DIPK202T_Corporate Finance Unit 5 PPT.ppt

CORPORATE FINANCE

1. Unit-5
Working Capital
Management –An Overview

2. Origin of Working Capital
Management
Originated from old Yankee peddler.
Who would load up his wagon with goods
and then go off on his route to peddle his
wares.
The merchandise was called as working
capital it he actually sold or “turned over”
to produce profits.

3. Why we called as working
capital
He generally owned horse and wagon, so
they were financed by equity capital.
However, he borrowed fund to buy the
merchandise.
Working Capital can be defined as: “It
refers to the funds, which a company must
possess to finance its day to day
operations”

4. The inference of origin
nThese loans were called working capital
loans, and they had to be repaid after
each trip to demonstrate to the bank that
credit was sound.
nBank would make another loan if peddler
was able to repay the loan.
nLater, it became sound banking practice.

5. WORKING CAPITAL
MANAGEMENT –AN OVERVIEW
Nature of Working Capital
Management of Working Capital in
India
Planning of Working Capital
Solved Problem
Mini Case

6. NATUREOFWORKINGCAPITAL
Workingcapitalmanagementisconcernedwiththeproblemsthatarisein
managingthecurrentassets(CA),currentliabilities(CL)andthe
interrelationshipsbetweenthem.ItsoperationalgoalistomanagetheCAand
CLinsuchawaythatasatisfactory/acceptablelevelofnetworkingcapital
(NWC)ismaintained.
ConceptsandDefinitionsofWorkingCapitalTherearetwoconceptsof
workingcapital:
1)Grossand
2)Net
GrossWorkingCapital
Grossworkingcapitalmeansthecurrentassetswhichrepresenttheproportion
ofinvestmentthatcirculatesfromoneformtoanotherintheordinaryconduct
ofbusiness.
NetWorkingCapitalThetermnetworkingcapitalcanbedefinedintwoways:
1)themostcommondefinitionofnetworkingcapital(NWC)isthedifference
betweencurrentassetsandcurrentliabilities;and
2)alternatedefinitionofNWCisthatportionofcurrentassetswhichis
financedwithlong-termfunds.

7. Planning of Working Capital
Theneedforworkingcapital(WC)arisesfromthecash/operating
cycleofafirm.Itreferstothelengthoftimerequiredtocomplete
thefollowingsequenceofevents:conversionofcashinto
inventory,inventoryintoreceivablesandreceivablesintocash.
Theoperatingcyclecreatestheneedforworkingcapitalandits
lengthintermsoftime-spanrequiredtocompletethecycleisthe
majordeterminantofthefirm’sworkingcapitalneeds.

8. Inotherwords,thetermcashcyclereferstothelengthoftime
necessarytocompletethefollowingcycleofevents:
1)Conversion of cash into inventory;
2)Conversion of inventory into receivables;
3)Conversion of receivables into cash.
Theoperatingcycle,whichisacontinuousprocess,isshownin
Fig.1.
Cash
Receivables
Inventory
Phase 3
Phase 1
Phase 2
Figure1: Operating Cycle

9. Workingcapitalcanbe
1)Permanentand
2)Temporary
Permanent(fixed)WorkingCapital
Permanentworkingcapitalisacertainminimumlevelofworkingcapitalon
acontinuousanduninterruptedbasis.
Temporary(fluctuating/variable)WorkingCapital
Temporary(fluctuating/variable)workingcapitalistheworkingcapital
neededtomeetseasonalaswellasunforeseenrequirements.
Thebasicdistinctionbetweenpermanentandtemporaryworkingcapitalis
illustratedinFig.2.Figure2showsthatthepermanentlevelisfairly
constant,whiletemporaryworkingcapitalisfluctuating–increasingand
decreasinginaccordancewithseasonaldemands.Inthecaseofan
expandingfirm,thepermanentworkingcapitallinemaynotbehorizontal.
Thisisbecausethedemandforpermanentcurrentassetsmightbe
increasing(ordecreasing)tosupportarisinglevelofactivity.Inthatcase
thelinewouldbearisingoneasshowninFig.3.
Bothkindsofworkingcapitalarenecessarytofacilitatethesalesprocess
throughtheoperatingcycle.Temporaryworkingcapitaliscreatedtomeet
liquidityrequirementsthatareofapurelytransientnature.

10. Amount of
Working Capital
Figure 2: Permanent and Temporary Working Capital
Temporary
Permanent
Time
Amount of
Working Capital
Figure 3: Permanent and Temporary Working Capital
Temporary or
fluctuating
Permanent
Time

11. DeterminantsofWorkingCapital
Workingcapitalrequirementsaredeterminedbyavarietyoffactors.Thesefactors,
however,affectdifferententerprisesdifferently.Ingeneral,thefactorsrelevantfor
properassessmentofthequantumofworkingcapitalrequiredare:
GeneralNatureofBusiness
Theworkingcapitalrequirementsofanenterprisearebasicallyrelatedtothe
conductofbusiness.Enterprisesfallintosomebroadcategoriesdependingonthe
natureoftheirbusiness.Forinstance,publicutilitieshavecertainfeatureswhich
haveabearingontheirworkingcapitalneeds.Thetworelevantfeaturesare:(i)the
cashnatureofbusiness,thatis,cashsale,and(ii)saleofservicesratherthan
commodities.Inviewofthesefeatures,theydonotmaintainbiginventoriesand
have,therefore,probablytheleastrequirementofworkingcapital.Attheother
extremearetradingandfinancialenterprises.Thenatureoftheirbusinessissuch
thattheyhavetomaintainasufficientamountofcash,inventoriesandbookdebts.
Theyhavenecessarilytoinvestproportionatelylargeamountsinworkingcapital.
ProductionCycle
Anotherfactorwhichhasabearingonthequantumofworkingcapitalisthe
productioncycle.Theterm‘productionormanufacturingcycle’referstothetime
involvedinthemanufactureofgoods.Itcoversthetime-spanbetweenthe
procurementofrawmaterialsandthecompletionofthemanufacturingprocess
leadingtotheproductionoffinishedgoods.Fundshavetobenecessarilytiedup
duringtheprocessofmanufacture,necessitatingenhancedworkingcapital.

12. BusinessCycle
Theworkingcapitalrequirementsarealsodeterminedbythenatureofthe
businesscycle.Businessfluctuationsleadtocyclicalandseasonalchanges
which,inturn,causeashiftintheworkingcapitalposition,particularlyfor
temporaryworkingcapitalrequirements.Thevariationsinbusinessconditions
maybeintwodirections:(i)upwardphasewhenboomconditionsprevail,and
(ii)downswingphasewheneconomicactivityismarkedbyadecline.During
theupswingofbusinessactivity,theneedforworkingcapitalislikelytogrow
tocoverthelagbetweenincreasedsalesandreceiptofcashaswellasto
financepurchasesofadditionalmaterialtocatertotheexpansionofthelevel
ofactivity.Additionalfundsmayberequiredtoinvestinplantandmachinery
tomeettheincreaseddemand.Thedownswingphaseofthebusinesscycle
hasexactlyanoppositeeffectonthelevelofworkingcapitalrequirement.
ProductionPolicy
Thequantumofworkingcapitalisalsodeterminedbyproductionpolicy.Inthe
caseofcertainlinesofbusiness,thedemandforproductsisseasonal,thatis,
theyarepurchasedduringcertainmonthsoftheyear.

13. CreditPolicy
Thecreditpolicyrelatingtosalesandpurchasesalsoaffectstheworking
capital.Thecreditpolicyinfluencestherequirementofworkingcapitalintwo
ways:
1)throughcredittermsgrantedbythefirmtoitscustomers/buyersofgoods;
2)credittermsavailabletothefirmfromitscreditors.
Thecredittermsgrantedtocustomershaveabearingonthemagnitudeof
workingcapitalbydeterminingthelevelofbookdebts.Thecreditsalesresult
inhigherbookdebts(receivables).Higherbookdebtsmeanmoreworking
capital.Ontheotherhand,ifliberalcredittermsareavailablefromthe
suppliersofgoods(tradecreditors),theneedforworkingcapitalisless.The
workingcapitalrequirementsofabusinessare,thus,affectedbythetermsof
purchaseandsale,andtherolegiventocreditbyacompanyinitsdealings
withcreditorsanddebtors.
GrowthandExpansion
Asacompanygrows,itislogicaltoexpectthatalargeramountofworking
capitalisrequired.
VagariesintheAvailabilityofRawMaterial
Tomeetvagariesintheunavailability,afirmshouldhaveexcessinventoryof
rawmaterialstosustainsmoothproduction.Suchafirmwouldtendtohave
highlevelofWC.

14. ProfitLevel
Cashprofit,per-se,shouldnotbeviewedasasourceoffinancingWC.The
actualavailabilityofsuchfundswoulddependuponthefirm’srequirementfor
paymentofdividend,paymentofloaninstalment,creationofsinkingfund,
purchaseoffixedassets,andsoon.Incasetheserequirementsare
substantial,cashprofitisnotlikelytobeavailabletomeettheneedsofafirm.
Alternatively,onlyadjustedcashprofitsafterprovisioningforthese
requirementsshouldbereckonedforWCfinancing.
LevelofTaxes
Thefirstappropriationoutofprofitsispaymentorprovisionfortax.The
amountoftaxestobepaidisdeterminedbytheprevailingtaxregulations.The
managementhasnodiscretioninthisrespect.Veryoften,taxeshavetobe
paidinadvanceonthebasisoftheprofitoftheprecedingyear.Taxliabilityis,
inasense,short-termliabilitypayableincash.Anadequateprovisionfortax
paymentsis,therefore,animportantaspectofworkingcapitalplanning.Iftax
liabilityincreases,itleadstoanincreaseintherequirementofworkingcapital
andviceversa.
DividendPolicy
Anotherappropriationofprofitswhichhasabearingonworkingcapitalis
dividendpayment.Thepaymentofdividendconsumescashresourcesand,
thereby,affectsworkingcapitaltothatextent.Conversely,ifthefirmdoesnot
paydividendbutretainstheprofits,workingcapitalincreases.

15. DepreciationPolicy
Depreciationpolicyalsoexertsaninfluenceonthequantumof
workingcapital.Depreciationchargesdonotinvolveanycash
outflows.Theeffectofdepreciationpolicyonworkingcapitalis,
therefore,indirect.
Higherdepreciation(enhancedratesofdepreciations)hasapositive
impactonWCfortworeasons:(i)lowertaxliabilityand,hence,more
cashprofitsand(ii)lowerdisposableprofitsand,therefore,asmaller
dividendpayment.Theyimplymorecashwithacorporate.
PriceLevelChanges
Changesinthepricelevelalsoaffecttherequirementsofworking
capital.Risingpricesnecessitatetheuseofmorefundsfor
maintaininganexistinglevelofactivity.Forthesamelevelofcurrent
assets,highercashoutlaysarerequired.Theeffectofrisingpricesis
thatahigheramountofworkingcapitalisneeded.
OperatingEfficiency
Efficiencyofoperationsacceleratesthepaceofcashcycleand
improvestheWCturnoverresultinginreducedrequirementofWC.

16. Computation of Working Capital
AfirmshouldhaveadequateWCtosupportitsbudgetedlevelofactivityin
termsofproduction/sales.ItshouldhaveneithermorenorlessWCthan
required.WhiletheexcessiveWCadverselyaffectsitsprofits,theinadequate
WCinterruptsitssmoothoperations.Therefore,itscorrectcomputationisan
importantconstituentofefficientWCmanagement.
TherearetwocomponentsofWC,namely,CAandCL.Eachcomponentisto
beseparatelyestimatedtodeterminethecorrectamountofWC.Therelevant
factorsaretheholdingperiodsofthevarioustypesofinventories,debtors
collectionperiod,creditorspaymentperiod,budgetedyearlyproduction/sales,
costofgoodsproduced,costofsales,averagetime-laginpaymentofwages
andotheroverheads,minimumcashbalancesandsoon.
Workingcapitalrequirementsaretobecomputedwithreferencetocashcosts
(excludingdepreciation)andnotthesalepriceasdepreciationisanon-cash
costand,hence,doesnotneedWC.Theinvestmentrequiredtofinance
debtorsareatcostprice.The‘cashcostapproach’isappropriatetodetermine
WCrequirementofafirm.

17. Group Discuss on
fundamental trade-off when
managing working capital.
nFirst identify what are the trade-offs.
nWhat kind of trade off needs to be
addressed and why?
nHow these trade-off would be addressed?
nMake a summary of what were discussed
by participants.

18. EstimationofCurrentAssets:RawMaterialsInventoryTheinvestmentinraw
materialsinventoryisestimatedonthebasisofEq.1.
Budgeted
production (in
units)
×Cost of raw material(s)
per unit
× Average inventory
holding period
(months/days)
12 months/365 days
Work-in-Process(W/P)InventoryTherelevantcoststodeterminework-in-
processinventoryaretheproportionateshareofcostofrawmaterialsand
conversioncosts(labourandmanufacturingoverheadcostsexcluding
depreciation).Incase,fullunitofrawmaterialisrequiredinthebeginning,the
unitcostofwork-in-proesswouldbehigher,thatis,costoffullunit+50per
centofconversioncost,comparedtotherawmaterialrequirementthroughout
theproductioncycle;W/Pisnormallyequivalentto50percentoftotalcostof
production.Symbolically,
Budgeted production
(in units)
× Estimated work-
in-process cost
per unit
× Average time span
of work-in-progress
inventory
(months/days)
12 months/365 days

19. FinishedGoodsInventory
Workingcapitalrequiredtofinancethefinishedgoodsinventoryisgivenbyfactors
summedupinEq.3.
Budgeted
production
(in units)
× Cost of goods produced
per unit (excluding
depreciation)
× Finished goods
holding period
(months/days)
12 months/365 days
Debtors
TheWCtiedupindebtorsshouldbeestimatedinrelationtototalcostprice
(excludingdepreciation)Symbolically,
Budgeted
credit sales
(in units)
× Cost of sales per
unit excluding
depreciation
× Average debt
collection period
(months/days)
12 months/365 days

20. TradeCreditors
Budgeted yearly
production
(in units)
× Raw material
cost
per unit
× Credit period
allowed by creditors
(months/days)
12 months/365 days
Note:Proportionaladjustmentshouldbemadetocashpurchasesofrawmaterials.
DirectWages
Budgeted yearly
production
(in units)
× Direct labour
cost per unit
× Average time-lag in
payment of wages
(months/days)
12 months/365 days
CashandBankBalances
ApartfromWCneedsforfinancinginventoriesanddebtors,firmsalsofindituseful
tohavesomeminimumcashbalanceswiththem.
EstimationofCurrentLiabilities
Theworkingcapitalneedsofbusinessfirmsarelowertothethatextentsuchneeds
aremetthroughthecurrentliabilities(otherthanbankcredit)arisingintheordinary
courseofbusiness.Theimportantcurrentliabilities(CL),inthiscontextare,trade-
creditors,wagesandoverheads:

21. Overheads(OtherThanDepreciationandAmortisation)
Budgeted yearly
production
(in units)
× Overhead cost
per unit
× Average time-lag in
payment of overheads
(months/days)
12 months/365 days
Theamountofoverheadsmaybeseparatelycalculatedfordifferenttypesof
overheads.Inthecaseofsellingoverheads,therelevantitemwouldbesales
volumeinsteadofproductionvolume.
Thecomputationofworkingcapitalissummarisedinformat1.
Theaveragecreditperiodforthepaymentofwagesapproximatestoahalf-a-
monthinthecaseofmonthlywagepayment:Thefirstdays’monthlywagesare
paidonthe30thdayofthemonth,extendingcreditfor29days,thesecond
day’swagesare,again,paidonthe30th,extendingcreditfor28days,andso
on.Averagecreditperiodapproximatestohalf-a-month.

22. FORMAT 1Determination of Working Capital
(I)Estimation of Current Asset: Amount
(a)Minimum desired cash and bank balances
(b)Inventories
Raw material
Work-in-process
Finished Goods
(c)Debtors*
Total Current Assets
(II)Estimation of Current Liabilities:
(a)Creditors**
(b)Wages
(c)Overheads
Total Current Liabilities
(III)Net Working Capital (I –II)
Add margin for contingency
(IV)Net Working Capital Required
*If payment is received in advance, the item would be listed in CL.
**Ifadvancepaymentistobemadetocreditors,theitemwouldappearunderCA.The
samewouldbethetreatmentforadvancepaymentofwagesandoverheads.

23. MANAGEMENT OF WORKING CAPITAL IN INDIA
Indiancorporatesseemtohaveadequateandsatisfactorylevelofworkingcapitalas
reflectedintheirliquidityratios.Theforeigncontrolledcompaniesareplacedinabetter
positionrelativetothedomesticcompanies.
Therearewideinter-industryvariationsintheliquidityratiosofthecorporateenterprises.
Withtheexceptionofsugar,allotherindustrygroupshavesafeandsatisfactoryliquidity
position.
ThemajorityofIndiancompaniesmaintainsrelativelylowercash/bankbalances.Marketable
securitiesareyettoemergeasapopularmeansofcashmanagement.Theexcesscashis
deployedtoretireshort-termdebt/inshort-termbankdeposits.
Inspiteofthenotabledeclineovertheyears,inventoryconsitutesasizeablepartofthe
totalcurrentassetsoftheIndiancorporates.Themostimportantobjectiveofinventory
managementinIndiais‘avoidlossofproduction/sales’.Thepopularcontroltechniquesare
ABC,FSNandSDEandinventoryturnoverratioandcomparisonwithcompetitorsare
widelyusedtoassesstheperformanceofinventorymanagement.
Debtors/receivablesalsoconstituteasignificantcomponentofcurrentassets.‘growthin
sales’isthemostimportantobjectiveofcreditpolicyandthe‘opencreditwithapprovalif
exceedsaspecifiedlimit’isthemostfavouredpolicy.Itiscommonpracticetoprepare
‘ageingschedule’ofdebtors’toassessthefinancialhealthofthecustomersbeforegranting
creditandmonitoringpurposes.Tospeedupcollections,thecorporatesoffercash
discount.Themajorityofthecompaniesalsochargepenalinterest.
Accountspayableandshort-termloans/advancesarethemajorcomponentsofcurrent
liabilities.
The‘lengthoftheoperatingcycle’isthemostwidelyusemethodtodetermineworking
capitalneed.Theworkingcapitalfinancingpolicyisbasedonthematchingapproach.The
majorityofthecompanieshaveoccasionallyexperiencedworkingcapitalshortagedue
mainlytoexcessinventoryaccumulationandpoordebtcollection.

24. SOLVED PROBLEM

25. Whilepreparingaprojectreportonbehalfofaclientyouhavecollectedthefollowing
facts.Estimatethenetworkingcapitalrequiredforthatproject.Add10percenttoyour
computedfiguretoallowcontingencies:
Particulars Amount per unit
Estimated cost per unit of production:
Raw material
Direct labour
Overheads (exclusive of depreciation, Rs 10 per unit)
Total cash cost
Rs 80
30
60
170
Additionalinformation:
Sellingprice,Rs200perunit
Levelofactivity,1,04,000unitsofproductionperannum
Rawmaterialsinstock,average4weeks
Workinprogress(assume50percentcompletionstageinrespectofconversioncosts
and100percentcompletioninrespectofmaterials),average2weeks
Finishedgoodsinstock,average4weeks
Creditallowedbysuppliers,average4weeks
Creditallowedtodebtors,average8weeks
Laginpaymentofwages,average1.5weeks
Cashatbankisexpectedtobe,Rs25,000.
Youmayassumethatproductioniscarriedonevenlythroughouttheyear(52weeks)and
wagesandoverheadsaccruesimilarly.Allsalesareoncreditbasisonly.

26. Solution
Networkingcapitalestimateofaproject
(A)Current assets:
(i) Raw materials in stock, (1,04,000 ×Rs 80 ×4/52) Rs 6,40,000
(ii) Work-in-progress
(a) Raw material (1,04,000 ×Rs 80 ×2/52) 3,20,000
(b) Direct Labour (1,04,000 ×Rs 15 ×2/52) 60,000
(c) Overheads (1,04,000 ×Rs 30 ×2/52) 1,20,000
(iii) Finished goods stock: (1,04,000 ×Rs 170 ×4/52) 13,60,000
(iv) Debtors: (1,04,000 ×Rs 170 ×8/52) 27,20,000
(v) Cash at bank 25,000
Total investment in current assets 52,45,000
(B)Current liabilities:
(i) Creditors, average 4 weeks: (1,04,000 ×Rs 80 ×4/52) 6,40,000
(ii) Lag in payment of wages (1,04,000 ×Rs 30 ×1.5/52) 90,000
Total current liabilities 7,30,000
(C)Net working capital: Current assets –Current liabilities 45,15,000
Add: 10 per cent contingencies 4,51,500
Net working capital required 49,66,500

27. WorkingNotes
Afullunitofrawmaterialisrequiredatthebeginningofthe
manufacturingprocessand,therefore,totalcostofthematerial,thatis,
Rs80perunithasbeentakenintoconsideration,whileinthecaseof
expenses,viz.directlabourandoverheads,theunithasbeenfinished
onlytotheextentof50percent.Accordingly,Rs15andRs30have
beenchargedfordirectlabourandoverheadsrespectivelyinvaluing
work-in-process.

28. Management of Cash And
Marketable Securities

29. Cash
Cashisthereadycurrencytowhichallliquidassetscan
bereduced.
NearCash
Nearcashimpliesmarketablesecuritiesviewedthe
samewayascashbecauseoftheirhighliquidity.
MarketableSecurities
Marketablesecuritiesareshort-terminterestearning
moneymarketinstrumentsusedbyfirmstoobtaina
returnontemporarilyidlefunds.

30. Motives For Holding Cash
Cashmanagementisoneofthekeyareasof
workingcapitalmanagement.Therearefour
motivesforholdingcash:
1)Transactionmotive,
2)Precautionarymotive,
3)Speculativemotive,and
4)Compensatingmotive.

31. 1.Transactionmotive
Thetransactionmotivereferstotheholdingofcashtomeetanticipated
obligationswhosetimeisnotperfectlysynchronisedwithcashreceipts.
2.Precautionarymotive
Precautionarymotiveisamotiveforholdingcash/near-cashasacushiont
meetunexpectedcontingencies/demandforcash.Theunexpectedcash
needsatshortnoticemaybetheresultof:
Floods,strikesandfailureofimportantcustomers;
Billsmaybepresentedforsettlementearlierthanexpected;
Unexpectedslowdownincollectionofaccountsreceivable;
Cancellationofsomeorderforgoodsasthecustomerisnotsatisfied;
and
Sharpincreaseincostofrawmaterials.
Thecashbalancesheldinreserveforsuchrandomandunforeseen
fluctuationsincashflowsarecalledasprecautionarybalances.Inother
words,precautionarymotiveofholdingcashimpliestheneedtoholdcash
tomeetunpredictableobligations.Thus,precautionarycashbalanceserves
toprovideacushiontomeetunexpectedcontingencies.

32. 3.Speculativemotive
Speculativemotiveisamotiveforholdingcash/near-
cashtoquicklytakeadvantageofopportunitiestypically
outsidethenormalcourseofbusiness.
4.Compensatingmotive
Compensatingmotiveisamotiveforholdingcash/near-
cashtocompensatebanksforprovidingcertainservices
orloans.

33. Objectives of Cash Management
Thebasicobjectivesofcashmanagementare
two-fold:
(a)tomeetthecashdisbursementneeds
(paymentschedule)
(b)tominimisefundscommittedtocash
balances.

34. MeetingPaymentsSchedule
Abasicobjectiveofcashmanagementistomeetthepaymentschedule,thatis,to
havesufficientcashtomeetthecashdisbursementneedsofafirm.
Theimportanceofsufficientcashtomeetthepaymentschedulecanhardlybe
overemphasised.Theadvantagesofadequatecashare:
1)itpreventsinsolvencyorbankruptcyarisingoutoftheinabilityofafirmtomeet
itsobligations;
2)therelationshipwiththebankisnotstrained;
3)ithelpsinfosteringgoodrelationswithtradecreditorsandsuppliersofraw
materials
4)acashdiscountcanbeavailedofifpaymentismadewithintheduedate.
Forexample,afirmisentitledtoa2percentdiscountforapaymentmadewithin10
dayswhentheentirepaymentistobemadewithin30days.Sincethenetamountis
duein30days,failuretotakethediscountmeanspayinganextra2percentfor
usingthemoneyforanadditional20days.Ifafirmweretopay2percentforevery
20-dayperiodoverayear,therewouldbe18suchperiods(360days÷20days).This
representsanannualinterestrateof36percent;
5)itleadstoastrongcreditratingwhichenablesthefirmtopurchasegoodson
favourabletermsandtomaintainitslineofcreditwithbanksandothersourcesof
credit;(vi)totakeadvantageoffavourablebusinessopportunitiesthatmaybe
availableperiodically;andfinally,(vii)thefirmcanmeetunanticipatedcash
expenditurewithaminimumofstrainduringemergencies,suchasstrikes,firesor
anewmarketingcampaignbycompetitors.

35. MinimisingFundsCommittedtoCashBalances
Thesecondobjectiveofcashmanagementistominimisecash
balances.Inminimisingthecashbalances,twoconflictingaspects
havetobereconciled.Ahighlevelofcashbalanceswill,asshown
above,ensurepromptpaymenttogetherwithalltheadvantages.But
italsoimpliesthatlargefundswillremainidle,ascashisanon-
earningassetandthefirmwillhavetoforegoprofits.Alowlevelof
cashbalances,ontheotherhand,maymeanfailuretomeetthe
paymentschedule.Theaimofcashmanagement,therefore,should
betohaveanoptimalamountofcashbalances.

36. Factors Determining Cash Needs
Thefactorsthatdeterminetherequiredcashbalancesare:
(1)Synchronisationofcashflows
Theneedformaintainingcashbalancesarisesfromthenon-
synchronisationoftheinflowsandoutflowsofcash:ifthereceipts
andpaymentsofcashperfectlycoincideorbalanceeachother,there
wouldbenoneedforcashbalances.Thefirstconsiderationin
determiningthecashneedis,therefore,theextentofnon-
synchronisationofcashreceiptsanddisbursements.Forthis
purpose,theinflowsandoutflowshavetobeforecastoveraperiod
oftime,dependingupontheplanninghorizonwhichistypicallya
one-yearperiodwitheachofthe12monthsbeingasubperiod.The
techniqueadoptedisacashbudget.

37. Short Costs
Anothergeneralfactortobeconsideredindeterminingcashneedsisthecost
associatedwithashortfallinthecashneeds.Includedintheshortcostsarethe
following:
(1)Transactioncostsassociatedwithraisingcashtotideovertheshortage.
Thisisusuallythebrokerageincurredinrelationtothesaleofsomeshort-
termnear-cashassetssuchasmarketablesecurities.
(2)Borrowingcostsassociatedwithborrowingtocovertheshortage.These
includeitemssuchasinterestonloan,commitmentchargesandother
expensesrelatingtotheloan.
(3)Lossofcash-discount,thatis,asubstantiallossbecauseofatemporary
shortageofcash.
(4)Costassociatedwithdeteriorationofthecreditratingwhichisreflectedin
higherbankchargesonloans,stoppageofsupplies,demandsforcash
payment,refusaltosell,lossofimageandtheattendantdeclineinsales
andprofits.
(5)Penaltyratesbybankstomeetashortfallincompensatingbalances.

38. ExcessCashBalanceCosts
Thecostofhavingexcessivelylargecashbalancesisknownastheexcess
cashbalancecost.Iflargefundsareidle,theimplicationisthatthefirmhas
missedopportunitiestoinvestthosefundsandhastherebylostinterest
whichitwouldotherwisehaveearned.Thislossofinterestisprimarilythe
excesscost.
ProcurementandManagement
Thesearethecostsassociatedwithestablishingandoperatingcash
managementstaffandactivities.Theyaregenerallyfixedandaremainly
accountedforbysalary,storage,handlingofsecuri-ties,andsoon.
UncertaintyandCashManagement
Finally,theimpactofuncertaintyoncashmanagementstrategyisalso
relevantascashflowscannotbepredictedwithcompleteaccuracy.The
firstrequirementisaprecautionarycushiontocopewithirregularitiesin
cashflows,unexpecteddelaysincollectionsanddisbursements,defaults
andunexpectedcashneeds.
Theimpactofuncertaintyoncashmanagementcan,however,bemitigated
through(i)improvedforecastingoftaxpayments,capitalexpenditure,
dividends,andsoon;and(ii)increasedabilitytoborrowthroughoverdraft
facility.

39. Determining Cash Need
Therearetwoapproachestoderiveanoptimalcash
balance,namely,
a)minimisingcostcashmodelsand
b)cashbudget.
CashManagement/ConversionModels
1)Baumol Model,
2)Miller-Orr Model and
3)Orgler’s Model.

40. Baumol Model
BaumolModelisamodelthatprovidesforcostefficienttransactional
balancesandassumesthatthedemandforcashcanbepredictedwith
certainlyanddeterminestheoptimalconversionsize/lot.
ThefocusofBaumolmodelistominimisethetotalcostassociatedwith
cashmanagementcomprisingtotalconversioncosts(thatis,costs
incurredeachtimemarketablesecuritiesareconvertedintocash)andthe
opportunitycostofkeepingidlecashbalanceswhichotherwisecouldhave
beeninvestedinmarketablesecurities.
Thetotalcostassociatedwithcashmanagement,accordingtothismodel,
hastwoelements:
(i)costofconvertingmarketablesecuritiesintocashand
(ii)thelostopportunitycost.
Theconversioncostsareincurredeachtimemarketablesecuritiesare
convertedintocash.Symbolically,.conversion each at sold securities marketable of value C
period, the for needs cash ntransactio total T
n,transactio the of size the of tindependen be to assumed conversion per cost b Where
(1)
C
Tb
period per cost conversion Total





41. Theopportunitycostisderivedfromthelost/forfeitedinterestrate(i)that
couldhavebeenearnedontheinvestmentofcashbalances.Themodel
assumesaconstantandacertainpatternofcashoutflows.Atthe
beginningofeachperiod,thefirmstartswithacashbalancewhichit
graduallyspendsuntilattheendoftheperiodithasazerocashbalance
andmustreplenishitseachsupplytothelevelofcashbalanceinthe
beginning.Symbolically,theaveragelostopportunitycost.
The total cost associated with cash management comprising total
conversion cost plus opportunity cost of not investing cash until needed in
interest-bearing instruments can be symbolically expressed as:2.by divided (zero) period the of balance
cash ending the plus (C) cash beginning the is, that balance cash average the C/2
earned. been have could that rate interest i
2
C
i














)2( )3(
C
Tb
2
C
i


















42. Tominimisethecost,therefore,themodelattemptstodeterminethe
optimalconversionamount,thatis,thecashwithdrawalwhichcoststhe
least.Thereasonisthatafirmshouldnotkeepthetotalbeginningcash
balanceduringtheentireperiodasitisnotneededatthebeginningofthe
period.Symbolically,theoptimalconversionamount(C),
ThemodelintermsofofEq.4hasimportantimplications.First,asthetotal
cashneedsfortransactionrisesbecauseofexpansion/diversification,the
optimalwithdrawalincreaseslessthanproportionately.Thisistheresultof
economyofscaleincashmanagement.Secondly,astheopportunity
interestrate(i)increases,theoptimalcashwithdrawaldecreases.Thisisso
becauseas(i)increasesitismorecostlytoforfeittheinvestment
opportunityandfinancialmanagerswanttokeepasmuchcashinvestedin
securitiesforaslongaspossible.)4(
i
bt2
C

43. Example1
TheABCLtdrequiresRs30lakhincashtomeetitstransactionneeds
duringthenextthree-monthcashplanningperiod.Itholdsmarketable
securitiesofanequalamount.Theannualyieldonthesemarketable
securitiesis20percent.Theconversionofthesesecuritiesintocashentails
afixedcostofRs3,000pertransaction.UsingBaumolmodel,computethe
amountofmarketablesecuritiesconvertedintocashperorder.Assuming
ABCLtdcansellitsmarketablesecuritiesinanyofthefivelotsizes:Rs
1,50,000,3,00,000,6,00,000,7,50,000and15,00,000,prepareatable
indicatingtheeconomiclotsizeusingnumericalanalysis.
Solution
whereC=optimalconversionamount/amountofmarketablesecurities
convertedintocashperorder;b=costofconversionintocashper
lot/transaction;T=projectedcashrequirementduringtheplanningperiod;i
=interestrateearnedperplanningperiodoninvestmentinmarketable
securities,
i
2bT
C 5%20%/4 yield@Annual6,00,000Rs
0.05
30,00,000Rs3,000Rs2
@




44. TABLE 1Optimal Cash Conversion Size/Lot
1.Total cash requirement (Rs lakh) 30 30 30 30 30
2.Lot size (Rs lakh) 1.5 3 6 7.5 15
3.Number of lots (1 ÷2) 20 10 5 4 2
4.Conversion cost per lot (Rs thousand) 3 3 3 3 3
5.Total conversion cost (3 ×4) (Rs
thousand)
60 30 15 12 6
6.Average lot size (Rs lakh) 0.75 1.5 3 3.75 7.5
7.Interest cost (6 ×0.05) (Rs) 3,750 7,50015,000 18,750 37,500
8.Total cost (5 + 7) (Rs) 63,75037,50030,000 30,750 42,500
The optimal cash conversion size is Rs 6 lakh.

45. WorkingNotes
1)Numberofconversionduringtheplanningperiod=(Totalcash
requirement(Rs30lakh)/Cashconversionlot/size).
2)Averagecashbalance=Cashconversionsize/2.
3)Interestincomeforegone=Averagecashbalance×interestrate
forthecashplanningperiod;interestrate=annualyield/4.
4)Costofcashconversion=Numberofconversions×costper
conversion.
5)Totalcostofconvertingandholdingcash=Interestincome
foregone+Costofcashconversion.

46. CashBudget:ManagementTool
Cashbudgetisastatementoftheinflowsandoutflowsofcashthatisused
toestimateitsshort-ternrequirements.
Afirmiswelladvisedtoholdadequatecashbalancesbutshouldavoid
excessivebalances.Thefirmhas,therefore,toassessitsneedforcash
properly.Thecashbudgetisprobablythemostimportanttoolincash
management.Itisadevicetohelpafirmtoplanandcontroltheuseofcash.
Itisastatementshowingtheestimatedcashinflowsandcashoutflowsover
theplanninghorizon.Thevariouspurposesofcashbudgetsare:
1)tocoordinatethetimingsofcashneeds.
2)itpinpointstheperiod(s)whenthereislikelytobeexcesscash;
3)itenablesafirmwhichhassufficientcashtotakeadvantageofcash
discountsonitsaccountspayable,topayobligationswhendue,to
formulatedividendpolicy,toplanfinancingofcapitalexpansionandto
helpunifytheproductionscheduleduringtheyearsothatthefirmcan
smoothoutcostlyseasonalfluctuations;finally,
4)ithelpstoarrangeneededfundsonthemostfavourabletermsand
preventstheaccumulationofexcessfunds.

47. Elements/PreparationofCashBudget
Thefirstelementofacashbudgetistheselectionoftheperiodoftimetobe
coveredbythebudget.Itisreferredtoastheplanninghorizon.Theplanning
horizonmeansthetimespanandthesub-periodswithinthattimespanover
whichthecashflowsaretobeprojected.
Theplanninghorizonofacashbudgetshouldbedeterminedinthelightofthe
circumstancesandrequirementsofaparticularcase.Forinstance,iftheflows
areexpectedtobestableanddependable,suchafirmmayprepareacash
budgetcoveringalongperiod,say,ayearanddivideitintoquarterlyintervals.In
thecaseofafirmwhoseflowsareuncertain,aquarterlybudget,dividedinto
monthlyintervals,maybeappropriate.Whereflowsareaffectedbyseasonal
variations,monthlybudgets,sub-dividedonaweeklyorevenadailybasis,may
benecessary.Iftheflowsaresubjecttoextremefluctuations,evenadailybudget
maybecalledfor.Theideabehindsubdividingthebudgetingperiodintosmaller
intervalsistohighlightthemovementofcashfromonesubperiodtoanother.
Thesecondelementofthecashbudgetistheselectionofthefactorsthathavea
bearingoncashflows.Theitemsincludedinthecashbudgetareonlycash
items;non-cashitemssuchasdepreciationandamortisationareexcluded.10
Thefactorsthatgeneratecashflowsaregenerallydivided,forpurposesofthe
constructionofcashbudget,intotwobroadcategories:
a)Operating,and
b)Financial.

48. OperatingCashFlows
Themainoperatingfactors/itemswhichgeneratecashoutflowsand
inflowsoverthetimespanofacashbudgetaretabulatedinExhibit1.
EXHIBIT 1Operating Cash Flow Items
Inflows/CashReceipts Outflows/Disbursements
1.Cash sales 1.Accounts payable/Payable payments
2.Collection of accounts
receivable
2.Purchase of raw materials
3.Disposal of fixed assets 3.Wages and salary (payroll)
4.Factory expenses
5.Administrative and selling expenses
6.Maintenance expenses
7.Purchase of fixed assets

49. Example4
Afirmsellsgoodsoncreditandallowsacashdiscountforpaymentsmadewithin20
days.Ifthediscountisnotavailedof,thebuyermustpaythefullamountin40days.
However,thefirmfindsthatsomeofitscustomersdelaypaymentsupto90days.The
experiencehasbeenthaton20percentofsales,paymentismadeduringthemonthin
whichthesaleismade,on70percentofthesalespaymentismadeduringthesecond
monthaftersaleandon10percentofsalespaymentismadeduringthethirdmonth.
Therawmaterialsandothersuppliesrequiredforproductionamountto70percentof
salesandareboughtinthemonthbeforethefirmexpectstosellitsfinishedproducts.
Itspurchasetermsallowthefirmtodelaypaymentonitspurchasesforonemonth.
Thecreditsalesofthefirmare: (Rslakh)
May 10 August 30 November 20
June 10 September 40 December 10
July 20 October 20 January 10
Prepareaworksheet,showingtheanticipatedcashinflowsonaccountofcollectionof
receivablesanddisbursementofpayables.
SolutionTheexpectedcashinflowsthroughcollectionofreceivablesandthe
anticipatedoutflowsonaccountofaccountspayablearepresentedinTable2inthe
formofaworksheet.

50. TABLE 2Work-Sheet (Rs lakh)
May JuneJulyAug.SeptOct.Nov.DecJan.
1 Credit sales
2. Collections:
During month of sale
(20%)
During the first month
after sale (70%)
During second month
after sale (10%)
10
2
—
—
10
2
7
—
20
4
7
1
30
6
14
1
40
8
21
2
20
4
28
3
20
4
14
4
10
2
14
2
10
2
7
2
Total collections 2 9 12 21 31 35 22 18 11
3. Credit purchases (70% of
next month’s sale) 7 14 21 28 14 14 7 7 7
Payment (one month lag) — 7 14 21 28 14 14 7 7
Total payments — 7 14 21 28 14 14 7 7
FinancialCashFlows
Themajorfinancialfactors/itemsaffectingthegenerationofcashflowsaredepictedinExhibit2.

51. EXHIBIT 2Financial Cash Flow Items
CashInflows/Receipts CashOutflows/Payments
1.Loans/Borrowings 1. Income-tax/Tax payments
2.Sales of securities 2. Redemption of loan
3.Interest received 3. Repurchase of shares
4.Dividend received 4. Interest paid
5.Rent received 5. Dividends paid
6.Refund of tax
7.Issue of new shares and securities
Preparation of Cash Budget
Afterthetimespanofthecashbudgethasbeendecidedandpertinentoperatingand
financialfactorshavebeenidentified,thefinalstepistheconstructionofthecash
budget.

52. Cash Management: Basic
Strategies
Thecashbudget,asacashmanagementtool,wouldthrowlightonthenetcash
positionofafirm.Afterknowingthecashposition,themanagementshouldwork
outthebasicstrategiestobeemployedtomanageitscash.Thepresentsection
attemptstooutlinethebasicstrategiesofcashmanagement.
Thebroadcashmanagementstrategiesareessentiallyrelatedtothecashturnover
process,thatis,thecashcycletogetherwiththecashturnover.Thecashcycle
referstotheprocessbywhichcashisusedtopurchasematerialsfromwhichare
producedgoods,whicharethensoldtocustomers,wholaterpaythebills.The
firmreceivescashfromcustomersandthecyclerepeatsitself.Thecashturnover
meansthenumberoftimescashisusedduringeachyear.Thecashcycleinvolves
severalstepsalongthewayasfundsflowfromthefirm’saccounts,asshownin
Exhibit3.

53. EXHIBIT 3Details of Cash Cycle
A B C D E F G H I
A = Materials ordered; B = Materials received;
C = Payments; D = Cheque clearance; E = Goods sold;
F = Customer mails payments; G = Payment received;
H = Cheques deposited; I = Funds collected
Inaddressingtheissueofcashmanagementstrategies,weareconcernedwith
thetimeperiodsinvolvedinstagesB,C,D,andF,G,H,I.Afirmhasnocontrol
overthetimeinvolvedbetweenstagesAandB.ThelagbetweenDandEis
determinedbytheproductionprocessandinventorypolicy.Thetimeperiod
betweenstagesEandFisdeterminedbycredittermsandthepaymentspolicy
ofcustomers.

54. Example7
Afirmwhichpurchasesrawmaterialsoncreditisrequiredbythecredit
termstomakepaymentswithin30days.Onitsside,thefirmallowsitscredit
buyerstopaywithin60days.Itsexperiencehasbeenthatittakes,onan
average,35daystopayitsaccountspayableand70daystocollectits
accountsreceivable.Moreover,85dayselapsebetweenthepurchaseofraw
materialsandthesaleoffinishedgoods,thatistosay,theaverageageof
inventoryis85days.Whatisthefirm’scashcycle?Also,estimatethecash
turnover.
Solution
Thecashcycleofthefirmcanbecalculatedbyfindingtheaveragenumber
ofdaysthatelapsebetweenthecashoutflowsassociatedwithpaying
accountspayableandthecashinflowsassociatedwithcollectingaccounts
receivable:
(i)Cashcycle=85days+70days–35days=120days
(ii)Cashturnover=theassumednumberofdaysinayeardividedbythe
cashcycle=365/120=3

55. MinimumOperatingCash
Minimumoperatingcashisthelevelofopeningcashbalanceatwhich
afirmwouldmeetallobligationsandiscomputedbydividingtotal
annualoutlaysbythecashturnover.
Cashmanagementstrategiesareintendedtominimisetheoperating
cashbalancerequirement.Thebasicstrategiesthatcanbeemployed
todotheneedfulareasfollows:
a)Stretching Accounts Payable,
b)Efficient Inventory-Production Management,
c)Speedy Collection of Accounts Receivable, and
d)Combined Cash Management Strategies.

56. StretchingAccountsPayable
Onebasicstrategyofefficientcashmanagementistostretchthe
accountspayable.Inotherwords,afirmshouldpayitsaccounts
payableaslateaspossiblewithoutdamagingitscreditstanding.It
should,however,takeadvantageofthecashdiscountavailableon
promptpayment.
Ifthefirm,inourExample7,canstretchitsaccountspayablefromthe
currentlevelof35daysto45days,itscashcyclewillbe110days(i.e.
reducedby10daysfromtheoriginal120days).Thereductioninthe
cashcycleby10daysasaresultofthestretchingoftheaccounts
payableby10dayswillincreasethecashturnoverfrom3(initially)to
3.27(360÷110).Thiswillleadtoadecreaseintheminimumcash
requirementfromRs80lakhtoRs73.40lakh(Rs240lakh÷3.27).That
is,therequirementhasbeenreducedbyRs6.60lakh.Assuminga10
percentrateofinterest,therewillbeasavingincosttothefirmtothe
extentofRs0.66lakh.

57. EfficientInventory-ProductionManagement
Anotherstrategyistoincreasetheinventoryturnover,avoidingstock-outs,
thatis,shortageofstock.Thiscanbedoneinthefollowingways:
1.Increasingtherawmaterialsturnoverbyusingmoreefficientinventory
controltechniques.
2.Decreasingtheproductioncyclethroughbetterproductionplanning,
schedulingandcontroltechniques;itwillleadtoanincreaseinthework-
in-progressinventoryturnover.
3.Increasingthefinishedgoodsturnoverthroughbetterforecastingof
demandandabetterplanningofproduction.
AssumethatthefirminExample7isabletoreducetheaverageageofits
inventoryfrom85to70,thatis,by15days.Asaresult,thecashcyclewill
declineby15daysfrom120daysto105days.Thecashturnoverwillincrease
to3.43(360÷105)fromtheoriginallevelof3.Theeffectofanincreaseinthe
cashturnoverwillbetoreducetheminimumcashrequirementfromRs80
lakhtoRs70lakh(Rs240lakh÷3.43).ThesavingincostonRs10lakhwillRe
1lakh(Rs10lakh×0.10).Thus,efficientinventoryandproduction
managementcausesadeclineintheoperatingcashrequirementand,hence,a
savingincashoperatingcost.

58. SpeedingCollectionofAccountsReceivable
Yetanotherstrategyforefficientcashmanagementistocollectaccounts
receivableasquicklyaspossiblewithoutlosingfuturesalesbecauseofhigh-
pressurecollectiontechniques.Theaveragecollectionperiodofreceivables
canbereducedbychangesin
1)Creditterms,
2)Creditstandards,and
3)Collectionpolicies.
IfthefirminourExample5managestoreducetheaverageageofitsaccounts
receivablefromthecurrentlevelof70daysto50days,thecashcyclewillbe
reducedto100daysfrom120days(declineby20days).Thecashturnoverwill
increaseinconsequenceto3.60(360÷100)fromtheoriginallevelof3.The
operatingcashrequirementwillfallfromRs80lakhtoapproximatelyRs66.67
lakh(Rs240÷3.60).ThereductionincashbalanceofaboutRs13.33lakhwill
leadtoasavingincostamountingtoRs1.33lakh(0.10×Rs13.33lakh).Thus,
areductionintheaveragecollectionperiodby20days,releasesfunds
equivalenttoRs13.33lakhandleadstoasavingincashoperatingcostofRs
1.33lakh.

59. CombinedCashManagementStrategies
AssumethefirminExample7simultaneously(i)increasestheaverage
accountspayableby10days;(ii)reducestheaverageageofinventoryby15
days;(iii)speedsupthecollectionofaccountsreceivableby20days.Now,the
cashcyclewillbe75days(120days–10days–15days–20days);thecash
turnoverwillincreaseto4.8(360÷75);theminimumoperatingcash
requirementwillgodowntoRs50lakh,thatis,areductionofRs30lakh;
assuminga10percentrateofinterest,thesavingincashoperatingcostwill
beRs3lakh.
Theforegoingdiscussionclearlyshowsthatthethreebasicstrategiesofcash
management,relatedto(1)accountspayable,(2)inventory,and(3)accounts
receivable,leadtoareductioninthecashbalance.But,theyimplycertain
problemsforthemanagement.First,iftheaccountspaya-blearepostponed
toolong,thecreditstandingofthefirmmaybeadverselyaffected.Secondly,a
lowlevelofinventorymayleadtoastoppageofproductionassufficientraw
materialsmaynotbeavailableforuninterruptedproduction,orthefirmmay
beshortofenoughstocktomeetthedemandforitsproduct,thatis,‘stock-
out’.Finally,restrictivecreditstandards,credittermsandcollectionpolicies
mayjeopardisesales.Theseimplicationsshouldbeconstantlykeptinview
whileworkingoutcashmanagementstrategies.

60. Cash Management
Techniques/Processes
Thecashmanagementstrategiesareintendedtominimisetheoperating
cashbalancerequirement.Thebasicstrategiesthatcanbeemployedare
SpeedyCashCollections
Inmanagingcashefficiently,thecashinflowprocesscanbeaccelerated
throughsystematicplanningandrefinedtechniques.Therearetwobroad
approachestodothis.Inthefirstplace,thecustomersshouldbe
encouragedtopayasquicklyaspossible.Secondly,thepaymentfrom
customersshouldbeconvertedintocashwithoutanydelay.
PromptPaymentbyCustomers
Onewaytoensurepromptpaymentbycustomersispromptbilling.What
thecustomerhastopayandtheperiodofpaymentshouldbenotified
accuratelyandinadvance.Another,andmoreimportant,techniqueto
encouragepromptpaymentbycustomers,isthepracticeofofferingcash
discounts.

61. EarlyConversionofPaymentsintoCash
Oncethecustomermakesthepaymentbywritingachequeinfavourofthe
firm,thecollectioncanbeexpeditedbypromptencashmentofthecheque.
Thereisalagbetweenthetimeachequeispreparedandmailedbythe
customerandthetimethefundsareincludedinthecashreservoirofthe
firm.ThisisrepresentedbystagesFtoIinExhibit3.Withinthistime
intervalthreestepsareinvolved:
(a)Transitormailingtime,thatis,thetimetakenbythepostofficesto
transferthechequefromthecustomerstothefirm.Thisdelayorlagis
referredtoaspostalfloat;
(b)Timetakeninprocessingthechequeswithinthefirmbeforetheyare
depositedinthebanks,termedaslethargy;and
(c)Collectiontimewithinthebank,thatis,thetimetakenbythebankin
collectingthepaymentfromthecustomer’sbank.Thisiscalledbankfloat.
Theearlyconversionofpaymentintocash,asatechniquetospeedup
collectionofaccountsreceivable,isdonetoreducethetimelagbetween
postingofthechequebythecustomerandtherealisationofmoneybythe
firm.Thepostalfloat,lethargyandbankfloatarecollectivelyreferredtoas
depositfloat.Thetermdepositfloatisdefinedasthesumofchequeswritten
bycustomersthatarenotyetusablebythefirm.15

62. Concentration Banking
Concentrationbankingisacollectionprocedureinwhichpayments
aremadetoregionallydispersedcollectioncentres,thendeposited
inlocalbanksforquickclearing;reducesfloatbyshorteningthe
postalandbankfloat.Asasystemofdecentralisedbillingand
multiplecollectionpoints,itisausefultechniquetoexpeditethe
collectionofaccountsreceivable.Itreducesthetimeneededinthe
collectionprocessbyreducingthemailingtime.
LockboxSystem
Lockboxsystemisacollectionprocedureinwhichpayerssendtheir
payments/chequestoanearbypostboxthatisemptiedbythefirm’s
bankseveraltimesandthebankdepositsthechequeinthefirm’s
account;reducesfloatbyshorteningthelethargyaswellaspostal
andbankfloats.

63. Example8
Afirmusesacontinuousbillingsystemthatresultsinanaveragedaily
receiptofRs40,00,000.Itiscontemplatingtheinstitutionofconcentration
banking,insteadofthecurrentsystemofcentralisedbillingandcollection.It
isestimatedthatsuchasystemwouldreducethecollectionperiodof
accountsreceivableby2days.
ConcentrationbankingwouldcostRs75,000annuallyand8percentcanbe
earnedbythefirmonitsinvestments.Itisalsofoundthatalock-boxsystem
couldreduceitsoverallcollectiontimebyfourdaysandcouldcostannually
Rs1,20,000.
(i)Howmuchcashwouldbereleasedwiththeconcentrationbanking
system?
(ii)Howmuchmoneycanbesavedduetoreductioninthecollectionperiod
by2days?Shouldthefirminstitutetheconcentrationbankingsystem?
(iii)Howmuchcashwouldbefreedbylock-boxsystem?
(iv)Betweenconcentrationbankingandlock-boxsystem,whichisbetter?

64. Solution
(i)Cashreleasedbytheconcentrationbankingsystem=Rs
40,00,000×2days=Rs80,00,000
(ii)Saving=0.08×Rs80,00,000=Rs6,40,000.
Thefirmshouldinstitutetheconcentrationbankingsystem.It
costsonlyRs75,000whilethesavingsexpectedareRs6,40,000.
(iii)Cashreleasedbythelock-boxsystem=Rs40,00,000×4days=
Rs1,60,00,000
(iv)Savinginlock-boxsystem:0.08×Rs1,60,00,000=Rs12,80,000
Lock-boxsystemisbetter.ItsnetsavingsRs11,60,000(Rs12,80,000
–Rs1,20,000)arehigherthanthatofconcentrationbanking.

65. SlowingDisbursements
Apartfromspeedycollectionofaccountsreceivable,theoperatingcash
requirementcanbereducedbyslowdisbursementsofaccounts
payable.Infact,slowdisbursementsrepresentasourceoffunds
requiringnointerestpayments.Thereareseveraltechniquestodelay
paymentofaccountspayable,namely,
AvoidanceofEarlyPayments
Onewaytodelaypaymentsistoavoidearlypayments.Accordingtothe
termsofcredit,afirmisrequiredtomakeapaymentwithinastipulated
period.Itentitlesafirmtocashdiscounts
CentralisedDisbursements
Anothermethodtoslowdowndisbursementsistohavecentralised
disbursements.Allthepaymentsshouldbemadebytheheadoffice
fromacentraliseddisbursementaccount.Suchanarrangementwould
enableafirmtodelaypaymentsandconservecashforseveralreasons.

66. Float
Averyimportanttechniqueofslowdisbursementsisfloat.Thetermfloat
referstotheamountofmoneytiedupinchequesthathavebeenwritten,but
haveyettobecollectedandencashed.Alternatively,floatrepresentsthe
differencebetweenthebankbalanceandbookbalanceofcashofafirm.The
differencebetweenthebalanceasshownbythefirm’srecordandtheactual
bankbalanceisduetotransitandprocessingdelays.Floatusedinthissense
iscalledaschequekiting.Therearetwowaysofdoingit:
1)Payingfromadistantbank,
2)Scientificcheque-cashinganalysis.
(a)PayingFromaDistantBank
Thefirmmayissueachequeonbanksawayfromthecreditor’sbank.This
wouldinvolverelativelylongertransittimeforthecreditor’sbanktoget
paymentand,thus,enablethefirmtouseitsfundslonger.

67. (b)Cheque-encashmentAnalysis.
Anotherwaytomakeuseoffloatistoanalyse,onthebasisofpast
experience,thetime-lagintheissueofchequesandtheirencashment.For
instance,chequesissuedtopaywagesandsalarymaynotbeencashed
immediately;itmaybespreadoverafewdays,say,25percentononeday,50
percentontheseconddayandthebalanceonthethirdday.Itwouldmean
thatthefirmshouldkeepinthebanknottheentireamountofapayrollbut
onlyafractionrepresentedbytheactualwithdrawaleachday.Thisstrategy
wouldenablethefirmtosaveoperatingcash
Accruals
Finally,apotentialtoolforstretchingaccountspayableisaccrualswhichare
definedascurrentliabilitiesthatrepresentaserviceorgoodsreceivedbya
firmbutnotyetpaidfor.Forinstance,payroll,thatis,remunerationto
employeeswhorenderserviceinadvanceandreceivepaymentlater.

68. CASH MANAGEMENT PRACTICES IN INDIA
CashmanagementinIndiapresentsadauntingtaskinlightofthehugenumberof
clearinghouses(1,056)andbankbranches(morethan75,000).Themainfeaturesof
cashmanagementpracticesinIndiaare:
1)Collectionmethods,
2)Paymentmechanisms,and
3)Electronicbanking.
Collection Methods
Collectionservicesprovidedbybanksusetheirownbranchesandtheircorrespondent
bank’snetworkaswellascountry-widearrangementswithcouriersandcoordinators.
TherearetwobroadcategoriesofcollectionproductsofferedbybanksinIndia:local
collectionandupcountrycollection/outstationclearing.
Localcollectionisusedforchequesdepositedwiththebank/itscorrespondentbankin
thelocationonwhichitisdrawn.Comparedwithoutstationchequecollections,local
collectionfundsarerealisedfaster.
Outstationclearingisusedwhenthelocationwherethechequeisdepositedwiththe
bankisdifferentfromthelocationonwhichitisdrawn.Banksoffertwotypesof
outstationchequecollectionproducts:oneforchequesdrawnonacorrespondentbank
locationandtheotherforchequesdrawnonlocationsthatarenotcoveredbythe
correspondentbank.Inthecaseoftheformer,thetypicalclearingperiodofthecheque
isrelativelyfaster,andtheriskinvolved(lossofchequesintransit)isalsomuchlower.

69. Thecollectionproceedscanbemadeavailabletothecustomeroneitheraclearedfundsor
guaranteedbasis(i.e.cheque-discounting)dependingonthecorporate’scashflow
requirements.Value-addedservicessuchaschequepick-ups,customisedmanagement
informationreporting,data-entryofdeposit-slipinformationandsoonarealsoprovided.
BulkCollectionisofferedbybanksforprocessinghigh-volumecollectionssuchascheque
collectionforinitialpublicofferings(IPOs),utilitybillcollectionsfortelephone,electricity,
cellularserviceprovidersandsoonthroughtimelyclearingofinstrumentstogetherwithstrong
reconciliationandreporting.
Post-datedCheque(PDC)Management solutionsarecriticalfornon-bankingfinance
companiesthatcollectPDCsfromtheirretailandauto-loandisbursementcustomers.
ElectronicClearingService—DebitSchemeoftheRBIenablescorporatestypicallyutilityor
insurancecompaniestocollecttheproceedsofsmallvaluelarge-volumepaymentsfromtheir
customers.
ChequeTruncationremovestheneedformuchofthephysicalhandlingandmovementof
paper-basedpaymentinstrumentsasonlytheelectronicimageoftheinstrumentistransmitted
throughtheclearingsystem.
CONTD.

70. Payment Mechanism
Currentlypaymentsaresignificantlypaper-basedthroughcash/cheques/demanddrafts.Thekey
mechanismavailabletocustomersinIndiaareillustratedbelow:
Paymentmechanism Features
Cheque Currentlythemostprevalentmodeofpayment.Thecustomer’saccountis
debitedonlywhenachequeispresentedinclearingbythebeneficiary.
Cheque payable at parAchequethatcanberedeemedatparatanyofthelocationswherethebank
hasabranch.Thecustomer’saccountisdebitedonlyonclearing.
Customer’s or pay
order
Apre-fundedpaymentinstrumentissuedbyabank,i.e.thecustomer’s
accountisdebitedupfront,andistypicallypayableatalllocationswherethe
bankhasbranches.
Demand draft Apre-fundedout-stationpayorder,whichisdrawnonalocationwherethe
bankdoesnothaveitsownbranch,buthasatie-upwithacorrespondent
bank.Thecustomer’saccountisdebitedupfront.
Real-time gross
settlement (RTGS)
Adomesticelectronicpaymentmechanismforfundstransfer(credit-push).
Thebeneficiary’sbankisrequiredtocredittheproceedsofaninwardRTGS
transactiontothebeneficiary’saccount,orreturnthefunds,withintwohours
ofreceiptofthepaymentnotification.ParticipationbybanksinRTGS
customerpaymentsiscurrentlyvoluntary.

71. Electronic
Funds
Transfer
(EFT)
Anelectronicpaymentmodeforsame-dayinter-andintra-cityfunds
transfer(credit-push).Itismandatoryforallbankbranches,in16
largemetrosinIndia,directlyinvolvedinclearing,toparticipatein
RBI’sEFTSystemforinwardEFT.
Special
Electronic
Funds
Transfer
(SEFT)
Anelectronicpaymentmodeforsame-dayinter-andintra-cityfunds
transfer(credit-push).ThisisanextensionofRBI’sEFTsystem,but
participationin
SEFTisvoluntaryforbanks,andonlynetworkedbranchesare
allowedtoparticipate.Thus,locationcoverageiswiderthanEFT,but
notallbanksparticipateinSEFT.
Electronic
Clearing
Service
(ECS) –
Credit
ECS(credit)isanelectronicmodeofpaymentwhichisdesignedfor
large-volumepayments.TheECSschemeisoperationalinsome46
citiesandallbanksdirectlyparticipatinginclearinghavetoprocess
inwardECS.TheECSsettlementcycleisfourdays;muchlongerthan
forRTGS,EFTorSEFT.
Interest/Divi
dend
warrants
Thesearepaper-basedpaymentinstrumentsthatarerequiredtobe
pre-funded(basedonapplicableregulations)andareusedforlarge-
volumeinterestanddividendpayments.
CONTD.

72. Themigrationfrompaper-basedtoelectronicmodesofpaymenthasbeenrelativelyslow
andgradual.Corporatesarerealisingthepotentialofcost-savingsinprocessing
electronicpaymentsastheseareconducivetosystem-integrationwiththeclient’s
internalsystems.
PaymentOutsourcingCorporatesandfinancialinstitutionsareincreasinglyoutsourcing
payment-processingtobanks.Paymentoutsourcingproductseliminatemanual
processingandtheoverheadcostsassociatedwithpreparing,verifyingand
signing/despatchingindividualcheques.Banksfacilitatetheinterfacingofcorporate’s
back-officepaymentsystemwiththebank’selectronicbankingplateforms.
Electronic Banking
Banksoffersophisticatedelectronicbankingdeliverychannels.Theynotonlyallow
customerstoaccessaccount-balanceinformationinreal-timebutalsoenablethemto
initiatetransactionsforpayments,inter-accounttransfers,depositplacementsandsoon.
Corporateshaveaccesstoextensivemanagementinformationreports.Theinternet
bankingofferingsalsoallowcorporatestoaccesstheiraccountswiththebanksfrom
differentcountries.
CONTD.

73. ThefollowingresultsareexpectedbyXYZLtdbyquartersnextyear,inthousandsof
rupees.
Particulars Quarter
1 2 3 4
Sales 7,50010,50018,00010,500
Cash payments:
Production costs 7,00010,000 8,000 8,500
Selling, administrative and other costs 1,000 2,000 2,900 1,600
Purchases of plant and other fixed assets 100 1,100 2,100 2,100
Thedebtorsattheendofaquarterareone-thirdofsalesforthequarter.Theopening
balanceofdebtorsisRs30,00,000.CashonhandatthebeginningoftheyearisRs
6,50,000andthedesiredminimumbalanceisRs5,00,000.Borrowingsaremadeatthe
beginningofquartersinwhichtheneedwilloccurinmultipliesofRs10,000andare
repaidattheendofquarters.Interestchargesmaybeignored.Youarerequiredto
prepare:
(a) acashbudgetbyquartersfortheyear;and
(b) statetheamountofloanoutstandingattheendoftheyear.

74. Solution
(a)Cashbudgetnextyear(quarter-wise) (thousandsofrupees)
Particulars Quarter
1 2 3 4 Total
(A) Cash inflows:
Collection from debtors
(i) From prior quarter (1/3 of sales)3,0002,5003,5006,00015,000
(ii) From current quarter (2/3 of
sales)
5,0007,00012,0007,00031,000
Total 8,0009,50015,50013,00046,000
(B) Cash outflows:
Production costs 7,00010,0008,0008,50033,500
Selling, administrative and other costs1,0002,0002,9001,6007,500
Plant and other fixed assets
purchased
1001,1002,1002,1005,400
Total 8,10013,10013,00012,20046,400
(c) Surplus/(deficiency) (100)(3,600)2,500 800(400)
Beginning balance 650 550 500 500 650
Ending balance (indicated) 550(3,050)3,0001,300 250
Borrowings required
(deficiency + minimum cash required) 3,550 3,550
(Repayments) made
(balance –minimum cash required) (2,500)(800)(3,300)
Ending balance (actually now estimated) 550 500 500 500 500
(b)Loanoutstanding=Rs35,50,000–Rs33,00,000=Rs2,50,000.

75. Receivables Management

76. RECEIVABLES MANAGEMENT
Objectives
Credit Policies
Credit Terms
Collection Policies
Solved Problem
Mini Case

77. Thetermreceivablesisdefinedas‘debtowedtothefirmbycustomers
arisingfromsaleofgoodsorservicesintheordinarycourseof
business’.Whenafirmmakesanordinarysaleofgoodsorservices
anddoesnotreceivepayment,thefirmgrantstradecreditandcreates
accountsreceivablewhichcouldbecollectedinthefuture.Receivables
managementisalsocalledtradecreditmanagement.Thus,accounts
receivablerepresentanextensionofcredittocustomers,allowing
themareasonableperiodoftimeinwhichtopayforthegoods
received.
Objectives

78. Costs
CollectionCostCollectioncostistheadministrativecostincurredin
collectingreceivables.
CapitalCostCapitalcostisthecostontheuseofadditionalcapitalto
supportcreditsaleswhichalternativelycouldhavebeenemployed
elsewhere.
DelinquencyCostDelinquencycostiscostarisingoutoffailureof
customerstopayonduedate.
DefaultCostDefaultcostsaretheoverduesthatcannotberecovered.
BenefitsApartfromthecosts,anotherfactorthathasabearingon
accountsreceivablemanagementisthebenefitemanatingfromcredit
sales.Thebenefitsaretheincreasedsalesandanticipatedprofits
becauseofamoreliberalpolicy.

79. Credit Policies
Thecreditpolicyofafirmprovidestheframeworktodetermine
1)whetherornottoextendcredittoacustomerand
2)howmuchcredittoextend.
Thecreditpolicydecisionofafirmhastwobroaddimensions:
1)Creditstandardsand
2)Creditanalysis.Afirmhastoestablishandusestandardsin
makingcreditdecisions,developappropriatesourcesofcredit
informationandmethodsofcreditanalysis.Weillustratebelow
howthesetwoaspectsarerelevanttotheaccountsreceivable
managementofafirm.

80. CreditStandards
Theterm‘creditstandards’representsthebasiccriteriaforthe
extensionofcredittocustomers.Thetrade-offwithreferenceto
creditstandardscovers
1)thecollectioncost,
2)theaveragecollectionperiod/costofinvestmentinaccounts
receivable,
3)levelofbaddebtlosses,and
4)levelofsales.Thesefactorsshouldbeconsideredwhile
decidingwhethertorelaxcreditstandardsornot
CollectionCosts
Theimplicationsofrelaxedcreditstandardsare
1)morecredit,
2)alargecreditdepartmenttoserviceaccountsreceivableand
relatedmatters,
3)increaseincollectioncosts.Theeffectoftighteningofcredit
standardswillbeexactlytheopposite.

81. CreditAnalysis
Thesecondaspectofcreditpoliciesofafirmiscreditanalysisand
investigation.Twobasicstepsareinvolvedinthecreditinvestigationprocess:
(a)obtainingcreditinformation,and
(b)analysisofcreditinformation.
ObtainingCreditInformation
Thefirststepincreditanalysisisobtainingcreditinformationonwhichtobase
theevaluationofacustomer.Thesourcesofinformation,broadlyspeaking,are
(1)internal,and
(2)external.
Internal
Usually,firmsrequiretheircustomerstofillvariousformsanddocuments
givingdetailsaboutfinancialoperations.Theyarealsorequiredtofurnish
tradereferenceswithwhomthefirmscanhavecontactstojudgethesuitability
ofthecustomerforcredit.Thistypeofinformationisobtainedfrominternal
sourcesofcreditinformation.
Anotherinternalsourceofcreditinformationisderivedfromtherecordsofthe
firmscontemplatinganextensionofcredit.Itislikelythataparticular
customer/applicantmayhaveenjoyedcreditfacilityinthepast.

82. External
InIndia,theexternalsourcesofcreditinformationarenotasdevelopedasinthe
industriallyadvancedcountriesoftheworld.Dependingupontheavailability,the
followingexternalsourcesmaybeemployedtocollectinformation.
FinancialStatements
Oneexternalsourceofcreditinformationisthepublishedfinancialstatements,that
is,thebalancesheetandtheprofitandlossaccount.
BankReferences
Anotherusefulsourceofcreditinformationisthebankofthefirmwhichis
contemplatingtheextensionofcredit.Themodusoperandihereisthatthefirm’s
bankercollectsthenecessaryinformationfromtheapplicant’sbanks.Alternatively,
theapplicantmayberequiredtoaskhisbankertoprovidethenecessary
informationeitherdirectlytothefirmortoitsbank.
TradeReferences
Theserefertothecollectionofinformationfromfirmswithwhomtheapplicanthas
dealingsandwhoonthebasisoftheirexperiencewouldvouchfortheapplicant.
CreditBureauReports
Finally,specialistcreditbureaureportsfromorganisationsspecialisingin
supplyingcreditinformationcanalsobeutilised.

83. AnalysisofCreditInformation
Oncethecreditinformationhasbeencollectedfromdifferentsources,itshouldbe
analysedtodeterminethecreditworthinessoftheapplicant.Theanalysisshould
covertwoaspects:
(1)Quantitative
Theassessmentofthequantitativeaspectsisbasedonthefactualinformation
availablefromthefinancialstatements,thepastrecordsofthefirm,andsoon.The
firststepinvolvedinthistypeofassessmentistoprepareanAgingScheduleofthe
accountspayableoftheapplicantaswellascalculatetheaverageageofthe
accountspayable.Anotherstepinanalysingthecreditinformationisthrougha
ratioanalysisoftheliquidity,profitabilityanddebtcapacityoftheapplicant.These
ratiosshouldbecomparedwiththeindustryaverage.
(2)Qualitative
Thequantitativeassessmentshouldbesupplementedbyaqualitative/subjective
interpretationoftheapplicant’screditworthiness.Thesubjectivejudgementwould
coveraspectsrelatingtothequalityofmanagement.Here,thereferencesfrom
othersuppliers,bankreferencesandspecialistbureaureportswouldformthebasis
fortheconclusionstobedrawn.Intheultimateanalysis,therefore,thedecision
whethertoextendcredittotheapplicantandwhatamounttoextendwilldepend
uponthesubjectiveinterpretationofhiscreditstanding.

84. Credit Terms
Theseconddecisionareainaccountsreceivable
managementisthecreditterms.Afterthecreditstandards
havebeenestablishedandthecreditworthinessofthe
customershasbeenassessed,themanagementofafirm
mustdeterminethetermsandconditionsonwhichtrade
creditwillbemadeavailable.Thestipulationsunderwhich
goodsaresoldoncreditarereferredtoascreditterms.
Theserelatetotherepaymentoftheamountunderthe
creditsale.Thus,credittermsspecifytherepaymentterms
ofreceivables.

85. Creditperiod,intermsofthedurationoftimeforwhichtradecreditis
extended–duringthisperiodtheoverdueamountmustbepaidbythe
customer;
Cashdiscount,ifany,whichthecustomercantakeadvantageof,thatis,the
overdueamountwillbereducedbythisamount;and
Cashdiscountperiod,whichreferstothedurationduringwhichthediscount
canbeavailedof.Thesetermsareusuallywritteninabbreviations,for
instance,‘2/10net30’.Thethreenumeralsareexplainedbelow:
2signifiestherateofcashdiscount(2percent),whichwillbeavailableto
thecustomersiftheypaytheoverduewithinthestipulatedtime;
10representsthetimeduration(10days)withinwhichacustomermustpay
tobeentitledtothediscount;
30meansthemaximumperiodforwhichcreditisavailableandtheamount
mustbepaidinanycasebeforetheexpiryof30days.

86. CashDiscount
Thecashdiscounthasimplicationsforthesalesvolume,averagecollection
period/averageinvestmentinreceivables,baddebtexpensesandprofitper
unit.Theimplicationsofincreasingorinitiatingcashdiscountareasfollows:
Thesalesvolumewillincrease.Thegrantofdiscountimpliesreduced
prices.Ifthedemandfortheproductsiselastic,reductioninpriceswill
resultinhighersalesvolume.
Sincethecustomers,totakeadvantageofthediscount,wouldliketopay
withinthediscountperiod,theaveragecollectionperiodwouldbereduced.
Thereductioninthecollectionperiodwouldleadtoareductioninthe
investmentinreceivablesasalsothecost.Thedecreaseintheaverage
collectionperiodwouldalsocauseafallinbaddebtexpenses.Asaresult,
profitswouldincrease.
Thediscountwouldhaveanegativeeffectontheprofits.Thisisbecause
thedecreaseinpriceswouldaffecttheprofitmarginperunitofsale.

87. The effects of increase in the cash discount are summarised in Table 2. The effect of
decrease in cash discount will be exactly opposite.
TABLE 2Effects of Increase in Cash Discounts
Item Direction of Change
(I = Increase D =
Decrease)
Effect on Profits
(Positive+ or Negative–)
Sales Volume I +
Average Collection Period D +
Bad Debt Expenses D +
Profit Per Unit D –

88. Example2
AssumethatthefirminourExample1iscontemplatingtoallow2percent
discountforpaymentwithin10daysafteracreditpurchase.Itisexpectedthat
ifdiscountsareoffered,saleswillincreaseby15percentandtheaverage
collectionperiodwilldropto15days.Assumebaddebtexpenseswillnotbe
affected;returnoninvestmentexpectedbythefirmis15percent;60percent
ofthetotalsaleswillbeondiscount.Shouldthefirmimplementtheproposal?
Solution
(i)Profitonsales:Theprofitonsale=saleofadditionalunitsmultipliedbythe
differencebetweenthesalespriceandthevariablecostperunit=4,500(Rs
10–Rs6)=4,500×Rs4=Rs18,000
(ii)Savingonaveragecollectionperiod:Thissavingiswhatwouldhavebeen
earnedonthereducedinvestmentsinaccountsreceivableasaresultofthe
cashdiscount. 
  
 
11,125Rs
24
2,67,000Rs
i.e.360/1524
6Rs4,5008Rs30,000
discount) (with plan Proposed (b)
20,000Rs
/30)12(i.e.360
8Rs30,000
discount) (without plan Present (a)
turnover sReceivable
sales of Cost
receivable accounts in investment Average








89. Thus,ifcashdiscountisallowed,theaverageinvestmentsinreceivableswill
declinebyRs8,875(i.e.Rs20,000–Rs11,125).Givena15percentrateofreturn,
thefirmcouldearnRs1,331.25onRs8,875.Thus,thesavingresultingfromadrop
intheaveragecollectionperiodisRs1,331.25.
(iii)Thetotalbenefitsassociatedwiththecashdiscount
Profit on additional sale Rs 18,000.00
Saving in cost 1,331.25
Total 19,331.25
(iv)Cashdiscount:Thecostinvolvedinthecashdiscountoncreditsales,thatis,2
percentofcreditsales=0.02×Rs2,07,000(i.e.0.60×Rs3,45,000)=Rs4,140
Thus,againstacostofRs4,140,thebenefitfrominitiatingcashdiscountisRs
19,331.25;thatis,thereisanetgainofRs15,191.25(Rs19,331.25–Rs4,140).The
firmshould,therefore,implementtheproposaltoallow2percentcashdiscountfor
paymentwithin10daysofthecreditpurchasebythecustomers.
Asimilartypeofanalysiscanbemadetoillustratetheeffectofeitherreductionor
eliminationofcashdiscount.

90. Credit Period
Thesecondcomponentofcredittermsisthecreditperiod.Theexpectedeffectofan
increaseinthecreditperiodissummarisedinTable3.
TABLE 3Effect of Increase in Credit Period
Item Direction of Change
(I = Increase D =
Decrease)
Effect on Profits
(Positive or Negative)
Sales Volume I +
Average Collection Period I –
Bad Debt Expenses I –
Areductioninthecreditperiodislikelytohaveanoppositeeffect.Thecreditperiod
decisionisillustratedinExample3.

91. Collection Policies
Thethirdareainvolvedintheaccountsreceivablemanagementis
collectionpolicies.Theyrefertotheproceduresfollowedto
collectaccountsreceivablewhen,aftertheexpiryofthecredit
period,theybecomedue.Thesepoliciescovertwoaspects:
1)degreeofefforttocollecttheoverdues,and
2)typeofcollectionefforts.
DegreeofCollectionEffort
Toillustratetheeffectofthecollectioneffort,thecreditpoliciesofafirm
maybecategorisedinto(i)strict/light,and(ii)lenient.Thecollection
policywouldbetightifveryrigorousproceduresarefollowed.Atight
collectionpolicyhasimplicationswhichinvolvebenefitsaswellcosts.
Themanagementhastoconsideratrade-offbetweenthem.Likewise,a
lenientcollectioneffortalsoaffectsthecost-benefittrade-off.Theeffect
oftighteningthecollectionisdiscussedbelow.

92. Inthefirstplace,thebaddebtexpenses(defaultcost)woulddecline.Moreover,
theaveragecollectionperiodwillbereduced.Asaresultofthesetwoeffects,
thefirmwillbenefitanditsprofitswillincrease.But,therewouldbeanegative
effectsalso.Averyrigorouscollectionstrategywouldinvolveincreased
collectioncosts.Yetanothernegativeeffectmaybeintheformofadeclinein
thevolumeofsales.Thismaybebecausesomecustomersmaynotlikethe
pressureandintenseeffortsinitiatedbythefirm,andmayswitchtootherfirms.
TheseeffectsaretabulatedinTable5.
TABLE 5Basic Trade-off from Tight Collection Effort
Item Direction of Change
(I = Increase D = Decrease)
Effect on Profits
[Positive (+) or Negative (–)
Bad Debt Expenses D +
Average Collection
Period
D +
Sales Volume D –
Collection Expenditure I –
Theeffectofthelenientpolicywillbejusttheopposite.Weillustratethebasictrade-
offinExample4.

93. Type of Collection Efforts
Thesecondaspectofcollectionpoliciesrelatestothestepsthat
shouldbetakentocollectoverduesfromthecustomers.Awell-
establishedcollectionpolicyshouldhaveclear-cutguidelinesasto
thesequenceofcollectionefforts.Afterthecreditperiodisoverand
paymentremainsdue,thefirmshouldinitiatemeasurestocollect
them.Theeffortshouldinthebeginningbepolite,but,withthe
passageoftime,itshouldgraduallybecomestrict.Thestepsusually
takenare
1)letters,includingreminders,toexpeditepayment;
2)telephonecallsforpersonalcontact;
3)personalvisits;
4)helpofcollectionagencies;andfinally,
5)legalaction.

94. Group Discussion on other
factors influencing credit
policy
nProfit Potential
nLegal Considerations

95. MINI CASE

96. (CreditPolicy)KhoobsuratIndustriesLtdisamajorplayerinthesoap
anddetergentbusiness.Ithasamarketshareof25percentwhichis
almosttwiceasmuchasthatofthenextcompetitor.Thecurrentsales
ofKhoobsuratamounttoRs1,400crore.Itsbaddebtsareintherange
of1percent.ThecompanyhasaP/Vratioof45percent.Thepolicyof
Khoobsuratistoextendtoallitscustomersacreditof30days.The
existingfixedcostsareRs120crorewhichareunaffectedbychanges
insales.
KhoobsuratIndustriesisfacingseverecompetitionbothfrom
multinationalandregionalplayers.TheCEOofthecompany,Sushant
Sachdeva,hasaskedAmitGupta,thechiefmarketingmanager,to
submitproposalstomeetthechallengefromthecompetitors.Amit
Guptahas,afteradetailedsurveyanddiscussion,proposedthree
optionsfortheconsiderationoftheCEO:

97. Option1:Increasethecreditperiodto60days.Inthatcase,thesales
arelikelytoincreaseby20percent.Butbaddebtswouldgoupto2per
centandanadditionalinvestmentofRs20crorewillberequiredin
workingcapital(withouttakingintoaccounttheeffectofdebtors).
Option2:Offeracreditterm,2/10net30.Inthiscase,salesare
expectedtoincreaseby10percent.Fiftypercentofthedebtorsare
likelytoavailofthediscount.Therewouldbenochangeinbaddebts.
Option3:Offerbothextendedcreditto60daysandcashdiscountof2
percent(2/10net30).Anincreaseof25percentinsalescouldbe
expectedandcashdiscountcouldbeavailedofby30percentofthe
customers.Butbaddebtswillincreaseto2percentandtheadditional
investmentinworkingcapitalofRs20crorewillberequired(without
takingintoaccounttheeffectofdebtors).
TheCEOofKhoobsuratIndustriesdesirestheCFOtocarryouta
financialevaluationoftheabovealternativeproposalsandsuggestthe
courseofactiontobetaken.TherequiredrateofreturnofKhoobsurat
is20percent.

98. Solution
Financial Evaluation of Credit Proposal (Rs crore)
Option1 Option2 Option3
Incremental sales (Rs 1,400 ×.20) 280(1,400 ×0.10)140(1,400 ×0.25) 350
Less incremental variable
cost
(280 ×0.55) 154 (140 ×0.55) 77 (350 ×0.55)192.5
Incremental contribution (280 ×0.45) 126 (140 ×0.45) 63 (350 ×0.45)157.5
Less other relevant costs:
Bad debts 19.6
a
1.4
c
21
d
Cost of investment in
working capital (20 ×0.20)
4 — 4
Cost of investment in debtors 19.97
b
— 12.2
e
Cash discount — 15.4 10.5
Add savings on account of
reduction in debtors
— _____ 4.1
f
____
Incremental profit 82.43 50.3 109.8

99. a (Rs 1,680 crore ×0.02) –(Rs 1,400 crore ×0.01) = Rs 19.6 crore
b Proposed investment in debtors [(Rs 1,680 crore ×0.55) + Rs 120 crore] ÷6
(Debtors turnover, 360 days ÷60 days = 6 days) = Rs 174 crore
Present investment in debtors [(Rs 1,400 crore ×0.55) + Rs 120
crore] ÷12 (360 ÷30)
74.2 crore
Incremental investment in debtors 99.8
Cost of incremental investment in debtors (Rs 99.8 crore ×0.20) 19.97
c (Rs 1,540 crore ×0.01) –(Rs 1,400 crore ×0.01) = 1.4 crore
d (Rs 1,750 ×0.20) –(Rs 1,400 crore ×0.01) = 21 crore
e Proposed investment in debtors [(Rs 1,750 crore ×0.55) ×Rs 120 crore)
÷8 (360 days ÷45 days) 135.3
Present investment in debtors 74.2
Incremental investment in debtors 61.1
Cost of incremental investment in debtors (Rs 61.1 crore ×0.20) 12.2

100. fDebtors turnover = 360 days/[(0.5 ×10 days) + (0.5 ×30 days) = 20 days] =
18
Proposedinvestmentindebtors[(Rs1,540crore×0.55)+Rs120crore)÷
18=Rs53.7crore
Decreaseininvestmentindebtors(Rs74.2crore–Rs53.7crore)=Rs20.5
crore
Savings on account of reduction in debtors (Rs 20.5 crore ×0.2) = Rs 4.1
crore
Recommendation
Option3whichcombinesextendedcreditperiodandcashdiscountwould
resultinthemaximumincrementalprofit.TheCEOmayconsiderthe
proposedpolicychangeduetoitsbeneficialeffect.

101. Debate
nAssuming the firm’s sales volume
remained constant would you expect
Higher cash balance
nduring tight money period
nDuring easy-money period

102. Inventory Management

103. Inventory
Inventoryreferstothestockpileoftheproductsafirm
wouldsellinfutureinthenormalcourseofbusiness
operationsandthecomponentsthatmakeuptheproduct.
Thefirmstoresthreetypesofinventories,namely,raw
materials,work-in-process/semi-finishedgoods and
finishedgood.
Themanagement ofinventoryisdifferentfromthe
managementofothercurrentassetsinthatvirtuallyallthe
functionalareasareinvolved.Thejobofthefinance
manageristoreconciletheconflictingviewpointsofthe
variousfunctionalareasregardingtheappropriateinventory
levels.

104. Objectives
Theobjectivesofinventorymanagementconsistsoftwo
counterbalancingparts:
1)tominimiseinvestmentsininventoryand
2)tomeetthedemandforproductsbyefficientlyorganising
theproductionandsalesoperations.
Inoperationalterms,thegoalofinventorymanagementisto
haveatrade-offbetweenthesetwoconflictingobjectives
whichcanbeexpressedintermsofcostsandbenefits
associatedwithdifferentlevelsofinventory.

105. Costs of Holding Inventory
Thecostsofholdinginventoryareorderingcostsandcarrying
costs.
Orderingcostisthefixedcostofplacingandreceivingan
inventoryorder.
Carryingcostsarethevariablecostsperunitofholdingan
itemininventoryforaspecifiedtimeperiod.

106. Thecostofholdinginventorymaybedividedintotwocategories:
(1)ThosethatAriseDuetotheStoringofInventoryThemaincomponentsofthis
categoryofcarryingcostsare
1.storagecost,thatis,tax,depreciation,insurance,maintenanceofthe
building,utilitiesandjanitorialservices;
2.insuranceofinventoryagainstfireandtheft;
3.deteriorationininventorybecauseofpilferage,fire,technicalobsolescence,
styleobsolescenceandpricedecline;
4.servingcosts,suchas,labourforhandlinginventory,clericaland
accountingcosts.
(2)TheOpportunityCostofFundsThisconsistsofexpensesinraisingfunds
(interestoncapital)tofinancetheacquisitionofinventory
BenefitsofHoldingInventory
Thesecondelementintheoptimuminventorydecisiondealswiththebenefits
associatedwithholdinginventory.Themajorbenefitsofholdinginventoryarethe
basicfunctionsofinventory. Thebasicfunctionofinventoriesistoactasa
buffertodecoupleoruncouplethevariousactivitiesofafirmsothatalldonot
havetobepursuedatexactlythesamerate.
Thekeyactivitiesare(1)purchasing,(2)production,and(3)selling.Theterm
uncouplingmeansthattheseinterrelatedactivitiesofafirmcanbecarriedon
independently.Theeffectofuncoupling(maintaininginventory)areasfollows.

107. BenefitsinPurchasingIfthepurchasingofrawmaterialsandothergoodsisnot
tiedtoproduction/sales,thatis,afirmcanpurchaseindependentlytoensurethe
mostefficientpur-chase,severaladvantageswouldbecomeavailable.Inthefirst
place,afirmcanpurchaselargerquantitiesthaniswarrantedbyusagein
productionorthesaleslevel.Thiswillenableittoavailofdiscountsthatare
availableonbulkpurchases.Moreover,itwilllowertheorderingcostasfewer
acquisitionswouldbemade.
BenefitsinProductionFinishedgoodsinventoryservestouncoupleproduction
andsale.Thisenablesproductionataratedifferentfromthatofsales.Thatis,
productioncanbecarriedonataratehigherorlowerthanthesalesrate.This
wouldbeofspecialadvantagetofirmswithseasonalsalespattern
BenefitsinWork-in-ProcessTheinventoryofwork-in-processperformstwo
functions.Inthefirstplace,itisnecessarybecauseproductionprocessesarenot
instantaneous.Theamountofsuchinventorydependsupontechnologyandthe
efficiencyofproduction.Inamulti-stageproductionprocess,thework-in-process
inventoryservesasecondpurposealso.Ituncouplesthevariousstagesof
productionsothatallofthemdonothavetobeperformedatthesamerate.The
stagesinvolvinghigherset-upcostsmaybemostefficientlyperformedin
batcheswithawork-in-processinventoryaccumulatedduringaproductionrun.5
BenefitsinSalesThemaintenanceofinventoryalsohelpsafirmtoenhanceits
salesefforts.Foronething,iftherearenoinventoriesoffinishedgoods,thelevel
ofsaleswilldependuponthelevelofcurrentproduction.

108. Techniques
1)ABCAnalysis
2)EconomicOrderQuantity
3)Reorder-Point
4)SafetyStock

109. ABC Analysis
TheABCsystemisawidely-usedclassificationtechniqueforthe
purpose.Onthebasisofthecostinvolved,thevarious
itemsareclassifiedintothreecategories:
1)A,consistingofitemswiththelargestinvestment.
2)C,withrelativelysmallinvestments,butfairlylargenumber
ofitems.
3)B,whichstandsmid-waybetweencategoryAandC.
CategoryAneedsthemostrigorouscontrol,Crequiresminimum
attention,andBdeserveslessattentionthanAbut
morethanC.

110. TABLE 1Inventory Breakdown between Number of Items and Inventory Value
Group Number of items (per cent) Inventory value (per cent)
A 15 70
B 30 20
C 55 10
Total 100 100
SomepointsstandoutfromTable1.WhilegroupAistheleastimportantinterms
ofthenumberofitems,itisbyfarthemostimportantintermsoftheinvestments
involved.Withonly15percentofthenumber,itaccountsforasmuchas70per
centofthetotalvalueofinventory.Thefirmshoulddirectmostofitsinventory
controleffortstotheitemsincludedinthisgroup.TheitemscomprisingBgroup
accountfor20percentoftheinvestmentsininventory.Theydeserveless
attentionthanA,butmorethanC,whichinvolvesonly10percentofthetotalvalue
althoughnumber-wiseitsshareisashighas55percent.TheABCanalysisis
illustratedinExample1.

111. Example1Afirmhas7differentitemsinitsinventory.Theaveragenumberof
eachoftheseitemsheld,alongwiththeirunitscosts,islistedbelow.Thefirm
wishestointroduceanABCinventorysystem.Suggestabreakdownofthe
itemsintoA,B,andCclassifications.
Itemnumber Average number of units in inventoryAverage cost per unit
1
2
3
4
5
6
7
20,000
10,000
32,000
28,000
60,000
30,000
20,000
Rs 60.80
102.40
11.00
10.28
3.40
3.00
1.3
SolutionTheABCanalysisispresentedinTable2.

112. TABLE 2ABC Analysis
Item Units Per cent of
total
Unit costTotal costPer cent of
total
(1) (2) (3) (4) (5) (6)
1 20,000 10 Rs 60.80Rs 12,16,00038.0070
2 10,000 5 15 102.40 10,24,00032.00
3 32,000 16 11.00 3,52,00011.0020
4 28,000 14 30 10.28 2,88,0009.00
5 60,000 30 3.40 2,04,0006.3810
6 30,000 15 55 3.00 90,000 2.80
7 20,000 10 1.30 26,000 0.82
Total 2,00,000100 32,00,000100.00
TheABCsystemofclassificationshould,however,beusedwithcaution.For
example,anitemofinventorymaybeveryinexpensive.UndertheABCsystemit
wouldbeclassifiedintoCcategory.Butitmaybeverycriticaltotheproduction
processandmaynotbeeasilyavailable.Itdeservesthespecialattentionof
management.ButintermsoftheABCframework,itwouldbeincludedinthe
categorywhichrequirestheleastattention.ThisisalimitationoftheABC
analysis.

113. Economic Order Quantity (EOQ)
EOQreferstothelevelofinventoryatwhichthetotalcostof
inventorycomprising
1)Order/Setupcost,and
2)Carryingcostistheminimum.
Carrying Costs arecost associated with the
maintenance/holding
ofinventory.
OrderingCostsarecostsassociatedwithacquisitionof/placing
orderforinventory.

114. Solution
Table 3: Inventory Cost for Different Order Quantities
1. Size of order (units)
2. Number of orders
3. Cost per order
4. Total ordering cost (2 ×3)
5. Carrying cost per unit
6. Average inventory (units)
7. Total carrying cost (5 ×6)
8. Total cost (4 + 7)
1,600
1
Rs50
50
1
800
800
850
800
2
Rs50
100
1
400
400
500
400
4
Rs50
200
1
200
200
400
200
8
Rs50
400
1
100
100
500
100
16
Rs50
800
1
50
50
850
Example 2
Afirm’sinventoryplanningperiodisoneyear.Itsinventoryrequirementforthisperiodis1,600
units.AssumethatitsacquisitioncostsareRs50perorder.Thecarryingcostsareexpectedtobe
Re1perunitperyearforanitem.
Thefirmcanprocureinventoriesinvariouslotsasfollows:(i)1,600units,(ii)800units,(iii)400
units,(iv)200units,and(v)100units.Whichoftheseorderquantitiesistheeconomicorder
quantity?
Working Notes
(i) Number of orders = Total inventory requirement/ Order size, (ii) Average inventory = Order size/2

115. Example3Thefollowingdetailsareavailableinrespectofafirm:
1.Inventoryrequirementperyear,6,000units
2.Costperunit(otherthancarryingandorderingcosts),Rs5
3.Carryingcostsperitemforoneyear,Re1
4.Costofplacingeachorder,Rs60
5.Alternativeordersizes:(units)6,000,3,000,2,000,1,200,1,000,600and200.
Determinetheeconomicorderquantity.
SolutionTheEOQisdeterminedinTable4.
TABLE 4Determination of Economic Order Quantity
1.
2.
3.
4.
5.
6.
7.
8.
Cost of items purchased
each year (Rs)
Order size (units)
Number of orders
Average inventory (units)
Total carrying costs (Rs)
Total ordering costs (Rs)
Total cost (carrying plus
ordering cost) (Rs)
Total cost (Rs)
30,000
6,000
1
3,000
3,000
60
3,060
33,060
30,000
3,000
2
1,500
1,500
120
1,620
31,620
30,000
2,000
3
1,000
1,000
180
1,180
31,180
30,000
1,200
5
600
600
300
900
30,900
30,000
1,000
6
500
500
360
860
30,860
30,000
600
10
300
300
600
900
30,900
30,000
200
30
100
100
1,800
1,900
31,900
Clearly,theEOQis1,000units.
WorkingNotes
(i) Numberoforders=Demandperyear/ordersize
(ii) Averageinventory=Ordersize/2
(iii) Totalcarryingcost=Averageinventory×Carryingcostperunit
(iv) Totalorderingcost=Numberoforders×Costperorder
(v) Totalcost=Costofitemspurchased+Totalcarryingandorderingcosts

116. Mathematical (Short-cut) Approach
Theeconomicorderquantitycan,usingashort-cutmethod,be
calculatedbythefollowingequation:
EOQ = 2 AB/C
WhereA=Annualusageofinventoryinunits,
B=Buyingcostperorder(OrderingCost),
C=Carryingcostperunitperyear.
√
Example4UsingthefactsinExample2,findouttheEOQby
applyingtheshort-cutmathematicalapproach.
EOQ =
2 ×1,600 ×50
= 400 units.
1√

117. Reorder Point
There-orderpointisthatlevelofinventorywhenafreshorder
shouldbeplacedwithsuppliers.Itisthatinventorylevelwhichis
equaltotheconsumptionduringtheleadtimeorprocurementtime.
Re-orderlevel=(Dailyusage×Leadtime)+Safetystock.
Minimumlevel=Re-orderlevel–(Normalusage×Averagedelivery
time).
Maximumlevel=Reorderlevel–(Minimumusage×Maximumdelivery
time)+Re-orderquantity.
Averagestocklevel=Minimumlevel+(Re-orderquantity)/2.
Dangerlevel=(Averageconsumptionperday×Leadtimeindaysfor
emergencypurchases).

118. Safety Stock
Thesafetystockaretheminimumadditionalinventorywhichserve
asasafetymargintomeetanunanticipatedincreaseinusage.
Thefirststepistoestimatetheprobabilityofbeingoutofstock,
aswellasthesizeofstock-out.
Stock-outcosts arecostsassociatedwiththeshortage
(stock-out)ofinventory.
Afterthedeterminationofthesizeandprobabilityofstock-out,
thenextstepisthecalculationofthestock-outcost.
Then,thecarryingcostshouldbecalculated.
Finally,thecarryingcostsandtheexpectedstock-outcostsateachsafetylevel
shouldbeadded.
Theoptimumsafetystockwouldbethatlevelofinventoryatwhichthetotalof
thesetwocostsisthelowest.

119. SOLVEDPROBLEM1
M/sTubesLtdarethemanufacturersofpicturetubesforT.V.Thefollowingarethe
detailsoftheoperationduringthecurrentyear.
Average monthly market demand (tubes) 2,000
Ordering cost (per order) Rs 100
Inventory carrying cost (per cent per annum) 20
Cost of tubes (per tube) 500
Normal usage (tubes per week) 100
Minimum usage (tubes per week) 50
Maximum usage (tubes per week) 200
Lead time to supply (weeks) 6-8
Computefromtheabove:
1.Economicorderquantity.Ifthesupplieriswillingtosupplyquarterly1,500units
atadiscountof5percent,isitworthaccepting?
2.Maximumlevelofstock
3.Minimumlevelofstock
4.Reorderlevel

120. Solution
1.Economicorderquantity
Annualdemand(A)=Normalusageperweek×52weeks=100tubes×52=
5,200tubes.Orderingcostperorder(B)=Rs100perorder
Inventorycarryingcostperunitperannum(C)=Rs500×0.20=Rs100perunit
perannum
Ifsupplieriswillingtosupply1,500unitsatadiscountof5percent:
Totalcost(Whenordersizeis1,500units)=Costof5,200units+Orderingcost
+Carryingcost
=[5,200×(500×0.95)]+[(5,200/1,500)×Rs100)+((1/2)×1,500×0.20×475)]
=Rs24,70,000+Rs346.67+Rs71,250=Rs25,41,596.67
Totalcost(whenordersizeis102units)=(5,200×500)+(5,200/102×Rs100)+
(1/2×102×0.20×500)
=Rs26,00,000+Rs5,098.03+Rs5,100=Rs26,10,198.03
Sincethetotalcostunderquarterlysupplyof1,500unitswith5percent
discountislowerthanwhenordersizeis102units,theoffershouldbe
accepted.Whileacceptingthisoffer,considerationofcapitalblockedonorder
sizeof1,500unitsperquarterhasbeenignored.  tubes102100Rs100Rsunits 200 5,2AB/C2EOQ 

121. 2.Maximumlevelofstock=Reorderlevel+Reorderquantity–(Minimum
usage×Minimumreorderperiod)
= 1,600 units + 102 units –(50 units ×6 weeks) = 1,402 units
3.Minimumlevelofstock=Reorderlevel–(Normalusage×Average
reorderperiod)
= 1,600 units –(100 units ×7 weeks) = 900 units
4.Reorderlevel=Maximumconsumption×Maximumreorderperiod=200
units×8weeks=1,600units.