Module IV: Working capital management

Working capital management: Concept of working capital, Need for working capital, Types of
working capital, Sources of working capital, Management of Cash – Motives for holding cash,
Objectives of cash management - Management of inventories – Kinds of inventories, Risks and
costs associated with inventories, Management of accounts receivables – Purpose of receivables,
Costs of maintaining receivables, Factors of affecting the size of receivables, Optimum size of
receivables.

Working capital management

Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to their most effective use.
● The efficiency of working capital management can be quantified using ratio analysis.
● Working capital management requires monitoring a company's assets and liabilities to
maintain sufficient cash flow to meet its short-term operating costs and short-term debt
obligations.
● Working capital management involves tracking various ratios, including the working
capital ratio, the collection ratio, and the inventory ratio.
● Working capital management can improve a company's cash flow management and
earnings quality by using its resources efficiently.

Understanding Working Capital Management

The primary purpose of working capital management is to enable the company to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A
company's working capital is made up of its current assets minus its current liabilities.
Current assets include anything that can be easily converted into cash within 12 months. These
are the company's highly liquid assets. Some current assets include cash, accounts receivable,
inventory, and short-term investments. Current liabilities are any obligations due within the
following 12 months. These include accruals for operating expenses and current portions of
long-term debt payments.
Why Manage Working Capital?
Working capital management helps maintain the smooth operation of the net operating cycle,
also known as the cash conversion cycle (CCC)—the minimum amount of time required to
convert net current assets and liabilities into cash.
Working capital management can improve a company's cash flow management and earnings
quality through the efficient use of its resources. Management of working capital includes
inventory management as well as management of accounts receivable and accounts payable.
Working capital management also involves the timing of accounts payable (i.e., paying
suppliers). A company can conserve cash by choosing to stretch the payment of suppliers and to
make the most of available credit or may spend cash by purchasing using cash—these choices
also affect working capital management.

Why Is Working Capital Important?

Working capital is used to fund operations and meet short-term obligations. If a company has
enough working capital, it can continue to pay its employees and suppliers and meet other
obligations, such as interest payments and taxes, even if it runs into cash flow challenges.
Working capital can also be used to fund business growth without incurring debt. If the company
does need to borrow money, demonstrating positive working capital can make it easier to qualify
for loans or other forms of credit.

Advantages of Working Capital

Working capital can help smooth out fluctuations in revenue. Many businesses experience some
seasonality in sales, selling more during some months than others, for example. With adequate
working capital, a company can make extra purchases from suppliers to prepare for busy months
while meeting its financial obligations during periods where it generates less revenue.

Elements Included in Working Capital

The current assets and liabilities used to calculate working capital typically include the following
items:
Current assets include cash and other liquid assets that can be converted into cash within one
year of the balance sheet date, including:
● Cash, including money in bank accounts and undeposited checks from customers.
● Marketable securities, such as U.S. Treasury bills and money market funds.
● Short-term investments a company intends to sell within one year.
● Accounts receivable, minus any allowances for accounts that are unlikely to be paid.
● Notes receivable — such as short-term loans to customers or suppliers — maturing
within one year.
● Other receivables, such as income tax refunds, cash advances to employees and insurance
claims.
● Inventory including raw materials, work in process and finished goods.
● Prepaid expenses, such as insurance premiums.
● Advance payments on future purchases.
Current liabilities are all liabilities due within a year of the balance sheet date, including:
● Accounts payable.
● Notes payable due within one year.
● Wages payable.
● Taxes payable.
● Interest payable on loans.
● Any loan principal that must be paid within a year.
● Other accrued expenses payable.
● Deferred revenue, such as advance payments from customers for goods or services not
yet delivered.

What is Working Capital?

Working capital is defined as the excess of current assets over current liabilities . It forms a part
of the aggregate capital of the business. Now, a business needs working capital to fund its short
term obligations. Typically, firms with an optimum level of working capital indicate efficiency in
managing its operations. This further enables the firm to pay for its short-term dues and
day-to-day operational expenses.
Therefore, working capital is a measure of business’ liquidity position, operational efficiency,
and short-term financial soundness.

Hence, working capital can be put into the following equation:

Working Capital = Current Assets – Current Liabilities

Types of Working Capital

Depending upon the Periodicity & concept working capital can be classified as below:

1. Permanent Working Capital

2. Regular Working Capital
3. Reserve Margin Working Capital
4. Variable Working Capital
5. Seasonal Variable Working Capital
6. Special Variable Working Capital
7. Gross Working Capital
8. Net Working Capital

1. Permanent Working Capital

It is that portion of the working capital that remains permanently tied up in current assets to
undertake business activity uninterruptedly. In other words, permanent working capital is the
least amount of current assets needed to carry out business effortlessly. Thus, it is also known as
fixed working capital.

The amount of fixed working capital required by a business depends upon the size and the
growth of the business. For instance, minimum cash or stock required by a firm to undertake the
operational activities of the business.Now, permanent working capital can be further subdivided
into two categories:
 2. Regular Working Capital
This is defined as the least amount of capital required by a business to fund its day-to-day
operations of a business. Examples include payment of salaries and wages and overhead
expenses for the processing of raw materials.

3. Reserve Margin Working Capital

Apart from day-to-day activities, a business may need some amount of capital for unforeseen
circumstances. Reserve Margin Working Capital is nothing but the amount of capital kept aside
apart from the regular working capital. These pool of funds are kept separately for unforeseen
circumstances such as strikes, natural calamities, etc

4. Variable Working Capital

This can be defined as the working capital invested for a temporary period of time in the
business. For this reason, it is also called as fluctuating working capital. Such a capital varies
with respect to the change in the size of the business or changes in the assets of the business.

Further, variable working capital is subdivided into two categories

5. Seasonal Variable Working Capital

This refers to the increased amount of working capital a business needs during the peak season of
the year. A business may even have to borrow funds to meet its working capital needs. Such a
working capital specifically meets the demands of business having a seasonal nature.

6. Special Variable Working Capital

Supplementary working capital may also be required by a business to undertake exceptional
operations or unforeseen circumstances. The capital required for such circumstances is termed as
special variable working capital. Funds needed to finance marketing campaigns, unforeseen
events like accidental fires, floods, etc.
 7. Gross Working Capital
This refers to the aggregate amount of funds invested in the current assets of the business. In
other words, Gross Working Capital is the total of the current assets of the business. These
include:
● Cash
● Accounts Receivable
● Inventory
● Marketable Securities and
● Short-Term Investments
Gross Working Capital used alone neither shows the complete picture of the short-term financial
soundness. Nor does it showcase the operational efficiency of the business. Current assets should
be compared with the current liabilities to get a better understanding of a business’s operational
efficiency. That is, how efficiently a business utilizes its short term assets to meet its day-to-day
cash requirements.

8. Net Working Capital

Net Working Capital is the amount by which current assets exceed the current liabilities of a
business. Thus, the working capital equation is defined as the difference between current assets
and current liabilities. Where current assets refer to the sum of cash, accounts receivable, raw
material and finished goods inventory. Whereas, current liabilities include accounts payable.
The amount of working capital in a business is the indicator of liquidity, operational efficiency
and short-term financial soundness of the business. Businesses having adequate working capital
typically have the ability to invest and grow.
On the other hand, businesses having insufficient working capital have higher odds of going
bankrupt. This is because of their inability to pay for their short-term obligations, thus making it
difficult for them to grow.

SOURCES OF WORKING CAPITAL:

A company has various sources of working capital. Depending upon its condition and
requirements, a company may use any of these sources of working capital. These sources may be
spontaneous, short term, or long term.
Spontaneous Sources: The sources of capital created during normal business activity are called
spontaneous sources of working capital. The amount and credit terms vary from industry to
industry and depend on the business relationship between the buyer and seller. The main
characteristic of spontaneous sources is ‘zero-effort’ and ‘negligible cost’ compared to traditional
financing methods. The primary sources of spontaneous working capital are trade credit and
outstanding expenses.
Short-term Sources: The sources of capital available to a business for less than one year are
called short-term sources of working capital.
Long-term Sources: The sources of capital available to a business for a longer period, usually
more than one year, are called long-term sources of working capital.

SHORT TERM SOURCES OF WORKING CAPITAL

Short-term sources of capital may further be divided into two categories – Internal Sources and
External Sources.

The short-term internal sources of working capital include provisions for tax and dividends.
These are essentially current liabilities that cannot be delayed beyond a point. All companies
make a separate provision for making these payments. These funds are available with the
company until these payments are made. Hence, these are called the internal sources of working
capital. However, this value is relatively small and thus not that significant.

On the other hand, the short-term external sources of working capital include capital from
external agencies like banks, NBFCs, or other financial entities. Some of the primary sources of
short-term external sources of working capital are listed below:

Loans from Commercial Banks: Businesses, mostly MSMEs, can get loans from commercial
banks with or without offering collateral security. There is no legal formality involved except
creating a mortgage on the assets. Repayment can be made in parts or lump sum at the time of
loan maturity. At times, banks may offer these loans on the personal guarantee of the directors of
a country. They get these loans at concessional rates; hence it is a cheaper source of financing for
them. However, the flip side is that getting this loan is a time-consuming process.
Public Deposits: Many companies find it easy and convenient to raise funds for meeting their
short-term requirements from public deposits. In this process, the companies invite their
employees, shareholders, and the general public to deposit their savings with the company. As
per the Companies Act 1956, companies can advertise their requirements and raise money from
the general public against issuing shares or debentures. The companies offer higher interest rates
than bank deposits to attract the general public. The biggest of this source of financing is that it is
simple and cheaper. However, its drawback is that it may not be available during the depression
and financial stringency.
Trade Credit: Companies generally source raw material and other items from suppliers on credit.
The amount payable to these suppliers is also treated as a source of working capital. Usually, the
suppliers grant their buyers a credit period of 3 to 6 months. Thus, they provide, in a way,
short-term finance to the purchasing company. The availability of trade credit depends on various
factors like the buyer’s reputation, financial position, business volume, and degree of
competition, among others. However, when a business avails trade credit, it stands to lose the
benefit of cash discount, which they would earn if they make the payment within 7 to 10 days of
making the purchase. This loss of cash discount is treated as an implicit cost of trade credit.
Bill Discounting:Just as business buys goods on credit, they offer credit to their buyers. The
credit period may vary from 30 days to 90 days and sometimes extends, even up to 180 days.
During this period, the company funds get blocked, which is not good. Instead of waiting that
long, sellers prefer to discount these bills with a bank or NBFC. The financial entity charges
some amount as commission, called ‘discount’ and makes the balance payment to the sellers.
This discount compensates them for the time gap between disbursing and collecting the money
on the maturity of the bill. This ‘discount’ charged by the bank is treated as the cost of raising
funds through this method. Businesses widely use this method for raising short-term capital.
Bank Overdraft:Some banks offertheir esteemed customers and current account holders a
facility to withdraw a certain amount of money over and above the funds held by them in their
current account with the bank. The bank charges interest on the amount overdrawn and the
period it is withdrawn. The overdraft facility is also granted against securities. The bank sets this
limit and is subject to revision anytime, depending upon the customer’s creditworthiness.
Advances from Customers: One effortless way to raise funds to meet the short-term requirement
is to ask customers for some payment in advance. This advance confirms the order and gives
much-needed cash to the business. No interest is payable to the customer for this advance. Even
if any business pays interest, it is very nominal. Hence, this is one of the cheapest sources of
raising funds to meet companies’ short-term working capital requirements. However, this is
possible only when the customers do not choose the terms of sellers.

LONG-TERM SOURCES OF WORKING CAPITAL

When the companies require funds for more than one year, it makes sense to go for long-term
sources, as they are generally cheaper than short-term sources.

Like short-term sources, long-term sources may also be classified as internal and external
sources. Retained profits and accumulated depreciation are internal sources wholly earned and
owned by the company itself. These funds are available to a company without any direct cost.

The external sources of long-term sources of working capital are listed below:

Share Capital: The Company may raise funds by offering the prospective shareholders a stake in
their business. These shares may be held by the general public, banks, financial institutions, or
even other companies. The response depends on several factors, including the company’s
reputation, the perceived profit potential, and general economic condition. In return, the
company offers dividends to their shareholders, which along with the floating cost, is treated as
the cost of sourcing. However, the company is not legally bound to pay this dividend. Also, no
rule prescribes how much dividend is to be given. All this makes this a very cheap source of
working capital. But, in reality, most companies do not use this for meeting their working capital
needs.
Long-term Loans: Also called Working Capital Loans, these long-term loans may be temporary
or long-term. The long-term here is generally 84 months (7 years) or more. This loan is not taken
for buying long-term assets or investments and is used to provide working capital to meet a
company’s short-term operational needs. Experts advise using long-term sources for permanent
needs and short-term sources for temporary working capital needs.
Debentures: Like shares, debentures also include generating money from the general public,
financial institutions, and other companies. However, unlike shares, in the case of debentures, the
company has to declare the interest they will pay to their lenders openly. The company is legally
bound to pay the agreed interest. So, here, if the funds are unused or even if the company runs
into losses, they have to pay the lenders.

Cash Management
Cash management is the process of collecting and managing cash flows. Cash management can
be important for both individuals and companies. In business, it is a key component of a
company's financial stability.
Cash is the primary asset individuals and companies use to pay their obligations on a regular
basis. In business, companies have a multitude of cash inflows and outflows that must be
prudently managed in order to meet payment obligations, plan for future payments, and maintain
adequate business stability.

Motive For Holding Cash

1) Transaction motive:
Business firm as well as individuals keep cash because they require it for meeting demand for
cash flow arising out of day to day transactions. In order t meet the obligations for cash flows
arising in the normal course of business , every firm has to maintain adequate cash balance. A
firm may require cash for making for purchase of goods & services.
These cash outflows are met out of cash inflows arising out of cash sales or recovery from the
debtors. Further, the cash inflows & outflows are not fully and exactly synchronized, a firm is
always required to maintain a minimum cash balance with it. The necessity of keeping a
minimum cash balance to meet payment obligations arising out of expected transactions, is
known as Transactions motive for holding cash.

2) Precautionary motive :
The precautionary motive for holding cash is based on the need to maintain sufficient cash to act
as a cushion or buffer against unexpected events. A firm should maintain larger cash balance
than required for day to day transactions in order to avoid any unforeseen situation arising
because of insufficient cash. The necessity of keeping a cash balance to meet any emergency
situation or unpredictable obligation, is known as precautionary motive for holding cash.

The amount of cash, a firm must hold for transaction & precautionary depends upon;
a) Degree of predictability of its cash flows
b) Its willingness and capacity to take risk of running hot of cash, and
c) Available immediate borrowing powers.

3) Speculative motive:
Cash may be held for speculative purpose in order to take advantage of potential profit making
situations. A firm may come across an unexpected opportunity to make profit, which is not
possible in normal business routine. The motive to keep balance for these purpose is obviously
speculative in nature. The firm’s desire to keep some cash balance to capitalize an opportunity of
making an unexpected profit is known as speculative motive. The speculative motive provide a
firm with sufficient liquidity to take advantage of unexpected profitable opportunity that may
suddenly appear ( and just suddenly disappear if not capitalize immediately.)

4) Compensation motive:
Commercial banks require that in every current account , there should always be a minimum
cash balance. This minimum cash balance is generally not allowed by the bank to used for
transaction purpose and therefore , it becomes a sort of investment by the firm in the bank. In
order to avail the convenience of holding a current account , the minimum cash balance must be
maintained by the firm and this provides the compensation motive for holding cash.

Out of different motives, the transactions motive is the most obvious one and is found in every
firm. Even the precautionary motive is common & a firm maintains cash balance both for the
transactions motives & the precautionary motive. However , the speculative motive is a
subjective one may differ from one firm to another. Generally, the speculative motive is the least
important component for a firm’s preference for liquidity. The transaction & precautionary
motives account for most of the reasons why affirm holds cash balance. The compensation
motive may be a compulsion and the firm may not have many options. The cash held for
transaction motive is necessary, the cash held for precautionary motive provides a margin of
safety, but holding a cash does not generate any explicit monetary return, rather it involves a
cost. The main cost of holding cash is the loss of interest which the firm could otherwise earn by
investment of cash elsewhere.

Objectives of Cash Management

1. It Controls Cash Flow

Perhaps the most vital objective of any cash management system is limiting your cash outflow
and accelerating cash inflow.
This objective is clear-cut. As a business owner, you want to increase the amount of money
flowing into the business. At the same time, if you minimize the cash leaving your store, you
reduce operational expenses and CIT costs. A currency recycler, for example, recycles the same
cash that comes in through transactions to fund your employee floats and cash registers.
A cash management system that’s integrated with cash management software also increases your
real-time visibility of cash, so you have greater control of your cash flow.

2. It Optimizes Cash Levels for the Business

Controlling your cash flow is essential to optimizing cash levels. If your inflow isn’t available
for your use – you have outstanding unpaid invoices or money is sitting in your cash registers –
you may not have the liquidity your business needs.

Your cash management system allows you to optimize your cash levels, creating better liquidity.

A good example is your store float. If you’re unsure what your inflows will look like for the day,
you might set the float higher than you need to. That money then sits in your petty cash fund or
smart safe, when it could be paying down debts or sitting in a deposit account earning interest.

Conversely, if you put all your cash on deposit, you’ve hampered your liquidity. When an
unexpected cost crops up, you may find you don’t have the cash to cover it.

Cash management software has many functions that will help optimize your cash levels,
including:

Cash analytics: Provide data around the movement of cash from tills to vault holdings. This
allows you to manage cash balances, reconciliation, and deposit reporting more effectively.
Cash forecasting: Provides insights into trends to forecast your cash needs and replenishments,
while enabling you to see cash on hand and what you need on a frequent basis to operate your
business efficiently.

Cash status: Gives you a view into your available cash on hand and frequency of denomination
usage. You’ll better understand which notes and coins are most in demand, so you always have
enough cash on hand.

3. It Enables More Efficient Cash Planning

The right cash management system helps optimize cash, which allows you to plan more
effectively. When you determine how often – and how much – to deposit, you control CIT fees
and keep the right amount of cash liquid for the business.

Automated cash management systems collect and provide data, which helps you make more
informed decisions. With the right system, you will stop worrying about cash shortages and
multiple deposits running up the costs of doing business.

4. It Enables More Effective Cash Management

Cash flow is a factor in more than 80 percent of business failures, so it’s easy to see why
business owners put so much emphasis on managing cash flow correctly.

Having the right cash management system in place is key here. A good management system
allows you to see cash as it flows through your business, giving you a bird’s eye view of where
cash is leaving the business and where it’s entering.

Inventory Management
Inventory management helps companies identify which and how much stock to order at what
time. It tracks inventory from purchase to the sale of goods. The practice identifies and responds
to trends to ensure there’s always enough stock to fulfill customer orders and proper warning of a
shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although reported as an asset
on the balance sheet) ties up cash. Therefore, too much stock costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An accounting

measurement, inventory turnover reflects how often stock is sold in a period. A business does not
want more stock than sales. Poor inventory turnover can lead to deadstock, or unsold stock.
Why Is Inventory Management Important?
Inventory management is vital to a company’s health because it helps make sure there is rarely
too much or too little stock on hand, limiting the risk of stockouts and inaccurate records.

Public companies must track inventory as a requirement for compliance with Securities and
Exchange Commission (SEC) rules and the Sarbanes-Oxley (SOX) Act. Companies must
document their management processes to prove compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re able to fulfill
incoming or open orders and raises profits. Inventory management also:

Saves Money:
Understanding stock trends means you see how much of and where you have something in stock
so you’re better able to use the stock you have. This also allows you to keep less stock at each
location (store, warehouse), as you’re able to pull from anywhere to fulfill orders — all of this
decreases costs tied up in inventory and decreases the amount of stock that goes unsold before
it’s obsolete.

Improves Cash Flow:

With proper inventory management, you spend money on inventory that sells, so cash is always
moving through the business.

Satisfies Customers:
One element of developing loyal customers is ensuring they receive the items they want without
waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much inventory and not being
able to sell it, not having enough inventory to fulfill orders, and not understanding what items
you have in inventory and where they’re located. Other obstacles include:
Getting Accurate Stock Details:
If you don’t have accurate stock details,there’s no way to know when to refill stock or which
stock moves well.
Poor Processes:
Outdated or manual processes can make work error-prone and slow down operations.

Changing Customer Demand:

Customer tastes and needs change constantly. If your system can’t track trends, how will you
know when their preferences change and why?
Using Warehouse Space Well:
Staff wastes time if like products are hard to locate. Mastering inventory management can help
eliminate this challenge.

Learn more about the challenges and benefits of inventory management.

What Is Inventory?
Inventory is the raw materials, components and finished goods a company sells or uses in
production. Accounting considers inventory an asset. Accountants use the information about
stock levels to record the correct valuations on the balance sheet.

What are the 4 types of inventory?

The four types of inventory most commonly used are Raw Materials, Work-In-Process (WIP),
Finished Goods, and Maintenance, Repair, and Overhaul (MRO). You can practice better
inventory control and smarter inventory management when you know the type of inventory you
have. That includes choosing the best inventory management software to keep track of all that
inventory.

1. Raw Materials
Materials that are needed to turn your inventory into a finished product are raw materials. These
inventory items are bits and pieces of component parts that are currently in stock but have not yet
been used in either work-in-process or finished goods inventory.
There are two types of raw materials: direct materials—which are used directly in finished
goods, and indirect materials—which are part of overhead or factory costs.

Inventory example: For example, direct raw materials might be leather to make belts for your
company would fall under this category. Or, if you sell artificial flowers for your interior design
business, the cotton used would be considered direct raw materials, too.

Indirect raw materials might be lightbulbs, batteries, or anything else that indirectly contributes
to keeping your shop running.

2. Work-In-Process
Inventory that is being worked on is Work-In-Process (WIP), just like the name sounds. From a
cost perspective, WIP includes raw materials (plus, sometimes labor costs) that are still “in
production” when the accounting period ends.

In other words, whatever direct and indirect raw materials your business is using to create
finished goods is WIP inventory.
Inventory example: If you sell medical equipment, the packaging would be considered WIP.
That’s because the medicine cannot be sold to the consumer until it is stored in proper packaging.
It’s literally a work-in-process.

Another example would be a custom wedding dress that’s not quite finished when the end of the
fiscal year rolls around. That lace, silk, and taffeta are no longer raw materials, but they’re not
quite a “finished goods” wedding dress, either.

3. Finished Goods
Maybe the most straightforward of all inventory types is finished goods inventory. That
inventory you have listed for sale on your website? Those are finished goods. Any product that is
ready to be sold to your customers falls under this category.

Inventory example: Finished goods could be a pre-packaged fruit salad, a monogrammed

bathrobe, or a custom-built laptop ready for an employee to use.

4. Overhaul / MRO
Also known as Maintenance, Repair, and Operating Supplies, MRO inventory is all about the
small details. It is inventory that is required to assemble and sell the finished product but is not
built into the product itself.

Depending on the specifics of your business, this inventory might be in storage, at a supplier, or
in transit out for delivery.

Inventory example: For example, gloves to handle the packaging of a product would be
considered MRO. Basic office supplies such as pens, highlighters, and paper would also be in
this category.

Risks and costs associated with inventories

1. Risk of price decline

Holding Inventory may increase the risk of decline in price. This may be due to increase in the
supply of products in market by competitors, introduction of a new competitive product,
competitive pricing policy of competitors etc.

2. Risk of obsolescence
The is a risk of inventory becoming obsolescence. The inventory may become obsolete/outdated
due to improved technology, improvements in product design, changes in customers’ taste etc.
3. Purchase cost
A firm has to pay high price for managing inventory. Inventory management has to take into
account of the price paid to the suppliers and the expense of transport for bringing the material to
stores, insurance and transportation cost.

4. Ordering cost
Cost of ordering is one another factor that a firm has to consider in Inventory management.
Ordering costs includes cost of requisitioning, preparation of purchase order, transportation of
inventory, receiving the supplies at the warehouse etc.

5. Carrying cost
Carrying cost includes the cost of storing the inventory in warehouse, handling expenses,
insurance and rent paid for managing the inventory, opportunity cost locked up in stocks etc.
Opportunity cost here refers to the alternative use of funds that the firm would have used to
invest in stocks.

6. Stock out (shortage) cost

Stocks results in higher costs when they fall short of demand. Shortage of stocks also results in
higher cost, dissatisfaction among customers, decrease in sales and increase of loss to firm.

Measurement of shortage cost is relatively difficult because of its intangible nature. In practice,
the lost contribution resulting from failure to meet demand provides a reasonable approximation.
In cases where stock out does not result in loss in business, additional cost for crash procurement
etc. may be considered as shortage cost.

Management of accounts receivables

What is Accounts Receivable?

The word receivable stands for the amount of payment not received. This means the company
has extended credit facility to its customers. Accounts receivable is the money that a business has
a right to receive after a certain period of time when the business has sold goods or services on
credit.
For example, the accounts receivable is the record of fact that a company has done some work
for customer X and that customer X owes money to the company. Generally, the credit period is
short ranging from a month or two to a year.

What is Accounts receivable management?

Accounts receivable management is the process of ensuring that customers pay their dues on
time. It helps the businesses to prevent themselves from running out of working capital at any
point of time. It also prevents overdue payment or non-payment of the pending amounts of the
customers. It builds the businesses financial and liquidity position.
A good receivable management contributes to the profitability by reducing the risk of any bad
debts. Management is not only about reminding the customers and collecting the money on time.
It also involves identifying the reasons for such delays and finding a solution to those issues.

What is the process involved in the Accounts receivable management?

An Account receivable management process involves the following :

● Credit rating i.e the paying ability of the customers shall be reviewed before agreeing to
any terms and conditions
● Continuously monitoring any risk of non-payment or delay in receiving the payments
● Customer relations should be maintained and thus to reduce the bad debts
● Addressing the complaints of the customers
● After receiving the payments, the balances in the particular account receivable should be
reduced
● Preventing any bad debts of the receivables outstanding during a particular period.

Purpose of Receivable Management –

The basic purpose of the firm’s receivable management is to determine effective credit policy
that increases the efficiency of a firm’s credit and collection department and contributes to the
maximization of the value of the firm. The specific purposes of receivable management are as
follows:
● To evaluate the creditworthiness of customers before granting or extending the credit.
● To minimize the cost of investment in receivables.
● To minimize the possible bad debt losses.
● To formulate the credit terms in such a way that results in maximization of sales revenue
and still maintaining a minimum investment in receivables.
● To minimize the cost of running a credit and collection department.
● To maintain a trade-off between costs and benefits associated with credit policy.

Costs of maintaining receivables

What is the Optimum Size of Receivables?

The optimum investment in receivables will be at a level where there is a trade-off between costs
and profitability. When the firm resorts to a liberal credit policy, the profitability of the firm
increases on account of higher sales. However, such a policy results in increased investment in
receivables, increased chances of bad debts and more collection costs. The total investment in
receivables increases and, thus, the problem of liquidity is created. On the other hand, a stringent
credit policy reduces the profitability but increases the liquidity of the firm.