Introduction

Chapter 1.1 Working Capital Management

1.1 .1Concept

Effective financial management is the outcome, among other things, of good

management of investment of funds in business. Funds can be invested for long-term

purposes such as acquisition of fixed assets, diversification and expansion of business,

modernisation of plants & machinery, and research & development. Funds are also

needed for short-term purposes, that is, for daily operations of the business. For example,

if you are managing a manufacturing unit you will have to arrange for procurement of

raw material, payment of wages and for meeting regular expenses.

All the goods, which are manufactured in a given time period may not be sold in that

period. Hence, some goods remain in stock, e.g., raw material, semi-finished

(manufacturing -in-process) goods and finished goods. Funds are thus blocked in

different types of inventory. Again, the whole of the stock of finished goods may not be

sold against ready cash; some of it may be sold on credit. The credit sales also involve

blocking of funds with debtors till cash is received or the bills are cleared. Credit sales

are also known as account receivables.

Different industry types require different levels of working capital. Service industries

need little to no inventory whereas retailers need more. Depending on the retailer’s

business their inventory will also vary. Manufacturers will probably require more because

they need raw material stocks, work‐in‐progress and finished goods. Retailers may sell

1
for cash therefore having few receivables and producers may have trade customers and

have greater receivables.

Working Capital refers to firm's investment in short-term assets, viz. cash, short-term

securities, debtors and inventories of raw materials, work-in-process and finished goods.

It can also be regarded as that part of the firm's total capital, which is employed in short-

term operations. It refers to all aspects of current assets and current liabilities. In simple

words, we can say that working capital is the investment needed for carrying out day-to-

day operations of the business efficiently. The management of working capital is as

important as that of long-term financial investment. The aim of working capital

management is to achieve balance between having sufficient working capital to ensure

that the business is liquid but not too much that the level of working capital reduced

profitability.

1.1.2 Significance of Working Capital

There is no running business firm, which does not require some amount of working

capital. Working capital management is essential for the long‐term success of a

business. No business can survive if it cannot meet its day‐to‐day obligations. A business

must therefore have clear policies for the management of each component of working

capital. Even a fully equipped manufacturing firm is sure to fail without an adequate

supply of raw materials to process, cash to meet the wage bill, the capacity to wait for the

market for its finished products, and the ability to grant credit to its customers.

2
Similarly, a firm in service sector or a commercial enterprise is virtually good for nothing

without merchandise to sell. Working capital, thus, is the life-blood of a business. As a

matter of fact, any firm, whether profit-oriented or otherwise, will not be able to carry on

day-to-day activities without sufficient working capital.

1.1.3 Operating Cycle

The time between purchase of inventory items and their conversion into cash is known as

operating cycle or working capital cycle. The successive events which are typically

involved in an operating cycle are depicted in figure 1. An examination of the operating

cycle would reveal that the funds invested in operations are re-cycled back into cash. The

cycle, of course, takes some time to complete. The longer the period of this conversion

the longer is the operating cycle. A normal operating cycle may be for any time period

but does not generally exceed a financial year. Obviously, the shorter the operating cycle,

the larger will be the turnover of funds invested for various purposes. The channels of the

investment are called current assets. Sometimes the available funds may be in excess of

the needs for investment in these assets, e.g., inventory, receivables and minimum

essential cash balance. Any surplus may be invested in secured securities like

government securities rather than being retained as idle cash balance.

3
 Figure 1: Operating Cycle

The operating cycle is made up of three elements:

 The inventory turnover days

 The average receivable collection days

 The average payable days

Operating cycle is calculated as follows:

Inventory days + receivable days ‐ payable days = operating cycle

Inventory days = Inventory / Cost of sales x 365days

Receivable days = Receivables / Sales x 365

Payable days = Payables / Cost of sales x 365

1.1.4 Concepts of Working Capital

There are two concepts of working capital, namely Gross concept and Net concept.

1.1.4.1 Gross Working Capital

4
According to this concept; working capital refers to the firm’s investment in current

assets. The amount of current liabilities is not deducted from the total of current assets.

This concept views Working Capital and sum of Current Assets as two inter-changeable

terms. This concept is also referred to as `Current Capital' or `Circulating Capital'.

The proponents of the gross working capital concept advocate this for the following

reasons:

Profits are earned with the help of assets, which are partly fixed and partly current. To a

certain degree, similarity can be observed in fixed and current assets so far as both are

partly financed by borrowed funds, and are expected to yield earnings over and above the

interest costs. Logic then demands that the aggregate of current assets should be taken to

mean the working capital. Management is more concerned with the total current assets as

they constitute the total funds available for operating purposes than with the sources from

which the funds come. An increase in the overall investment in the enterprise also brings

about an increase in the working capital.

1.1.4.2 Net Working Capital

The net working capital refers to the difference between current assets and current

liabilities. Current liabilities are those claims of outsiders, which are expected to mature

for payment within an accounting year and include creditors dues, bills payable, bank

overdraft and outstanding expenses. Net working capital can be positive or negative. A

negative net working capital occurs when current liabilities are in excess of current

assets.

5
"Whenever working capital is mentioned it brings to mind current assets and current

liabilities with a general understanding that working capital is the difference between the

two".

‘Net working capital’ is a qualitative concept, which indicates the liquidity position of the

firm and the extent to which working capital needs may be financed by permanent

sources of finds. Current assets should be sufficiently in excess of current liabilities to

constitute a margin or buffer for obligations maturing within the ordinary operating cycle

of a business. A weak liquidity position poses a threat to the solvency of the company

and makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of

current assets. Therefore, prompt and timely action should be taken by management to

improve and correct the imbalance in the liquidity position of the firm.

The net working capital concept also covers the question of a judicious mix of long-term

and short-term funds for financing current assets. Every firm has a minimum amount of

net working capital, which is permanent. Therefore, this portion of the working capital

should be financed with permanent sources of funds such as owners' capital, debentures,

long-term debt, preference capital and retained earnings: Management must decide the

extent to which current assets should be financed with equity capital and/or borrowed

capital.

Several economists uphold the net working capital concept. In support of their stand, they

state that:

6
  In the long run what matters is the surplus of current assets over current liabilities.

It is this concept which helps creditors and investors to judge the financial

soundness of the enterprise.

 It is the excess of current assets over current liabilities, which can be relied upon

to meet contingencies since this amount is not liable to be returned.

 It helps to ascertain the correct comparative financial position of companies

having the same amount of current assets.

It may be stated that gross and net concepts of working capital are two important facets of

working capital management. Both the concepts have operational significance for the

management and therefore neither can be ignored. While the net concept of working

capital emphasizes the qualitative aspect, the gross concept underscores the quantitative

aspect.

1.1.5 Kinds of Working Capital

Ordinarily, working capital is classified into two categories:

 Fixed, Regular or Permanent Working Capital; and

 Variable, Fluctuating, Seasonal, Temporary or Special Working Capital

1.1.5.1 Fixed Working Capital

The need for current assets is associated with the operating cycle, which, as you know, is

a continuous process. As such, the need for current assets is felt constantly. The

7
magnitude of investment in current assets however may not always be the same. The

need for investment in current assets may increase or decrease over a period of time

according to the level of production. Nevertheless, there is always a certain minimum

level of current assets, which is essential for the firm to carry on its business irrespective

of the level of operations. This is the irreducible minimum amount necessary for

maintaining the circulation of the current assets. This minimum level of investment in

current assets is permanently locked up in business and is therefore referred to as

permanent or fixed or regular working capital. It is permanent in the same way as

investment in the firm's fixed assets is.

1.1.5.2 Fluctuating Working Capital

Depending upon the changes in production and sales, the need for working capital, over

and above the permanent working capital, will fluctuate. The need for working capital

may also vary on account of seasonal changes or abnormal or unanticipated conditions.

For example, a rise in the price level may lead to an increase in the amount of funds

invested in stock of raw materials as well as finished goods. Additional doses of working

capital may be required to face cutthroat competition in the market or other contingencies

like strikes and lockouts. Any special advertising campaigns organised for increasing

sales or other promotional activities may have to be financed by additional working

capital. The extra working capital needed to support the changing business activities is

called the fluctuating (variable, seasonal, temporary or special) working capital.

Figure 2 : Permanent and Temporary Working Capital

8
As seen in Figure 2, that fixed working capital is stable over time, where as variable

working capital is fluctuating-sometimes increasing and sometimes decreasing. The

permanent working capital line, however, may not always be horizontal. Both these kinds

of working capital - permanent and temporary, are required to facilitate production and

sales through the operating cycle, but temporary working capital is arranged by the firm

to meet liquidity requirements that are expected to be temporary.

1.1.6 Components of Working Capital

You have already noted that working capital has two components: Current assets and

Current liabilities. Current assets comprise several items. The typical items are:

 Cash to meet expenses as and when they occur.

 Accounts Receivables or sundry trade debtors

 Inventory of:

Raw materials, stores, supplies and spares,

Work-in-process, and

Finished goods

9
  Advance payments towards expenses or purchases, and other short-term advances

which are recoverable.

 Temporary investment of surplus funds which could be converted into cash

whenever needed.

A part of the need for funds to finance the current assets may be met from supply of

goods on credit, and deferment, on account of custom, usage or arrangement, of payment

for expenses.. The remaining part of the need for working capital may be met from short-

term borrowing from financiers like banks. These items are collectively called current

liabilities. Typical items of current liabilities are:

 Goods purchased on credit

 Expenses incurred in the course of the business of the organisation (e.g., wages or

salaries, rent, electricity bills, interest etc.) which are not yet paid for.

 Temporary or short term borrowings from banks, financial institutions or other

parties

 Advances received from parties against goods to be sold or delivered, or as short

term deposits.

 Other current liabilities such as tax and dividends payable. Some of the major

components of current assets are explained here in brief:

Cash: All of us know that the basic input to start any business is cash. Cash is initially

required for acquiring fixed assets like plants and machinery which enables a firm to

produce products and generate cash by selling them. Cash is also required and invested in

working capital. An investment in working capital is required, as firms have to store

10
certain quantity of raw materials and finished goods and also for providing credit terms to

the customers.

A minimum level of cash helps in the conduct of everyday ordinary business such as

making of purchases and sales as well as for meeting the unexpected payments,

developments and other contingencies. Cash invested at the beginning of-the operating

cycle gets released at the end of the cycle to fund fresh investments. However, additional

cash is required by the firm when it needs to buy more fixed assets, increase the level of

operations or for bringing out change in working capital cycle such as extending credit

period to the customers.

The demand for cash is affected by several factors, some of them are within the control of

the managers and some are outside their control. It is not possible to operate the business

without holding cash but at the same time holding it without a purpose also costs a firm

either directly in the form of interest or loss of income that could be earned out of the

cash.

In the context of working capital management, cash management refers to optimizing the

benefit and cost associated with holding cash. The objective of cash management is best

achieved by speeding up the working capital cycle, particularly the collection process and

investing surplus cash in short term assets in most profitable avenues.

Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competitive

pressures force most firms to offer credit. Today the use of credit in the purchase of

goods and services is so common that it is taken for granted. Selling goods or providing

11
services on credit basis leads to accounts receivable. When consumers expect credit,

business units in turn expect credit from their suppliers to match their investment in credit

extended to consumers. The granting of credit from one business firm to another for

purchase of goods and services is popularly known as trade credit.

Though commercial banks provide a significant part of requirements for working capital,

trade credit continues to be a major source of funds for firms and accounts receivable that

result from granting trade credit are major investment for the firm.

Both direct and indirect costs are associated with carrying receivables, but it has an

important benefit for increasing sales. Excessive levels of accounts receivables result in

decline of cash flows and many results in bad debts which in turn may reduce the profit

of the firm. Therefore, it is very important to monitor and manage receivables carefully

and regularly.

Inventory: Three things will comes to ones mind when one thinks of a manufacturing unit

- machines, men and materials. Men using machines and tools convert the materials into

finished goods. The success of any business unit depends on the extent to which these are

efficiently managed. Inventory is an asset to the organization like other components of

current assets.

Inventory constitutes a very significant part of working capital or current assets in

manufacturing organization. It is essential to control inventories (physical/quantity

12
control and value control) as these are significant elements in the costing process

constituting sometimes more than 60% of the current assets.

Inventory holding is desirable because it meets several objectives and needs but an

excessive inventory is undesirable because it costs a lot to firms. Inventory which

consists of raw material components and other consumables, work in process and

finished goods, is an important component of `current assets'. There are several factors

like nature of industry, availability of material, technology, business practices, price

fluctuation, etc. that determines the amount of inventory holding. Holding inventory

ensures smooth production process, price stability and immediate delivery to customers.

Since inventory is like any other form of assets, holding inventory has a cost. The cost

includes opportunity cost of funds blocked in inventory, storage cost, stock out cost, etc.

The benefits that come from holding inventory should exceed the cost to justify a

particular level of inventory.

Marketable Securities: Cash and marketable securities are normally treated as one item in

any analysis of current assets although these are not the same as cash they can be

converted to cash at a very short notice. Holding cash in excess of immediate requirement

means the firm is missing out an opportunity income. Excess cash is normally invested in

marketable securities, which serves two purposes namely, provide liquidity and, also earn

a return.

13
1.1.7 Importance of Working Capital Management

Because of its close relationship with day-to-day operations of a business, a study of

working capital and its management is of major importance to internal, as well as

external analysts. It is being increasingly realized that inadequacy or mismanagement of

working capital is the leading cause of business failures. We must not lose sight of the

fact that management of working capital is an integral part of the overall financial

management and, ultimately, of the overall corporate management. Working capital

management thus throws a challenge and should be a welcome opportunity for a financial

manager who is ready to play a pivotal role in his organization.

Neglect of management of working capital may result in technical insolvency and even

liquidation of a business unit. With receivables and inventories tending to grow and with

increasing demand for bank credit in the wake of strict regulation of credit in India by the

Central Bank, managers need to develop a long-term perspective for managing working

capital. Inefficient working capital management may cause either inadequate or excessive

working capital, which is dangerous.

A firm may have to face the following adverse consequences from inadequate working

capital:

Growth may be stunted. It may become difficult for the firm to undertake profitable

projects due to non-availability of funds.

 Implementation of operating plans may become difficult and consequently the

firm's profit goals may not be achieved.

14
  Operating inefficiencies may creep in due to difficulties in meeting even day to

day commitments.

 Fixed assets may not be efficiently utilized due to lack of working funds, thus

lowering the rate of return on investments in the process.

 Attractive credit opportunities may have to be lost due to paucity of working

capital.

 The firm loses its reputation when it is not in a position to honour its short-term

obligations. As a result, the firm is likely to face tight credit terms.

On the other hand, excessive working capital may pose the following dangers:

 Excess of working capital may result in unnecessary accumulation of inventories,

increasing the chances of inventory mishandling, waste, and theft.

 It may provide an undue incentive for adopting too liberal a credit policy and

slackening of collection of receivables, causing a higher incidence of bad debts.

This has an adverse effect on profits.

 Excessive working capital may make management complacent, leading eventually

to managerial inefficiency.

 It may encourage the tendency to accumulate inventories for making speculative

profits, causing a liberal dividend policy, which becomes difficult to maintain

when the firm is unable to make speculative profits.

15
An enlightened management, therefore, should maintain the right amount of working

capital on a continuous basis. Financial and statistical techniques can be helpful in

predicting the quantum of working capital needed at different points of time.

1.1.8 Determinants of Working Capital Needs

There are no set rules or formulas to determine the working capital requirements of a

firm. The corporate management has to consider a number of factors to determine the

level of working capital. The amount of working capital that a firm would need is

affected not only by the factors associated with the firm itself but is also affected by

economic, monetary and general business environment. Among the various factors the

following are important ones.

1.1.8.1 Nature and Size of Business

The working capital needs of a firm are basically influenced by the nature of its business.

Trading and financial firms generally have a low investment in fixed assets, but require a

large investment in working capital. Retail stores, for example, must carry large stocks of

a variety of merchandise to satisfy the varied demand of their customers. Some

manufacturing businesses' like tobacco, and construction firms also have to invest

substantially in working capital but only a nominal amount in fixed assets. In contrast,

public utilities have a limited need for working capital and have to invest abundantly in

fixed assets. Their working capital requirements are nominal because they have cash

sales only and they supply services, not products. Thus, the amount of funds tied up with

debtors or in stocks is either nil or very small. The working capital needs of most of the

16
manufacturing concerns fall between the two extreme requirements of trading firms and

public utilities.

The size of business also has an important impact on its working capital needs. Size may

be measured in terms of the scale of operations. A firm with larger scale of operations

will need more working capital than a small firm. The hazards and contingencies inherent

in a particular type of business also have an influence in deciding the magnitude of

working capital in terms of keeping liquid resources.

1.1.8.2 Manufacturing Cycle

The manufacturing cycle starts with the purchase of raw materials and is completed with

the production of finished goods. If the manufacturing cycle involves a longer period the

need for working capital will be more, because an extended manufacturing time span

means a larger tie-up of funds in inventories. Any delay at any stage of manufacturing

process will result in accumulation of work-in-process and will enhance the requirement

of working capital. You may have observed that firms making heavy machinery or other

such products, involving long manufacturing cycle, attempt to minimise their investment

in inventories (and thereby in working capital) by seeking advance or periodic payments

from customers.

1.1.8.3 Business Fluctuations

Seasonal and cyclical fluctuations in demand for a product affect the working capital

requirement considerably, especially the temporary working capital requirements of the

firm. An upward swing in the economy leads to increased sales, resulting in an increase

17
in the firm's investment in inventory and receivables or book debts. On the other hand, a

decline in the economy may register a fall in sales and, consequently, a fall in the levels

of stocks and book debts.

Seasonal fluctuations may also create production problems. Increase in production level

may be expensive during peak periods. A firm may follow a policy of steady production

in all seasons to utilise its resources to the fullest extent. This will mean accumulation of

inventories in off-season and their quick disposal in peak season. Therefore, financial

arrangements for seasonal working capital requirement should be made in advance. The

financial plan should be flexible enough to take care of any seasonal fluctuations.

1.1.8.4 Production Policy

If a firm follows steady production policy, even when the demand is seasonal, inventory

will accumulate during off-season periods and there will be higher inventory costs and

risks. If the costs and risks of maintaining a constant production schedule are high, the

firm may adopt the policy of varying its production schedule in accordance with the

changes in demand. Firms whose physical facilities can be utilised for manufacturing a

variety of products can have the advantage of diversified activities. Such firms

manufacture their main products during the season and other products during off-season.

Thus, production policies may differ from firm to firm, depending upon the

circumstances. Accordingly, the need for working capital will also vary.

1.1.8.5 Turnover of Circulating Capital

18
The speed with which the operating cycle completes its round (i.e., cash . raw materials .

finished product . accounts receivables . cash) plays a decisive role in influencing the

working capital needs.

1.1.8.6 Credit Terms

The credit policy of the firm affects the size of working capital by influencing the level of

book debts. Though the credit terms granted to customers to a great extent depend upon

the norms and practices of the industry or trade to which the firm belongs; yet it may

endeavor to shape its credit policy within such constraints. A long collection period will

generally mean tying of larger funds in book debts. Slack collection procedures may even

increase the chances of bad debts. The working capital requirements of a firm are also

affected by credit terms granted by its creditors. A firm enjoying liberal credit terms will

need less working capital.

1.1.8.7 Growth and Expansion Activities

As a company grows, logically, larger amount of working capital will be needed, though

it is difficult to state any firm rules regarding the relationship between growth in the

volume of a firm's business and its working capital needs. The fact to recognize is that the

need for increased working capital funds may precede the growth in business activities,

rather than following it. The shift in composition of working capital in a company may be

observed with changes in economic circumstances and corporate practices. Growing

industries require more working capital than those that are static.

19
1.1.8.8 Operating Efficiency

Operating efficiency means optimum utilization of resources. The firm can minimize its

need for working capital by efficiently controlling its operating costs. With increased

operating efficiency the use of working capital is improved and pace of cash cycle is

accelerated. Better utilisation of resources improves profitability and helps in relieving

the pressure on working capital.

1.1.8.9 Price Level Changes

Generally, rising price level requires a higher investment in working capital. With

increasing prices the same levels of current assets need enhanced investment. However,

firms which can immediately revise prices of their products upwards may not face a

severe working capital problem in periods of rising levels. The effects of increasing price

level may, however, be felt differently by different firms due to variations in individual

prices. It is possible that some companies may not be affected by the rising prices,

whereas others may be badly hit by it.

1.1.8.10 Other Factors

There are some other factors, which affect the determination of the need for working

capital. A high net profit margin contributes towards the working capital pool. The net

profit is a source of working capital to the extent it has been earned in cash. The cash

inflow can be calculated by adjusting non-cash items such as depreciation, out-standing

expenses, losses written off, etc, from the net profit.

20
The firm's appropriation policy, that is, the policy to retain or distribute profits also has a

bearing on working capital. Payment of dividend consumes cash resources and thus

reduces the firm’s working capital to that extent. If the profits are retained in the

business, the firm's working capital position will be strengthened.

In general, working capital needs also depend upon the means of transport and

communication. If they are not well developed, the industries will have to keep huge

stocks of raw materials, spares, finished goods, etc. at places of production, as well as at

distribution outlets.

1.1.9 Approaches to Managing Working Capital

Two approaches are generally followed for the management of working capital: (i) the

conventional approach, and (ii) the operating cycle approach.

1.1.9.1 The Conventional Approach

This approach implies managing the individual components of working capital (i.e.

inventory, receivables, payables, etc) efficiently and economically so that there are

neither idle-funds nor paucity of funds. Techniques have been evolved for the

management of each of these components. In India, more emphasis is given to the

management of debtors because they generally constitute the largest share of the

investment in working capital. On the other hand, inventory control has not yet been

practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever

rising prices.
21
1.1.9.2 The Operating Cycle Approach

This approach views working capital as a function of the volume of operating expenses.

Under this approach the working capital is determined by the duration of the operating

cycle and the operating expenses needed for completing the cycle. The duration of the

operating cycle is the number of day involved in the various stages, commencing with

acquisition of raw materials to the realisation of proceeds from debtors. The credit period

allowed by creditors will have to be set off in the process. The optimum level of working

capital will be the requirement of operating expenses for an operating cycle, calculated on

the basis of operating expenses required for a year.

In India, most of the organizations use to follow the conventional approach earlier, but

now the practice is shifting in favor of the operating cycle approach. The banks usually

apply this approach while granting credit facilities to their clients.

1.1.10 Working Capital Management under Inflation

It is desirable to check the increasing demand for capital, for maintaining the existing

level of activity. Such a control acquires even more significance in times of inflation. In

order to control working capital needs in periods of inflation, the following measures may

be applied. Greater disciplines on all segments of the production front may be attempted

as under:

The possibility of using substitute raw materials without affecting quality must be

explored in all seriousness. Research activities in this regard may be under- taken, with

financial assistance provided by the Government and the corporate sector, if any.
22
Attempts must be made to increase the productivity of the work force by proper

motivational strategies. Before going in for any incentive scheme, the cost involved must

be weighed against the benefit to be derived. Though wages in accounting are considered

a variable cost, they have tended to become partly fixed in nature due to the influence of

various legislative measures adopted by the Central or State Governments in recent times.

Increased productivity results in an increase in value added, and this has the effect of

reducing labour' cost per unit.

The managed costs should be properly scrutinized in terms of their costs and benefits.

Such costs include office decorating expenses, advertising, managerial salaries and

payments, etc. Managed costs are more, or less fixed costs and once committed they are

difficult to retreat. In order to minimise the cost impact of such items, the maximum

possible use of facilities already created must be ensured. Further the management should

be vigilant in sanctioning any new expenditure belonging to this cost.

The increasing pressure to augment working capital will, to some extent, be neutralised if

the span of the operating cycle can be reduced. Greater turnover with shorter intervals

and quicker realisation of debtors will go a long way in easing the situation.

Only when there is a pressure on working capital does the management become

conscious of the existence of slow-moving and obsolete stock. The management tends to

adopt ad hoc measures, which are grossly inadequate. Therefore, a clear-cut policy

regarding the disposal of slow-moving and obsolete stocks must be formulated and

23
adhered to. In addition to this, there should be an efficient management information

system reflecting the stock position from various standpoints.

The payment to creditors in time leads to building up of good reputation and

consequently it increases the bargaining power of the firm regarding period of credit for

payment and other conditions. Projections of cash flows should be made to see that cash

inflows and outflows match with each other. If they do not, either some payments have to

be postponed or purchase of some avoidable items has to be deferred.

24
 Chapter 1.2: Inventory Management

1.2.1 Concept

“Inventory" to many business owners is one of the more visible and tangible aspects of

doing business. Raw materials, goods in progress and finished goods all represent various

forms of inventory. Each type represents funds tied up until the inventory leaves the

company as purchased products. Likewise, merchandise stocks in a retail store contribute

to profits only when their sale puts money into the cash account.

In a literal sense, inventory refers to stocks of anything necessary to do business. These

stocks represent a large portion of the business investment and must be well managed in

order to maximize profits. In fact, many businesses cannot absorb the types of losses

arising from weak inventory management. Unless inventories are controlled, they are

unreliable, inefficient and costly.

1.2.2 Inventory management should focus on:

 There should be proper accounting and physical controls.

 The inventory should be stored properly to avoid the losses.

 Fixation of inventory levels like minimum, maximum and reorder levels and

economic order quantity to ensure the optimum levels of stocks.

 Proper care should be taken to avoid stock out situations.

 Continuous supply of material should be ensured at the right time and right cost.

 The investment in inventory should be optimized by avoiding over stocking.

25
1.2.3 Successful Inventory Management

Successful inventory management involves balancing the costs of inventory with the

benefits of inventory. Many business owners fail to appreciate fully the true costs of

carrying inventory, which include not only direct costs of storage, insurance and taxes,

but also the cost of money tied up in inventory (opportunity cost). This fine line between

keeping too much inventory and not enough is not the manager's only concern. Others

include:

 Maintaining a wide assortment of stock -- but not spreading the rapidly moving

ones too thin;

 Increasing inventory turnover -- but not sacrificing the service level;

 Keeping stock low -- but not sacrificing service or performance.

 Obtaining lower prices by making volume purchases -- but not ending up with

slow-moving inventory; and

 Having an adequate inventory on hand -- but not getting caught with obsolete

items.

The degree of success in addressing these concerns is easier to gauge for some than for

others. For example, computing the inventory turnover ratio is a simple measure of

managerial performance. This value gives a rough guideline by which managers can set

goals and evaluate performance, but it must be realized that the turnover rate varies with

the function of inventory, the type of business and how the ratio is calculated (whether on

sales or cost of goods sold).

26
1.2.4 Aspects of Inventory Management

1.2.4.1 The Purchasing Plan

One of the most important aspects of inventory control is to have the items in stock at the

moment they are needed (Just in time). This includes going into the market to buy the

goods early enough to ensure delivery at the proper time. Thus, buying requires advance

planning to decide inventory needs for each time period and then making the

commitments without procrastination.

For retailers, planning ahead is very crucial. Since they offer new items for sale months

before the actual calendar date for the beginning of the new season, it is imperative that

buying plans be formulated early enough to allow for intelligent buying without any last

minute panic purchases. The main reason for this early offering for sale of new items is

that the retailer regards the calendar date for the beginning of the new season as the

merchandise date for the end of the old season.

Part of your purchasing plan must include accounting for the depletion of the inventory.

Before a decision can be made as to the level of inventory to order, you must determine

how long the inventory you have in stock will last.

For instance, a retail firm must formulate a plan to ensure the sale of the greatest number

of units. Likewise, a manufacturing business must formulate a plan to ensure enough

inventory is on hand for production of a finished product.

27
1.2.4.2 Controlling Your Inventory

To maintain an in-stock position of wanted items and to dispose of unwanted items, it is

necessary to establish adequate controls over inventory on order and inventory in stock.

There are several methods for inventory control. Some of them are listed below:

 Visual control enables the manager to examine the inventory visually to

determine if additional inventory is required. In small businesses where this

method is used, records may not be needed at all or only for slow moving or

expensive items.

 Tickler control enables the manager to physically count a small portion of the

inventory each day so that each segment of the inventory is counted every so

many days on a regular basis.

 Click sheet control enables the manager to record the item as it is used on a sheet

of paper. Such information is then used for reorder purposes.

 Stub control enables the manager to retain a portion of the price ticket when the

item is sold. The manager can then use the stub to record the item that was sold.

As a business grows, it may find a need for a more sophisticated and technical form of

inventory control. Today, the use of computer systems to control inventory is far more

feasible for small business than ever before, both through the widespread existence of

computer service organizations and the decreasing cost of small-sized computers. Often

the justification for such a computer-based system is enhanced by the fact that company

accounting and billing procedures can also be handled on the computer.

28
  Point-of-sale terminals relay information on each item used or sold. The manager

receives information printouts at regular intervals for review and action.

 Off-line point-of-sale terminals relay information directly to the supplier's

computer who uses the information to ship additional items automatically to the

buyer/inventory manager.

The final method for inventory control is done by an outside agency. A manufacturer's

representative visits the large retailer on a scheduled basis, takes the stock count and

writes the reorder. Unwanted merchandise is removed from stock and returned to the

manufacturer through a predetermined, authorized procedure.

A principal goal for many of the methods described above is to determine the minimum

possible annual cost of ordering and stocking each item. Two major control values are

used:

 the order quantity, that is, the size and frequency of orders; and

 the re-order point, that is, the minimum stock level at which additional quantities

are ordered.

The Economic Order Quantity (EOQ) formula is one widely used method of computing

the minimum annual cost for ordering and stocking each item. The EOQ computation

takes into account the cost of placing an order, the annual sales rate, the unit cost, and

the cost of carrying inventory.

29
1.2.5 Developments In Inventory Management

In recent years, two approaches have had a major impact on inventory management:

Material Requirements Planning (MRP) and Just-In-Time (JIT and Kanban). Their

application is primarily within manufacturing but suppliers might find new requirements

placed on them and sometimes buyers of manufactured items will experience a difference

in delivery.

Material requirements’ planning is basically an information system in which sales are

converted directly into loads on the facility by sub-unit and time period. Materials are

scheduled more closely, thereby reducing inventories, and delivery times become shorter

and more predictable. Its primary use is with products composed of many components.

MRP systems are practical for smaller firms. The computer system is only one part of the

total project which is usually long-term, taking one to three years to develop.

Just-in-time inventory management is an approach which works to eliminate inventories

rather than optimize them. The inventory of raw materials and work-in-process falls to

that needed in a single day. This is accomplished by reducing set-up times and lead times

so that small lots may be ordered. Suppliers may have to make several deliveries a day or

move close to the user plants to support this plan.

1.2.6 Elements of a programme

The firm may establish a programme of inventory monitoring and control consisting

of the following elements:

30
  Exercise of vigilance against imbalance of raw materials and work in process

which tends to limit the utility of stocks.

 Vigorous efforts to expedite completion of unfinished production jobs to get

them into saleable condition.

 Active disposal of goods that is surplus, obsolete or unusable.

 Shortening of the production cycle.

 Strict adherence to production schedules.

 Special pricing to dispose of unusually slow moving items.

 Evening out of seasonable sales fluctuations to the extent possible.

1.2.7 Inventory Management Practices to be followed

Good inventory Management practices in the company help by adding value in terms of

having control over and maintaining lean inventory. Inventory should not be too much or

too less. Both the situations are bad for the company. However often we see that

inventory is not focused upon by the management and hence lot of inefficiencies build up

over a period of time without the knowledge of the management. It is only when we start

a cost reduction drive that the inventory goof ups and skeletons come out of the cupboard

and results in revamping the entire operations.

However those companies, which have always focused on inventory as a principle

function and recognized that the inventory effects their sales, as well as the books of

accounts and profits, have managed to introduce and improve inventory management

processes. Many business models work on lean inventory principle or JIT inventory
31
along with other models like VMI etc. Inventory management to a large extent is

dependant upon the supply chain efficiency as well as operations.

Inventory management is a management cum operations function. It requires operational

processes to be followed and maintained on the floor and in inventory management

systems. Coupled with operations, it entails continuous study; analysis and decision

making to control and manage inventory levels.

Following are few of the points which when followed, can go a long way in ensuring that

the inventory is lean and clean.

 Review Inventory periodically and revise stocking patterns and norms

Inventory is dependent upon the demand as well as the supply chain delivery

time. Often companies follow one stocking policy for all items. For example, all

A, B & C categories may be stocking inventory of 15 days, which may not be the

right thing that is required. While some items may have a longer lead-time thus

affecting the inventory holding, the demand pattern and the hit frequency in terms

of past data may show up differently for each of the inventory items. Therefore

one standard norm does not suit all and can lead to over stocking of inventory as

well as in efficiencies in the system.

32
 Get into detailed inventory planning - One size does not fit all

Understand the inventory types and the specific characteristics of the items you

are carrying. Then build the inventory stocking parameters taking into account the

unique characteristics of the particular inventory.

From amongst your inventory list, you will find that all types of materials are not

of the same value. Some might be very expensive and need to be carried in stock

for a longer period, while another item might have a shorter lead-time and may be

fast moving. Quite a few items often have shelf life and hence require separate

norms and focus to manage such items.

Getting into the detailed understanding will help you identify the inventory-

stocking norm required to manage these characteristics to ensure optimum

efficiency. The solution quite often may not be to carry stocks; rather it may

involve setting up the customer service standard for such items and specifying a

delivery time depending upon the frequency of demand. Quite a few items often

have shelf life and hence require separate norms and focus to manage such items.

 Study demand pattern, movement patterns and cycles to build suitable inventory

norms for different categories of inventory

Companies which are into retail segments and dealing with huge inventories in

terms of number of parts as well as value will necessarily need to ensure they

practice review of inventory list and clean up operations on ongoing basis.

33
Popularly known as catalogue management, inventory norms review should be carried

out based on detailed study of the sales data, demand pattern, sales cycles etc.

Understanding of the business and sales cycles specific to the product category helps one

manage inventories better. For example, in case of retail garments, with every season

certain skus become redundant no matter how their demand was in the previous months.

This helps identify those stocks which are required to be managed at a micro level and

identify the high value and fast moving items that need to be always on the radar to avoid

stock outs.

It does not help for example to carry standard stocks of all items including low value

items as well as high value items. If the low value items are locally available and the

lead-time is less, one can cut down on the inventory and change the buying pattern.

Similarly high value items too can be managed by cutting down the delivery lead times

and in turn reducing inventory.

It helps to periodically study the past data and extrapolate the same to identify slow

moving and obsolete items. The dead stocks should be flushed out and active catalogue

items should be made available.

34
 Chapter 1.3 Cash Management

Management of cash is an important function of the finance manager. It is concerned

with the managing of:-

 Cash flows into and out of the firm;

 Cash flows within the firm; and

 Cash balances held by the firm at a point of time by financing deficit or investing

surplus cash.

1.3.1 Objectives of cash management

The main objectives of cash management for a business are:-

 Provide adequate cash to each of its units;

 No funds are blocked in idle cash; and

 The surplus cash (if any) should be invested in order to maximize returns for the

business.

A cash management scheme therefore, is a delicate balance between the twin objectives

of liquidity and costs.

1.3.2 The Need for Cash

The following are three basic considerations in determining the amount of cash or

liquidity as have been outlined by Lord Keynes:

 Transaction need: Cash facilitates the meeting of the day-to-day expenses and

other debt payments. Normally, inflows of cash from operations should be

35
 sufficient for this purpose. But sometimes this inflow may be temporarily

blocked. In such cases, it is only the reserve cash balance that can enable the firm

to make its payments in time.

 Speculative needs: Cash may be held in order to take advantage of profitable

opportunities that may present themselves and which may be lost for want of

ready cash/settlement.

 Precautionary needs: Cash may be held to act as for providing safety against

unexpected events. Safety as is explained by the saying that a man has only three

friends an old wife, an old dog and money at bank.

1.3.3 Aspects important for cash management

1.3.3.1 Cash Planning

Cash Planning is a technique to plan and control the use of cash. This protects the

financial conditions of the firm by developing a projected cash statement from a forecast

of expected cash inflows and outflows for a given period. This may be done periodically

either on daily, weekly or monthly basis. The period and frequency of cash planning

generally depends upon the size of the firm and philosophy of management. As firms

grows and business operations become complex, cash planning becomes inevitable for

continuing success.

The very first step in this direction is to estimate the requirement of cash. For this

purpose cash flow statements and cash budget are required to be prepared. The technique

36
of preparing cash flow and funds flow statements have been discussed in this book. The

preparation of cash budget has however, been demonstrated here.

1.3.3.2 Cash budgeting

Cash Budget is the most significant device to plan for and control cash receipts and

payments. This represents cash requirements of business during the budget period. CB or

short term cash forecasting is the principal tool of cash management. CB helps in:

 Estimating cash requirement

 Planning short term financing

 Scheduling payments in connection with capital expenditure projects

 Planning purchase of raw material

 Developing credit policies

The principal methods of short term forecasting are the receipts and payments method

and the adjusted net income method.

 In receipt and payment method forecast for each time of cash receipts and cash

payments has to be made.

 All cash receipts of income and non-income nature are considered.

 Finally the firm finds out the net cash inflow and cash outflow for each month.

 In adjusted net income method only those receipts and payments are considered

that are of revenue nature.

37
1.3.3.3 Monitoring collections and receivables

To enhance the efficiency of cash management, collections and disbursements must be

properly monitored. Following are helpful:

 Prompt billing

 Expeditious collection of cheques

 (Concentration banking, lock box)

 Control of payables (payment on due date, centralized payments, match with

receipts)

1.3.3.4 Optimal cash balance

The optimal cash balance is the one when the cost of holding cash will be minimum and

the holding cost is minimum when there is a trade off between transaction cost and

opportunity cost. Transaction cost decreases with increase in cash balance whereas

opportunity cost increases with the increase in cash balance.

1.3.3.5 Investment of surplus funds

Investing surplus cash involves two basic problems:

1.3.3.5.1 Determining the amount of surplus cash

 Surplus cash is the cash in excess of the firm’s normal cash requirements.

 While determining surplus cash the firm should keep minimum cash balance

called safety level to avoid any risk.

 Safety levels are determined both for normal periods and peak periods.

 During normal period

38
 Safety level=desired days of cash *avg daily cash outflow

 During peak period

Safety level=desired days of cash at the busiest period * avg of highest daily cash

outflows

1.3.3.5.2 Determining of channels of investment

Surplus funds for a short term can be invested some where to earn some return keeping

safety, liquidity, yield and maturity in mind. Types of short term investment opportunities

are as follows:

 Treasury bills

They are short term govt. securities usually issued at discount and redeemed at par on

maturity. They are quite liquid as they can be bought and sold any time and they do not

carry any default risk.

 Commercial papers

They are short term unsecured securities issued by highly credit worth companies and

issued at a maturity of 3 months to 1 year. They are quite liquid.

 Certificate of deposits

They are issued by banks accepting deposits for specified period. They are negotiable

instruments that make them marketable securities.

 Inter-corporate deposits

They are popular short term investment alternative for companies in India. A cash surplus

company will lend its funds in a sister company or with outside company with high credit

standing. The risk of default is high but returns are very attractive.
39
  Money market mutual fund

They focus on short term marketable securities such as TBs, CPs etc. they have a

minimum lock in period of 30 days and after this the investor cancan withdraw his or her

money anytime at a short notice. They offer attractive yields.

1.3.3.6 Recent Developments in Cash Management

It is important to understand the latest developments in the field of cash management,

since it has a great impact on how we manage our cash. Both technological advancement

and desire to reduce cost of operations has led to some innovative techniques in

managing cash. Some of them are:-

1.3.3.6.1 Electronic Fund Transfer

With the developments which took place in the Information technology, the present

banking system is switching over to the computerisation of banks branches to offer

efficient banking services and cash management services to their customers. The network

will be linked to the different branches, banks. This will help the customers in the

following ways:

 Instant updation of accounts.

 The quick transfer of funds.

 Instant information about foreign exchange rates.

1.3.3.6.2 Zero Balance Account

For efficient cash management some firms employ an extensive policy of substituting

marketable securities for cash by the use of zero balance accounts. Every day the firm
40
totals the cheques presented for payment against the account. The firm transfers the

balance amount of cash in the account if any, for buying marketable securities. In case of

shortage of cash the firm sells the marketable securities.

1.3.3.6.3 Money Market Operations

One of the tasks of ‘treasury function’ of larger companies is the investment of surplus

funds in the money market. The chief characteristic of money market banking is one of

size. Banks obtain funds by competing in the money market for the deposits by the

companies, public authorities, High Net worth Investors (HNI), and other banks. Deposits

are made for specific periods ranging from overnight to one year; highly competitive

rates which reflect supply and demand on a daily, even hourly basis are quoted.

Consequently, the rates can fluctuate quite dramatically, especially for the shorter-term

deposits. Surplus funds can thus be invested in money market easily.

1.3.3.6.4 Petty Cash Imprest System

For better control on cash, generally the companies use petty cash imprest system

wherein the day-to-day petty expenses are estimated taking into account past experience

and future needs and generally a week’s requirement of cash will be kept separate for

making petty expenses. Again, the next week will commence with the pre-determined

balance. This will reduce the strain of the management in managing petty cash expenses

and help in the managing cash efficiently.

41
1.3.3.6.5 Management of Temporary Cash Surplus

Temporary cash surpluses can be profitably invested in the following:

 Short-term deposits in Banks and financial institutions.

 Short-term debt market instruments.

 Long-term debt instruments.

 Shares of Blue chip listed companies.

1.3.3.6.6 Electronic Cash Management System

Most of the cash management systems now-a-days are electronically based, since ‘speed’

is the essence of any cash management system. Electronically, transfer of data as well as

funds play a key role in any cash management system. Various elements in the process of

cash management are linked through a satellite. Various places that are interlinked may

be the place where the instrument is collected, the place where cash is to be transferred in

company’s account, the place where the payment is to be transferred etc.

Certain networked cash management system may also provide a very limited access to

third parties like parties having very regular dealings of receipts and payments with the

company etc. A finance company accepting deposits from public through sub-brokers

may give a limited access to sub-brokers to verify the collections made through him for

determination of his commission among other things.

42
Electronic-scientific cash management results in:

 Significant saving in time.

 Decrease in interest costs.

 Less paper work.

 Greater accounting accuracy.

 More control over time and funds.

 Supports electronic payments.

 Faster transfer of funds from one location to another, where required.

 Speedy conversion of various instruments into cash.

 Making available funds wherever required, whenever required.

 Reduction in the amount of ‘idle float’ to the maximum possible extent.

 Ensures no idle funds are placed at any place in the organization.

 It makes inter-bank balancing of funds much easier.

 It is a true form of centralised ‘Cash Management’.

 Produces faster electronic reconciliation.

 Allows for detection of book-keeping errors.

 Reduces the number of cheques issued.

 Earns interest income or reduce interest expense.

1.3.3.7 Virtual Banking

The practice of banking has undergone a significant change in the nineties. While banks

are striving to strengthen customer base and relationship and move towards relationship

43
banking, customers are increasingly moving away from the confines of traditional branch

banking and are seeking the convenience of remote electronic banking services. And

even within the broad spectrum of electronic banking the virtual banking has gained

prominence

Broadly, virtual banking denotes the provision of banking and related services through

extensive use of information technology without direct recourse to the bank by the

customer. The origin of virtual banking in the developed countries can be traced back to

the seventies with the installation of Automated Teller Machines (ATMs). Subsequently,

driven by the competitive market environment as well as various technological and

customer pressures, other types of virtual banking services have grown in prominence

throughout the world.

The Reserve Bank of India has been taking a number of initiatives, which will facilitate

the active involvement of commercial banks in the sophisticated cash management

system. One of the pre-requisites to ensure faster and reliable mobility of funds in a

country is to have an efficient payment system. Considering the importance of speed in

payment system to the economy, the RBI has taken numerous measures since mid

Eighties to strengthen the payments mechanism in the country.

Introduction of computerized settlement of clearing transactions, use of Magnetic Ink

Character Recognition (MICR) technology, provision of inter-city clearing facilities and

high value clearing facilities, Electronic Clearing Service Scheme (ECSS), Electronic

44
Funds Transfer (EFT) scheme, Delivery vs. Payment (DVP) for Government securities

transactions, setting up of Indian Financial Network (INFINET) are some of the

significant developments.

Introduction of Centralised Funds Management System (CFMS), Securities Services

System (SSS), Real Time Gross Settlement System (RTGS) and Structured Financial

Messaging System (SFMS) are the other top priority items on the agenda to transform the

existing system into a state of the art payment infrastructure in India.

The current vision envisaged for the payment systems reforms is one, which

contemplates linking up of at least all important bank branches with the domestic

payment systems network thereby facilitating cross border connectivity. With the help of

the systems already put in place in India and which are coming into being, both banks

and corporates can exercise effective control over the cash management.

Factors for effective cash management

The effective management of cash and more importantly cash flow depends on six

critical factors:

 Cash flow forecasting of likely cash receipts and payments to ensure a

business can meet its payment obligations as they fall due.

 Treasury management to establish funding lines with investors and banks

(including effective control of borrowing facilities to enable the drawing down

45
 of cash for either a substantial asset purchase or working capital when short-

term cash demand exceeds short-term cash supply).

 Efficiently managing day-to-day operations to minimise the amount of cash

required to maintain and grow activities.

 Selecting appropriate investment opportunities that will result in overall

positive cash flow for the business.

 Monitoring the portfolio of products and services to ensure they are cash

generative and not cash consuming, thereby managing the future viability of

the business.

 Having a plan for managing surplus cash.

46
 Chapter 1.4: Receivables Management

Management of trade credit is commonly known as Management of Receivables.

Receivables are one of the three primary components of working capital, the other being

inventory and cash, the other being inventory and cash. Receivables occupy second

important place after inventories and thereby constitute a substantial portion of current

assets in several firms. The capital invested in receivables is almost of the same amount

as that invested in cash and inventories. Receivables thus, form about one third of current

assets in India. Trade credit is an important market tool. It acts like a bridge for

mobilization of goods from production to distribution stages in the field of marketing.

Receivables provide protection to sales from competitions. It acts no less than a magnet

in attracting potential customers to buy the product at terms and conditions favourable to

them as well as to the firm. Receivables management demands due consideration not

financial executive not only because cost and risk are associated with this investment but

also for the reason that each rupee can contribute to firm's net worth.

1.4.1 Meaning and Definition

When goods and services are sold under an agreement permitting the customer to pay for

them at a later date, the amount due from the customer is recorded as accounts

receivables. So, receivables are assets accounts representing amounts owed to the firm as

a result of the credit sale of goods and services in the ordinary course of business. The

value of these claims is carried on to the assets side of the balance sheet under titles such

as accounts receivable, trade receivables or customer receivables. This term can be

47
defined as "debt owed to the firm by customers arising from sale of goods or services in

ordinary course of business."

According to Robert N. Anthony, "Accounts receivables are amounts owed to the

business enterprise, usually by its customers. Sometimes it is broken down into trade

accounts receivables; the former refers to amounts owed by customers, and the latter

refers to amounts owed by employees and others".

Generally, when a concern does not receive cash payment in respect of ordinary sale of

its products or services immediately in order to allow them a reasonable period of time to

pay for the goods they have received. The firm is said to have granted trade credit. Trade

credit thus, gives rise to certain receivables or book debts expected to be collected by the

firm in the near future.

In other words, sale of goods on credit converts finished goods of a selling firm into

receivables or book debts, on their maturity these receivables are realized and cash is

generated. According to Prasanna Chandra, "The balance in the receivables accounts

would be; average daily credit sales x average collection period." The book debts or

receivable arising out of credit has three dimensions:

 It involves an element of risk, which should be carefully assessed. Unlike cash

sales credit sales are not risk less as the cash payment remains unreceived.

48
  It is based on economics value. The economic value in goods and services passes

to the buyer immediately when the sale is made in return for an equivalent

economic value expected by the seller from him to be received later on.

 It implies futurity, as the payment for the goods and services received by the

buyer is made by him to the firm on a future date.

1.4.2 Reasons for maintaining Receivables

1.4.2.1 Increase in Profit As receivables will increase the sales, the sales expansion

would favorably raise the marginal contribution proportionately more than the

additional costs associated with such an increase. This in turn would ultimately

enhance the level of profit of the concern.

1.4.2.2 Meeting Competition A concern offering sale of goods on credit basis always

falls in the top priority list of people willing to buy those goods. Therefore, a firm

may resort granting of credit facility to its customers in order to protect sales from

losing it to competitors. Receivables acts as an attracting potential customers and

retaining the older ones at the same time by weaning them away firm the

competitors.

1.4.2.3 Augment Customer's Resources Receivables are valuable to the customers on

the ground that it augments their resources. It is favoured particularly by those

customers, who find it expensive and cumbersome to borrow from other

49
 resources. Thus, not only the present customers but also the Potential creditors are

attracted to buy the firm's product at terms and conditions favourable to them.

1.4.2.4 Speedy Distribution

Receivables play a very important role in accelerating the velocity of

distributions. As a middleman would act quickly enough in mobilizing his quota

of goods from the productions place for distribution without any hassle of

immediate cash payment. As, he can pay the full amount after affecting his sales.

Similarly, the customers would hurry for purchasing their needful even if they are

not in a position to pay cash instantly. It is for these receivables are regarded as a

bridge for the movement of goods form production to distributions among the

ultimate consumer.

1.4.2.6 Misllaneous

The usual practice companies may resort to credit granting for various other

reasons like industrial practice, dealers relationship, status of buyer, customers

requirements, transits delay etc. In nutshell, the overall objective of making such

commitment of funds in the name of accounts receivables aims at generating a

large flow of operating revenue and earning more than what could be possible in

the absence of such commitment.

50
1.4.3 Aspect of Credit Policy

The discharge of the credit function in a company embraces a number of activities for

which the policies have to be clearly laid down. Such a step will ensure consistency in

credit decisions and actions. A credit policy thus, establishes guidelines that govern grant

or reject credit to a customer, what should be the level of credit granted to a customer etc.

A credit policy can be said to have a direct effect on the volume of investment a company

desires to make in receivables. A company falls prey of many factors pertaining to its

credit policy.

In addition to specific industrial attributes like the trend of industry, pattern of demand,

pace of technology changes, factors like financial strength of a company, marketing

organization, growth of its product etc. also influence the credit policy of an enterprise.

Certain considerations demand greater attention while formulating the credit policy like a

product of lower price should be sold to customer bearing greater credit risk. Credit of

smaller amounts results, in greater turnover of credit collection. New customers should be

least favored for large credit sales. The profit margin of a company has direct relationship

with the degree or risk. They are said to be inter-woven. Since, every increase in profit

margin would be counterbalanced by increase in the element of risk.

As observed by Harry Gross, "Two very important considerations involved in incurring

additional credit risk are: the market for a company's product and its capacity to satisfy

that market. If the demand for the seller's product is greater than its capacity to produce,

then it would be more selective in granting credit to its customers. Conversely, if the
51
supply of the product exceeds the demand, the seller would be more likely to lower credit

standards with resulting greater risk."Such a condition would appear in case of a

company having excess capacity coupled with high profitability and increased sales

volume.

Credit policy of every company is at large influenced by two conflicting objectives

irrespective of the native and type of company. They are liquidity and profitability.

Liquidity can be directly linked to book debts. Liquidity position of a firm can be easily

improved without affecting profitability by reducing the duration of the period for which

the credit is granted and further by collecting the realized value of receivables as soon as

they fails due. To improve profitability one can resort to lenient credit policy as a booster

of sales, but the implications are:

 Changes of extending credit to those with week credit rating.

 Unduly long credit terms.

 Tendency to expand credit to suit customer's needs; and

 Lack of attention to over dues accounts.

The important variables of credit policy should be identified before establishing an

optimum credit policy. The three important decisions variables of credit policy are:

1.4.3.1 Credit terms,

1.4.3.2 Credit standards, and

1.4.3.3 Collection policy.

52
 1.4.3.1 Credit Terms

Credit terms refer to the stipulations recognized by the firms for making credit sale of the

goods to its buyers. In other words, credit terms literally mean the terms of payments of

the receivables. A firm is required to consider various aspects of credit customers,

approval of credit period, acceptance of sales discounts, provisions regarding the

instruments of security for credit to be accepted are a few considerations which need due

care and attention like the selection of credit customers can be made on the basis of firms,

capacity to absorb the bad debt losses during a given period of time. However, a firm

may opt for determining the credit terms in accordance with the established practices in

the light of its needs. The amount of funds tied up in the receivables is directly related to

the limits of credit granted to customers. These limits should never be ascertained on the

basis of the subjects own requirements, they should be based upon the debt paying power

of customers and his ledger record of the orders and payments.

1.4.3.2 Credit Standards

Credit standards refers to the minimum criteria adopted by a firm for the purpose of short

listing its customers for extension of credit during a period of time. Credit rating, credit

reference, average payments periods a quantitative basis for establishing and enforcing

credit standards. The nature of credit standard followed by a firm can be directly linked to

changes in sales and receivables.

In the opinion of Van Home, "There is the cost of additional investment in receivables,

resulting from increased sales and a slower average collection period”. A liberal credit

53
standard always tends to push up the sales by luring customers into dealings. The firm, as

a consequence would have to expand receivables investment along with sustaining costs

of administering credit and bad-debt losses. A more liberal extension of credit may cause

certain customers to the less conscientious in paying their bills on time.

Contrary, to these strict credit standards would mean extending credit to financially

sound customers only. This saves the firm from bad debt losses and the firm has to spend

lesser by a way of administrative credit cost. But, this reduces investment in receivables

besides depressing sales. In this way profit sacrificed by the firm on account of losing

sales amounts more than the cost saved by the firm.

Prudently, a firm should opt for lowering its credit standard only up to that level where

profitability arising through expansion in sales exceeds the various costs associated with

it. That way, optimum credit standards can be determined and maintained by inducing

tradeoff between incremental returns and incremental costs.

1.4.3.3 Collection Policy

Collection policy refers to the procedures adopted by a firm (creditor) collect the amount

of from its debtors when such amount becomes due after the expiry of credit period. R.K.

Mishra States, "A collection policy should always emphasize promptness, regulating and

systematization in collection efforts. It will have a psychological effect upon the

customers, in that; it will make them realize the obligation of the seller towards the

obligations granted. "The requirements of collection policy arises on account of the

54
defaulters i.e. the customers not making the payments of receivables in time. A few turn

out to be slow payers and some other non-payers.

A collection policy shall be formulated with a whole and sole aim of accelerating

collection from bad-debt losses by ensuring prompt and regular collections. Regular

collection on one hand indicates collection efficiency through control of bad debts and

collection costs as well as by inducing velocity to working capital turnover. On the other

hand it keeps debtors alert in respect of prompt payments of their dues. A credit policy is

needed to be framed in context of various considerations like short-term operations,

determinations of level of authority, control procedures etc.

Credit policy of an enterprise shall be reviewed and evaluated periodically and if

necessary amendments shall be made to suit the changing requirements of the business. It

should be designed in such a way that it co-ordinates activities of concerns departments

to achieve the overall objective of the business enterprises. Finally, poor implementation

of good credit policy will not produce optimal results.

55