X days from invoice date –
payment to reach us by (date)’.

To save time and resources use the 80/20 rule to identify the few accounts that buy most of your sales;
that is, list accounts in descending order of value and give the top 80 per cent a full credit check and
review, and undertake only brief checks on smaller ones. Review the check on specific smaller accounts if
monitoring starts to reveal a poor payment performance. A full credit report on a limited company will
cost in the region of £30 from a rating agency. Credit agencies should give you full customer details,
financial results, payment experience of other suppliers, county court judgments, registered lending and
a recommended credit rating.

This information can be received online. Use an agency with a complete database and a fast response. The
reference agency will also provide a rating/score i.e. 80/100 would indicate a safe risk, 60/100 is not so
safe, 20/100 would probably indicate that the company is either unlikely to survive or may be a new
start-up with little capital (or both). The agency will provide a full description to accompany the score. If
your customer is a sole trader or a partnership you can still obtain information in the same way as you
would with a limited company.

3. Fulfillment, Shipping and Handling: The proper fulfillment of your customers’ orders is most important.
The cash conversion period is increased significantly if your business is unable to supply to specification
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 or within the agreed timetable. For any business that sells products rather than services, this occurs
when the business fails to control its inventory or its production process. For a service-related business,
this occurs when the business cannot provide the skilled resources to provide the services requested.

4. Invoicing the Customer: Design an invoice that is better than any coming into your own company. Keep it
brief and clear. Get rid of any advertising clutter – the invoice is for accounts staff. Invoice within 24
hours of the chargeable event. Remember that you won’t get paid until your bill gets into the customer’s
payment process. An invoice includes the following information:

 Customer name and address;

 Description of goods or services sold to the customer;
 Delivery date;
 Payment terms and due date;
 Date the invoice was prepared;
 Price and total amount payable;
 To whom payable;
 Customer order number or payment authorization.

Send the invoice to a named individual. Use first class post to beat customer payment deadlines. If there are
ways to bypass the postal system, such as the Internet, use them. Use a courier for very large values. Make
sure, above all, that the invoice is accurate.

5. The Collection Period: Customers are generally given 20 or 30 days from the date of the invoice in which
to pay. The time allowed is under your control and you can specify a shorter period if you need to. Some
companies specify a period of fourteen days to all its customers. You must judge the benefit to your cash
flow against the possible cost of deterring some potential customers. Don’t feel guilty about collecting a
debt. You are owed money for goods or services supplied. The law is on your side. Start the collection
process as soon as the sale is made. Debtors often put off paying small businesses longer than they would
a large company. Never forget that the reputation, survival and success of your business may depend on
how well you are able to collect overdue accounts.

Try applying these ideas when you are contemplating a sale of goods or services, thinking about
extending the line of credit, or dealing with an overdue payment:

 Realise that when a customer lists references on credit application, they will put down their best
references. Find out why they have switched business to you. Find out if they have other debt and
whether other suppliers have cut them off.
 Take action when a client, especially a new account, is seven days past its due date. Collecting is a
competitive sport; if you’re not getting paid then someone else is.
 Verbal communication is best. Don’t wait longer than 60 days past the due date before cutting off
credit.
 When you need to, defer to a third party – don’t get emotionally involved. Let a debt collection agency
handle it.

Ask yourself the following questions:

 How soon do your invoices go out after the goods are dispatched? Can this be speeded up?
 How soon do monthly statements go out following the last day of the month? Can this be speeded up?
 Are the terms of sale clearly and precisely shown on all quotations, price lists, invoices and
statements?
 What is the actual average length of credit you are giving – or your customers are taking? What
length of credit do you allow?
 Do you have a collection procedure timetable? Do you stick to it?
 Are you politely firm but insistent in your collection routine?

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  Do you watch the ratio of total debt on balances on the sales ledger at the end of each month in
relation to the sales of the immediately proceeding twelve months? Is the position improving,
deteriorating or static? Why?
 Do your sales people recognize that ‘It’s not sold until it’s paid for’?

6. Payment and Deposit Of Funds: Payment and deposit of funds is the last step in the cash conversion
process. This involves looking at when and how you get paid, and how long it takes you to see the cash
inflow in your bank account. Consider the customer’s position. He or she will delay payment as long as
possible, to improve his or her cash flow cycle. It is up to you to insist on prompt payment. Think of ways
to encourage your invoice to be settled on time. Remember, relying on the postal service for receipt of
your customers’ cheques can add one to three days (possibly more) to your cash conversion period. Find
ways to bypass the postal service, such as by using couriers or electronic means to pay direct to your
company bank account. This will accelerate and improve your cash inflow.

Chapter Three
Management of Accounts Receivable & Inventory
3.4 Credit Policy.
The expression credit policy refers to the firm’s decisions that will affect the amount of trade credit it will
grant. Although general economic conditions & industry practices have strong impacts on level of
receivables, the firm’s investment in receivables is also affected by its own credit policy decisions. Moreover,
the firm can change credit policies in response to changing economic conditions.

Impacts of Credit Policy

Developing a credit policy is something a business eventually has to face. One of the basic decisions you have
to make when starting a business is whether or not you are going to extend credit to other businesses and
consumers. This is a decision to be taken very seriously as it will impact your cash flow and even your profit.

Here are six factors that you should consider when developing a credit policy and that should influence your
decision whether or not to extend credit to customers. You should grant credit only if the positives of doing so
outweigh the negatives. Often, this is difficult to determine.

 The Effect on Sales Revenue: The reason you would grant credit in the first place is so your
customers can delay paying you. This is convenient for your customers and will probably win
customers for you, but it is not so convenient for you and your bottom line, at least on an
immediate basis. Sales revenue from the sale you made to your customer will be delayed for either
the discount period or the credit period, or perhaps longer if the customer is late in making the
payment. The upside is that you may be able to raise your prices if you offer credit.

You have a trade-off. The possibility of more customers and higher sales prices if you offer credit in
exchange for possible delayed and late payments. Unfortunately, it’s hard to quantify this.

 The Effect on Cost of Goods Sold: Whether you sell products or services you have to have them
available and, in the case of products, in stock, when a sale is made. When you extend credit, that
means paying for that product or service in order to have it in stock but not getting paid for it
immediately when it is purchased. Even though you will eventually get paid, your business has to
have enough cash flow to compensate for the delayed payment. In addition, you lose any interest
income you might have earned on that money.

Again, you have a trade-off. This time it is more customers and higher sale prices in exchange for
lost interest income and temporarily lower cash flow.

 The Probability of Bad Debts: If a company makes all its sales for cash, there is no possibility of
bad debts or debts it cannot collect. If any percentage of the company’s sales are on credit, there
exists the possibility of bad debts or debts you, as a business owner, will never collect. When you

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 are developing your credit policy, you should allow for some percentage of your credit accounts
that will never be paid.

The trade-off here is that some percentage of your credit sales will never be paid. You have to decide
if this factor is worth more customers and higher sales prices.

 Offering a Cash Discount: Particularly when you offer credit on a business-to-business (B2B)
basis, most companies offer other businesses a cash discount. In other words, if the business pays
the bill within the discount period, that business gets a discount. If they don’t pay within the
discount period, then they must pay within the credit period or the original period within which
the bill is due.

Cash discounts are often stated like this example: 2/10, net 30. If those are your credit terms, it
means that you offer a 2% discount if the bill is paid in 10 days. If you don’t take the discount, the
bill is due within the 30 day credit period.

Is getting your money in 10 days worth the 2% discount that you offer? That’s the trade-off you
have regarding cash discounts and whether you should offer them.

 Taking on Debt: If you, as a business owner, decide to offer credit to your customers, chances are
you will have to take on debt to finance your accounts receivables. As a small business, you may not
be able to afford to sell your products or services without immediate payment unless you have a
good working capital base. If you have to take on debt, you have to factor in the cost of short-term
borrowing as part of your decision to offer credit.

Offering credit to your customers is a big decision with wide-reaching effects for your company.
You have to consider the factors above and more. Will offering credit result in repeat business? Do
you have the time and resources to collect late payments? Make this decision wisely.

Costs of Extending Trade Credit

 Production, Selling & Administrative Costs.

 Cash Discounts.
 Bad-Debt Losses.
 Taxes.
 Required Rate of Return.

Making Credit Policy Decisions

Making optimal credit policy decisions requires identification of the credit granting decision framework.
There are four major components:

1. Setting credit standard.

2. Developing credit terms.
3. Evaluating receivables management.
4. Establishing a collection policy.

1. Setting Credit Standard

Credit standards designate the standards a customer of the firm must meet to be granted credit. They
require a subjective judgment of the customer’s likelihood of paying the debt incurred. Credit standards
traditionally have been depicted in the terms of the seven “C”s of credit.

 Character: Refers to the willingness of the customer to pay the bill on time.
 Capacity: Refers to the ability of the customer to pay.
 Conditions: Refers to the present economic conditions of the state.
 Capital: Refers to the adequacy of capital position of the customer to run the business smoothly.

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  Collateral: Refers to the amount of fixed assets of customer to repay the obligations if the revenues
are not sufficient to pay the bill.
 Cash: Refers to the portion of liquid asset to repay the bill on the due date.
 Credit Report: Refers to the past credit history of customer to assess the repayments habit of the
customer.

Sources of Credit Information: When an order is received from a new customer, a decision must be
met whether credit will be granted. The firm would like to gather as much as information as possible
about the applicant, but the search will be limited by the time & cost involved. Information about the
applicant could be collected from:
 Credit Rating Agencies, &
 Financial Statements of the Applicant.

Credit Risk Classes: Typically, credit standards are stated in term of what risk class of customers
the firm will extend trade credit to. Customer credit ratings are frequently designated by both
estimated financial strength & the credit appraisal supplied by credit rating agencies.

Setting Credit Standards: How does a firm analyze the profitability of extending credit to individual
applicants or of changing the firm’s credit standards? The procedure is to account for all cash costs &
benefits as they occur, & then discount them at the daily required rate of return.

Example: Setting Credit Standards Data – Cupertino Computer Company

Credit Terms 2/10, net 30.

Sales increase $73, 00,000 per year or $20,000 per day.
Collection Period 60 days
% of new sales that will take the cash discount 0
Cost Increases:
1. Production, Selling & Administrative costs 80% of increased sales:
$20,000 X 80% = $16,000 per day
2. Cash discounts 2% of the sales that take discount:
2% X 0 X $20,000 = $0 per day.
3. Bad Debt losses 10% of increased sales:
$20,000 X 10% = $2,000 per day.
4. Taxes 40% of (increased sales – increased production,
selling & administrative costs – increased cash
discounts – increased bad-debt losses):
40% of ($20,000 - $16,000 - $0 - $2,000) = $800
per day.
5. Required Rate of Return 20% per year:
20%/365 = 0.00055 per day.

Initial Investment = Production, Selling & Administrative Costs = $16,000 per day.

Benefits = Sales – Cash Discount – Bad Debt Losses – Taxes = $20,000 - $0 - $2,000 - $800
Benefits = $17,200 per day.

NPV = - $16,000 + (0.968)($17,200) = $650 per day.

Since the NPV is positive, Cupertino should be willing to offer credit to applicants from this group.

2. Developing Credit Terms

When the firm changes its credit terms, there can be two effects. Suppose the change is to more liberal
terms. Sale should increase, as new customers are attracted & old customers are induced to buy more.
But there should also be a change in the payments pattern of the old customers as they react to the new
terms.

12
 Example: Suppose in the previous example, if the credit terms changes from 2/10, net 30 to 2/10, net
60.

Credit Terms Data

Present Terms Proposed Terms

(2/10, net 30) (2/10, net 60)
Daily Sales $100,000 $110,000
Production, Selling & Administrative costs 80% of sales 80% of sales
Tax rate 40% 40%
Required rate of return 0.00055 per day 0.00055 per day
Bad debt losses 5% of sales 5% of sales
Collection Period 30 days 60 days
% of sales taking cash discounts 40% 35%

Credit Terms Analysis (Present Terms 2/10, net 30)

Initial investment ($100,000 X 80%) $80,000 per day

Sales $100,000 per day
Less:
Cash Discounts (40% X 2% X $100,000) $800 per day
Bad debt losses (5% X $100,000) $5,000 per day
Taxes {40% X ($100,000 - $80,000 - $800 - $5,000)} $5,680 per day
Benefit $88, 520 per day
NPV $7,104 per day

Credit Terms Analysis (Proposed Terms 2/10, net 60)

Initial investment ($110,000 X 80%) $88,000 per day

Sales $110,000 per day
Less:
Cash Discounts (35% X 2% X $110,000) $770 per day
Bad debt losses (5% X $110,000) $5,500 per day
Taxes {40% X ($110,000 - $88,000 - $770 - $5,500)} $6,292 per day
Benefit $97,438 per day
NPV $6,320 per day

From the above comparison, it is found that NPV is better in the present term. So the seller should not
change the present term

3. Evaluating Receivables Management

The control function is an important part of the financial management area. This idea also applies to
receivables, & the firm should continually check on how well it manages its investment in receivables.

Collection Period: If credit terms are 2/10, net 30 & the collection period is 60 days, something seems
wrong. Also, the time pattern of the collection period can be analyzed to see if there have been major
changes that would indicate difficulties. However, the collection period is very sensitive to sales
fluctuations & the period over which sales are measured, so it may give misleading signals about the
status of the receivables management during periods when sales are changing.

Aging Schedule: The aging schedule shows what volume & percentage of the accounts receivable have
been outstanding for various lengths of time. The following is an example of an aging schedule:

Periods Outstanding Amounts of Accounts % of Total Accounts

Receivable Outstanding Receivable
13
 Less than 30 days $25, 00,000 62.5%
30 days to 60 days 10, 00,000 25%
60 days to 90 days 300,000 7.5%
90 days to 180 days 160,000 4%
Over 180 days 40,000 1%
Total $40, 00,000 100%

If significant amounts of accounts receivable have been outstanding longer than the item’s stated credit
terms, they will be identified by an aging schedule. While the aging schedule provides more information than
the collection period, it, too, is subject to giving misleading signals when sales change.

4. Establishing a Collection Policy

A certain portion of the firm’s customers will be tardy or nonpayers. Collection policy is directed toward:

a. Speeding up collections from tardy payers, &

b. Limiting bad debt losses.

A well-established collection policy will have clear-cut guidelines for the sequence of collection activities.
After the credit period is over & the receivable is identified as tardy, the first step in the sequence is
usually a letter reminding the customer the account is overdue. If the receivable remains tardy, other
letters are sent, progressively more stern in tone. Eventually, a telephone call or personal visit by a
representative of the firm’s credit department will be made.

Example: Suppose that a particular $2,000 account is delinquent & that the firm’s credit department is
considering whether it is worthwhile to pursue collection further. A credit analyst estimates that it will
cost $200 plus 50% of the amount collected to pursue the collection. The analyst also estimates the
amounts likely to be collected ultimately & the probabilities of collecting them as:

Amount Collected ($) Probabilities (%)

0 40
500 30
1,000 20
2,000 10

Expected amount collected = (0 X 0.40) + (500 X 0.30) + (1,000 X 0.20) + (2,000 X 0.10)
= $550.

Expected Cost = $200 + ($550 X 50%) = $475

Expected Net Benefit = ($550 - $475) = $75.

Since the expected collection is greater than the expected costs, the firm should pursue the account, other
things being equal.

3.6 Needs for Inventory Management.

Inventory is a necessary evil that every organization would have to maintain for various purposes. Optimum
inventory management is the goal of every inventory planner. Over inventory or under inventory both cause
financial impact and health of the business as well as effect business opportunities. Inventory holding is
resorted to by organizations as hedge against various external and internal factors, as precaution, as
opportunity, as a need and for speculative purposes.

Reasons why organizations maintain Raw Material Inventory

14
Most of the organizations have raw material inventory warehouses attached to the production facilities
where raw materials, consumables and packing materials are stored and issue for production on JIT basis.
The reasons for holding inventories can vary from case to case basis.

1. Meet variation in Production Demand: Production plan changes in response to the sales, estimates,
orders and stocking patterns. Accordingly the demand for raw material supply for production varies
with the product plan in terms of specific SKU as well as batch quantities. Holding inventories at a
nearby warehouse helps issue the required quantity and item to production just in time.

2. Cater to Cyclical and Seasonal Demand: Market demand and supplies are seasonal depending upon
various factors like seasons; festivals etc and past sales data help companies to anticipate a huge surge
of demand in the market well in advance. Accordingly they stock up raw materials and hold inventories
to be able to increase production and rush supplies to the market to meet the increased demand.

3. Economies of Scale in Procurement: Buying raw materials in larger lot and holding inventory is
found to be cheaper for the company than buying frequent small lots. In such cases one buys in bulk
and holds inventories at the plant warehouse.

4. Take advantage of Price Increase and Quantity Discounts: If there is a price increase expected few
months down the line due to changes in demand and supply in the national or international market,
impact of taxes and budgets etc, the company’s tend to buy raw materials in advance and hold stocks as
a hedge against increased costs. Companies resort to buying in bulk and holding raw material
inventories to take advantage of the quantity discounts offered by the supplier. In such cases the
savings on account of the discount enjoyed would be substantially higher that of inventory carrying
cost.

5. Reduce Transit Cost and Transit Times: In case of raw materials being imported from a foreign
country or from a far away vendor within the country, one can save a lot in terms of transportation cost
buy buying in bulk and transporting as a container load or a full truck load. Part shipments can be
costlier. In terms of transit time too, transit time for full container shipment or a full truck load is
direct and faster unlike part shipment load where the freight forwarder waits for other loads to fill the
container which can take several weeks. There could be a lot of factors resulting in shipping delays and
transportation too, which can hamper the supply chain forcing companies to hold safety stock of raw
material inventories.

6. Long Lead and High demand items need to be held in Inventory: Often raw material supplies from
vendors have long lead running into several months. Coupled with this if the particular item is in high
demand and short supply one can expect disruption of supplies. In such cases it is safer to hold
inventories and have control.

Reasons why organizations maintain Finished Goods Inventory

All Manufacturing and Marketing Companies hold Finished Goods inventories in various locations and all
through FG Supply Chain. While finished Goods move through the supply chain from the point of
manufacturing until it reaches the end customer, depending upon the sales and delivery model, the
inventories may be owned and held by the company or by intermediaries associated with the sales channels
such as traders, trading partners, stockiest, distributors and dealers, C & F Agents etc.

1. Markets and Supply Chain Design: Organizations carry out detailed analysis of the markets both at
national as well as international / global levels and work out the Supply Chain strategy with the help of
SCM strategists as to the ideal location for setting up production facilities, the network of and number
of warehouses required to reach products to the markets within and outside the country as well as the
mode or transportation, inventory holding plan, transit times and order management lead times etc,
keeping in mind the most important parameter being, to achieve Customer Satisfaction and Demand
Fulfillment.
2. Production Strategy necessitates Inventory holding: The blue print of the entire Production
strategy is dependant upon the marketing strategy. Accordingly organizations produce based on
marketing orders. The production is planned based on Build to stock or Build to Order strategies.
15
 While Build to Order strategy is manufactured against specific orders and does not warrant holding of
stocks other than in transit stocking, Build to Stock production gets inventoried at various central and
forward locations to be able to cater to the market demands.

3. Market Penetration: Marketing departments of companies frequently run branding and sales
promotion campaigns to increase brand awareness and demand generation. Aggressive market
penetration strategy depends upon ready availability of inventory of all products at nearest
warehousing location so that product can be made available at short notice – in terms of number of
hours lead time, at all sales locations through out the state and city. Any non-availability of stock at the
point of sale counter will lead to dip in market demand and sales. Hence holding inventories becomes a
necessity.

4. Market Size, location and supply design: Supply chain design takes into account the location of
market, market size, demand pattern and the transit lead time required to reach stocks to the market
and determine optimum inventory holding locations and network to be able to hold inventories at
national, regional and local levels and achieve two major objectives. The first objective would be to
ensure correct product stock is available to service the market. Secondly stocks are held in places
where it is required and avoid unwanted stock build up.

5. Transportation and Physical Barriers: Market location and the physical terrain of the market
coupled with the local trucking and transportation network often demand inventory holding at nearest
locations. Hilly regions for example may require longer lead-time to service. All kinds of vehicles may
not be available and one may have to hire dedicated containerized vehicles of huge capacities. In such
cases the will have to have an inventory holding plan for such markets. Far away market locations
means longer lead times and transportation delays. Inventory holding policy will take into account
these factors to work out the plan.

6. Local tax and other Govt. Rules: In many countries where GST is not implemented, regional state tax
rules apply and vary from state to state. Accordingly while one state may offer a tax rebate for a
particular set of product category, another state may charge higher local taxes and lower inter state
taxes. In such cases the demand for product from the neighboring state may increase than from the
local state. Accordingly inventory holding would have to be planned to cater to the market fluctuation.
While in case of exports from the country of origin into another market situated in another country,
one needs to take into account the rules regarding import and customs duties to decide optimum
inventories to be held en route or at destination.

7. Production lead times: FG inventory holding becomes necessary in cases where the lead-time for
production is long. Sudden market demand or opportunities in such cases require FG inventories to be
built up and supplies to be effected.

8. Speculative Gain: Companies always keep a watch on the economy, annual state budget, financial
environment and international environment and are able to foresee and estimate situations, which can
have an impact on their business and sales. In cases where they are able to estimate a increase in
industry prices, taxes or other levies which will result in an overall price increase, they tend to buy and
hold huge stocks of raw materials at current prices. They also hold up finished stock in warehouses in
anticipation of a impending sale price increase. All such moves cause companies to hold inventories at
various stages.

9. Avoid Certain Costs: Finally organizations hold FG inventories to satisfy customer demand, to reduce
sales management and ordering costs, stock out costs and reduce transportation costs and lead times.

3.15 Challenges in Inventory Management.

The latest trend in all industries has been to outsource inventory management functions to Third Party
Service providers. Companies outsource both Raw Material Inventory as well as Finished Goods to the Service
Provider. In case of finished goods inventory, depending upon the supply chain design, there may be multiple
stocking points at national, regional and state levels. In such an event each of the warehouse a different

16
service provider may manage operations, as one may not be able to find a supplier having operations all over
the country.

Therefore the inventory in such a situation will be managed in the Company’s system as well as in the Service
provider’s system. Inventory management and control becomes a critical function especially in such
situations where multi locations and multiple service providers are involved. To ensure Inventory control is
maintained across all locations, following critical points if focused upon will help:

1. Establish and outline Operations Process for Service Providers: Draw up SOP - Standard Operating
procedure detailing warehouse operations process, warehouse inventory system process as well as
documentation process. Especially in a 3rd Party Service Provider’s facility, it is important to have
process adherence as well as defined management, authorization and escalation structure for
operations failing which inventory operations will not be under control.
2. Establish inventory visibility at each of the location through MIS Reports: Draw up list of reports and
MIS data for all locations and ensure they are mailed to a central desk in the inventory team for daily
review. The inventory team leader should analyze daily reports of all locations and highlight any non-
conformity and resolve them as well as update the management.
3. Initiate Daily Stock count procedure to be carried out at all of the locations and reported back to the
inventory desk. Daily stock count should be able to reflect location accuracy, stock accuracy as well as
transaction summary for the day.
4. Monthly audits and inventory count should be implemented at all locations without fail and insist on
one hundred percent adherence.
5. Quarterly inventory - wall-to-wall count or half yearly and annual wall-to-wall count should be
implemented depending upon the volume of transactions as well as value of transactions at each
location.
6. Central Inventory team to be responsible for ensuring review of all reports and controlling inventories
at all locations.
7. Inventory reconciliation - involves reconciling physical inventory at site with the system inventory at
3PL Site and then reconciling 3PL System stocks with company’s system stock.
8. Visiting major sites and being present during physical stock audits on quarterly or half yearly basis is
very important.
9. Lastly keep reviewing processes and ensure training and re training is carried out regularly and at all
times at site so that a process oriented culture is imbibed and all operating staff understand the
importance of maintaining processes as well as inventory health.

Inventory is nothing but money to the company. If 3PL vendor is managing the inventory, needless to say you
should have your processes in place to be able to control and maintain inventory health.

17
 Chapter Four
Short-Term Financing

4.1 What is Short‐Term Financing?

Funds available for the period of one year or less are called Short-Term Financing. The main purpose of short
term financing is to fulfill the requirement for working capital of the business. The working capital is
required to purchase raw materials, paying wages to labor, to incur the different types of administrative &
marketing expenses on a daily basis. To incur all of these costs, short term financing is required.

There are two portions in current assets. Permanent component & Fluctuating component. Short term
financing is needed for the fluctuating portion of the current assets. Usually intermediate term or long term
sources are used to finance the permanent component.

Characteristics of Short‐Term Financing:

Compare to intermediate & long term sources of financing, the short term financing has the following
features:

1. The Duration of the short term funds is one year or less.

2. The main Purpose of the short term financing is to fulfill the needs for working capital.
3. Short term financing is Costly & Risky because within a very short period of time the borrower has
to repay the debts.
4. No Collateral is usually required because the loans are repaid on the basis of daily cash inflows or
sales revenue.
5. Short term financing is a Revolving credit because if the borrower/buyer could repay the bill within
due date, then he could enjoy another extension of credit by lender/supplier.
6. Short term financing from financial institutions can be easily renewed if the borrower can repay the
debts within due date & fulfill all the terms & conditions.
7. The Size & Nature of short term borrowers are quite large since small, medium, large, i.e. every
kinds of manufacturing & business organizations need short term financing to continue their day to
day operations.
8. Since the purpose of short term financing is to invest in current assets, so the Amount required is
relatively small.

4.2 Different Types of Short‐Term Financing & their Sources.

The sources of short-term financing can be categorized into two groups:

A. Spontaneous Financing.

1. Trade Credit.
i. Open Account.
ii. Notes Payable.
iii. Trade Acceptance

2. Advances from Customers & Deferred Income.

3. Accrued Expenses.

B. Negotiated Financing.

1. Money Market Credit.

i. Commercial Paper.
ii. Banker’s Acceptance.

18
 2. Short-Term Unsecured Bank Loan.
i. Line of Credit.
ii. Revolving Credit.
iii. Single Payment Credit Transaction Loan.

3. Secured Short-Term Bank Credit.

i. Accounts Receivable Financing.
ii. Inventory of Goods Financing.

Spontaneous Financing

1. Trade Credit

Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United
States and is a critical source of capital for a majority of all businesses. For example, Wal-Mart, the largest
retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade
credit for Wal-Mart is 8 times the amount of capital invested by shareholders.

For many borrowers in the developing world, trade credit serves as a valuable source of alternative data
for personal and small business loans. Here are many forms of trade credit in common use. Various
industries use various specialized forms. They all have, in common, the collaboration of businesses to
make efficient use of capital to accomplish various business objectives.

According to J.F.Weston & E.F. Brigham: “ Trade credit is an interim debt arising from credit sales &
recorded as an account receivable by the seller & as an accounts payable by the buyers.” The features of
trade credit are:

 Credit sale or purchase.

 Less formality.
 The duration of the credit usually one to three months.
 Financing volume is relatively high if the frequency of transactions is large.
 The purpose of trade credit is to buy raw materials.
 No collateral is required.
 Continuing credit facility can be enjoyed by the buyers.
 Trade credit is provided against those purchases where the purpose is resale of the same but not
consumption.
 Trade credit is widely available.
 The main foundation of trade credit is the mutual trust & relationship between buyer & seller.

There are three types of Trade Credit:

i. Open Account: An open account transaction is a sale where the goods are shipped and
delivered before payment is due, which is usually in 30 to 90 days. Obviously, this option is
the most advantageous to the importer in terms of cash flow and cost, but it is consequently
the highest-risk option for an exporter. Because of intense competition in export markets,
foreign buyers often press exporters for open account terms. In addition, the extension of
credit by the seller to the buyer is more common abroad.
ii. Notes Payable: A promissory note is a negotiable instrument, wherein one party (the
maker or issuer) makes an unconditional promise in writing to pay a determinate sum of
money to the other (the payee), either at a fixed or determinable future time or on demand
of the payee, under specific terms. The terms of a note usually include the principal amount,
the interest rate if any, the parties, the date, the terms of repayment (which could include
interest) and the maturity date. Sometimes, provisions are included concerning the payee's
rights in the event of a default, which may include foreclosure of the maker's assets. Demand
promissory notes are notes that do not carry a specific maturity date, but are due on demand
of the lender. Usually the lender will only give the borrower a few days notice before the

19
 payment is due. For loans between individuals, writing and signing a promissory note are
often instrumental for tax and record keeping.
iii. Trade Acceptance: Bill of exchange that is accepted (signed) only by the drawee (party on
whom it is drawn, usually a buyer or importer), and is not countersigned by the drawee's
bank. Such bills are only as good as the drawee's creditworthiness.

Factors Determining the Terms of Trade Credit

 Policies of Sales Administration.
 Sales Volume.
 Financial Condition of the Seller.
 Nature & Behavior of the Buyer.
 Financial Condition & Goodwill of the Buyer.
 Risk of Credit.
 Distance & Communication between Buyer & Seller.
 Nature & Size of the Market.
 Nature of Goods & Services.
 Trade Cycle.

Factors Determining the Volume of Trade Credit

 Capital Structure Policy.
 Nature of Buying Company.
 Size of the Buying Company.
 Nature of Goods & Services.
 Ability to Repay the Credit.
 Liquidity Position.
 Market Condition.
 Availability of Fund from other Sources.
 Seasonal Variations of Demand & Supply.
 Sales/Credit Policy of the Seller.
 Attitude of the Seller.
 Ability & Willingness of the Seller.
 Repayment Habit.
 Understanding of the Seller about the Buyer.
 Overall Capital Market Conditions.
 Overall Economic Conditions of the State.
Advantages of Trade Credit

 Widely Available.
 Possibility of More Profit by Increasing Sale.
 Less Formality.
 Financing Volume is Relatively High.
 Less Costly.
 No need for Collateral.
 Benefit of Increased Volume of Credit.
 Development of Mutual Trust & Good Relation.
 Flexibility in Determining the Volume of Credit.
 Less Risk of Bad Debt.
 Only & Last Resorts for Small Traders.

Disadvantages of Trade Credit

 Shorter Payment Period.

 High Cost of Forgoing Cash Discount.
 High Price of Goods.

20
  Possibility of Bad Debt Loss.
 No Tax Exemption.

Trade Acceptance:

i. Buyer will issue a purchase order to the Seller

ii. Buyer will request his bank to issue LC
iii. Buyer’s bank will issue a LC and will send it to the seller’s bank
iv. Seller’s bank will issue “Letter of notification to the seller.
v. Seller will deliver the goods
vi. Seller will submit the shipping document to the seller’s bank
vii. Seller’s bank will present the document to the buyer’s bank
viii. Buyers bank will issue “Banker acceptance” in favor of seller’s bank
ix. Seller’s bank will collect the money on the due date.

21
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