Subject Name :FM WHAT IS CAPITAL BUDGETING? Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, new equipments, rebuilding or replacing existing equipments, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one time. Capital budgeting usually involves calculation of each project’s future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors. Capital is the total investment of the company and budgeting is the art of building budgets. FEATURES OF CAPITAL BUDGETING 1) It involves high risk 2) Large profits are estimated 3) Long time period between the initial investments and estimated returns CAPITAL BUDGETING PROCESS: A) Project identification and generation: The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be addition of a new product line or expanding the existing one. It could be a proposal to either increase the production or reduce the costs of outputs. B) Project Screening and Evaluation: This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal. This has to match the objective of the firm to maximize its market value. The tool of time value of money comes handy in this step. Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and appropriate provisioning has to be done for the same.
Transcript
Subject Name :FM
WHAT IS CAPITAL BUDGETING?
Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets. The large expenditures include the
purchase of fixed assets like land and building, new equipments, rebuilding or replacing existing
equipments, research and development, etc. The large amounts spent for these types of projects are
known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits
since most companies are able to manage only a limited number of large projects at any one time.
Capital budgeting usually involves calculation of each project’s future accounting profit by period, the
cash flow by period, the present value of cash flows after considering time value of money, the
number of years it takes for a project’s cash flow to pay back the initial cash investment, an
assessment of risk, and various other factors.
Capital is the total investment of the company and budgeting is the art of building budgets.
FEATURES OF CAPITAL BUDGETING
1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments and estimated returns
CAPITAL BUDGETING PROCESS:
A) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for investments. There could be
various reasons for taking up investments in a business. It could be addition of a new product line or
expanding the existing one. It could be a proposal to either increase the production or reduce the
costs of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal. This
has to match the objective of the firm to maximize its market value. The tool of time value of money
comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow
along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly
and appropriate provisioning has to be done for the same.
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C) Project Selection:
There is no such defined method for the selection of a proposal for investments as different
businesses have different requirements. That is why, the approval of an investment proposal is done
based on the selection criteria and screening process which is defined for every firm keeping in mind
the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to
be explored by the finance team. This is called preparing the capital budget. The average cost of
funds has to be reduced. A detailed procedure for periodical reports and tracking the project for the
lifetime needs to be streamlined in the initial phase itself. The final approvals are based on
profitability, Economic constituents, viability and market conditions.
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D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like implementing
the proposals, completion of the project within the requisite time period and reduction of cost are
allotted. The management then takes up the task of monitoring and containing the implementation of
the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the standard ones.
The unfavorable results are identified and removing the various difficulties of the projects helps for
Lending terms of financial institutions Economic value of the project
CAPITAL BUDGETING DECISIONS:
The crux of capital budgeting is profit maximization. There are two ways to it; either increase the
revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations
by adding a new product line. Reducing costs means representing obsolete return on assets.
Accept / Reject decision – If a proposal is accepted, the firm invests in it and if rejected the firm
does not invest. Generally, proposals that yield a rate of return greater than a certain required rate of
return or cost of capital are accepted and the others are rejected. All independent projects are
accepted. Independent projects are projects that do not compete with one another in such a way that
acceptance gives a fair possibility of acceptance of another.
Mutually exclusive project decision – Mutually exclusive projects compete with other projects in
such a way that the acceptance of one will exclude the acceptance of the other projects. Only one
may be chosen. Mutually exclusive investment decisions gain importance when more than one
proposal is acceptable under the accept / reject decision. The acceptance of the best alternative
eliminates the other alternatives.
Capital rationing decision – In a situation where the firm has unlimited funds, capital budgeting
becomes a very simple process. In that, independent investment proposals yielding a return greater
than some predetermined level are accepted. But actual business has a different picture. They have
fixed capital budget with large number of investment proposals competing for it. Capital rationing
refers to the situation where the firm has more acceptable investments requiring a greater amount of
finance than that is available with the firm. Ranking of the investment project is employed on the
basis of some predetermined criterion such as the rate of return.
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Capital Budgeting
Capital budgeting (or investment appraisal) is the process of determining the
viability to long-term investments on purchase or replacement of property plant
and equipment, new product line or other projects.
Capital budgeting consists of various techniques used by managers such as:
1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index
All of the above techniques are based on the comparison of cash inflows and outflow of a project however they are substantially different in their approach.
A brief introduction to the above methods is given below:
Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.
Net Present Value (NPV) is equal to initial cash outflow less sum of discounted
cash inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.
Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not discounted.
Internal Rate of Return (IRR) is the discount rate at which net present value of the project becomes zero. Higher IRR should be preferred.
Profitability Index (PI) is the ratio of present value of future cash flows of a
project to initial investment required for the project.
criteria that any project having ARR higher than the minimum rate established by the management
will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept of
net earnings. However, this method also ignores time value of money and doesn’t consider the
length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the
market value of shares.
ARR= Average income/Average Investment
Discounted cash flow method:
The discounted cash flow technique calculates the cash inflow and outflow through the life of an
asset. These are then discounted through a discounting factor. The discounted cash inflows and
outflows are then compared. This technique takes into account the interest factor and the return after
the payback period.
Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals. In this technique
the cash inflow that is expected at different periods of time is discounted at a particular rate. The
present values of the cash inflow are compared to the original investment. If the difference between
them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of
money and is consistent with the objective of maximizing profits for the owners. However,
understanding the concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in the initial year
(tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present, value cannot be known.
NPV = PVB – PVC
where,
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PVB = Present value of benefits
PVC = Present value of Costs
Internal Rate of Return (IRR):
This is defined as the rate at which the net present value of the investment is zero. The discounted
cash inflow is equal to the discounted cash outflow. This method also considers time value of
money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out
of the cash inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the
project and not any rate determined outside the investment.
It can be determined by solving the following equation:
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject
Profitability Index (PI):
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial
cash outflow of the investment. It may be gross or net, net being simply gross minus one. The
formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,
PI = NPV (benefits) / NPV (Costs)
All projects with PI > 1.0 is accepted.
IMPORTANCE OF CAPITAL BUDGETING
1) Long term investments involve risks: Capital expenditures are long term investments which
involve more financial risks. That is why proper planning through capital budgeting is needed.
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2) Huge investments and irreversible ones: As the investments are huge but the funds are
limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment
decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur
losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the
profitability of the company. It helps avoid over or under investments. Proper planning and analysis
of the projects helps in the long run.
SIGNIFICANCE OF CAPITAL BUDGETING
Capital budgeting is an essential tool in financial management
Capital budgeting provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments
It helps in exposing the risk and uncertainty of different projects
It helps in keeping a check on over or under investments
The management is provided with an effective control on cost of capital expenditure projects
Ultimately the fate of a business is decided on how optimally the available resources are
used
Example of Capital Budgeting:
Capital budgeting for a small scale expansion involves three steps: recording the investment’s cost,
projecting the investment’s cash flows and comparing the projected earnings with inflation rates and
the time value of the investment.
For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to
"pay back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent
annually, then the estimated return value at the end of the first year ($20,000) is actually worth
$15,385 when you account for inflation ($20,000 divided by 1.3 equals $15,385). The investment
generates only $385 in real value after the first year.
Conclusion:
According to the definition of Charles T. Hrongreen, “Capital Budgeting is a long-term planning for
making and financing proposed capital outlays.”
One can conclude that capital budgeting is the attempt to determine the future.
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Two Methods of capital budgeting
In earlier articles, we have discussed the capital budgeting and its types. Today we will discuss the
methods of capital budgeting:
(I)Traditional methods
i) Pay back period method: this method means the period in which the total investment in the
permanent assets pays back itself. This method is based upon the concept that every capital
expenditure pays itself back within a certain period of time. Thus, this method measures the period
of time means the time taken where the cost of project is recovered from the earning of the project
itself.
Decision rule: the investment with a shorter pay back period is accepted and the one which has a
longer pay back period is rejected.
Pay back period= original cost of asset/ cash inflow
Advantages of Pay back period method:
1. it is easy to calculate, simple to understand.
2. it saves cost.
3. a firm having less funds can select the shorter time period for pay back
Disadvantages of Pay back period method:
1. it fails to take in account cash inflow earned after pay back period.
2. it does not take into account salvage value of asset.
ii) Improvement to traditional approach to pay back method:
a) Post pay back profitability method: the main disadvantage of pay back method is that it fails to
take in account cash inflow earned after pay back period so true profitability of the project can not be
ascertained. An improvement to this method can be done only by taking into account the return
received after the pay back period.
Post pay back profitability= post pay back profit *100/inveastment
b) Pay back reciprocal method: this method is used to find out the internal rate of return generated
by a project. It is used when equal cash inflow is generated every year.
Pay back reciprocal = annual cash inflow*100/ total investment
c) Post pay back period method: the limitation of the pay back method was that it ignores the life of
the project beyond the pay back period. But this method takes into account the
life of the project beyond the pay back period. Hence the project which gives the greatest post pay
back period is accepted.
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d) Discounted pay back method: the pay back method ignores the time value of money. Discounted
pay back method is an improvement over this method. Under this method the present value of all
cash inflow and cash outflow is calculated at an appropriate discount rate. Discounted pay back
period is the period at which the present value of cash inflow = present value of cash outflow. The
project with the shorter time period is accepted.
iii) Rate of return method or accounting method: this method takes into account the earning
expected from the investment over their whole life. This is called accounting method as it used the
accounting concept of profit after tax and depreciation.
Decision rule: the project with higher rate of return is accepted and the project with the lower rate of
return is rejected.
a) Average rate of return method: under this method average profit after tax and depreciation is
calculated and then it is divided by total investment.
Average rate of return= average annual profit after tax and depreciation*100/net investment
b) Return per unit of investment method: it is slightly different from the above method. under this
method total profit after tax and depreciation is divided by total investment.
Return per unit of investment = total profit after tax and depreciation *100/net investment
c) Average return on average investment: it is a good method of finding out rate of return on
investment.
Average return on average investment = average annual profit after tax and depreciation*100/aveage
investment
Advantages of rate of return method:
1. It is easy to calculate, simple to understand.
2. It gives better view of profitability.
3. It is based upon the accounting concept.
Disadvantages of rate of return method:
1. It fails to take in account cash flow.
2. It does not take into time value of money.
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(II)Time adjusted or discounted method:
The main drawback of the traditional method is that it gives equal value to the present and future
flow of incomes and do not take into consideration the time value of money. A rupee earned today
has more value than the rupee earned after five years. This method is also called modern method of
capital budgeting.
i) Net present value method: this method takes into account the time value of money which
means the return on investment is calculated by introducing the time element. This method realizes
the concept that a rupee earned today has more value than the rupee earned after five years. To
calculate net present value the following steps are used:
a) First of all determine the appropriate rate of interest selected as minimum rate of return or
discount rate.
b) Compute the present value of cash outflow at determined discount rate.
c) Compute the present value of cash outflow at determined discount rate.
d) Calculate the net present value of each project by subtracting the present value of cash inflow from
the present value of cash outflow.
Decision rule: if the net present value is positive or zero or than project is accepted otherwise
rejected.
NPV is + accepted
NPV is zero accepted
NPV is – rejected
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The project having maximum positive value is accepted among various proposals.
Present value = 1/ (1+r)n
Advantages of net present value method:
1. It takes into account maximum profitability.
2. It gives better view of profitability.
3. It recognizes the time value of money.
Disadvantages of net present value method:
1. It is difficult to understand.
2. It is difficult to determine the discount rate.
ii) Internal rate of return method: this method is also known as time adjusted rate of return,
discounted rate of return, yield method, discounted cash flow, and trial and error method. Under this
method cash flow of a project is discounted at a suitable rate by hit and trial method. It is the rate
where present value of cash inflow= present value of cash outflow. To calculate internal rate of return
the following steps are used:
a) Determine the future net cash flow.
b) Determine the discount rate at which cash inflow = cash outflow.
Decision rule: IRR > minimum required rate of return than accept the proposal
IRR < minimum required rate of return than reject the proposal
IRR = minimum required rate of return than indifferent
Advantages of internal rate of return method:
1. It takes into account maximum profitability.
2. It gives better view of profitability.
3. It recognizes the time value of money.
Disadvantages of internal rate of return method:
1. It is difficult to understand.
2. The result of NPV and IRR differs.
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iii) Profitability index or benefit cost ratio: it is the relationship between present value of cash
inflow and present value of cash outflow.
Profitability index = present value of cash inflow/ present value of cash outflow
Or
Profitability index = net present value/ initial cash outlay
Net profitability index = profitability index – 1
Decision rule: if PI > 1 accepts the project
if PI < 1 reject the project
if PI = 1 indifferent.
Advantages of profitability index method
1. This method takes into consideration all the requirements of sound investment decisions.
2. It recognizes the time value of money.
Disadvantages of profitability index method
1. It is difficult to understand.
2. This method does not take into account size of investment.
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CHAPTER OBJECTIVES
Meaning and Concept of Working Capital
Classification or Kinds of Working Capital Importance or Advantages of Adequate Working
Capital Excess or Inadequate Working Capital
Need or Objects of Working Capital Factors determining Working Capital Requirements Management of Working Capital Principles
Determining Working Capital Financing Mix
Lets Sum Up
Questions
Meaning of Working Capital
Capital required for a business can be classified under two main categories viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and to
carry out its day-to-day operations. Long-term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, Building etc. Investments in these assets represent that
part of firm‟s capital which is blocked on permanent basis and is called fixed capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of wages and other day-to-day expenses etc. These
funds are known as working capital which is also known as Revolving or
circulating capital or short term capital. According to Shubin, “Working capital is amount of funds necessary to cover the cost of operating the enterprise”.
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Concept of Working Capital
There are two concepts of working capital:
(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current assets of the enterprise. Examples of current assets are : cash in hand and bank balances, Bills Receivable, Short term loans and advances, prepaid
expenses, Accrued Incomes etc. The gross working capital is financial or
going concern concept. Net working capital is excess of Current Assets over Current liabilities.
Net Working Capital = Current Assets – Current Liabilities When current assets exceed the current liabilities the working capital is positive and negative working capital results when current liabilities are more than current assets. Examples of current liabilities are Bills Payable,
Sunday debtors, accrued expenses, Bank Overdraft, Provision for taxation etc. Net working capital is an accounting concept of working capital.
Classification or Kinds of Working Capital Working capital may be classified in two ways:
(a) On the basis of concept
(b) On the basis of time
On the basis of concept working capital is classified as gross working capital
and net working capital. On the basis of time working capital may be classifies as Permanent or fixed working capital and Temporary or variable working capital.
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Permanent or Fixed working capital
It is the minimum amount which is required to ensure effective
utilisation of fixed facilities and for maintaining the circulation of current assets. There is always a minimum level of current assets which its continuously required by enterprise to carry out its normal business
operations. As the business grows, the requirements of permanent working capital also increase due to increase in current assets. The permanent working capital can further be classified as regular working capital and
reserve working capital required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so on. Reserve working capital is the excess mount over the requirement for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.
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Temporary or Variable working capital
It is the amount of working capital which is required to meet the
seasonal demands and some special exigencies. Variable working capital is further classified as seasonal working capital and special working capital. The capital required to meet seasonal needs of the enterprise is
called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research etc.
Importance or Advantages of Adequate Working Capital : Working capital is the life blood and nerve centre of a business. Hence, it is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as
follows:
1. Solvency of the Business: Adequate working capital helps in maintaining solvency of business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business
concern to make prompt payments and hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on purchases and hence it reduces cost.
5. Regular Supply of Raw Material: Sufficient working capital ensure regular supply of raw materials and continuous production.
6. Regular payment of salaries, wages and other day to day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day to day commitments which raises morale of its employees, increases their efficiency, reduces costs and wastages.
7. Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression.
8. Quick and regular return on investments: Every investor wants a quick and regular return on his
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investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to is investor as there may not be much pressure to plough back profits which gains the confidence of investors and creates a favourable market to raise additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices.
10. High Morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business.
Excess or Inadequate Working Capital Every business concern should have adequate working capital to run its
business operations. It should have neither excess working capital nor inadequate working capital. Both excess as well as short working capital
positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for business and hence business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may also fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and other financial institutions may not be maintained.
Disadvantages of Inadequate working capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions and
undertake profitable projects due to lack of working capital.
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4. The rate of return on investments also falls with shortage of working
capital.
5. The firm cannot pay day-to-day expenses of its operations and it created
inefficiencies, increases costs and reduces the profits of business.
The Need or Objects or Working Capital
The need for working capital arises due to time gap between production
and realisation of cash from sales. There is an operating cycle involved in sales and realisation of cash. There are time gaps in purchase of raw materials and production, production and sales, and sales and realisation of
cash. Thus, working capital is needed for following purposes.
1. For purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel, power etc.
4. To meet selling costs as packing, advertisement
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work in progress, stores and spares and finished stock.
Greater size of business unit large will be requirements of working
capital. The amount of working capital needed goes on increasing with growth and expansion of business till it attains maturity. At maturity the amount of working capital needed is called normal working capital.
Factors Determing the Working Capital Requirements The following are important factors which influence working capital requirements:
1. Nature or Character of Business: The working capital requirements of firm depend upon nature of its business.
Public utility undertakings like electricity, water supply need very limited working capital because they offer cash sales only and supply services, not products, and such no funds are tied up in
inventories and receivables whereas trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets and as such they need large amount of
working capital. Manufacturing undertaking require sizeable working capital between these two.
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2. Size of Business/Scale of Operations: Greater the size of a business unit, larger will be requirement of working capital and vice-versa.
3. Production Policy: The requirements of working capital depend upon production policy. If the policy is to keep production
steady by accumulating inventories it will require higher working capital. The production could be kept either steady by accumulating inventories during slack periods with view to meet high demand
during peak season or production could be curtailed during slack season and increased during peak season.
4. Manufacturing process / Length of Production cycle: Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing
time, the raw materials and other supplies have to be carried for longer period in the process with progressive increment of labour and service costs before finished product is finally obtained.
Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen.
5. Credit Policy: A concern that purchases its requirements on credit and sell its products/services on cash requires lesser amount of working capital. On other hand a concern buying its
requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.
6. Business Cycles: In period of boom i.e. when business is prosperous, there is need for larger amount of working capital
due to increase in sales, rise in prices etc. On contrary in times of depression the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have large amount of working capital lying idle.
7. Rate of Growth of Business: The working capital
requirements of a concern increase with growth and expansion of its business activities. In fast growing concerns large amount of working capital is required whereas in normal rate of expansion in the volume of business the firm may have retained profits to provide for more working capital.
8. Earning Capacity and Dividend Policy. The firms with high earning capacity generate cash profits from operations and contribute to working capital. The dividend policy of concern
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also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its
generation of profits need more working capital than firm that retains larger part of its profits and does not pay so high rate of cash dividend.
9. Price Level Changes: Changes in price level affect the working capital requirements. Generally, the rising prices will
require the firm to maintain large amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the working capital cycle starts with the purchase of raw material and
ends with realisation of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work in progress with
progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realisation of cash and this cycle again from cash to purchase of raw material and so on. The speed with which the working capital
completes one cycle determines the requirements of working capital longer the period of cycle larger is requirement of working capital.
Managemant of Working Capital
Working capital refers to excess of current assets over current liabilities. Management of working capital therefore is concerned with the problems that arise in attempting to manage current assets, current liabilities and inter relationship that exists between them. The basic goal of working
capital management is to manage the current assets and current of a firm in such a way that satisfactory level of working capital is maintained i.e. it is neither inadequate nor excessive. This is so because both inadequate as well
as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working
capital implies idle funds which earns no profits for the business. Working
capital Management policies of a firm have a great effect on its profitability, liquidity and structural health of organization. In this context,
evolving capital management is three dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard to profitability, risk and liquidity.
2. Dimension II is concerned with decisions about composition and level of current assets.
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3. Dimension III is concerned with decisions about composition and level of current liabilities.
Principles of Working Capital Management
Principles of Working Capital Management
Principle of Risk Principle of Principle of Principle of
Variation Cost of Capital Equity position Maturity of
Payment
1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as and when they become due for payment. Larger
investment in current assets with less dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases opportunity for gain or loss. On other hand less investment in current assets with greater
dependence on short-term borrowings increases risk, reduces liquidity and increases profitability.
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There is definite direct relationship between degree of risk and profitability. A conservative management prefers to minimize risk by maintaining higher
level of current assets while liberal management assumes greater risk by reducing working capital. However, the goal of management should be to establish suitable trade off between profitability and risk. The various
working capital policies indicating relationship between current assets and sales are depicted below:-
2. Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and degree of risk
involved. Generally, higher the risk lower is cost and lower the risk higher is the cost. A sound working capital management should always try to achieve proper balance between these two.
3. Principle of Equity Position: This principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by firm‟s equity position. Every rupee invested in
current assets should contribute to the net worth of firm. The level of current assets may be measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.
4. Principle of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital. According to this principle, a firm should make every effort to relate maturities of payment to
its flow of internally generated funds. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater inability to meet its obligations in time.
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(1) The Hedging or Matching Approach: The term „hedging‟
refers to two off-selling transactions of a simultaneous but opposite nature
which counterbalance effect of each other. With reference to financing mix,
the term hedging refers to „process of matching of maturities of debt with
maturities of financial needs‟. According to this approach the maturity of
sources of funds should match the nature of assets to be financed. This
approach is also known as „matching approach‟ which classifies the
requirements of total working capital into permanent and temporary
working capital.
The hedging approach suggests that permanent working capital requirements should be financed with funds from long-term sources while
temporary working capital requirements should be financed with short-term funds.
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(2) The Conservative Approach: This approach suggests that the entire estimated investments in current assets should be financed from long-
term sources and short-term sources should be used only for emergency requirements. The distinct features of this approach are:
(ii) Liquidity is greater
(iii) Risk is minimised
(iv) The cost of financing is relatively more as interest has to be paid even on seasonal requirements for entire period.
Trade off Between the Hedging and Conservative Approaches
The hedging approach implies low cost, high profit and high risk while the conservative approach leads to high cost, low profits and low risk. Both the
approaches are the two extremes and neither of them serves the purpose of efficient working capital management. A trade off between the two will then be an acceptable approach. The level of trade off may differ from case
to case depending upon the perception of risk by the persons involved in financial decision making. However, one way of determining the trade off is by finding the average of maximum and the minimum requirements of
current assets. The average requirements so calculated may be financed out of long-term funds and excess over the average from short-term funds.
(3). Aggressive Approach: The aggressive approach suggests that entire estimated requirements of current asset should be financed from short-term sources
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even a part of fixed assets investments be financed from short-term sources. This approach makes the finance – mix more risky, less costly and more profitable.
Hedging Vs Conservative Approach
Hedging Approach Conservative Approach
1. The cost of financing is reduced.
1. The cost of financing is higher
2. The investment in net working capital is nil.
2. Large Investment is blocked in temporary working capital.
3. Frequent efforts are required to arrange funds.
3. The firm does not face frequent financing problems.
4. The risk is increased as firm is vulnerable to sudden shocks.
4. It is less risky and firm is able to absorb shocks.
Lets Sum Up
The term working capital may be used to denote either the gross working capital
which refers to total current assets or net working capital which refers to excess of current asset over current liabilities.
The working capital requirement for a firm depends upon several factors such as
Nature or Character of Business, Credit Policy, Price level changes, business cycles, manufacturing process, production policy.
The working capital need of the firm may be bifurcated into permanent and temporary working capital.
The Hedging Approach says that permanent requirement should be financed by long term sources while the temporary requirement should be financed by short-term sources of finance. The Conservative approach on the other hand says that the working capital requirement be financed from long-term sources. The Aggressive approach says that even a part of permanent requirement may be financed out of short-term funds.
Every firm must monitor the working capital position and for this purpose certain accounting ratios may be calculated.
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Working Capital: 8 Sources of Working Capital Finance –
Explained!
The two segments of working capital viz., regular or fixed or permanent and variable are financed by the long-term
and the short-term sources of funds respectively. The main sources of long-term funds are shares, debentures, term-
loans, retained earnings etc.
The sources of short-term funds used for financing variable part of working capital mainly include
the following:
1. Loans from commercial banks
2. Public deposits
3. Trade credit
4. Factoring
5. Discounting bills of exchange
6. Bank overdraft and cash credit
7. Advances from customers
8. Accrual accounts
These are discussed in turn.
1. Loans from Commercial Banks:
Small-scale enterprises can raise loans from the commercial banks with or without security. This method of financing
does not require any legal formality except that of creating a mortgage on the assets. Loan can be paid in lump sum or
in parts. The short-term loans can also be obtained from banks on the personal security of the directors of a country.
Such loans are known as clean advances. Bank finance is made available to small- scale enterprises at concessional
rate of interest. Hence, it is generally a cheaper source of financing working capital requirements of enterprise.
However, this method of raising funds for working capital is a time-consuming process.
2. Public Deposits:
Often companies find it easy and convenient to raise short- term funds by inviting shareholders, employees and the
general public to deposit their savings with the company. It is a simple method of raising funds from public for which
the company has only to advertise and inform the public that it is authorised by the Companies Act 1956, to accept
public deposits.
Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank deposits.
However, the companies can raise funds through public deposits subject to a maximum of 25% of their paid up capital
and free reserves.
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But, the small-scale enterprises are exempted from the restrictions of the maximum limit of public
deposits if they satisfy the following conditions:
The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is less.
(i) The paid up capital does not exceed Rs. 12 lakhs.
(ii) The number of depositors is not more than 50%.
(iii) There is no invitation to the public for deposits.
The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest disadvantage
associated with this source is that it is not available to the entrepreneurs during depression and financial stringency.
3. Trade Credit:
Just as the companies sell goods on credit, they also buy raw materials, components and other goods on credit from
their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade creditors for credit purchases are
regarded as sources of finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months.
Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact, availability of this
type of finance largely depends upon the volume of business. More the volume of business more will be the
availability of this type of finance and vice versa.
Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its financial
position, degree of competition in the market, etc. However, availing of trade credit involves loss of cash discount
which could be earned if payments were made within 7 to 10 days from the date of purchase of goods. This loss of cash
discount is regarded as implicit cost of trade credit.
4. Factoring:
Factoring is a financial service designed to help firms in managing their book debts and receivables in a better
manner. The book debts and receivables are assigned to a bank called the 'factor' and cash is realised in advance from
the bank. For rendering these services, the fee or commission charged is usually a percentage of the value of the book
debts/receivables factored.
This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps the supplier
companies to secure finance against their book debts and receivables, and on the other, it also helps in saving the
effort of collecting the book debts.
The disadvantage of factoring is that customers who are really in genuine difficulty do not get the opportunity of
delaying payment which they might have otherwise got from the supplier company.
In the present context where industrial sickness is spreading like an epidemic, the reason for which particularly in SSI
sector being delayed payments from their suppliers; there is a clear-cut rationale for introduction of factoring system.
There has been some progress also on this front.
The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of factoring
organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have been accepted by the
Government of India. The Group is of the view that factoring for SSI units could prove to be mutually beneficial to
both Factors and SSI units and Factors should make every effort to orient their strategy to crystallize the potential
demand from the sector.
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5. Discounting Bills of Exchange:
When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The bills
are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill till the
date of maturity, prefers to discount them with commercial banks on payment of a charge known as discount.
The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills' is used in respect of
demand bills. The rate of discount to be charged by the bank is prescribed by the Reserve Bank of India (RBI) from
time to time. It generally amounts to the interest for the period from the date of discounting to the date of maturity of
bills.
If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then becomes liable to
pay the amount to the bank. The cost of raising finance by this method is the amount of discount charged by the bank.
This method is widely used by companies for raising short-term finance.
6. Bank Overdraft and Cash Credit:
Overdraft is a facility extended by the banks to their current account holders for a short-period generally a week. A
current account holder is allowed to withdraw from its current deposit account upto a certain limit over the balance
with the bank. The interest is charged only on the amount actually overdrawn. The overdraft facility is also granted
against securities.
Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a specified-limit known
as 'cash credit limit.' The cash credit facility is allowed against the security. The cash credit limit can be revised from
time to time according to the value of securities. The money so drawn can be repaid as and when possible.
The interest is charged on the actual amount drawn during the period rather on limit sanctioned. The rate of interest
charged on both overdraft and cash credit is relatively higher than the rate of interest given on bank deposits.
Arranging overdraft and cash credit with the commercial banks has become a common method adopted by companies
for meeting their short- term financial, or say, working capital requirements.
7. Advances from Customers:
One way of raising funds for short-term requirement is to demand for advance from one's own customers. Examples
of advances from the customers are advance paid at the time of booking a car, a telephone connection, a flat, etc. This
has become an increasingly popular source of short-term finance among the small business enterprises mainly due to
two reasons.
First, the enterprises do not pay any interest on advances from their customers. Second, if any company pays interest
on advances, that too at a nominal rate. Thus, advances from customers become one of the cheapest sources of raising
funds for meeting working capital requirements of companies.
8. Accrual Accounts:
Generally, there is a certain amount of time gap between incomes is earned and is actually received or expenditure
becomes due and is actually paid. Salaries, wages and taxes, for example, become due at the end of the month but are
usually paid in the first week of the next month. Thus, the outstanding salaries and wages as expenses for a week help
the enterprise in meeting their working capital requirements. This source of raising funds does not involve any cost.
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A constant flow of working capital is an intrinsic component of a successful business. This is
especially true considering the outflow that is a part and parcel of every cycle: salaries and wages
need to be paid; raw materials need to be purchased and equipment need to be serviced; funds are
needed for marketing, advertising, and other general overhead costs; reserves are required till the
customers make their payment. Working capital is truly the lifeline for any company.
The question arises as to how does a business acquire funds for working capital. There are two
types of financing: short term and long term.
Short Term Financing
Banks can be an invaluable source of short term working capital finance.
1. Overdraft Agreement:
By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up
to a certain limit without the need for further discussion. The bank might ask for security in the form
of collateral and they might charge daily interest at a variable rate on the outstanding debt. However,
if the business is confident of making the repayments quickly, then an overdraft agreement is a
valuable source of financing, and one that many companies resort to.
2. Accounts Receivable Financing:
Many banks and non-banking financial institutions provide invoice discounting facilities. The
company takes the commercial bills to the bank which makes the payment minus a small fee. Then,
on the due date the bank collects the money from the customer. This is another popular method of
financing especially among small traders. Businesses that offer large terms of credit can carry on
their operations without having to wait for the customers to settle their bills.
3. Customer Advances:
There are many companies that insist on the customer making an advance payment before selling
them goods or providing a service. This is especially true while dealing with large orders that take a
long time to fulfill. This method also ensures that the company has some funds to channelize into its
operations for fulfilling those orders.
4. Selling Goods on Installment:
Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles and
so on, allow customers to make their payments in installments. Since many of these items have
become modern day essentials, their customers might not come from well-to-do backgrounds or the
cost of the product might be too prohibitive for immediate payment. In such a case, instead of
waiting for a large payment at the end, they allow the customers to make regular monthly payments.
This ensures that there is a constant flow of funds coming into the business that does not choke up
the accounts receivable numbers.
Long-Term Financing
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Relying purely on short-term funds to meet working capital needs is not always prudent, especially
for industries where the manufacture of the product itself takes a long time: automobiles, aircraft,
refrigerators, and computers. Such companies need their working capital to last for a long time, and
hence they have to think about long term financing.
1. Long-Term Loan from a Bank:
Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their
working capital needs for two, three or more years.
2. Retain Profits:
Rather than making dividend payments to shareholders or investing in new ventures, many
businesses retain a portion of their profits so that they may use it for working capital. This way they
do not have to take loans, pay interest, incur losses on discounted bills, and they can be self-
sufficient in their financing.
3. Issue Equities and Debentures:
In extreme cases when the business is really short of funds, or when the company is investing in a
large-scale venture, they might decide to issue debentures or bonds to the general public or in some
cases even equity stock. Of course, this will be done only by conglomerates and only in cases when
there is a need for a huge quantum of funds.
Companies cannot rely only on limited sources for their working capital needs. They need to tap
multiple avenues. They also need to constantly evaluate what their needs are, through analysis of
financial statements and financial ratios, and choose their working capital channels judiciously. This
is an ongoing process, and different routes are appropriate at different points in time. The trick is to
choose the right alternative as per the situation.
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Motives for Holding Cash Definition: The Motives for Holding Cash is simple, the cash inflows and outflows are not well
synchronized, i.e. sometimes the cash inflows are more than the cash outflows while at other
times the cash outflows could be more. Hence, the cash is held by the firms to meet the certain as
well as uncertain situations.
Motives for Holding Cash
Majorly there are three motives for which the firm holds cash.
1. Transaction Motive: The transaction motive refers to the cash required by a firm to meet the day to day needs of its business operations. In an ordinary course of business, the firm requires cash to make the payments in the form of salaries, wages, interests, dividends, goods purchased, etc.
Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash inflows
and outflows do not match, and hence, the cash is held up to meet its routine commitments.
2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold cash, to meet the contingencies or unforeseen circumstances arising in the course of business.
Since the future is uncertain, a firm may have to face contingencies such as an increase in the
price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet
with these uncertainties, the cash is held by the firms to have an uninterrupted business
3. Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit of bargain purchases that may arise in the future. For example, if the firm feels the prices of raw material are likely to fall in the future, it will hold cash and wait till the prices actually fall.
Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of
business. These opportunities could be in the form of the low-interest rate charged on the
borrowed funds, expected fall in the raw material prices or favorable change in the government
policies.
Thus, the cash is the most significant and liquid asset that the firm holds. It is significant as it is
used to pay off the firm’s obligations and helps in the expansion of business operations.
Cash Budget Definition: The Cash Budget is a budget prepared to estimate the cash inflows and outflows
during a specific period of time. In other words, cash budget shows the cash inflows and cash
outflows expected to occur in the immediate future period.
The purpose of preparing the cash budget is to determine that whether the enterprise has
sufficient cash balance to meet out its short-term cash requirements or whether too much cash is
being left idle and unproductive in the organization. Thus, it helps the management to determine
the surplus and shortage of funds so that suitable actions can be undertaken.
One of the major advantages of cash budget is that it provides a clear picture of all the expected
cash flows, thereby enabling the firms to plan their expenditures accordingly. Also, the
companies can raise adequate funds in case of the shortage of the cash balance and can make an
optimum utilization of funds in case of cash surplus, for example investing in marketable
securities.
But however, these cash budgets are not free from the limitations. These are less reliable as the
future is uncertain and the cash forecast may not be correct. For example, unseen demands of
cash, delayed cash collection, unanticipated cash disbursements, etc. Also, the cash budget is
inefficient to track a significant movement in the working capital items.
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RECEIVABLES MANAGEMENT
5
RECEIVABLES MANAGEMENT
Smriti Chawla
Shri Ram College of Commerce
University of Delhi
Delhi
CHAPTER OBJECTIVES
Introduction
Meaning of Receivables Costs of Maintaining Receivables
Factors influencing the size of receivables Meaning and Objectives of Receivable
Management
Dimensions of Receivable Management Illustrations Lets Sum Up
Questions
Introduction
A sound managerial control requires proper management of liquid
assets and inventory. These assets are a part of working capital of the business. An efficient use of financial resources is necessary to avoid financial distress. Receivables result from credit sales. A concern is required
to allow credit sales in order to expand its sales volume. It is not always possible to sell goods on cash basis only. Sometimes, other concerns in that line might have established a practice of selling goods on credit basis. Under
these circumstances, it is not possible to avoid credit sales without adversely affecting sales. The increase in sales is also essential to increase
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profitability. After a certain level of sales the increase in sales will not proportionately increase production costs. The increase in sales will bring in
more profits.
Thus, receivables constitute a significant portion of current assets of a firm. But, for investment in receivables, a firm has to incur certain costs.
Further, there is a risk of bad debts also. It is, therefore, very necessary to have a proper control and management of receivables.
Meaning of Receivables
Receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and form part of its current assets. Receivables are also known as accounts receivables, trade receivables,
customer receivables or book debts. The receivables are carried for the customers. The period of credit and extent of receivables depends upon the credit policy followed by the firm. The purpose of maintaining or investing
in receivables is to meet competition, and to increase the sales and profits.
Costs of Maintaining Receivables
The allowing of credit to customers means giving funds for the
customer‟s use. The concern incurs the following cost on maintaining receivables:
(1) Cost of Financing Receivables: When goods and services are provided on credit then concern‟s capital is allowed to be used by the
customers. The receivables are financed from the funds supplied by shareholders for long term financing and through retained earnings. The concern incurs some cost for colleting funds which finance receivables.
(2) Cost of Collection: A proper collection of receivables is essential for receivables management. The customers who do not pay the money during a stipulated credit period are sent reminders for early payments. Some persons may have to be sent for collection these amounts.
All these costs are known as collection costs which a concern is generally required to incur.
(3) Bad Debts : Some customers may fail to pay the amounts due towards them. The amounts which the customers fail to pay are known as
bad debts. Though a concern may be able to reduced bad debts through efficient collection machinery but one cannot altogether rule out this cost.
Factors Influencing the Size of Receivables
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Besides sales, a number of other factors also influence the size of receivables. The following factors directly and indirectly affect the size of
receivables.
(1) Size of Credit Sales: The volume of credit sales is the first factor which increases or decreases the size of receivables. If a concern sells only on cash basis as in the case of Bata Shoe Company, then there will be
no receivables. The higher the part of credit sales out of total sales, figures of receivables will also be more or vice versa.
(2) Credit Policies: A firm with conservative credit policy will have a low size of receivables while a firm with liberal credit policy will be
increasing this figure. If collections are prompt then even if credit is liberally extended the size of receivables will remain under control. In case receivables remain outstanding for a longer period, there is always a
possibility of bad debts.
(3) Terms of Trade: The size of receivables also depends upon the terms of trade. The period of credit allowed and rates of discount given are linked with receivables. If credit period allowed is more then
receivables will also be more. Sometimes trade policies of competitors have to be followed otherwise it becomes difficult to expand the sales.
(4) Expansion Plans: When a concern wants to expand its activities, it will have to enter new markets. To attract customers, it will
give incentives in the form of credit facilities. The period of credit can be reduced when the firm is able to get permanent customers. In the early stages of expansion more credit becomes essential and size of receivables will be more.
(5) Relation with Profits: The credit policy is followed with a view to increase sales. When sales increase beyond a certain level the additional costs incurred are less than the increase in revenues. It will be beneficial to increase sales beyond the point because it will bring more
profits. The increase in profits will be followed by an increase in the size of receivables or vice-versa.
(6) Credit Collection Efforts: The collection of credit should be streamlined. The customers should be sent periodical reminders if they fail
to pay in time. On the other hand, if adequate attention is not paid towards credit collection then the concern can land itself in a serious financial problem. An efficient credit collection machinery will reduce the size of
receivables.
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(7) Habits of Customers: The paying habits of customers also have bearing on the size of receivables. The customers may be in the habit of delaying payments even though they are financially sound. The concern
should remain in touch with such customers and should make them realise the urgency of their needs.
Meaning and Objectives of Receivables Management
Receivables management is the process of making decisions relating to investment in trade debtors. We have already stated that certain investment in receivables is necessary to increase the sales and the profits
of a firm. But at the same time investment in this asset involves cost considerations also. Further, there is always a risk of bad debts too. Thus, the objective of receivables management is to take a sound decision as
regards investment in debtors. In the words of Bolton, S.E., the objectives of receivables management is “to promote sales and profits until that point is reached where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit.”
Dimensions of Receivables Management
Receivables management involves the careful consideration of the following aspects:
1. Forming of credit policy.
2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt a
credit policy. A credit policy is related to decisions such as credit standards, length of credit period, cash discount and discount period, etc.
(a) Quality of Trade Accounts of Credit Standards: The volume of sales will be influenced by the credit policy of a concern. By
liberalising credit policy the volume of sales can be increased resulting into increased profits. The increased volume of sales is associated with certain risks too. It will result in enhanced costs and risks of bad debts and delayed
receipts. The increase in number of customers will increase the clerical wok of maintaining the additional accounts and collecting of information about the credit worthiness of customers. There may be more bad debt losses due
to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments resulting into
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tying up of additional capital in receivables. On the other hand, extending credit to only credit worthy customers will save costs like bad debt losses,
collection costs, investigation costs, etc. The restriction of credit to such customers only will certainly reduce sales volume, thus resulting in reduced profits.
A finance manager has to match the increased revenue with additional costs. The credit should be liberalised only to the level where incremental revenue matches the additional costs. The quality of trade
accounts should be decided so that credit facilities are extended only upto that level. The optimum level of investment in receivables should be where there is a trade off between the costs and profitability. On the other hand, a tight credit policy increases the liquidity of the firm. On the other hand, a
tight credit policy increases the liquidity of the firm. Thus, optimum
level of investment in receivables is achieved at a point where there is a trade off between cost, profitability and liquidity as depicted below:
(b) Length of Credit Period: Credit terms or length of credit period means the period allowed to the customers for making the payment.
The customers paying well in time may also be allowed certain cash discount. A concern fixes its own terms of credit depending upon its customers and the volume of sales. The competitive pressure from other
firms compels to follow similar credit terms, otherwise customers may feel inclined to purchase from a firm which allows more days for paying credit purchases. Sometimes more credit time is allowed to increase sales to
existing customers and also to attract new customers. The length of credit period and quantum of discount allowed determine the magnitude of investment in receivables.
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(c) Cash Discount: Cash discount is allowed to expedite the collection of receivables. The concern will be able to use the additional funds received from expedited collections due to cash discount. The
discount allowed involves cost. The discount should be allowed only if its cost is less than the earnings from additional funds. If the funds cannot be profitably employed then discount should not be allowed.
(d) Discount Period: The collection of receivables is influenced by the period allowed for availing the discount. The additional period allowed for this facility may prompt some more customers to avail discount and make payments. This will mean additional funds released from
receivables which may be alternatively used. At the same time the extending of discount period will result in late collection of funds because those who were getting discount and making payments as per earlier
schedule will also delay their payments.
2. Executing Credit Policy
After formulating the credit policy, its proper execution is very important. The evaluation of credit applications and finding out the credit
worthiness of customers should be undertaken.
(a) Collecting Credit information: The first step in implementing credit policy will be to gather credit information about the customers. This information should be adequate enough so that proper
analysis about the financial position of the customers is possible. This type of investigation can be undertaken only upto a certain limit because it will involve cost.
The sources from which credit information will be available should be ascertained. The information may be available from financial statements, credit rating agencies, reports from banks, firm‟s records etc. Financial reports of the customer for a number of years will be helpful in determining
the financial position and profitability position. The balance sheet will help in finding out the short term and long term position of the concern. The income statements will show the profitability position of concern. The
liquidity position and current assets movement will help in finding out the current financial position. A proper analysis of financial statements will be helpful in determining the credit worthiness of customers. There are credit
rating agencies which can supply information about various concerns. These agencies regularly collect information about business units from various
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sources and keep this information upto date. The information is kept in confidence and may be used when required.
Credit information may be available with banks too. The banks have their credit departments to analyse the financial position of a customer.
In case of old customers, business own records may help to know their
credit worthiness. The frequency of payments, cash discounts availed, interest paid on over due payments etc. may help to form an opinion about the quality of credit.
(b) Credit Analysis: After gathering the required information, the finance manager should analyse it to find out the credit worthiness of potential customers and also to see whether they satisfy the standards of the concern or not. The credit analysis will determine the degree of risk
associated with the account, the capacity of the customer borrow and his ability and willingness to pay.
(c) Credit Decision: After analysing the credit worthiness of the customer, the finance manager has to take a decision whether the credit is to be extended and if yes then upto what level. He will match the
creditworthiness of the customer with the credit standards of the company. If customer‟s creditworthiness is above the credit standards then there is no problem in taking a decision. It is only in the marginal case that such
decisions are difficult to be made. In such cases the benefit of extending the credit should be compared to the likely bad debt losses and then decision should be taken. In case the customers are below the company credit
standards then they should not be outrightly refused. Rather they should be offered some alternative facilities. A customer may be offered to pay on delivery of goods, invoices may be sent through bank. Such a course help in
retaining the customers at present and their dealings may help in reviewing their requests at a later date.
(d) Financing Investments in Receivables and Factoring: Accounts receivables block a part of working capital. Efforts should be made that funds are not tied up in receivables for longer periods. The finance manager should make efforts to get receivables financed so that working capital needs are met in time. The quality of receivables will
determine the amount of loan. The banks will accept receivable of dependable parties only. Another method of getting funds against receivables is their outright sale to the bank. The bank will credit the
amount to the party after deducting discount and will collect the money from the customers later. Here too, the bank will insist on quality receivables only. Besides banks, there may be other agencies which can buy
Subject Name :FM
receivables and pay cash for them. This facility is known asfactoring. The factoring may be with or without recourse. It is without recourse then any bad debt loss is taken up by the factor but if it is with recourse then bad
debts losses will be recovered from the seller.
Factoring is collection and finance service designed to improve he cash flow position of the sellers by converting sales invoices into ready cash. The
procedure of factoring can be explained as follows:
1. Under an agreement between the selling firm and factor firm, the latter
makes an appraisal of the credit worthiness of potential customers and may also set the credit limit and term of credit for different customers.
2. The sales documents will contain the instructions to make payment
directly to factor who is responsible for collection.
3. When the payment is received by the factor on the due date the factor shall deduct its fees, charges etc and credit the balance to the firm‟s accounts.
4. In some cases, if agreed the factor firm may also provide advance finance to selling firm for which it may charge from selling firm. In a way this tantamount to bill discounting by the factor firm. However factoring is
something more than mere bill discounting, as the former includes analysis of the credit worthiness of the customer also. The factor may pay whole or a substantial portion of sales vale to the selling firm
immediately on sales being effected. The balance if any, may be paid on normal due date.
Benefits and Cost of Factoring A firm availing factoring services may have the following benefits:
§ Better Cash Flows
§ Better Assets Management
§ Better Working Capital Management
§ Better Administration
§ Better Evaluation
§ Better Risk Management
However, the factoring involves some monetary and non-monetary costs as follows:
Monetary Costs
Subject Name :FM
a) The factor firm charges substantial fees and commission for collection of receivables. These charges sometimes may be too much in view of amount involved.
b) The advance fiancé provided by factor firm would be available at a higher interest costs than usual rate of interest.
Non-Monetary Costs
a) The factor firm doing the evaluation of credit worthiness of the customer will be primarily concerned with the minimization of risk of delays and defaults. In the process it may over look sales growth
aspect.
b) A factor is in fact a third party to the customer who may not feel comfortable while dealing with it.
c) The factoring of receivables may be considered as a symptom of financial weakness.
Factoring in India is of recent origin. In order to study the feasibility of factoring services in India, the Reserve Bank of India constituted a study group for examining the introduction of factoring services, which submitted its report in 1988.On the basis of the recommendations of this study group
the RBI has come out with specific guidelines permitting a banks to start factoring in India through their subsidiaries. For this country has been divided into four zones. In India the factoring is still not very common. The
first factor i.e. The SBI Factor and Commercial Services Limited started working in April 1991. The guidelines for regulation of a factoring are as follows:
(1) A factor firm requires an approval from Reserve Bank of India.
(2) A factor firm may undertake factoring business or other incidental activities.
(3) A factor firm shall not engage in financing of other firms or firms engaged in factoring.
3. Formulating and Executing Collection Policy
The collection o f amounts due to the customers is very important. The collection policy the termed as strict and lenient. A strict policy of
Subject Name :FM
collection will involve more efforts on collection. Such a policy has both positive and negative effects. This policy will enable early collection of dues
and will reduce bad debt losses. The money collected will be used for other purposes and the profits of the concern will go up. On the other hand a rigorous collection policy will involve increased collection costs. It may also
reduce the volume of sales. A lenient policy may increase the debt collection period and more bad debt losses. A customer not clearing the dues for long may not repeat his order because he will have to pay earlier
dues first, thus causing.
The objective is to collect the dues and not to annoy the customer. The steps should be like (i) sending a reminder for payments (ii) Personal request through telephone etc. (iii) Personal visits to the customers (iv)
Taking help of collecting agencies and lastly (v) Taking legal action. The last step should be taken only after exhausting all other means because it will have a bad impact on relations with customers.
Illustration 1: A company has prepared the following projections
for a year
Sales 21000 units
Selling Price per unit Rs.40
Variable Costs per unit Rs.25
Total Costs per unit Rs.35
Credit period allowed One month
The company proposes to increase the credit period allowed to its customers from one month to two months .It is envisaged that the change in policy as
above will increase the sales by 8%. The company desires a return of 25% on its investment. You are required to examine and advise whether the proposed credit policy should be implemented or not?
Illustration 2: ABC & Company is making sales of Rs.16,00,000
and it extends a credit of 90 days to its customers. However,
in order to overcome the financial difficulties, it is
considering to change the credit policy. The proposed terms
of credit and expected sales are given hereunder:
Policy Terms Sales
I 75 days Rs.15,00,000
II 60 days Rs. 14,50,000
III 45 days Rs 14,25,000
IV 30 days Rs 13,50,000
V 15 days Rs.13,00,000
Subject Name :FM
The firm has variable cost of 80% and fixed cost of Rs.1,00,000. The cost of capital is 15%. Evaluate different policies and which policy should be
adopted?
Solution:
figures in Rs.
Particulars
Present
I II III IV V
Sales
-- Variable cost
-- Fixed Cost
Profit (A)
Total Cost
Average
Receivable (at cost)
(Cost¸360x credit period
Cost of debtors @
15% (B)
Net profit (A – B)
16,00,000
12,80,000
1,00,000
2,20,000
13,80,000
3,45,000
51,750
1,68,250
15,00,000
12,00,000
1,00,000
2,00,000
13,00,000
2,70,833
40,625
1,59,350
14,50,000
11,60,000
1,00,000
1,90,000
12,60,000
2,10,000
31,500
1,58,500
14,25,000
11,40,000
1,00,000
1,85,000
12,40,000
1,55,000
23,250
1,61,750
13,50,000
10,80,000
1,00,000
1,70,000
11,80,000
98,333
14,750
1,55,250
13,00,000
10,40,000
1,00,000
1,60,000
11,40,000
47,500
7,125
1,52,875
Subject Name :FM
Illustration3: A trader whose current sales are Rs.15 lakhs per annum and average collection period is 30 days wants to pursue a more liberal credit policy to improve sales. A study made by consultant firm reveals the
following information.
Credit Policy increase in collection
period Increase in sales
A 15 days Rs.60,000
B 30 days 90,000
C 45 days
1,50,000
D 60 days 1,80,000
E 90 days 2,00,000
The selling price per unit is Rs.5. Average Cost per unit is Rs.4 and variable
cost per unit I Rs.2.75 paise per unit. The required rate of return on additional investments is 20 percent Assume 360 days a year and also assume that there are no bad debts. Which of the above policies would you
recommend for adoption.
Solution:
Particulars
Present
A B C D E
Credit period
No. of units
@ Rs.5
Sales
Variable cost@ 2.75
30 days
3,00,000
45 days
3,12,000
15,60,00
60 days
3,18,000
15,90,00
75 days
3,30,000
16,50,00
90 days
3,36,000
16,80,00
120 days
3,40,000
17,00,00
Subject Name :FM
Fixed Cost
Total Cost
Profit (A)
Average
debtors(at cost)
cost¸360x credit period
Cost of
investment@ 20% (B)
Net Profit (A-B)
15,00,00
0
8,25,000
3,75,000
12,00,00
0
3,00,000
1,00,000
20,000
2,80,000
0
8,58,000
3,75,000
12,33,000
3,27,000
1,54,125
30,825
2,96,175
0
8,74,500
3,75,000
12,49,500
3,40,500
2,08,250
41,650
2,98,850
0
9,07,500
3,75,000
12,82,500
3,67,500
2,67,188
53,437
3,14,063
0
9,24,000
3,75,000
12,99,000
3,81,000
3,24,750
64,950
3,16,050
0
9,35,000
3,75,000
13,10,000
3,90,000
4,36,667
87,333
3,02,667
Subject Name :FM
Lets Sum Up
The receivables emerge when goods are sold on credit and the payments
are deferred by the customers. So, every firm should have a well-defined credit policy.
The receivables management refers to managing the receivables in the light of costs and benefit associated with a particular credit policy.
Receivables management involves the careful consideration of the
following aspects: Forming of credit policy, Executing the credit policy, Formulating and executing collection policy.
The credit policy deals with the setting of credit standards and credit terms relating to discount and credit period.
The credit evaluation includes the steps required for collection and analysis of information regarding the credit worthiness of the customer.
Subject Name :FM
Inventory Management In any business or organization, all functions are interlinked and connected to each other and are often overlapping. Some
key aspects like supply chain management, logistics and inventory form the backbone of the business delivery function.
Therefore these functions are extremely important to marketing managers as well as finance controllers.
Inventory management is a very important function that determines the health of the supply chain as well as the
impacts the financial health of the balance sheet. Every organization constantly strives to maintain optimum inventory to
be able to meet its requirements and avoid over or under inventory that can impact the financial figures.
Inventory is always dynamic. Inventory management requires constant and careful evaluation of external and internal factors
and control through planning and review. Most of the organizations have a separate department or job function called
inventory planners who continuously monitor, control and review inventory and interface with production, procurement and
finance departments.
Defining Inventory
Inventory is an idle stock of physical goods that contain economic value, and are held in various forms by an organization in
its custody awaiting packing, processing, transformation, use or sale in a future point of time.
Any organization which is into production, trading, sale and service of a product will necessarily hold stock of various
physical resources to aid in future consumption and sale. While inventory is a necessary evil of any such business, it may be
noted that the organizations hold inventories for various reasons, which include speculative purposes, functional purposes,
physical necessities etc.
From the above definition the following points stand out with reference to inventory:
All organizations engaged in production or sale of products hold inventory in one form or other.
Inventory can be in complete state or incomplete state.
Inventory is held to facilitate future consumption, sale or further processing/value addition.
All inventoried resources have economic value and can be considered as assets of the organization.
Different Types of Inventory
Inventory of materials occurs at various stages and departments of an organization. A manufacturing organization holds
inventory of raw materials and consumables required for production. It also holds inventory of semi-finished goods at various
stages in the plant with various departments. Finished goods inventory is held at plant, FG Stores, distribution centers etc.
Further both raw materials and finished goods those that are in transit at various locations also form a part of inventory
depending upon who owns the inventory at the particular juncture. Finished goods inventory is held by the organization at
various stocking points or with dealers and stockiest until it reaches the market and end customers.
Besides Raw materials and finished goods, organizations also hold inventories of spare parts to service the products.
Defective products, defective parts and scrap also forms a part of inventory as long as these items are inventoried in the
books of the company and have economic value.
Types of Inventory by Function
INPUT PROCESS OUTPUT
Raw Materials Work In Process Finished Goods
Consumables required for Semi Finished Production in Finished Goods at Distribution
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processing. Eg : Fuel,
Stationary, Bolts & Nuts etc.
required in manufacturing
various stages, lying with
various departments like
Production, WIP Stores, QC,
Final Assembly, Paint Shop,
Packing, Outbound Store etc.
Centers through out Supply
Chain
Maintenance
Items/Consumables
Production Waste and Scrap Finished Goods in transit
Packing Materials Rejections and Defectives Finished Goods with Stockiest
and Dealers
Local purchased Items
required for production
Spare Parts Stocks & Bought
Out items
Defectives, Rejects and Sales
Returns
Repaired Stock and Parts
Sales Promotion & Sample
Stocks
Need for Inventory Management - Why do
Companies hold Inventories ? 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.
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.
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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.
1. 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.
