Unit 05 PDF
Unit 05 PDF
Unit 05 PDF
CAPITAL MANAGEMENT
5
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the firm while not keeping too high or too low any one of them. Again,
each of the current liabilities must be effectively managed to ensure that
the short-term sources are obtained and used in the best possible manner.
Therefore, the interaction between the current asset and current liabilities
should be the main theme of the working capital management.
The firm’s policies for managing its working capital should be designed
to achieve three goals such as maintenance of adequate liquidity;
minimization of risks and maximization of the value of the firm through
its profit and wealth maximization. If a firm lacks sufficient cash to pay
its bills when due, it will experience continuing problems. Therefore, the
most important goal is to achieve and also maintain adequate liquidity
for the conduct of day-to-day operation. The matching of assets and
liabilities among current accounts is a task of minimizing the risk of
being unable to pay bills and other obligations. The investment of surplus
cash, minimizing of investment in inventory and receivable, speedy
collection of receivable and elimination of unnecessary and costly short-
term financing, all contribute to maximizing wealth, profit and in turn the
value of a firm.
Nature of Trade-off
If a firm wants to increase its profitability, it must also increase its risk.
On the hand, if it is to decrease risk it must decrease profitability. The
trade-off between these variables is that regardless of how the firm
increases its profitability through the manipulation of working capital,
the consequence a corresponding increase in risk as measured by the
level of NWC.
In evaluating the profitability – risk trade-off related to the level of
NWC, three basic assumptions, which are generally true, are as follows:
(i) That the firm is a manufacturing one
(ii) That current assets are less profitable than the fixed assets
(iii) That the short-term funds are less costly than the long-term funds.
In reality, the principal reason for the failure of the firms is that they are
unable to meet their working capital requirements. Thus, sound working
capital management policy is a pre-requisite for the survival of a firm.
Therefore, much of the financial manager’s time is devoted to working
capital management and many of you who get jobs in financial areas will
find your first assignment on the job would involve working capital. For
these reasons, working capital management policy is very essential.
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Review Questions
A. Short Questions
1. Define working capital and working capital management.
2. What is a working capital policy? Explain with examples.
3. Examine the nature of working capital management policy.
4. What is the goal of working capital management policy? Discuss.
B. Broad Questions
5. Discuss the significance of working capital management policy in
case of a manufacturing enterprise.
To know the cash conversion cycle and its various stages and
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(iii) The finished products are sold on credit, thereby creating accounts
receivables. Such sales have no immediate cash inflows to the
business.
(iv) Later on, the question of paying off accounts payable and other
accrued operating costs like wages and factory overheads arises
which involves cash outflows.
(v) The last process arises when the question of collection from
accounts receivables arises. This leads to cash inflows in the
business.
There are three important stages of a cash conversion cycle namely, the
inventory conversion period, receivables collection period and the
payables deferral period. The following paragraphs deal with the
following stages:
(i) The Inventory Conversion Period: The inventory conversion
period is the average length of time required to convert materials
into finished goods and then to sell those goods? It is the amount
of time the product remains in inventory in various stages of
completion. The inventory conversion period is calculated by
dividing inventory by the cost of goods sold per day.
(ii) The Receivables Collection period: It is the average length of
time required to convert the firm’s receivables into cash – that is,
to collect cash following a sale. The receivables collection period
also is called the day’s sales outstanding (DSO), and it is
calculated by dividing accounts receivable by the average credit
sales per day.
(iii) The Payable Deferred Period: It is the average length of time
between the purchase of raw materials and labor and the
payment of cash for them. It is computed by dividing accounts
payable by the daily credit purchases.
The cash conversion cycle computation nets out the three periods just
The cash conversion
defined, resulting in a value that equals the length of time between the cycle thus equals the
firm’s actual cash expenditure to pay for (invest in) productive resources average length of
(materials and labor) and its own cash receipts from the sale of the time a Taka is tied
products that is, the length of time between paying for labor and up in current assets.
materials and collecting on receivables. The cash conversion cycle thus
equals the average length of time a Taka is tied up in current assets.
Therefore, the formula for finding out cash conversion cycle goes as
follows :
of current assets are carried to support any given level of sales. These
policies are –
1. Relaxed Current Investment Policy: A policy under which relatively
large amounts of cash and marketable securities and inventories are
carried and under which sales are stimulated by a liberal credit policy
that results in a high level of receivables.
2. Restricted Current Asset Investment Policy: A policy under which
holdings of cash and marketable securities, inventories, and receivables
are minimized.
3. Moderate Current Assets Investment Policy: A policy that is in
between the relaxed and restrictive policies.
In terms of the cash conversion cycle, a restricted investment policy
would tend to reduce the inventory conversion and receivables collection
periods, which would result in a relatively short cash conversion cycle.
Conversely, a relaxed policy would create higher levels of inventories
and receivables, longer inventory conversion and receivables collection
periods, and a relatively long cash conversion cycle. A moderate policy
would produce a cash conversion cycle somewhere between the two
extremes.
The following Figure presents the alternative current assets investment
policies of a corporate firm.
Current Assets
40 Relaxed
Moderate
30
Restricted
20
10
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Summary of Figure 1:
Sales ($)
Policy Current Assets to Support
Sales of $100
Relaxed $30
Moderate 23
Restricted 16
Finished Inventory
(i) Inventory Conversion Period = -----------------------------------
Cost of goods sold per day
90,000
= -----------------------------
60% of 6,00,000/360
90,000
= --------------- = 90 days
1,000
Receivables 4,50,000
(ii) Receivables Collection Period = ---------------------------- =----------------- = 360 days
Credit sales per day 1,250
Therefore Cash Conversion Cycle = 90 days + 360 days – 137 days = 313 days
= Tk. 3,95,000
Problem - 2
The Saliford Corporation has an inventory conversion period of 60 days,
a receivables collection period of 36 days, and a payables deferred period
of 24 days.
a. What is the length of the firm’s cash conversion cycle?
b. If Saliford’s annual sales are $3,960,000 and all sales are on credit,
what is the average balance in accounts receivable?
c. How many times per year does Saliford turn over its inventory?
d. What would happen to Saliford’s cash conversion cycle if, on
average, inventories could be turned over eight times a year ?
Solution
= Tk. 3,96,000
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Sales 39,60,000
c. Inventory Turnover = --------------- = ------------------ = 6 times
Inventory 6,60,000
360
d. Cash conversion cycle = ---------- + 36 – 24 days = 57 days
8
Review Questions
Short Questions
1. What is working capital investment policy?
2. Discuss the significance of working capital investment policy.
3. What is a cash conversion cycle? Explain.
4. What two key issues does working capital investment policy
involve?
5. How would you determine:
a) Inventory conversion period, b) Receivables collection period
and
c) Payable Deferral Period
Broad Questions
6. What is meant by working capital investment policy? Discuss its
various forms. Which one is the best and why?
Review Problems
Problem - 1
Peoples Ltd. had projected sales for 2004 Tk. 1,650 million. The
projected cost of goods sold was 1,353 million. Assume all sales and
purchases are made on credit:
a) Calculate inventory conversion period as of September 30 and
December 31, 2004.
b) Calculate receivables collection period as on those dates.
c) Calculate the payables deferral period as on those days.
d) Calculate cash conversion cycle as on those days.
Problem - 2
Rahim Afrooz is a leading producer of automobile batteries. It turns out
1,500 batteries a day at a cost of Tk. 6 per battery for materials and labor.
It takes the firm 22 days to convert raw materials into the battery. It
allows its customers 40 days in which to pay for the batteries and the
firm generally pays its suppliers in 30 days.
a) What is the length of cash conversion cycle?
b) If the firm always produces and sales 1,500 batteries a day, what
amount of working capital must it finance?
c) By what amount would the firm reduce its working capital
financing needs if it was able to stretch its payables deferral period
to 35 days?
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The manner in current assets because their levels remain stable no matter the seasonal
which the or economic conditions. Temporary current assets are those amounts of
permanent and current assets that vary with respect to the seasonal or economic
temporary current conditions of a firm. The manner in which the permanent and temporary
assets are financed
is called the firm’s current assets are financed is called the firm’s current asset financing
current asset policy, which generally can be classified as one of the three approaches
financing policy described next.
Maturity Matching, or “Self-liquidating” Approach: A financing
policy that matches asset and liability maturities. This would be
considered a moderate current asset financing policy.
Aggressive Approach : A policy where all of the fixed assets of a firm
are financed with long-term capital, but some of the firm’s permanent
current assets are financed with short-term nonspontaneous sources of
funds.
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balance and provides a financing plan that lies between these two
extremes. It may be, therefore, called a moderate approach.
The exact trade-off between the two approaches will differ from case to
case depending on the perception of risk of those who have to take the
decision. One possible trade-off could be assumed to be equal to the
average of the minimum and maximum monthly requirements of funds
during a given period of time. This level of requirement of funds may be
financed through long term sources and any other additional funds may
be financed through short term sources.
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Problem - 2
Max Printing Corporation and Azad Publishing House had the following
Balance Sheets as of December 31, 2000 (thousands of dollars) :
c. Azad’s position is riskier. First, its profit and return on equity are
much more volatile than Max’s. Second, Azad must renew its large
short-term loan every year, and if the renewal comes up at a time when
money is ver tight, when its business is depressed, or both, then Azad
could be denied credit, which could put it out of business.
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Review Questions
A. Short Questions
1. Define working capital financing policy and examine its
significance.
2. Distinguish between : (a) Permanent working capital and
Temporary working capital
3. Explain the risk return trade-off working capital financing.
B. Broad Questions
4. Discuss the various types of current assets in the context of
financing.
5. Explain the various elements of working capital financing. Which
one is the best and why ?
Review Problems
Problem -1
Janata Firm has an investment of Tk. $500 million in total assets of
which 60% I fixed assets and 40% in current assets. It is expected that
the investment will earn a return of 18% before interest and taxes. Tax
rate is 35%. The firm maintains a debt ratio of 60%. The firm has to
decide whether it should use a 12% short-term debt or a 14% long-term
debt to finance its current assets. The financing plans would affect the
return on equity fund. Calculate return on equity under different
financing plans.
Problem - 2
The Sunshine Corporation is attempting to determine the optimum level
of current assets for the coming year. Management expects sales to
increase to $2 million as a result of an asset expansion undertaken. Fixed
assets total $1 million and the firm finances 60% of its total assets with
debt and the rest with equity. The firm’s interest cost currently is 8% on
both the short-term and long-term debts. Three alternatives regarding the
projected current assets level are (i) a tight policy requiring current assets
of only 45% of projected sales, (ii) a moderate policy of 50% of sales
and (iii) relaxed policy of 60% of sales. The firm expects to generate
EBIT at a rate of 12% on total assets.
a. What is the expected return on equity under each current asset
level, assuming 40% tax rate.
Case Study
Three companies namely Aggressive Between and Defensive have
different working capital management policies as indicated by their
names. Aggressive employs only minimal current assets and finances
almost entirely with current liabilities and equity. These light shit
approach has a duel effect. It keeps total assets lower which would tend
to increase return on assets. But for reasons such as stock-outs total
assets are reduced but variable cost is increased because of more frequent
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order of similar quantities of raw materials. The balance sheets for the
three companies as of 31-12-2004 are presented below :
The cost of goods sold functions for the firms are as follows :
Cost of goods sold = Fixed costs + Variable costs
Aggressive = Tk. 2,00,000 + 70% of sales
Between = Tk. 2,50,000 + 60% of sales
Defensive = Tk. 3,00,000 + 60% of sales
A Company with normal net working capital such as Between will sell
Tk. 10,00,000 in a year when economic growth is average. If the
company is weak sales for Between will be reduced by Tk. 1,00,000; if
strong, sales for Between will increase by Tk. 1,00,000. In any given
economic conditions, Aggressive will sell Tk. 1,00,000 less than
Between, and Defensive will sell Tk. 1,00,000 more. This is because of
working capital differences.
Questions
a. Complete the income statement that follow for strong, average and
weak economies.
b. Compare the rates of return (EBIT/Assets) and return on equity.
Which company is the best in a strong economy ? In an average
economy ? In a weak economy ?
c. What are the considerations for management of working capital
that are indicated by this problem ?
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Temporary
Permanent
Time
Figure : Permanent and Temporary Working Capital
Figure 2 shows that the permanent level is fairly constant, while
temporary working capital is fluctuating – sometimes increasing and
sometimes decreasing in accordance with seasonal demands. In the case
of an expanding firm the permanent working capital line may not be
horizontal. This is because the demand for permanent current assets
might be increasing (or decreasing) to support a rising level of activity.
In that case the line would be rising one as shown in Figure 3.
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Working Capital
Temporary or
Accounting of
Permanent Fluctuating
Time
Figure : Permanent and Temporary Working Capital
Both kinds of working capital are necessary to facilitate the sales process
Temporary working
through the operating cycle. Temporary working capital is created to capital is created to
meet liquidity requirements that are of a purely transient nature. meet liquidity
requirements that
Changes in Working Capital : The changes in the level of working are of a purely
capital occur for the following three basic reasons : (i) changes in the transient nature.
level of sales and/or operating expenses, (ii) policy changes and (iii)
changes in technology.
Balanced Working Capital Position:
A corporate firm should maintain a balanced working capital position,
A corporate firm
which means not excess of working capital nor shortage of working should maintain a
capital. Both excessive as well as shortage of working capital positions balanced working
are dangerous for the firm. Excessive working capital means idle funds capital position,
which earns no profit for the firms. Shortage of working capital not only which means not
excess of working
impairs the firm’s profitability but also results in production interruptions
capital nor shortage
and inefficiencies. of working capital.
The dangers of excessive working capital are as follows:
(i) Unnecessary accumulation of inventories;
(ii) Defective credit policy and slack collection period;
(iii) Managerial inefficiency and
(iv) Growing speculative profits.
Inadequate working capital has the following dangers:
(i) Stagnating growth;
(ii) Difficulty to implement operating plans and to achieve the profit
target;
(iii) Creeping operating inefficiencies;
(iv) Under-utilization of fixed assets;
(v) Failure to avail attractive credit opportunities and
(vi) Tightening credit terms.
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Production Cycle
Another factor which has a bearing on the quantum of working capital is
the production cycle. The term “production” or “manufacturing cycle”
refers to the time involved in the manufacture of goods. It covers the
time-span between the procurement of raw materials and the completion
of the manufacturing process leading to production of finished goods.
Funds will have to be necessarily tied-up during the process of
manufacture, necessitating enhanced working capital. In other words,
there is some gap before raw materials become finished goods. To
sustain such activities the need for working capital is obvious. The longer
the time-span (i.e. the production cycle), the larger the working capital
needed and vice-versa.
Business Cycle
The working capital requirements are also determined by the nature of
the business cycle. Business fluctuations lead to cyclic and seasonal
changes which, in turn, cause a shift in the working capital position,
particularly for temporary working capital requirements. The variations
in business conditions may be in two directions : (i) upward phase when
boom conditions prevail and (ii) downswing phase when economic
activity is marked by decline.
Production Policy
The quantum of working capital is also determined by production policy.
In the case of certain lines of business, the demand for products is
seasonal, i.e., they will be purchased during certain months of the year.
What kind of production policy should be followed in such cases ? There
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are two options open to such enterprises : either they confine their
production only to periods when goods are purchased or they follow a
steady production policy throughout the year and produce goods at a
level to meet the peak demand. In the former case, there will be serious
production problems. During the slack season the firm will have to
maintain its working force and physical facilities without adequate
production and sale.
Credit Policy
The level of working capital is also determined by credit policy which
relates to sales and purchases. The credit policy influences the
requirement of working capital in two ways : (i) through credit terms
granted by the firms to its customers/ buyers of goods; (ii) credit terms
available to the firm from its creditors.
Level of Taxes
The first appropriation out of profits is payment or provision for tax. The
amount of taxes to be paid is determined by the prevailing tax
regulations. The management has no discretion in this respect. Very
often taxes have to be paid in advance on the basis of the profit of the
preceding year. Tax liability is, in a sense, short–term liability payable in
cash. An adequate provision for tax payments is, therefore, an important
aspect of working capital planning. If tax liability increases, it will lead
to an increase in the requirement of working capital and vise - versa.
Dividend Policy
Another appropriation of profits which has a bearing on working capital
is dividend payment. The payment of dividend consumes cash resources
and, thereby, affects working capital to that extent. Conversely, if the
firm does not pay dividend but retains the profit, working capital will
increase. In planning working capital requirements, therefore, a basic
question to be decided is whether profits will be retained or paid out to
shareholders. In theory, a firm should retain profits to preserve cash
resources and, at the same time, it must pay dividends to satisfy the
expectations of investors. When profits are relatively small, the choice is
between retention and payment. The choice must be made after taking
account of all the relevant factors.
Depreciation Policy
Depreciation policy also exerts and influence on the quantum of working
capital. Depreciation charges do not involve any cash outflow. The effect
of depreciation policy on working capital is, therefore, indirect. In the
first place, deprecation affects the tax liability and retention of profits.
Depreciation is allowable expenditure in calculating net profits.
Enhanced rates of depreciation will lower the profits and, therefore, The
tax liability and, thus, more cash profits. Higher depreciation will also
mean lower disposable profits and, therefore, a smaller dividend
payment.
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accelerates the pace of the cash cycles and improves the working capital
turnover. It releases the pressure on working capital by improving
profitability and the internal generation of funds.
estimates and are advised to add 10% to your figure to allow for
contingencies.
Estimates Amount
(Tk.)
Average amount backed up for finished products 5,000
Average amount backed up for materials etc. 8,000
Average credit given :
Local sales - 6 weeks credits 3,12,000
Export sales- 1.5 weeks credit 78,000
Average time lag in payment of :
Wages- 1.5 weeks 2,60,000
Stocks, materials etc.- 1.5 months 48,000
Rent, Royalties etc.- 6 months 10,000
Clerical staff- 0.5 month 62,400
Manager – 0.5 month 4,800
Other expenses- 1.5 months 48,000
Payment in advance :
Sundry expenses- paid quarterly 8,000
Undrawn profits 11,000
Solution
Statement to determine Net Working Capital for Bata Company
(A) Current assets : Amount (Tk.)
(i) Stock of finished product 5,000
(ii) Stock stores, materials, etc. 8,000
(iii) Debtors :
Inland sales 6 weeks
Credit sales
= ------------------------
Debtors turnover
Tk. 3,12,000 x 6
= ------------------------ 36,000
52
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Tk .2,60,000
(i) Wages
104 7,500
Tk .48,000 x3
(ii) Stocks, materials etc.
24 6,000
Tk .10,000 x6
(iii) Rent, royalties, etc.
12 5,000
Tk .62,400 x1
(iv) Clerical staff
24 2,600
Tk .4,800 x1
(v) Manager
24 200
Tk .48,000 x3
(vi) Miscelleneous expenses
24 6,000
Assumptions :
(i) For calculations a time period of 52 weeks/12 months has been
assumed in a year.
(ii) Undrawn profit has been ignored in the working capital
computation for the following reasons:
(a) For the purpose of determining working capital provided by
net profit, it is necessary to adjust the net profit for income tax and
dividends/ drawing, etc.
(b) Profit need not always be a source of financing working
capital. It may be used for other purposes like purchase of fixed
assets, repayment of long-term loans, etc.
(iii) Actual working capital requirement would be more than what is
estimated here as in the question cash component of current assets
is not given.
Problem - 2
While preparing a project report on behalf of a client you have collected
the following facts. Estimate the net working capital required for that
project. Add 10% to your computed figure to allow contingencies.
Amount per unit (Tk.)
Raw materials 80
Direct labor 30
Additional information :
You may assume that production is carried on evenly throughout the year
(52 weeks) and wages and overheads accrue similarly. All sales are on
credit basis only.
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Solution
Amount (Tk.)
(A) Current assets :
(i) Raw materials in stock, average 4 weeks :
Tk .1,04,000 xTk .80 x 4
6,40,000
52
(ii) Work in progress, average 2 weeks :
(c) Overheads
Tk .1,04,000 xTk .30 x 2
1,20,000
52
(iii) Finished goods stock, average 4 weeks :
Tk .1,04,000 xTk .170 x 4
13,60,000
52
(iv) Debtors, average 8 weeks :
Tk .1,04,000 xTk .170 x8
27,20,000
52
(v) Cash at bank 25,000
Total investment in current assets 52,45,000
(B) Current liabilities :
(i) Creditors, average 4 weeks
6,40,000
Tk .1,04,000 xTk .80 x 4
52
(ii) Lag in payment of wages, average 1.5 weeks :
Tk .1,04,000 xTk .30 x3
90,000
104
Review Questions
A. Short Questions
1. How would you assess the need for working capital of a corporate
firm?
2. “Length of operating cycle is the main determinant of working
capital needs of a firm”. Explain.
3. Distinguish between operating cycle and production cycle of a
manufacturing firm.
4. What are the three phases of operating cycle ? Discuss.
5. Distinguish between permanent and temporary working capital.
6. What do you mean by balanced working capital ?
7. What are the dangers of excessive working capital ?
8. What are the adverse impacts of shortage of working capital ?
9. What are the major techniques of working capital planning ?
Explain.
10. How would you estimate working capital needs of a firm ?
B. Broad Questions
11. Describe the various factors which affect the working capital
requirement of a manufacturing firm.
Review Problems
Problem - 1
A proforma cost sheet of a company provides the following data :
Tk.
Cost (per unit) :
Raw materials 52.0
Direct labor 19.50
Overheads 39.0
Total cost (per unit) 110.50
Profit 19.50
Selling price 130.0
The following is the additional information available :
Average raw materials in stock : one month; average materials in process
: half month. Credit allowed by suppliers : one month; credit allowed to
debtors : two months. Time lag in payment of wages : One and half a
weeks. Overheads : one month. One-fourth sales are on cash basis. Cash
balance is expected to be Tk. 1,20,000.
You are required to prepare a statement showing the working capital
needed to finance a level of activity of 70,000 units of output. You may
assume that production is carried on evenly throughout the year and
wages and overheads accrue similarly.
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Problem - 2
While preparing a project report on behalf of client you have collected
the following facts. Estimate the net working capital required for that
project. Add 10% to your computed figure to allow for contingencies.
Amount per unit (Tk.)
Estimated cost per unit of production
is:
Raw material 42.4
Direct labor 15.9
Overheads (exclusive of depreciation) 31.8
Total cost 90.1
Amount per unit (Tk.)
Additional information :
Selling price Tk. 106
Level of activity 1,00,000units of production
annually
Raw material in stock Average 4 weeks
Work in progress (50% completion) Average 2 weeks
Finished goods in stock Average 4 weeks
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at bank (expected) 1,25,000
Cash payments
cash inflow will be more than cash payments because there may be large
cash sales and debtors may be realized in large sums promptly. Cash
management is also important because cash constitutes the smallest
portion of the total current assets, yet management’s considerable time is
devoted in managing it. In recent past, a number of innovations have
been done in cash management techniques. An obvious aim of the firm
now-a days is to manage its cash affairs in such a way as to keep cash
balance at a minimum level and to invest the surplus cash in profitable
investment opportunities.
The ideal cash management system will depend on the firm’s products,
The ideal cash
management system
organization structure, competition, culture and options available. The
will depend on the task is complex, and decisions taken can affect important areas of the
firm’s products, firm. For example, to improve collections if the credit period is reduced,
organization it may affect sales. However, in certain cases, even without fundamental
structure,
changes, it is possible to significantly reduce cost of cash management
competition, culture
and options system by choosing a right bank and controlling the collections properly.
available.
Motives for Holding Cash
There are four primary motives for holding cash which are discussed
below :
(i) Transaction Motive : A very important reason for maintaining cash
balance is the transaction motive. The requirement of cash balances to
meet routine cash needs is known as the transaction motive and such
cash balances are called transaction balances. Thus, transaction motive
refers to the holding of cash to meet anticipated obligations whose timing
is not perfectly synchronized with cash receipts.
(ii) Precautionary Motive : A firm may have to pay cash for the
purposes which cannot be predicted or anticipated. The unexpected cash
needs at a short notice may arise due to : (a) any natural calamities and
strikes and lockouts; (b) failure of important customers; (iii) unexpected
slow down in collection of debtors; (iv) cancellation of some orders for
goods; (v) sharp increase in cost of raw materials etc. The cash balances
held in reserve for such random and unforeseen fluctuations in cash
flows are called precautionary balances. Hence, precautionary motive
implies the need to hold the cash to meet unpredictable obligations.
(iii) Speculative Motive : It refers to the desire of a firm to take
advantage of opportunities which present themselves at unexpected
moments and which are typically outside the normal course of business.
Such motive represents a positive and aggressive approach. Firms aim to
exploit profitable opportunities keep cash in reserve to do so.
(iv) Compensation Motive : Customers of a bank are usually required to
maintain a minimum cash balance at that bank for providing services to
them. Since this balance cannot be utilized by the firms for transaction
purposes, the banks themselves can use the amount to earn a return. Such
balances are known as compensating balances. These balances are also
required by some loan agreements between a bank and its customers.
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How to determine the optimum cash balance if cash flows are predictable
and if they are not predictable ?
Optimum Cash Balance under Certainty : Baumol’s Model
The Baumol’s cash management model provides a formal approach for
determining firm’s optimum cash balance under certainty. It considers
cash management similar to an inventory management problem . As
such, the firm attempts to minimize the sum of the cost of holding cash
(inventory of cash) and the cost of converting marketable securities to
cash.
The Baumol’s model makes the following assumptions :
The firm will incur the same transaction cost whenever it converts
securities to cash.
together with the cash turn-over. The cash cycle refers to the process by
which cash is used to purchase materials from which are produced goods,
which are then sold to customers, who later pay bills. The firm receives
cash from customers and the cycle repeats itself. The cash turn-over
means the number of times firm’s cash is used during each year.
Minimum Operating Cash
The higher the cash turn-over, the less cash the firm requires. The firm
should, therefore, try to maximize the cash turn-over. But it must
maintain a minimum amount of operating cash balance so that it does not
run out of cash.
The cash management strategies are intended to minimize the operating
cash balance requirement. The basic strategies that can be employed to
do the needful are-
(i) Stretching accounts payable,
(ii) Efficient inventory – production management,
(iii) Speedy collection of accounts receivables and
(iv) Combined cash management strategy.
Each of the above strategies are discussed below briefly :
(i) Stretching accounts payable
One of the basic strategies of efficient cash management is to stretch the
accounts payable. This means that a firm should make delay as far as
possible in paying its accounts payable without its credit standing. It
should however take advantage of the cash discount available on prompt
payment.
(ii) Efficient inventory – production management
Another important strategy is to increase the inventory turnover rate
avoiding stock-outs. This can be done as follows :
(a) Increasing raw materials turn-over
(b) Decreasing production cycle
(c) Increasing finished goods turn-over
(iii) Speedy collection of accounts receivables
Another strategy for efficient cash management is to collect accounts
receivables as quickly as possible without loosing future sales. The
average collection period can be reduced by bringing changes in credit
terms, credit standards and collection policies.
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Review Questions
Short Questions
1. What is cash management ?
2. What are the objectives of cash management ?
3. What are the adverse consequences of poor cash management ?
4. What are the goals of cash management strategies ?
5. Examine the significance of speedy receivables collection.
6. What is the significance of slow payments of accounts payable ?
7. Explain the deposit float and payment float ?
Broad Questions
8. Examine the significance of cash management.
9. What are the factors that influence cash requirements of a firm.?
Explain.
10. What are the models that can be used in determining the cash
needs of a firm ? Discuss.
11. Describe the basic strategies of efficient cash management.
12. Narrate the processes of efficient cash management
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Review Questions
Short Questions
1. What do you mean by inventory and inventory management ?
Explain.
2. Discuss the various types of inventory held by a manufacturing
enterprise.
3. State the significance of inventory management.
4. Explain the necessity of holding inventory.
Broad Questions
5. What are the objectives of inventory management ? Explain.
6. What is an optimum level of inventory ? Discuss the benefits of
holding optimum level of inventory.
7. “The management of inventory must meet two opposite needs”.
What are they ? How is a balance made in these two opposite
needs.
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Besides, ordering and carrying costs there are stock out costs which are
In general, carrying
costs increase as the
also included in inventory costs. In general, carrying costs increase as the
level of inventory level of inventory rises; but ordering costs and stock out costs decline
rises; but ordering with larger inventory holdings.
costs and stock out
costs decline with Determination of various Inventory Costs
larger inventory
holdings. Total Inventory Cost (TIC) =
Total Carrying Costs + Total ordering costs
= (Carrying cost per unit) (Average units in inventory) + (Cost per order)
(Number of orders)
=(C×PP) × (Q/2) + (O) (T/Q)
The variables in the equation are defined as follows:
C = Carrying costs as a percent of the purchase price of each inventory item.
PP = Purchase price, or cost, per unit.
Q = Number of units purchased with each order.
T = Total demand, or number of units sold, per period.
O = Fixed costs per order.
Re-order Point
The problem, how much to order, is solved by determining the economic
The re-order point
is that inventory
order quantity, yet the answer should be sought to the second problem,
level at which an when to order. This is a problem of determining the re-order-point. The
order should be re-order point is that inventory level at which an order should be placed
placed to replenish to replenish the inventory. To determine the re-order under certainty, we
the inventory. should know : (a) lead time, (b) average usage, and (c) economic order
quantity. Lead time is the time normally taken in replenishing inventory
after the order has been placed. By certainty we mean that usage and lead
time do not fluctuate. Under such a situation, re-order point is simply that
inventory level which will be maintained for consumption during the
lead time. That is :
Re-order point = Lead time x Average usage
Safety Stock
The re-order point is determined under the assumption of certainty. But it
In order guard
against the stock is difficult to predict usage and lead time accurately. The demand for
out, the firm may materials may fluctuate from day to day, week to week or month to
maintain a safety month. Similarly, the actual delivery time may be different from the
stock – some normal lead time. If the actual usage increases or the delivery of
minimum or buffer
inventory as cushion
inventory is delayed, the firm can face a problem of stock out which can
against expected prove to be costly for the firm. Therefore, in order guard against the
increased usage stock out, the firm may maintain a safety stock – some minimum or
and/or delay in buffer inventory as cushion against expected increased usage and/or
delivery time.
delay in delivery time.
Safety stocks are held to avoid shortages arisen from: (i) demand
increases and (ii) shipping delays are caused. Such safety stocks also
involves costs. The cost of carrying safety stocks is equal to the
percentage cost of carrying inventories times the purchase price per unit
times the number of units held as the safety stock. Thus :
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Incremental Analysis
The investment in inventory should be analyzed involving the following
The incremental
analysis should be four steps :
used to compute the Estimation of operating profit
values of operating
Estimation in investment in inventory
profit, investment in
inventory, rate of Estimation of the rate of return on investment in inventory
return and cost of Comparison of the rate of return on investment with the cost of
funds. funds.
The incremental analysis should be used to compute the values of
operating profit, investment in inventory, rate of return and cost of funds.
A change in the inventory policy is desirable if the incremental rate of
return exceeds the required rate of return.
Choice of Policy The choice of the inventory policy by the management
If a firm increases of a corporate firm will depend on the required rate of return, k, on
its investment in
inventories, its risk incremental (or marginal) investment in inventories. The concept of the
increases. required rate of return, k, has been discussed in earlier Lesson. At this
stage, we shall emphasize that the required rate of return is not the
borrowing rate. It depends on the risk of investment. Higher the risk,
higher the rate of return. If a firm increases its investment in inventories,
its risk increases. For example, the company may not be able to realize
receivables, or inventory may become obsolete if it cannot sell goods
because of recession or other unfavorable market conditions.
Thus, the choice of inventory policy will depend on a comparison of the
The firm should
invest in higher
expected rate of return and the required rate of return. The firm should
level of inventory if invest in higher level of inventory if r ≥ k.
r ≥ k.
Problems and Solutions
Problem - 1
The Homemade Bread Company buys and then sells (as bread) 2.6
million bushels of wheat annually. The wheat must be purchased in
multiples of 2,000 bushels. Ordering costs are $5,000 per order. Annual
carrying costs are two percent of the purchase price of $5 per bushel. The
delivery time is six weeks.
a. What is the EOQ ?
b. At what inventory level should an order be placed ?
c. What are the total inventory costs ?
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Solution
20T
a. EOQ =
C PP
(2)($5,000)(2,600,000)
=
(0.02)($5.00)
= 509,902 bushels
Because the firm must order in multiples of 2,000 bushels, it should
order in quantities of $10,000 bushels.
b. Average weekly sales = 2,600,000/52
= 50,000 bushels.
Reorder point = 6 weeks’ sales
= 6 (50,000)
= 300,000 bushels
Q T
TIC = (C)PP O
2 Q
510,000 2,600,000
= (0.02)($5) $5,000
2 510,000
= $25,500 + $25,490.20
= $50,990.20
Problem - 2
Vostick Filter Company is a distributor of air filters to retail stores. Its
buys its filters from several manufacturers. Filters are ordered in lot sizes
of 1,000 and each order costs $40 to place. Demand from retail stores is
20,000 filters per month, and carrying cost is $.10 a filter per month.
a. What is the optimal order quantity with respect to so many lot
sizes?
b. What would be the order quantity if the carrying cost were $.50 per
month ?
c. What would be the optimal order quantity if ordering costs were $
10 ?
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Solution
2(20)(40)
a. Q* = 4
100
Carrying costs = $.10 x 1,000 = $100. The optimal order size would be
4,000 filters, which five orders a month.
2(20)(40)
b. Q* 5.66
50
Since the lot size is 1,000 filters, the company would order 6,000 filters
each time. The lower the carrying cost, the more important ordering costs
become relatively, and the larger the optimal order size.
2(20)(10)
c. Q* = 2
100
The lower the order cost, the more important carrying costs become
relatively and the smaller the optimal order size.
Problem - 3
The following inventory data have been established for the Thompson
Company :
(1) Orders must be placed in multiples of 100 units.
(2) Annual sales are 338,000 units.
(3) The purchase price per unit is $6.
(4) Carrying cost is 20 percent of the price of goods.
(5) Fixed order cost is $48.
(6) Three days are required for delivery.
a. What is the EOQ ?
b. How many orders should an Thompson place each year ?
c. At what inventory level should an order be made ?
d. Calculate the total cost of ordering and carrying inventories if
the order quantity is (1) 4,000 units, (2) 4,800 units, or (3)
6,000 units. (4) What are the total costs if the order quantity is
the EOQ ?
Solution
2(0)(T )
(a) EOQ =
(C )( PP )
Where :
O = Fixed cost per Order
T = Annual Sales in Units
C = % Cost of Carrying Inventory
PP = Purchase price per unit
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2(48)(3,38,000)
EOQ=
(.20)(6)
= 2,70,40,000
= 5,200 units
AnnualSales 3,38,000
(b) No. of order to be placed = 65
EOQ 5,200
(c) Reorder Point = Safety Stock + (Lead Time x Usage Rate) – Goods
in Transit
3,38,000
= 12,000 + 2x -10,400
52
= 12,000 + 13,000 – 10,400
= 14,600 Units
Goods in Transit = EOQ x Lead Time
= 5,200 x 2 = 10,400 Units
(d) (i) Total Inventory Cost (TIC) = Total Carrying Cost (TCC) + Total
Ordering Cost (TOC)
T
= (C)(PP)(A) + (O)
Q
4,000 3,38,000
= (.20)(6) (48)
2 4,000
= $2,400 + $4,056
= $6,456
Review Questions
Short Questions
1. What is EOQ ? How it is determined ?
2. What are ordering costs ? Give examples.
3. What are carrying costs ? Give examples.
4. What do you mean by inventory planning ? Explain.
5. What is inventory control ? Explain.
6. What is re-order point ? Discuss. How it is computed.
7. What is safety stock ? Explain. How it is determined ?
8. How would you analyze investment in inventory ?
9. What is ABC control of inventory ? Explain.
10. What is lead time ? How it is calculated ?
Broad Questions
11. Discuss briefly the techniques involved in inventory management.
12. Explain the steps involved in analyzing investment in inventories.
Illustrate with an example.
Review Problems
Problem - 1
Two components, A and B are, used as follows :
Normal usage : 50 units each per week
Minimum usage : 25 units each per week
Maximum usage : 75 units each per week
Re-order quantity : A : 300 units; B : 500 units
Re-order period : A : 4 to 6 weeks; B : 2 to 4
weeks
Calculate for each component :
(a) Reorder level
(b) Minimum level
(c) Maximum level
(d) Average stock level
Problem - 2
Green Thumb Garden Centers sells 240,000 bags of lawn fertilizer
annually. The optimal safety stock (which is on hand initially) is 1,200
bags. Each bag costs (Green Thumb $4, inventory carrying costs are 20
percent, and the cost of placing an order with its supplier is $25.
(a) What is the Economic Ordering Quantity ?
(b) What is the maximum inventory of fertilizer ?
(c) What will Green Thumb’s average inventory be ?
(d) How often must the company order ?
Problem - 3
The Hedge Corporation manufactures only one product : planks. The
single raw material used in making planks is the dint. For each plank
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Profitability
A
Costs & benefits
Liquidity
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Credit terms
Credit Analysis
Credit standards influence the quality of the firm’s customers. There are
two aspects of the quality of customers : (i) the time taken by customers
to repay credit obligation and (ii) the default rate. The average collection
The average period (ACP) determines the speed of payment by customers. It
collection period
(ACP) determines measures the number of days for which credit sales remain outstanding.
the speed of The longer the average collection period, the higher the firm’s
payment by investment in accounts receivable. Default rate can be measured in terms
customers. of bad-debt losses ratio – the proportion of uncollected receivable. Bad-
debt losses ratio indicates default risk. Default risk is the likelihood that a
customer will fail to repay the credit obligation. On the basis of the past
practice and experience, the financial or credit manager should be able to
form a reasonable judgment regarding the chances of default. To
estimate the probability of default, the financial or credit manager should
consider five C’s viz., (i)character, (ii) collateral, (iii) capital, (iv)
capacity and (v) condition.
Capital : Capital refers to the total amount of both the fixed and
working capital invested by a businessman in his business. Such
capital may be either owned capital or debt capital or both. The
question of capital arises in case of an existing business.
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Credit Terms
The stipulations under which the firm sells on credit to customers are
The stipulations
called credit terms. These stipulations include : (a) the credit period and under which the
(b) the cash discount. firm sells on credit
to customers are
Credit Period The length of time for which credit is extended to called credit terms.
customers is called the credit period. It is generally stated in terms of a
net date. A firm’s credit period may be governed by the industry norms.
But depending on its objective, the firm can lengthen the credit period.
On the other hand, the firm may tighten its credit period if customers are
defaulting too frequently and bad-debt losses are building up.
Cash Discounts A cash discount is reduction in payment offered to
customers to induce them to repay credit obligations within a specified
period of time, which will be less than the normal credit period. It is
usually expressed as a percentage of sales. Cash discount terms indicate
the rate of discount and the period for which it is available. If the
customer does not avail the offer, he must make payment within the
normal credit period.
In practice, credit terms would include : (i) the rate of cash discount, (b)
the cash discount period, and (c) the net credit period. For example,
credit terms may be expressed as ‘2/10, net 30’. This means that a 2
percent discount will be granted if the customer pays within 10 days; if
he does not avail the offer he must make payment within 30 days.
A firm uses cash discount as a tool to increase sales and accelerate
collections from customers. Thus the level of receivable and associated
costs may be reduced. The cost involved is the discounts taken by
customers.
Credit Policy Effects
In evaluating credit policy, there are five basic effects to consider :
1. Revenue effects. If the firm grants credit, then there will be a delay
in revenue collections as some customers take advantage of the
credit offered and pay later. However, the firm may be able to
charge a higher price if it grants credit and it may be able to
increase the quantity sold. Total revenues may thus increase.
2. Cost effects. Although the firm may experience delayed revenues if
it grants credit, it will still incur the costs of sales immediately.
Whether the firm sells for cash or credit, it will still have to acquire
or produce the merchandise (and pay for it).
3. The cost of debt. When the firm grants credit, it must arrange to
finance the resulting receivables. As a result, the firm’s cost of
short-term borrowing is a factor in the decision to grant credit.
Debtors x 360
ACP =
Credit Sales
The average
The average collection period so calculated is compared with the firm’s
collection period stated credit period to judge the collection efficiency. An extended
measures the quality collection period delays cash inflows, impairs the firm’s liquidity
of receivable since it position and increases the chances of bad-debt losses. The average
indicates the speed collection period measures the quality of receivable since it indicates the
of their
collectability.
speed of their collectability.
There are two limitations of this method. First, it provides an average
picture of collection experience and is based on aggregate data. For
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household use; (b) the factor is to perform at least two of the following
functions – (i) finance for supplier, including loans and advance
payments; (ii) maintenance of accounts (ledgering relating to the
receivables); (iii) collection of accounts (ledgering relating to the
receivables) and (iv) protection against default in payment by debtors
and (c) notice of assignment of the receivables is to be given to debtors”.
The agreement between the suppliers and the factor specifies the
factoring procedure.
Factoring Services
While purchase of receivables is the fundamental to the functioning of
factoring, the factor provides the following three basic services to the
clients :
Credit collection and protection against default and bad debt losses
and
Non-notification factoring.
Full service non-recourse : Under this method accounts receivables are
purchased by the factors, assuming 100 percent credit risk.
Full service recourse factoring : In this method, the client is not
protected against the risk of bad debts. He has no indemnity against
uncollected debts.
Agency factoring : Under this method, the factor finances the bad debts
against agency either on recourse or without recourse.
Non-notification factoring : In this type, customers are not informed
about the factoring agreement. The factor performs all his usual
functions without a disclosure to customers that he owns the book debts
Costs and Benefits of Factoring
There are two types of costs involved in factoring. These are discussed
below :
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966.50
Hence, effective rate of interest = X 12 X 100 16.57%
70,000
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Problem - 2
A firm is thinking about stringent collection policy. The following details
are available :
(a) At present the firm is selling 36,000 units on credit at a price of Tk.
32 each; the variable cost per unit is Tk. 25 while the average cost
per unit is Tk. 29; average collection period is 58 days; collection
expenses amount to Tk. 10,000 and bad debts are 3%.
(b) If the collection procedures are tightened, additional collection
charges of Tk. 20,000 would be required; bad debts will be 1%; the
collection period will be 40 days and sales volume is likely to
decline by 500 units.
Assuming a 20% ROI, what would be your recommendation ? Should
the firm implement the decision ?
Solution
The decision to implement the new strategy of tightening the collection
policy should be based on the cost benefit analysis. The benefits are from
reduced bad debt expenses and average collection period. On the
contrary, the costs of implementing the decision are : (i) decrease in sales
volume and (ii) additional collection charges. All these calculations are
shown below :
Cost of sales
Average investment =
Re ceivables turnover
Proposed plan =
36,000 XTk.29 500 XTk.26 Tk .1,14,611
360 / 40
Savings in average investments: Tk. 53,589
Assuming a 20% return, the firm will be able to earn Tk. 10,718 on this
saving
(iii) Sales volume :
Since the sales volume will decline by 500 units, there would be a loss of
Tk. 3,500 (500 x Tk. 7).
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Working Notes :
(i) Calculation of investment cost at present policy = Tk. 35,00,000/4
times = Tk. 8,75,000. Therefore, its cost is 25% of Tk. 8,75,000 =
Tk. 2,18, 750.
(ii) Calculation of investment cost at policy option I = Tk. 42,00,000/3
times = Tk. 14,00,000, its cost is 25% of 14,00,000 = Tk. 3,50,000.
(iii) Calculation of investment cost at policy option II = Tk.
47,25,000/2.4 times = Tk. 19,68,750, its cost is 25% of 19,68,750
= 4,92,187.50.
In the above cases in absence of total costs, investment cost is
determined with reference to variable costs only.
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Review Questions
Short Questions
1. What do you mean by accounts receivables and accounts
receivables management ?
2. What is the basic objective of account receivable management ?
3. Explain the specific costs and benefits relevant to the
determination of accounts receivables policy.
4. What are the goals of a credit policy ?
5. What is a credit policy ? What are its elements ?
6. What is an optimum credit policy ?
7. Examine the role of cost benefit analysis in the formulation of an
optimum credit policy.
8. What is a credit period ?
9. What is cash discount ? Give an example.
10. What is credit collection policy ?
11. What is credit analysis ? Explain.
Broad Questions
12. Explain the major credit policy variables.
13. What are the basic factors considered in evaluating a credit policy
of a firm ? Explain.
14. What is meant by monitoring of accounts receivables ? Explain its
main methods.
15. What is factoring ? Discuss its nature. Examine the cost and
benefit involved in factoring.
Review Problems
Problem - 1
A small firm has a total credit sales of Tk. 80,00,000 and its average
collection period is 80 days . The past experience indicates that bad-debt
losses are around 1 percent of credit sales. The firm spends about Tk.
1,20,000 per annum on administering its credit sales. This cost includes
salaries of one officer and two clerks who handle credit checking,
collection etc., telephone and telex charges. These are avoidable costs. A
factor is prepared to buy the firm’ receivables. He will charge 2 percent
commission. He also pay advance against receivables to the firm at an
interest rate of 18% after withholding 10% as reserve. What should the
firm do ?
Problem - 2
The Hypothetical Ltd. has currently annual credit sales of Tk. 7,80,000.
Its average age of accounts receivable is 60 days.
It is contemplating a charge in its credit policy that is expected to
increase sales to Tk. 10,00,000 and increase the average age of accounts
receivable to 72 days.
The firm’s sales price is Tk. 25 per unit, the variable cost per unit is Tk.
12 and the average cost per unit at Tk. 7,80,000 sales volume is Tk. 17.
Assume a 360-day year.
(i) What is the average accounts receivable with both the present and
the proposed plans ?
(ii) What is the average cost per unit with the proposed plan ?
(iii) Calculate the marginal investments in accounts receivable resulting
from the proposed change.
(iv) What is the cost of marginal investment if the assumed rate of
return is 15%.
Problem - 3
Durham-Feltz Corporation presently gives terms of net 30 days. It has $
60 million in sales, and its average collection period is 45 days. To
stimulate demand, the company may give terms of net 60 days. If it does
instigate these terms, sales are expected to increase by 15 percent. After
the change, the average collection period is expected to be 75 days, with
no difference in payment habits between old and new customers.
Variable costs are $ .80 for every $1.00 of sales, and the company’s
required rate of return on investment in receivables is 20 percent. Should
the company extend its credit period ? (Assume a 360-day year).
Case Study
The Boca Grande Company expects to have sales of $10 million this year
under its current operating policies. Its variable costs as a percentage of
sales are 80 percent, and its costs short-term funds is 16 percent.
Currently, Boca Grande’s credit policy is net 25 (no discount for early
payment). However, its DSO is 30 days, and its bad debt loss percentage
is two percent. Boca Grande spends $50,000 per year to collect bad
debts, and its marginal tax rate is 40 percent.
The credit manager is considering two alternative proposals for changing
Boca Grnde’s credit policy. Find the expected change in net income,
taking into consideration anticipated changes in carrying costs for
accounts receivable, the probable bad debt losses, and the discounts
likely to be taken, for each proposal. Should a change in credit policy be
made ?
Proposal 1 : Lengthen the credit period by going from net 25 to net 30.
Collection expenditures will remain constant. Under this proposal, sales
are expected to increase by $1 million annually, and the bad debt loss
percent on all sales is expected to rise to three percent. In addition, the
DSO is expected ti increase from 30 to 45 days on all sales.
Proposals 2 : Shorten the credit period by going from net 25 to 20.
Again, collection expenses will remain constant. The anticipated effects
of this change are a decrease in sales of $1 million per year, a decline in
the DSO from 30 to 22 days, and a decline in the bad debt loss
percentage to one percent on all sales
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These are legal Repurchase Agreements These are legal contracts that involve the
contracts that actual sale of securities by a borrower to the lender with a commitment
involve the actual on the part of the former to repurchase the securities at the current price
sale of securities by
plus a stated interest charge. The securities involved are government
a borrower to the
lender. securities and other money market instruments. The borrower is either a
financial institution or a security dealer.
There are two major reasons why a firm with excess cash prefers to buy
repurchase agreements rather than a marketable security. First, the
original maturities of the instrument being sold can, in effect, be adjusted
to suit the particular needs of the investing firm. Therefore, funds
available for a very short period, that is, one/two days can be employed
to earn a return. Closely related to the first is the second reason, namely,
since the contract price of the securities that make up the arrangement is
fixed for the duration of the transaction, the firm buying the repurchase
agreement is protected against market fluctuations throughout the
contract period. This makes it a sound alternative investment for funds
that are surplus for only short periods.
Units The units of the Mutual Trust or Unit Trust offer a reasonably
convenient alternative avenue for investing surplus liquidity as (i) there
is a very active secondary market for them, (ii) the income from units is
tax-exempt up to a specified amount and, (iii) the units appreciate in a
fairly predictable manner.
Inter-corporate Deposits Inter-corporate deposits, that is, short-term
deposits with other companies are a fairly attractive form of investment
of short-term funds in terms of rate of return. However, apart from the
fact that one month’s time is required to convert them into cash, inter-
corporate deposits suffer from high degree of risk.
Bills Discounting Surplus funds may be deployed to purchase/discount
Surplus funds may bills. Bills of exchange are drawn by seller (drawer) on the buyer
be deployed to
purchase/ discount (drawee) for the value of goods delivered to him. During the pendency of
bills. the bill, if the seller is in need of funds, he may get it discounted. On
maturity, the bill should be presented to the drawee for payment. A bill
of exchange is a self-liquidating instrument. Bill discounting is superior
to inter-corporate deposits for investing surplus funds. While parking
surplus funds in bills discounting, it should be ensured that the bills are
trade bills arising out of genuine commercial transaction and, as far as
possible, they should be backed by letter of credit /acceptance by banks
It enables corporate to ensure absolute safety of funds.
firms to utilize their
float money Call Market It deals with funds borrowed/lent overnight one-day (call)
gainfully. money and notice money for periods up to 14 days. It enables corporate
firms to utilize their float money gainfully. However, the returns (call
rates) are highly volatile. The stipulations pertaining to the maintenance
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Yield The final selection criterion is the yields that are available on the
different financial assets suitable for inclusion in the marketable/near-
cash portfolio. All the four factors listed above, financial risk, interest
rate risk, liquidity and taxability; influence the available yields on
financial instruments. Therefore, the yield criterion involves a weighing
of the risks and benefits inherent in these factors. If a given risk is
assumed, such as lack of liquidity, then a higher yield may be expected
on the instrument lacking the liquidity characteristics. In brief, the
finance manager must focus on the risk-return trade-off associated with
the four factors on yield through his analysis. Coming to grips with these
trade-off will enable the finance manager to determine the proper
marketable securities mix for his firm.
Review Questions:
A. Short questions:
1. Define marketable securities. Examine their main features.
2. Why do investors prefer marketable securities?
3. What is portfolio management relating to marketable securities?
4. How higher yields can be achieved from investment in marketable
securities? Examine.
5. How does taxability affect selection of marketable securities?
6. How does return/yield affect selection of marketable securities?
7. Write short notes on:
(a) Treasury bills; (b) Commercial paper; (c) Bankers acceptance
and (d) Bills discounting.
8. What is a repurchase agreement? Why do the firms with excess
cash prefer to the repurchase agreements?
9. What are the motives for maintaining liquidity in the form of
marketable securities?
B. Broad questions
10 Discuss briefly the various types of marketable securities.
11. Describe the considerations that help the firms selecting a proper
marketable securities mix.
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Trade Credit
Features
Trade credit refers to the credit extended by the supplier of goods and Trade credit refers
to the credit
services in the normal course of transaction/business/sale of the firm.
extended by the
According to trade practices, cash is not paid immediately for purchases supplier of goods
but after an agreed period of time. Thus, deferral of payment (trade and services in the
credit) represents a source of finance for credit purchases. There is, normal course of
however, no formal/specific negotiation for trade credit. It is an informal transaction/business
/sale of the firm.
arrangement between the buyer and the seller. There are no legal
instruments/ acknowledgements of debt, which are granted on an open
account basis. Such credit appears in the records of the buyer of goods as
sundry creditors/accounts payable.
There are two components of trade credit namely free and costly.
Free trade credit Credit received during the discount period.
Costly trade credit Credit taken in excess of “free” trade credit, whose
cost is equal to the discount lost.
Costs of Trade Credit
Trade credit does not involve any explicit interest charge. However, there
There is an implicit
is an implicit cost of trade credit. It depends on the credit terms offered
cost of trade credit.
It depends on the by the supplier of goods. If the terms of the credit are, say, 45 days net,
credit terms offered the payable amount to the supplier of goods is the same whether paid on
by the supplier of the date of purchase or on the 45th day and, therefore, trade credit has no
goods. cost, that is, it is cost-free. But if the credit terms are, say, 2/15, net 45,
that is, there is discount for prompt payment, the trade credit beyond the
discount period has a cost equals to : [( Discount/1 – Discount) (360
days/Credit period - Discount period)]. Alternatively, the credit terms,
2/15, net 45, imply that the firm (buyer) is entitled to 2 percent discount
for payment made within 15 days when the entire payment is to be made
within 45 days.
To sum up, as the cost of trade credit is generally very high beyond the
discount period, firms should avail of the discount on prompt payment.
If, however, they are unable to avail of discount, the payment of trade
credit should be delayed till the last day of the credit (net) period and
beyond without impairing their credit-worthiness. But, a precondition for
obtaining trade credit particularly by a new company is cultivating good
relationship with suppliers of goods and obtaining their confidence by
honoring commitments.
The following equation can be used to calculate the approximate
percentage cost, on an annual basis, of not taking cash discounts – that is,
the cost of forgoing discounts.
Bank Credit
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We can compute the effective annual rate and the annual percentage rate
(APR) using the following formula :
Where m is the number of borrowing periods in one year (i.e., if the loan
is for one month, m = 12).
Simple Interest Loan
Both the amount borrowed and the interest charged on that amount are
paid at the maturity of the loan; there are no payments made before
maturity.
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Face value The amount of the loan or the amount borrowed; also called
the principal amount of the loan.
Discount Interest Loan: A loan in which the interest, which is
calculated on the amount borrowed, is paid at the beginning of the loan
period; interest is paid in advance.
Add-on Interest: Interest that is calculated and then added to the amount
borrowed to obtain the total dollar amount to be paid back in equal
installments.
Accruals
Accruals refer to continually recruiting short-term liabilities, liabilities
such as wages and taxes that increase spontaneously with operations.
Firms generally pay employees on a weekly, biweekly, or monthly basis,
so the balance sheet typically will show some accrued wages. Similarly,
the firm’s own estimated income taxes, the social, the social security and
income taxes withheld from employee payrolls, and the sales taxes
collected generally are paid on a weekly, monthly, or quarterly basis, so
that balance sheet typically will show some accrued taxes along with
accrued wages.
Accruals increase automatically or spontaneously, as a firm’s operations
expand. Further, this type of debt generally is considered “free” in the
sense that no explicit interest is paid on funds raised through accruals.
However, a firm ordinarily cannot control its accruals. The timing of
wage payments is set by economic forces and industry custom, while tax
payment dates are established by law. Thus, firms use all the accruals
they can, but they have little control over the levels of these accounts.
Commercial Paper :
Commercial paper (CP) is a short-term unsecured negotiable instrument,
Commercial paper
consisting of usance promissory notes with a fixed maturity. It is issued (CP) is a short-term
on a discount on face value basis but it can also be issued in interest- unsecured
bearing form. A CP when issued by a company directly to the investor is negotiable
called a direct paper. The companies announce current rates of CPs of instrument,
consisting of usance
various maturities and investors can select those maturities which closely promissory notes
approximate their holding period. When CPs are issued by security with a fixed
dealers/dealers on behalf of their corporate customers, they are called maturity.
dealer paper. They buy at a price less than the commission and sell at the
highest possible level. The maturities of CPs can be tailored within the
range to specific investments.
As the CPs are issued at discount and redeemed at it face value, their
effective pre-tax cost/interest yield
Where net amount realized = Face value – discount – issuing and paying
agent (IPA) charges, that is, stamp duty, rating charges, dealing bank fee
and fee for stand by facility.
Factoring
Factoring provides resources to finance receivables as well as facilitates
the collection of receivables. Although such services constitute a critical
segment of the financial services scenario in the developed countries; but
in our country factoring is quite new.
Definition Factoring can broadly be defined as an agreement in which
receivables arising out of sale of goods/services are sold by a firm
(client) to the factor (a financial intermediary) as a result of which the
title of the goods/services represented by the said receivables passes on
to the fact the factor.
Mechanism Credit sales generate the factoring business in the ordinary
Once a sale
transaction is
course of business dealings Realization of credit sales is the main
completed the factor function of factoring services. Once a sale transaction is completed the
steps in to realize factor steps in to realize the sales. Thus, the factor works between the
the sales. seller and the buyer and sometimes with the seller s banks together.
Functions of a Factor
Depending on the type/form of factoring the main functions of a factor in
general terms can be classified into five categories;
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Lien : The term ‘lien’ refers to the right of a party to retain goods
belonging to another party until a debt due to him is paid. Lien can be of
two types (i) particular lien and (ii) general lien Particular lien is a right
to retain goods until a claim pertaining to these goods is fully paid. On
the other general lien can be applied till all dues of the claimant are paid.
Banks usually enjoy general lien.
Mortgage : It is the transfer of a legal/equitable interest in specific
It is the transfer of a
immovable property for securing the payment of debt. The person who legal/
parts with the interest in the property is called ‘mortgagor’ and the bank equitable interest in
in whose favor the transfer takes place is the ‘mortgagee. The mortgage specific immovable
interest in the property is terminated as soon as the debt is paid. property for
securing the
Mortgages are taken as an additional security for working capital credit
payment of debt.
by banks.
Charge : Where immovable property of one person is, by the act of
parties or by the operation of law, made security for the payment of
money to another and the transaction does not amount to mortgage, the
latter person is said to have a charge on the property and all the
provisions of simple mortgage will apply to such a charge.
Secured Loan : It refers to a loan backed by collateral; for short-term
loans the collateral often is inventory, receivables, or both. So far we
have not addressed the question of whether loans should be secured or
not. Commercial paper is never secured, but all other types of loans can
be secured if this is deemed necessary or desirable. Given a choice, it
ordinarily is better to borrow on an unsecured basis because the
bookkeeping costs of secured loans often are high. However, weak firms
might find that they can borrow only if they put up some type of security
or that by using security they can borrow at a lower rate.
Uniform Commercial Code : It refers to a system of standards that
simplifies procedure for establishing loan security.
Accounts Receivable Financing : Pledging Receivables using accounts
receivable as collateral for a loan. Accounts receivable financing
involves either the pledging of receivables or the selling of receivables
(called factoring). The pledging of accounts receivable is characterized
by the fact that the lender not only has a claim against the receivables but
also has recourse to the borrower.
Recourse : Under this, the lender can seek payment from the borrowing
firm when receivables’ accounts used to secure a loan are uncollectible.
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Problem – 2
Gifts Galore Inc. borrowed $1.5 million from National City Bank (NCB).
The loan was made at a simple annual interest rate of nine percent a year
for three months. A 20 percent compensating balance requirement raised
the effective interest rate because the company does not maintain a
checking balance at NCB.
a. The approximate interest rate (APR) on the loan was 11.25
percent. What was the true effective rate ?
b. What would be the effective cost of the loan if the note required
discount interest ?
Solution
Total amount of loan = $ 15,00,000
Interest 9% on $ 15,00,000 = $ 1,35,000
Effective loan = Total loan – Compensating balance
= $ 15,00,000 – 20% of $ 15,00,00
= $ 12,00,00
Total Interest
x 100
Hence, true effective interest rate =
Effective Loan
1,35,000
x 100
= 12,00,000
= 11.25%
Problem – 3
Calculate the approximate cost of non-free trade credit under each of the
following terms :
(a) 1/15, net 20;
(b) 2/10, net 60
(c) 3/10, net 45
(d) 2/10, net 45
(e) 2/15, net 40
Solution
a) We know that approximate cost of foregoing cash discount (ie. Cost of
non free trade credit)
Discount % 360
100 Discount %) (Total days net payable - Discount period)
1 360
100 1) 20 - 15
= 7.27%
2 360
b) Cost of non free trade credit 14 69%
100 2 (60 - 10)
c) Cost of non free trade credit
3 360 1080
3.18%
100 3 (45 - 10) 3395
d) Cost of non free trade credit
2 360 720
20.99%
100 2 (45 - 10) 3430
e) Cost of non free trade credit
2 360 720
29.39%
100 2 (40 - 15) 2450
Problem – 4
a) If a firm buys under terms of 3/15, net 45, but actually pays on the 20th
day and still takes the discount, what is the approximate cost of its non-
free trade credit ?
(b) Does it receive more or less credit than it would if it paid within 15
days ?
Solution
a) Approximate cost of non free trade credit
Discount % 360
100 Discount % (Total days net payable - Discount period)
3 360 3 360
100 3 (45 - 20) 97 25
1080
44.54%
2425
3 360 1080
37.11%
100 3 (45 - 15) 2910
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Problem – 5
Susan Visscher, owner of Visscher’s Hardware, is negotiating with First
Merchant’s Bank for a $50,000, one-year loan, first Merchant’s has
offered Visscher the following alternatives. Calculate the effective
interest rate for each alternative. Which alternative has the lowest
effective interest rate?
(A) A 12 percent annual rate on a simple interest loan with no
compensating balance required and interest due at the end of the
year.
(B) A nine percent annual rate on a simple interest loan with a 20
percent compensating balance required and interest against due at
the end of the year.
(C) An 8.75 percent annual rate on a discounted loan with a 15 percent
compensating balance.
Solution
6000
100 12%
50,000
Review Questions
A. Short Questions
1. Why shot term financing is necessary ? Explain.
2. Why do the financial managers aware of the selection of sources of
finance ?
3. What is a trade credit ? What are its main features ?
4. Examine the components of trade credit.
5. What is the cost of trade credit ? How it is determined ?
6. What is bank credit ? Distinguish between bank credit and trade
credit.
7. How accounts play the role of short-term financing ? Examine.
8. What is the cost of bank credit ? How it is measured ?
9. Examine the role of commercial paper as the source of short term
financing.
10. 10. What is a factoring ? What are the main functions of a factor ?
11. What is receivable financing ?
12. What is inventory financing ?
B. Broad Questions
13. Briefly discuss the major sources of short-term financing.
14. Discuss the modes of procedures of using security in short term
financing.
15. What are the merits of demerits of short term financing? Explain.
Review Problems
Problem - 1
Gallinger Corporation projects an increase in sales from $1.5 million to
$2 million, but it needs an additional $300,00 of current assets to support
this expansion. The money can be obtained from the bank at an interest
rate of 13 percent, discount interest; no compensating balance is
required. Alternatively, Gallinger can finance the expansion by no longer
taking discounts, thus increasing accounts payable Gallinger purchases
under terms of 2/10, net 30, but it can delay payment for an additional 35
days- paying in 65 days and thus becoming 35 days past due- without a
penalty because of its suppliers’ current excess capacity problems.
a. Based strictly on effective annual interest rate comparisons, how
should Gallinger finance its expansion ?
b. What additional qualitative factors should Gallinger consider
before reaching a decision ?
Problem – 2
The UFSU Corporation intends to borrow $450,000 to support its short-
term financing requirements during the next year. The company is
evaluating its financing options at the bank where it maintains its
checking account. UFSU’s checking account balance, which averages
$50,000 can be used to help satisfy any compensating balance
requirements the bank might impose. The financing alternatives offered
by the bank include the following:
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Problem – 5
Bankston Feed and Supply company buys on terms of 1/10, net 30, but it
has not been taking discounts and has actually been paying in 60 rather
than 30 days. Bankston’s balance sheet follows (thousands of dollars):
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