Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. ‘WORKING CAPITAL MANAGEMENT THEORY TOPICS S.No TOPICS 1. | Significance of Working Capital (1-2 marks) Importance of Adequate Working Capital Managing working capital is a crucial responsibility for a finance manager. The goal is to maintain an appropriate balance, ensuring that the available working capital is neither excessive nor insufficient for the company's needs. If an entity has too much working capital implies that the company has funds sitting idle. Since holding funds has a cost, the company ends up paying significant interest on these unused funds. Additionally, there's an opportunity cost. as the surplus Funds could have been invested in long-term opportunities to generate returns, In essence, maintaining excess working capital can result in both direct costs and missed investment opportunities for the company. Optimum Working Capital Ifa company cannot pay its short-term debts promptly because its current assets are less than its current liabilities, it risks damaging its reputation. This can deter vendors from wanting to do business with the company. Acurrent ratio of 2 fora manufacturing firm suggests an optimal level of working capital. A higher ratio may signal inefficient fund utilization, while a lower ratio could indicate liquidity issues, as mentioned earlier. 2. | Determinants of Working Capital (1-2 marks) Working capital management is concerned with: (2) Maintainingadequate working capital (managing the level of individual current assets and the current liabilities); and (b) Financing of the working capital 3. | Factors_which_need_to_be considered while planning for working capital requirements (3-4 marks) 1. Need for Cash: Identify the cash balance which allows for.the’business to meet day-to- day expenses but reduces cash holding costs (Example: loss of interest on long term investment had the surplus cash invested therein). 2. Desired level of Inventory: Identify the level: Of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow. The techniques like just in Time (JIT) and Economic order quantity (E09) are used for this. . Receivables: Identify the appropriate credit policy, ie., credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa), . Short-term Financing Options: Inventory is ideally financed by credit granted by the supplier. However, depending on the cash conversion cycle, it may be necessary to utilize a bank loan (or overdrait), or to “convert debtors to cash’ through “factoring” in order to finance working capital requirements. 5. Nature of Business: For example, in a business of restaurant, most ofthe sales are in Cash, Therefore, need for working capital is very less. On the other hand, there would be a higher inventory in case of a pharmacy or a bookstore. 6. Market and:Demand Conditions: For example, if an item’s demand far exceeds its production, the working capital requirement would be less as investment in finished goods inventory would be very less with continuous sales. . Technology and Manufacturing Policies: For example, in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production throughout the whole year or rather may choose a policy of production only during the demand season. 8. Operating Efficiency: A company can reduce the working capital requirement by eliminating waste, improving coordination, process improvements etc. wwwescholars.inUnauthorized sharing or distribution of this e-book is prohibited and subject to legal action. 9. Price Level Changes & Exchange Rate Fluctuations: For example, 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. 4. | Liquidity and Profitability (2:3 marks) Liquidity in Working Capital: 1. in working capital emphasizes the ability to cover short-term obligations and operational needs. 2. Maintaining sufficient liquidity in working capital ensures that a company can meet day-to-day expenses, pay short-term debts, and handle unexpected cash needs. 3. Common liquidity ratios like the current ratio and quick ratio are relevant for assessing a company's ability to meet short-term obligations using its working capital. Profitability in Working Capita: Profitability in working capital looks at how effectively a company can generate returns on the funds invested in its operational cydle. 2. Bificient use of working capital contributes to profitability by minimizing costs, reducing the cash conversion cycle, and optimizing the use of resources. 3. Key metrics include the return on working capital, which assesses the returns generated in relation to the capital invested in day-to-day operations. Balance and Trade-Off: 1. Achieving a balance between liquidity and profitability in working capital management is crucial. While maintaining sufficient liquidity is necessary for operational stability, overly conservative liquidity management might result in missed opportunities for higher returns. 2. Efficient working capital management aims to strike the right balance between having enough liquidity to meet short-term needs and deploying funds effectively to maximize profitability, 3. In summary, the relationship between liquidity and profitability in the context of working capital involves managing short-term obligations while optimizing the use of funds to enhance overall profitability and financial performance. 3. Componentof | Advantages of ‘Advantages of ‘Working higher side lower side Capital (Profitability) (Liquidity) Inventory Fewer stock-outs | Use techniques like | Lower inventory increase the |-EOQ. JIT ete. to carry | requires less capital profitability optimum level of] but endangered inventory, stock-out_and loss - of goodwill. Receivables | Higher Credit ‘period | Evaluate the credit | Cash sales provide attract customers and | policy; use the | liquidity but fails to increase revenue (but | services of debt | boost sales and can result in more bad | management revenue (due to debts) (factoring) agencies. | lower credit period) Pre-payment of | Reduces uncertainty | Cost-benefit analysis | Improves or expenses and profitable in | required maintains liquidity. inflationary environment. Cash“and Cash | Payables are honored | Cash budgets and [Cash canbe. equivalents | in time, improves the | other cash | invested in some goodwill and helpful in | management other investment getting future | techniques can be | avenues discounts. used wwwescholars.in 2Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. Payables and | Capital can be used in | Evaluate the credit | Payables are Expenses some other | policy and related | honored in time, investment avenues | cost. improves the goodwill and helpful in getting future discounts. Investment and Financing in respect to Working capital (2-3 marks) Working capital policy is a function of two decisions, first is investment in working capital and the second is financing of the investment. Investment in working capital is concerned with the level of investment in the current assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organisation objectives (i. Effectiveness of fund). Financing decision concerned with the arrangement of funds to finance the working capital. It gives the answer ‘Where from’ fund to be sourced at lowest cost as possible (i Economy). Financing decision, we will discuss this in later unit of this chapter. Deciding how much to invest in working capital is a strategic choice for a company. It depends on organizational goals, trade policies, and financial considerations. There are no fixed rules; each organization's unique needs determine the required investment. Some businesses, due to their specific characteristics, may need more working capital than others. Hence, level of investment depends on the various factors listed below: a) Nature of Industry: Construction companies, breweries ete. requires large investment in working capital due long gestation period. b) Types of products: Consumer durable has large inventory as compared to perishable products. ©) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory ie. raw material, work-in-process and finished goods whereas a trading and a service entity has to maintain inventory only in the form of trading stock and consumables respectively. 4) Volume of sales: Where the sales are high, there is a possibility of high receivables as, well. €) Credit policy: An entity whose credit policy is liberal kas not only high level of receivables but may require more capital to fund raw material purchases as that will depend on credit period allowed by suppliers. ‘Approaches of Working Capital Management (2-3 marks Working capital investment decisions are categorized into three approaches ie, aggressive, conservative and moderate. 1. Aggressive approach - the company minimizes investments in current assets. This means lower inventory, strict credit policies, and maintaining less cash. The benefit is reduced financial costs, but the downside includes the risk of stock-outs and limited growth potential. This approach may result in underutilization of fixed assets and long- term debts 2. Conservative Approach - organizations opt for higher investments in current assets. This involves maintaining higher inventory, lenient credit policies, and a substantial cash balance to promptly meet any current obligations. The advantages include increased sales volume, heightened demand from liberal eredit policies, and enhanced goodwill with suppliers due to timely payments. However, the drawbacks consist of higher capital costs, potential inventory obsolescence, increased risk of bad debts, and potential long-term liquidity challenges due to extended operating cycles. 3. Moderate Approach - this approach strikes a balance between the two extremes ‘mentioned earlier. Itaims to find a middle ground, managing risk and return efficiently to maximize benefits from fund utilization. wwwescholars.in 3 |Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. ‘The operating cycle stands out as a dependable approach for calculating working capital ‘The computation involves: 1. Average Holding Period of Current Assets: This method determines working capital requirements by analyzing the average holding period of current assets, considering costs based on the company's prior-year experience, The approach is grounded in the Operating Cycle Concept. 2, Ratio of Sales: Working capital needs are estimated as a ratio of sales, assuming that current assets fluctuate in tandem with sales variations. 3. Ratio of Fixed Investments: Working capital requirements are assessed as a percentage of fixed investments, providing a perspective on the capital needed in relation to fixed assets. 10. Cash cost concept (1-2 marks) Working capital is determined by the variance between current assets and current liabilities. To predict working capital needs, it's essential to forecast the necessary amounts for each current asset and current liability item. This approach is rooted in the idea that for certain current assets such as sundry debtors and finished goods, the actual funds tied up are less than the recorded amounts of these assets. For example: If we have sundry debtors worth Rs 1 lakh and our cost of sales is 75,000, the actual amount of funds blocked in sundry debtors is ¥75,000 the cost of sundry debtors, i. the rest (¥ 25,000) is profit. Functions of Treasury Department (3-4. marks) Over the years, the role of the treasury department has expanded significantly. Initially focused on cash handling, it now encompasses complex tasks related to managing foreign exchange risks and determining the composition of the company's capital structure. 4. Cash management - Cash management involves effectively collecting and disbursing cash within and outside the organization. Itcan be fully centralized in a group treasury or involve providing guidance to subsidiaries on matters like payment periods and discounts. The treasury also oversees investing surplus funds, aligning with company policies on liquidity needs and acceptable risk levels. 2. Currency management - The treasury department oversees the management of the company’s exposure to foreign currency risk. In a large multinational company, the initial step ty ically involves offsetting intra-group indebtedness. Aligning receipts and payments in the same currency helps reduce transaction costs and shields the organization from adverse exchange rate movements. The treasury may also provide recommendations on invoicing currency for overseas sales. To minimize risks, the treasury employs forward contracts to buy or sell currency as per company p 3. Fund management - The treasury department plans and secures the company's short, ‘medium, and long-term cash requirements. They manage temporary investments for surplus funds by aligning the timing of cash inflows and outflows. Additionally, the treasury department plays a role in déciding the company's capital structure and predicts future interest rates and foreign currency rates. 4. Banking - Maintaining a positive relationship with bankers is crucial fora company. The treasury department handles negotiations on interest rates and foreign exchange rates, serving as the primary contact with the banks. Short-term finance can be obtained through bank loans or by selling commercial paper in the money market. 5. Corporate finance - The treasury department manages acquisition and divestment activities within the group and is also responsible for investor relations. In markets where share-price performance is crucial, investor relations become vital as it can impact the company's ability to pursue acquisitions or make it vulnerable to hostile bids ifthe share price declines significantly. wwnwescholars.in 4Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. 12. ‘Steps in preparation of cash budget (2-3 marks) 4: 2 Selection of the period of time to be covered by the budget: It also defines the planning horizon. Selection of factors that have a bearing on cash flows. The factors that generate cash flows are generally divided into following two categories: - a. Operating (cash flows generated by operations of the firm); and b._Financial (cash flows generated by financial activities of the firm). 13. Managing Cash collection and Disbursements (2-3 marks) To achieve this cash management, efficiency will have to be brought in by proper control of cash collection and disbursement. ‘The twin objectives in managing the cash flows should be: 1. Accelerate cash collections as much as possible - First, let's consider the time associated with the cash collection process. The term “float” refers to the periods impacting cash as it progresses through various stages of the collection process. There are four types of floats concerning cash management: + Billing float - Billing float refers to the time delay between the creation of an invoice and its presentation to the customer for payment. During this period, the company hasissued the bill, butit has not yet been received by the customer or entered into the payment processing system. The billing float represents a potential delay in the cash collection process as the customer may take some time to process and pay the ‘Mail float - Mail float is the time delay between the point when a payment is mailed and when it is received and processed by the recipient. It represents the time it takes for a physical payment, such as a check, to be sent through the postal system and reach its destination. «Cheque processing float - Cheque processing float refers to the time delay involved in the processing of a cheque from the moment it is received by the recipient until the funds are made available in the account. This float encompasses the time required for the cheque to be deposited, cleared by the bank, and for the funds to be credited to the recipient's account. ‘© Banking processing float - Bank processing float refers to the time delay associated with the processing of financial transactions by a bank. It encompasses the time taken by a bank to process various transactions, such as deposits, withdrawals, and fund transfers. This float is erucial for businesses as it impacts the availability and usability of funds in bank accounts. Decelerate or delay cash disbursements within permissible time frame/Controlling Cash payments - Efficient payment control accelerates cash turnover. Achieving this involves making payments promptly on the due date and utilizing drafts (bills of exchange) more frequently than cheques. Maximizing cash availability involves leveraging the float. In this strategy, a firm accurately estimates when issued cheques Will be presented for encashment. The firm takes advantage of this float period by issuing more cheques but maintaining in the bank account only enough cash as is needed to honor the cheques expected to be presented on a specific daté. 4. ‘Types of Decentralized collection system (2-3 marks} A firm can also use decentralized collection system known as concentration banking and lock box system to speed up cash collection and reduce float time. 1. Concentration Banking: Involves setting up multiple collection centers in different regions instead of a single center at the head office. This approach minimizes the time between customer remittances and the availability of funds for the company. Each collection center deposits payments in their local banks, and surplus funds are then transferrad to the central concentration bank at the head office. This method, often located at the headquarters, is an effective way to reduce the overall float. wwnwescholars.in 5Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. 2. Lock Box system: To speed up fund flow, a lockbox system is used in addition to concentration banking. In concentration banking, remittances are processed by 2 collection center before being deposited. The lockbox system aims to eliminate the time between the company receiving remittances and depositing them in the bank. Typically organized regionally based on billing patterns, a lockbox arrangement helps in quicker fund processing, 15. | Recent Developments In Cash Management (3-4 marks Each) Electronic Fund Transfer Advancements in Information Technology have prompted banks to computerize their branches, providing efficient banking and cash management services. The interconnected network links various branches and banks, benefiting customers in the following ways: + Accounts updated instantly. * Swift fund transfers. «Immediate access to foreign exchange rates. ‘Zero Balance Account To enhance cash management, some firms adopt a strategy of replacing cash with marketable securities using zero balance accounts. Daily, the firm tallies presented cheques against the account, transferring any excess cash (after payments) to purchase marketable securities. Ifthere's a cash shortage, the firm sells marketable securities. Money Market Operations Large companies’ treasury function includes investing surplus funds in the money market. Money market banking involves obtaining funds by banks through competition for deposits from companies, public authorities, High Net Worth Investors (HNI), and other banks. Deposits range from overnight to one year, with highly competitive rates quoted daily or even hourly based on supply and demand. The rates can fluctuate significantly, making it easy to invest surplus funds in the money market. Petty Cash Imprest system To enhance control over cash, companies often employ the petty cash imprest system. It involves estimating daily petty expenses based’on past experience and future needs. A separate amount fora week's worth of petty expenses is kept. and the next weekstarts with the predetermined balance. This approach minimizes the management's efforts in handling petty cash expenses and promotes efficient cash management. 46. | Electronic Cash Management System (2-3 marks) Today, most cash management systems rely on electronic methods due to the critical importance of speed in these systems. Electronic data and fund transfers play a key role in ensuring the efficiency of any-cash management system. Electronic-sctentific cash management results in: Significant saving in time. Increase in interest earned & decrease in interest expense. Reduces paper-work & hence manpower. Greater accounting accuracy asit allows easy detection of book-keeping errors. More control over time and funds. Supports electronic payments, Faster transfer of funds from one location to another, where required, Speedy conversion of various instruments into cash. Making available funds wherever required, whenever required. Reduction in the amount of ‘idle float’ to the maximum possible extent. Ensures no idle funds are placed at any place in the organization. It makes inter-bank balancing of funds much easier. wwwescholars.in « |Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. 17, | Virtual Banking (2-3 marks) In the 1990s, banking underwent a notable transformation. Banks aimed to enhance customer relationships and move towards relationship banking, while customers increasingly favored the convenience of remote electronic services like net banking and mobile banking over traditional branch banking, Virtual banking has particularly gained prominence within the realm of electronic banking. ‘The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machines (ATMs). Due to competitive market conditions, technological advancements, and changing customer preferences, various forms of virtual banking services have gained prominence globally. Advantages + Lower cost ofhandling a transaction. + The increased speed of response to customer requirements. © The lower cost of operating branch network along with reduced staff costs leads to cost efficiency. ‘© Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience. 18. | Management of Marketable Securities (1-2 marks) Managing marketable securities is crucial for investingcash, serving both liquidity and cash purposes if chosen correctly. Given the fluctuating nature of working capital needs, parking excess funds in short-term securities allows for quick liquidation when cash is needed. The selection of securities should be guided by three principles. © Safety: In this investment context, the pursuit of liquidity aligns with the primary objective, and the key criterion for selection is minimizing risk, emphasizing the inherent association between returns and risks. © Maturity: It is crucial to align the maturity of securities with projected cash requirements. Long-term securities exhibit higher volatility in response to interest rate fluctuations, introducing greater risk. Given the temporary nature of excess funds, @ preference is given to short-term securities. + Marketability: Liquidity pertains to the ease, promptness, and cost-effectiveness of converting security into cash. A security is considered highly liquid or marketable ifit can be swiftly sold without significant delays or loss in value. 19. | Aspects of Management of Debtors (2-3 marks) There are basically three aspects of management of receivables: 1. Credit Policy: Establishing a balanced credit policy is crucial for effective receivables management. This policy includes decisions on credit standards, credit terms, and collection efforts, It requires finding the right balance between the additional sales profits gained from offering credit and the costs associated with carrying debtors and potential bad debt losses. Further, the cash discount poligy of the firm specifies: (a) The rate of cash discount. (b) The cash discount period: and (c) The net credit period. 2. Credit Analysis: The finance manager needs to assess the risk of extending credit to a specific party: This involves conducting due diligence or checking the reputation of customers to determine their creditworthiness. 3. Control of Receivable: The finance manager is responsible for pursuing debtors and establishing an effective credit collection policy. This entails not only defining credit, policies but also implementing and executing them. ‘There is always cost of maintaining receivables which comprises of following costs: (i) The company requires additional funds as resources are blocked in receivables, which involves a cost in the form of interest (loan funds) or opportunity cost (own funds). wwwescholars.inUnauthorized sharing or distribution of this e-book is prohibited and subject to legal action. (ii) Administrative costs which include record keeping, investigation of credit worthiness ete. Collection costs. costs. 20. | Factors determining Credit Policy (2:3 marks) The credit policy significantly influences both the quantity and quality of accounts receivables. Several factors, such as, for example, determine the extent of a company's investment in accounts receivables. (i) The effect of credit on the volume of sales: (ii). Credit terms, Cash discount: (iv) Policies and practices of the firm for selecting credit customers; (v)_ Paying practices and habits of the customers: (vi) The firm’s policy and practice of collection; and (vii) The efficiency of billing, record-keeping, adjustments, and other costs like interest, collection expenses, and bad debts affects the investment in receivables. Increasing costs in these areas would decrease the overall investment in receivables. 21. | Factors under the control of the finance manager (1-2 marks) ‘The finance manager has operating responsibility for the management ofthe investment in receivables. His involvement includes: (a) Supervising the administration of credit; (b) Contribute to top management decisions relating to the best credit policies of the firm: (0) Deciding the criteria for selection of credit applications: and (d)_Speed up the conversion of receivables into cash by aggressive collection policy. 22. | Functions of Forfaiting (1-2 marks) The functionality can be understood in the following manners (i) Exporter sells goods or services to an overseas buyer. (ii) ‘The overseas buyers ice. the importer on the basis trade bills and import documents draws a letter of credit (or other negotiable instruments) through its bank (Known as importer’s bank). ‘The exporter on receiving the letter of credit (or other negotiable instruments) approaches to its bank (known as exporter's bank). (iv) The exporter’s bank buys the letter of credit (or other negotiable instruments) ‘without recourse basis’ and provides the exporter the payment for the bill. 23. | Features of Forfail marks} Gi The Salient features of forfaiting are: (i) It motivates exporters to explore new geographies aS payment is assured. (ii) An overseas buyer (importer) can import goods-and services on deferred payment terms. (ili) The exporter enjoys reduced transaction costs and complexities of international trade transactions. (iv) The exporter gets to compete in the initernational market and can continue to put his working capital to good use to scale up operations. (¥) White importers avail of forfaiting facility from international financial institutions in order to finance their imports at competitive rates 24, | Re-engineering in Receivables Process (2-3 marks] In certain organizations, significant cost reductions and performance enhancements have been accomplished through re-engineering in the accounts receivable process. Re- engineering involves a fundamental rethinking and redesign of business processes, integrating modern business approaches to improve efficiency and effectiveness. wwwescholars.in a |Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. The following aspects provide an opportunity to improve the management of accounts receivables: 1. Centralisation: Centralisation of high nature transactions of accounts receivables and payable is one of the practices for better efficiency. 2, Alternative Payment Strategies: Alternative payment strategies in addition to traditional practices result into efficiencies in the management of accounts receivables. (W) Direct debit: 1. authorization for the transfer of funds from the purchaser's bank account. (li) Integrated Voice Response (IVR): This system combines human operators witha computer-based platform, enabling customers to make payments over the phone. It has proven advantageous for organizations that handle a substantial volume of payments on a regular basis. (lil) Collection by a third party: An authorized external firm has the capability to collect payments, which can be made through various channels such as cash, checks, credit cards, or electronic fund transfers. Banks may also serve as collecting agents for their customers, depositing the collections directly into the respective customers’ bank accounts. {lv) Lock Box Processing: In this system, an external partner is responsible for capturing data from checks and invoices, transmitting the file to the client firm for processing within its own systems. {v) Online transactions through methods such as RTGS, NEFT, UPI, and mobile applications like Paytm and PhonePe enable electronic fund transfers over the Internet. 3. Customer orientation: In cases where individual customers or a specific customer segment holds strategic significance for the firm, adopting a case study approach can be instrumental in cultivating strong customer relations. A thorough examination of this customer group can facitate the development ofa strategy simed at expeditions debt settlement. 25. Taiauearn = Risk evaluation is crucial for creating a robust control system. After assessing risks, controls can be implemented to either manage them ta‘an acceptable level or eliminate them completely. This process also presents an opportunity to eliminate inefficient practices by re-evaluating and questioning how tasks are performed. This approach allows for improvements in the efficiency and effectiveness of managing accounts receivables. 26. Latest technology to manage receivables (2-3 marks) E-commerce: It involves utilizing computer and electronic communication technologies, primarily at an inter-organizational level, to facilitate the trading of goods and services. It employs technologies like Blectronic Data Interchange (EDI), Electronic Mail, Electronic Funds Transfer (EFT), and Electronic Catalogue Systems. These technologies enable buyers and sellers, as seen on platforms like Amazon and Flipkart, to conduct business by exchanging information between computer application systems. Automated Accounts Receivable Management Systems: Big companies now use automated accounts receivable management systems. replacing manual and cumbersome processes. These systems automatically update accounting records for each transaction, making them more efficient and cost-effective, For instance, in a credit sale, the system increases the customer's owed amount, deereases the inventory, and records the sale. This integrated approach allows for easy tracking and management of receivables, enabling efficient processing of customer payments and adjustments. The automated system also stores essential information for ntimerous customers and transactions. 27. Receivables collection Practices (2-3 marks) The primary goal of managing debtors’ collections is to minimize, oversee, and regulate accounts receivable while preserving positive customer relationships. A key principle in effective receivable management is to shorten the time between making a sale and collecting payment. Any delays in this process can lead to a buildup of receivables and wwwescholars.inUnauthorized sharing or distribution of this e-book is prohibited and subject to legal action. elevate the risk of bad debts. These delays can stem from both internal factors, such as billing and collection procedures, and external factors related to the customer. The focus should be on minimizing the time lag to enhance cash flow and reduce the likelihood of non- payment. The following are major receivable collection procedures and practices: () Issue of Invoice. Open account or open-end credit. Credit terms or time limits. Periodic statements and follow ups. Use of payment incentives and penalties. Record keeping and Continuous Audit. Export Factoring: Factors provide comprehensive credit management, loss protection collection services and provision of working capital to the firms exporting internationally. (viii) Business Process Outsourcing: This refers to a strategic business tool whereby an outside agency takes over the entire responsibility for managing a business process like collections in this case. 28. Use of Financial tools/techniques (2-3 marks each) Finance managers employ various tools and techniques to handle accounts receivables. Here's a simplified overview: 1. Credit Aicipeaer Wines calhay-eeli-earns,a coinganpoelces axmeas exch customer's creditworthiness and the risk of potential bad debts. This involves determining a credit rating for prospective customers. Credit rating is crucial for the finance manager to make decisions about extending credit and for how long. In some cases, especially in foreign countries, specialized agencies provide information on the creditworthiness of individual parties. These agencies help the finance manager evaluate how much credit can be offered and for what duration, The credit rating process assists in’ managing the risk associated with extending credit to different customers. 2. Credit Granting: Decision tree analysis - Deciding to grant credit involves weighing costs and benefits. When a customer pays, the seller earns a profit. However, if the customer doesn't pay, the costs invested in the product are lost. To make this decision, one can analyze the probability of receiving payment. For example, if there's a 9 out of 10 chance of recovering dues.the probability of recovery is 0.9, and the probability of default (non-payment) is 0.1. This probability distribution helps in understanding and managing the risk associated with extending credit. 3. Control of Receivables: Managing debtors goes beyond creating rules and a credit policy. It's crucial to actively control receivables through constant monitoring and follow-ups. Simply put, it's not sufficient to set guidelines: you must closely watch receivables and consistently follow up to ensure payments are made on time. This ongoing oversight is essential for financial stability and minimizing the risk of delayed or missed payments. 4. Collection Policy: Efficiently collecting debts in a timely manner minimizes bad debt losses and shortens the average collection period. When a firm allocates more resources to debt collection, it’s likely to experience fewer bad debts. Therefore, finding the optimal amount to spend on debt collection involves a trade-off between expenses and the reduction in bad debt losses, as well as the investment in debtors. The collection team mist strike a balance. They need to work in a way that avoids creating resentment among customers while keeping outstanding amounts in check. This requires a smooth and diplomatic approach to ensure effective debt collection without jeopardizing customer relationships. wwnwescholars.in 10Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. 29, | Monitoring of Receivables (2:3 marks) Regularly checking the current status of receivables is crucial for any organization to ensure that its receivables management is as effective as it needs to be. This involves taking various steps to monitor the situation consistently. 1. Computation of average collection period. 2, Ageing schedule: Analyzing receivables based on their age is called preparing aging schedules. Calculating the average age of receivables is a fast and effective way to compare their liquidity over time and against competitors. It assists in predicting future collection patterns. This periodic comparison is a valuable tool for a firm to assess and manage its receivables effectively. Classifying receivables into age groups serves the purpose of closely monitoring, the quality of individual accounts, This involves reviewing the receivables ledger, which contains the dates of each customer's purchases and payments. The aging schedule, by highlighting the tendency for old accounts to accumulate, adds valuable information to the analysis of the average collection period of receivables sales, 3. Debt collection Programme: (a) Monitoring the state of receivables. (b) Intimation to customers when due date approaches. (6) Bemail and telephonic advice to customers on the due date. (a) Reminding the legal recourse on overdue A/cs and follow escalation matrix if available, (€) Legal action on overdue A/cs. 30. (i) Price: Firms often face a discount on the price when utilizing trade credit, as they can only avail the discount by making immediate payments. This discount can represent a significant implicit cost, (ii) Loss on goodwill: 1f a customer exceeds the credit limit, suppliers might treat them unfavorably during shortages. The impact of any goodwill loss depends on the market strengths of the involved parties. (iii) Cost of managing: Management of creditors involves administrative and accounting costs that would otherwise be incurred. (iv) Conditions: Sometimes most of the suppliers insist that for availing the credit facility the order should be of some minimum size or even on regular basis. B. Cost of not taking Trade credit - On the flip side, not using credit facilities has the following costs: (i) Impact of Inflation: Inflation’ favors borrowers over lenders, as paying a fixed amount later is more advantageous. Additionally, future transactions may occur at higher prices due to inflation. (ii) Interest: Trade creditis essentially an interest-free loan, Not taking advantage of this facility results in an interest cost. especially if interest rates are high. (iii) Inconvenience: It may cause inconvenience for the supplier, particularly if they are prepared for deferred payments. 31. | Categories of Working Capital finance (1-2 marks) ‘The working capital finance may be classified between the two categories: (i) Spontaneous sources - naturally arise during business operations. Trade credit, credit from employees, credit from suppliers of services, ete. (ii) Negotiable sources. - Those which have to be specifically negotiated with lenders say, ‘commercial banks, financial institutions, general public etc. The parameters to decide the source or combination:- Cost factor Impact on eredit rating (iii) Feasibility wwnwescholars.in uUnauthorized sharing or distribution of this e-book is prohibited and subject to legal action. (iv)Reliability (v) Restrictions (vi)Hedging approach or matching approach ie,, Financing of assets with the same maturity as of assets. 32. | SOURCES of FINANCE (1-2 marks each) 1, Trade Credit: Trade credit, as mentioned earlier, is a type of spontaneous financing provided by sellers or service providers to the purchasing organization. It plays a significant role, covering around one-third of short-term financing needs. Its importance lies in its lower cost compared to other financing sources. When a company acquires goods or services and defers immediate payment, this is termed as ‘open account trade credit,’ and it often involves minimal formalities for the buyer. Bills Payable: In contrast, with "Bills Payable," the purchaser provides a written commitment to pay the bill amount either immediately upon request or at a specified future date. This source is widely relied upon in organizations, both small and large, due to its simplicity, easy accessibility, and lower explicit costs. It is particularly beneficial for small and medium enterprises. The extent of this financing is determined by the purchasing volume and the timing of payments. 3. Accrued Expenses: Accrued expenses, or outstanding expense liabilities, serve as a spontaneous short-term financing source, They involve services received by the firm for which payment is yet to be made. This is a built-in and automatic source of finance, especially for services like wages, salaries, taxes, and duties that are typically paid at the end of a period. Accrued expenses offer interest-free financing, with no explicit or implicit costs. By accruing these expenses, a firm can ensure liquidity. 33. | Inter-corporate Loans and Deposits (1-2 marks) Organizations with extra funds sometimes invest in short-term arrangements with other companies. The interest rates in these cases are usually higher than standard bank rates, and are influenced by the financial. strength of the borrowing company. This method of finance helps reduce reliance on bank loans. 34. | Commercial Papers (2-3. marks) It isa short-term unsecured promissory note issued by a company to raise funds. It's a tool used by well-rated corporate borrowers for short-term borrowing, offering an additional financial option for investors with a negotiable interest rate. The maturity period typically spans from a minimum of 7 days to less than 1 year from the issue date, CP can be issued in denominations of Rs 5 lakhs or multiples thereof. Advantages of Commercial Paper (CP) for the issuing company include: (a) Unsecured Basis: CP is sold without any collateral or restrictive conditions. (b) Continuous Source of Fimnds: Maturing CP can be repaid by issuing new CP, ensuring a consistent source of funds, (0) Flexible Maturity: The maturity of CP can be customized to meet the specific needs of the issuing firm. (Accessibility in Tight Money Markets: CP can be issued as a source of funds even when the moriey marketis constrained. (€) Cost Efficiency: Typically, the cost of CP for the issuing firm is lower compared to the cost of commercial bank loans. Commercial Paper (CP) has limitations: (@) Credit Rating Requirement: Only firms with a high credit rating can use CP. New or ‘moderately rated firms usually cannot issue CP. (b) Maturity Constraints: CP cannot be redeemed before its maturity date, nor can it be extended beyond that date. 35. | Funds generated from Operations and Public Deposit as a source of Finance (1. marks} Funds generated from operations in an accounting period, mainly comprising profit and depreciation, directly increase working capital by the same amount. In simpler terms, working capital goes up by the funds generated from operations. wwnwescholars.in 2Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. Deposits from the public are a crucial source of finance, especially for large, well- established companies with substantial capital needs in the short and medium term. 36. | Bills Discounting as a source of finance (1-2 marks) Bill discounting is a significant short-term financial tool widely used for financing. In this process, a supplier issues a bill of exchange instructing the buyer to pay a specific amount after a set period The supplier then receives acceptance from the buyer or drawee of the bill. 37. | Bills Re-discounting scheme (2-3 marks) Bill rediscounting is a financial arrangement where a bank or a financial institution purchases bills of exchange or promissory notes from a business or individual. In simpler terms, it involves selling previously discounted bills to another party. This scheme helps businesses obtain immediate funds by selling their bills before the maturity date, enabling them to address short-term cash flow needs. The party rediscounting the bills typically charges a fee or interest for providing this service. 38. | Working Capital Finance from Banks (2-3 marks) Banks in India play a crucial role as the primary providers of working capital credit for businesses. Some term lending financial institutions have also introduced schemes for ‘working capital financing. The Tandon Committee and Chore Committee have established clear guidelines and parameters in this regard, forming the basis for development and innovation in working capital financing, Instructions on Working Capital Finance by Banks In April 1997, the Reserve Bank of India removed the requirement for assessing working capital needs based on the concept of Maximum Permissible Bank Finance (MPBF). Banks are now free to develop their methods for evaluating the working capital requirements of borrowers, with approval from their Boards, However, banks must consider the Reserve Bank's instructions related to directed credit (ike priority sector, export, etc.) and prohibition of credit (such as bridge finatice, rediscounting of bills previously discounted by NBFCs) when formulating their lending policies. Due to the recent liberalizations, all instructions related to Maximum Permissible Bank Finance (MPBF) issued by the RBI are no longer applicable. Adaitionally, various guidelines aimed at maintaining lending discipline in the appraisal, sanction: monitoring, and use of bank finance are no longer mandatory. However, banks can choose to include any of these instructions or guidelines in their lending policies andprocedures if they find them necessary. 39. | Forms of Bank Credi 3 marks) Bank credit typically takes various forms, including: (@ Cash Credit: This involves the bank providing customers with a continuous credit facility up to a specified limit, preventing borrowers from exceeding the sanctioned limits, (ii) Bank Overdraft: This is a short-ferm borrowing option for companies facing urgent fund requirements, with the bank setting limits on the amount lent. Repayment is swift and straightforward once the funds are no longer needed. (iii) Bills Discounting: Companies selling goods on credit often draw bills on buyers, who accept and forward them to the seller. The seller then discounts the bill with the bank, which typically sets.a discounting bill limit. (iv) Bills Acceptance: In this arrangement, a company draws a bill of exchange on the bank tosecure finance. The bank accepts the bill, committing to pay the specified amount at a future date. (¥) Line of Credit: This involves a bank committing to lend a predetermined amount of funds on demand, specifying the maximum limit. (vi) Letter of Credit: This is an agreement where the issuing bank, based on customer instructions or its own initiative, agrees to pay, accept, negotiate, or authorizes another bank to do so against specified documents, subject to defined terms and conditions. wwnwescholars.in 3Unauthorized sharing or distribution of this e-book is prohibited and subject to legal action. i) Bank Guarantees: Commercial banks offer bank guarantees on behalf of clients to third parties who are the beneficiaries of these guarantees. 40. | Three basic considerations in determining the amount of cash or liquidity (3-4 Marks) (@ Transaction need: Cash is essential for covering daily expenses and debt payments. While cash from operations is typically enough, there are occasions when these funds may be temporarily unavailable. In such instances, having a reserve cash balance becomes crucial for the company to meet its payment obligations on time. ii) Speculative needs: Cash may be retained to capitalize on lucrative opportunities that ‘may arise and could be forfeited due to a lack of readily available funds or prompt settlement. (iii) Precautionary needs: Cash may be maintained to serve as a safeguard against unforeseen events, aligning with the notion that a person's three steadfast ‘companions are a long-standing spouse, a loyal canine companion, and funds securely deposited in a bank. wwnwescholars.in 14