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Working Capital
Learning Objectives
 Describe the need for short term funds management
 Describe how working cycle works in a company
 Explain how to analyse the needs of working capital
 Understand how to manage receivables and payables
 Explain how inventory is managed in a company

Working capital could be defined as the portion of assets used in current operations. The movement of funds from working capital to income and profits and back to working capital is one of the most important characteristics of business. This cyclical operation is concerned with utilisation of funds with the hope that they will return with an additional amount called Income. If the operations of a company are to run smoothly, a proper relationship between fixed capital and current capital has to be maintained.

Sufficient liquidity is important and must be achieved and maintained to provide the funds to pay off obligations as they arise or mature. The adequacy of cash and other current assets together with their efficient handling, virtually determine the survival or demise of the company. A businessman should be able to judge the accurate requirement of working capital and should be quick enough to raise the required funds to finance the working capital needs.

Working capital is often classified as Gross Working Capital and Net Working Capital. The former refers to the total of all Current Assets and the latter refers to the difference between Current Assets and Current Liabilities.

The maintenance of a sound Working Capital position is an important function of the Finance Department of the organisation. With the magnitude of business rising with globalisation, the quantum of working capital to be managed is on the increase. No wonder, working capital management is talked about more today than ever before.

Importance of Short Term Funds Management
Long-term investment decisions (capital budgeting) and long-term financing decisions are characterized by the facts that they (a) generally involve large amounts of money, and (b) are relatively infrequent occurrences. Decisions that come under the heading "short-term finance" are equally important, because, while typical decisions often don't involve as much money, decisions are much more frequent. This is suggested in the results of a recent survey of CFOs.

Ranked Greatest Importance Average Time Allocated
Financial Planning 59% 35%
Working Capital Mgmt 27% 32%
Capital Budgeting 9% 19%
Long-Term Financing 5% 14%
Total 100% 100%

In defining short term finance, we focus on the cash flows connected with the operations of a company. Because the cash inflows and cash outflows are not synchronised, a company needs a temporary parking place for cash, which we can call a liquidity portfolio. This liquidity portfolio may consist of cash and marketable securities. Since cash flows for a company are uncertain, both in amount and timing, the amount of cash in temporary storage may not be adequate for all time periods. Thus, it is necessary to provide some backup liquidity for periods when the normal store of liquidity is insufficient.

Also there is a need to move cash from one point to another within a company. We need to have internal cash flows to connect these various inflows, outflows and sources of liquidity. The cash system of a company is the mechanism that provides the linkage between cash flows. The financial manager of the company has the responsibility, at least in part, to develop and maintain the policies and procedures necessary to achieve an efficient flow of cash for the company's operations.

Short term financial management thus encompasses decisions about activities that affect cash inflows, cash outflows, liquidity, backup liquidity, and internal cash flows. Many decisions of a company have a short term financial management aspect. For example, the decision to sell a bond issue in order to raise funds to finance an expansion in plant and equipment is clearly a long term decision. However, the decision on how to invest the proceeds from the bond issue until they are needed to pay for the construction is a short term financial decision.

The use of a 1-year time horizon to separate short term and long term decisions is arbitrary and, in some cases, ambiguous. To refine the definition of short term finance, it is helpful to examine the differences and interrelationships between the decisions that are classified as short term finance and those that are considered long term finance. Decisions usually classified as long term are difficult to reverse and essentially determine the basic nature of the business and how it will be carried out. Short term financial policies take the results of these decisions as a starting point and concentrate on how they can be efficiently and economically carried out. We can think of short term decisions as being more operational. Once implemented they are easier to change.
Components of Working Capital

The elements of working capital are as follows:
• Current Assets ( in descending order of liquidity):

1. Cash
2. Bank Balance
3. Short term investments
4. Trade Debtors
5. Inventory
• Finished Goods
• Work in process
• Raw materials
• Stores & Spares
6. Pre-payments (Insurance, advances etc.)

• Current Liabilities:

1. Trade Creditors
2. Bank Overdraft or Cash Credit
3. Short Term Borrowings
4. Provision for taxes
5. Provision for dividends

If current assets is the source from which current liabilities are to be met (as and when they fall due) during the course of business operations, then their strengths or weaknesses will have significant bearing on the short run liquidity of the company. The importance of preserving this short term liquidity need not be emphasised and hence the need to manage the working capital.

Working parameters of a company influence the composition mix of various components of working capital. Whether the company is single product or multiple product? Whether the company does made-to-order work or it keeps stock in inventory? Whether it is a manufacturing company or a trading company? Whether it extends credit to its customers or does not? Whether it gets credit from its suppliers or does not? These are some of the questions that the company has to answer before it can really decide what levels of working capital that the company needs.

Single product companies normally operate with a lower quantum of working capital than a multi-product or multi-process companies. Trading operations, which get the payments in cash everyday, will necessarily have to manage their funds in a different way than a defence contractor who gets his payment after six months of the completion of the job. The management of funds will be altogether different for an infrastructure contractor whose payment terms are divided over a number of years.
The Size of the Company’s Investment in Current Assets
The size of the company's investment in current assets is determined by its short-term financial policies. There are three types of policies that the company can use: 1) Flexible policy, 2) Restrictive policy and 3) A compromise policy that lies between the two.

1) A company keeping a flexible working capital policy means that the company is very liberal in its trade terms and has invested a large amount of funds in its operations. Flexible policy actions include:
• Keeping large cash and securities balances
• Keeping large amounts of inventory
• Granting liberal credit terms

2) A company keeping a restrictive working capital policy is basically investing the lowest amount possible in the operations. for Restrictive policy actions include:
• Keeping low cash and securities balances
• Keeping small amounts of inventory
• Allowing few or no credit sales

3) A company keeping a compromise working capital policy is realistically investing the money in the operations, neither has very large amount of cash nor runs always short of it like the restrictive policy does.

The three types of policies are shown in figure 18.1 below:

Figure 18.1: Types of Financing Policies

As you can see in the figure 18.1, a company that keeps a flexible policy keeps enough liquid assets that are sufficient to finance its peak requirements of working capital. This means that the company invests the excess money that it has when there is less than the peak demand. A company with a restrictive policy keeps enough liquid assets that are sufficient to meet the lowest level of working capital requirements. This means that the company borrows as the seasonal needs grow to fund its working capital needs. With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted.

A restrictive policy is associated with higher risk and higher expected profitability. A conservative policy ensures higher liquidity and cover risk but is always accompanied by lower profitability. The policy to be adopted is based on managements' perception of the risk with a view to maximise the utility value of the funds used in the working capital management. This means that the risk-return trade-off is to be kept in mind while formulating the WC policy.

Flexible policy means that the company is carrying excess cash and hence bearing higher carrying costs than the other two policies. Restrictive policy means that the company is out of cash many times and hence carries shortage costs like loss of orders, etc. This is depicted in the figure 18.2 below.

As the level of working capital increases, shortage costs go down while the carrying costs increase. This means that there would be a point where the sum total of carrying costs and the shortage costs would be the lowest. This is the optimum level of current assets that the company should keep.

Factors Influencing Working Capital
In addition to the working parameters peculiar to a company that determine the quantum of required working capital, the following factors are also equally important:

1. Profit levels

A company earning huge amounts of profits can add to the working capital pool a larger quantum of funds. Such companies should, however, guard against the temptation of expanding beyond necessity and tying up the funds in unproductive capital expenditure or allow unnecessary increase in overheads. Generally it is seen that companies with high profit levels become lax in management of funds
and usually mismanage by blocking funds excessively in stocks or debtors.

2. Tax Levels and Planning

Income Tax laws provide for payment of advanced tax in instalments. Excise and sales tax are payable at time of despatch of goods from the factory premises and the point of sales respectively. Any working capital management must make adequate and timely provision for the same as all of them involve cash outlays.

3. Dividend Policies and Retained Earnings

Dividend policy and retained earnings are directly related. There has to be a proper balance between the need to preserve cash resources and the obligation to satisfy shareholder expectations. Sometimes reserves are sacrificed for consistent dividends. Dividends once declared become a short time liability which has to be paid for in cash and this impact should be recognised in the working capital budget. On the other hand, it would be of little satisfaction to the general body of the shareholders to enjoy a liberal dividend at the expense of ploughing back the same for the growth of the company. Reserves in the form of retained earnings is a very important source of augmenting working capital.

4. Depreciation Policy

The extent to which depreciation provision is made during the course of making the financial statements has a direct bearing on the dividend policy and retained earnings. This so because a higher quantum of depreciation would leave lesser profits resulting in reduced retained earnings and dividends. The quantum of depreciation can be made to vary by choosing different methods to provide for the use of assets. As provisions for depreciation are actually only book entries and represent no cash flow at that time, they will have no bearing on working capital except to the extent they may hold back distribution of dividends.

5. Expansion/ Diversification Plans

Addition of fixed assets to produce new products, resorting to multiple shifts, or marginally adding to the plant and machinery are some of the common known ways to expand or diversify. Either of them represent an increase in production which calls for a higher quantum of spending of current assets, e.g. , you buy more raw material when you produce more and so on. In such situations, it is unwise to strain the internal resources for avoiding external funding.

6. Price level changes in raw material and finished goods

Inflation has got a direct bearing on the working capital. It depends to a large extent on the companies ability to readjust its own prices to cover the increase in the cost. In case the product or service requires government approval or is administered as far as the price is concerned, inflation may have a very significant bearing on the working capital needs. Inflation could be either recessive or expensive. During recessive inflation the companies are unable to sell more products due to lack of demand which results in the reduction of production. Inventories pile up and fixed expenses need a drastic reduction.

7. Operating Efficiency of the company

Operating efficiency of a company plays a major role in working capital management. An efficient company will have a shorter manufacturing period, long credit terms available from suppliers and minimal customers credit outstanding. If this is achieved then the quantum of working capital required will be naturally reduced.

The Working Capital Cycle
The Working Capital Cycle (or operating cycle) is the length of time between a company's paying for material entering into stock and receiving the inflow of cash from sales. The movements in the cycle are different for different types of companies and are dependent on the nature of the company. Operating cycle is shown in figure 18.3.

The operating cycle is the time period from inventory purchase until the receipt of cash. (Sometimes the operating cycle does not include the time from placement of the order until the arrival of stock.) There is another cycle shown in the figure. 18.3 known as cash cycle. The cash cycle is the time period from when cash is paid out, to when cash is received.
Receivables Management
If we are getting trade credit to fund our needs, we also have to extend trade credit to our customers. A company grants trade credit to protect its sales from the competitors and to attract the potential customers to buy its products at favourable terms. There are several affects of extending credit to the customers on various operating parameters of the company. These include:

1. Revenue effects

As the customers are extended credit, payment for goods is received later giving the customers time to generate sales from the goods and pay back the company. This may allow the company to charge a higher price and also the quantity sold may increase.

2. Cost effects

Extending credit means that the company has to maintain a credit department. This involves costs. Also collecting receivables has its own costs associated with it.

3. The cost of debt

If the company has to extend credit it must finance these receivables from its own money or from borrowings. Both of these methods involve costs.

4. The probability of nonpayment

The company always gets paid if it sells for cash but if it extends credit there is a probability that the customer may not pay. This means that the company may not get its payments resulting in a loss to the company.

5. The cash discount

The cash discount affects payment patterns and amounts that the company recieves early. If the cash discount is high then there is higher probability that the company will get more cash upfront and vice versa.

Extending trade credit creates receivables or book debts which the company expects to collect in the near future. The book debts or receivables arising out of trade credit has three characteristics:

1. It involves an element of risk

This should be carefully analysed. Cash sales are riskless, but not the credit sales as the cash is yet to be received.

2. It is based on economic value

To the buyer, the economic value in goods or services passes immediately at the time of sale, while the seller expects an equivalent amount of value to be received later on.

3. It implies futurity

The cash payment for the goods or services received by the buyer will be made by him in a future period. The customers from whom receivables or book debts are due are called "debtors" and represent the company's claim or asset.

Let us take up an example to illustrate the benefit of providing trade credit.


A company is planning to extend credit to its customers. The choice is between one month and two month's credit. The first year's results under the three alternatives, of providing no credit and one & two months credit, are tabulated below.

(Rupees) No credit One month’s credit Two month’s credit
Sales 120,000 160,000 240,000
Debtors 13,333 40,000
Stocks (less creditors (Say, 1/12 of sales value) 10,000 13,333 20,000
Total 10,000 26,666 60,000
Increase in working capital through granting credit 16,666 50,000
Marginal contribution 30,000 40,000 60,000
Less: Cost of:
Credit control (6,000) (6,000)
Bad debts (1,600) (4,800)
Relevant comparable profits 30,000 32,400 49,000
Increase in profits 2,400 19,200
But the company requires a return of15% on the increase in capital employed; i.e. 2,500 7,500
The net advantage (or disadvantage) of the proposed changes in credit policy is therefore (Rs.100) Rs.11,700

Note that we have not shown an 'interest' charge on the increased working capital because in due course the increase in stocks and debtors will in effect be financed out of the improved profits, and no specific borrowing may be needed. However, regardless of how the working capital is financed it must still produce the required rate of return.

The example makes the fairly obvious points that giving credit involves cost, including the opportunity cost of additional capital employed. In some cases these costs will cancel out or outweigh any gains from increased business like in the second alternative above. In some cases the granting of credit may not increase the sales of the business but may be justified because it will prevent a loss of sales to a competitor.

There are two costs that we can associate with extending credit as depicted in figure 18.4 i) credit costs and ii) opportunity costs. Credit costs are the cash flows that must be incurred when credit is granted. They are positively related to the amount of credit extended. Opportunity costs are the lost sales from refusing credit. These costs go down when credit is granted.

This means that there is a point where the sum total of these two costs are minimum for the company. This point depicts the optimum credit policy that the company must follow.

Figure 18.4 : The Costs of Granting Credit

The above discussion will suggest three ways of management control in connection with credit policy:

(a) Debtors expressed in relationship to sales - either as a percentage or as a number of weeks sales. This provides an overall confirmation that the business is effective in carrying out its own credit policy.

With a seasonal business, however, these calculations could be misleading. Another disadvantage of averages is that they may conceal the fact that some long-overdue debts are being compensated by quicker collections from other customers. For management control there is no substitute for a complete listing of debtor accounts, analysed by age, compiled every month.

(b) Bad debts as a percentage of sales value, or reported otherwise in detail.

(c) Credit control costs.

This means that credit control involves three types of action:

(a) deciding the normal credit period to be allowed;

(b) establishing credit limits for individual customers;

(c) implementing the system (that is to say, ensuring that credit limits and the credit period are not exceeded).

(a) Deciding the Credit Period

If a business is offering a unique product or service, or one for which demand exceeds supply, there may be no need to offer credit terms at all. In other cases the starting point in deciding credit policy is a review of the credit terms offered by competitors, and from this basis the credit terms of the particular business will be developed.

Other factors that affect the length of the credit period are the following:

• Buyer's inventory and operating cycle
• Perishability and collateral value
• Consumer demand
• Cost, profitability and standardisation
• Credit risk
• The size of the account
• Competition
• Customer type

Long credit period may be offered to the customers if this will enable the business to capture a larger share of the available market, or the break into a new market. The initial effect of granting long credit periods may be adverse because of the extra costs involved but profits from increased volumes should more than offset the losses. If it does not there is no use in extending longer credit periods. Even otherwise it is necessary to look to the longer term where, among other possibilities, selling prices may be increased because smaller competitors have been eliminated in the 'credit war'.

Shorter credit may be imposed if demand is inelastic, so that the quantity sold will not be affected simply by changes in credit terms.

Establishing Credit Limits
The fact that the business has a credit policy does not mean that credit terms will be granted to every customer. It is not always easy to decide whether a particular customer is 'credit worthy' in the sense that he has both the ability and the inclination to pay at the due date. Many companies require cash with order from new customers until their creditworthiness have been established.

Five Cs of Credit that a bank looks at are the ones that you should also look at while granting credit:

• Character: Willingness to pay back the credit
• Capacity: Ability to pay back
• Capital: Financial reserves including cash
• Collateral: What assets could be pledged or are pledged to others that hinder payments
• Conditions: Relevant economic conditions

That means that in assessing the creditworthiness of a customer two things are absolutely necessary:

(a) Facts about his business, in particular whether it is profitable, whether it is generating or has access to sufficient cash to met its liabilities, and whether it has suitable assets available to cover the claims of unsecured creditors in the event of winding up. In brief, it is necessary to analyse the accounts of the business. It is helpful also if the customer will supplement these with the sort of information they do not give; e.g., the current order book, any plans for future development, and the condition and market value of the assets owned by his business.

(b) Opinions about the business and the people running it, formed from either personal contacts (director level, or at any reliable and knowlegeable level) or obtained from third parties such as business associates, mutual acquaintances or employees changing jobs.

There are other sources from which we can have information about the company as well as the industry that it is operating in:

(a) Reports from the relevant trade protection association, if one exists;

(b) Trade references from other companies with which the customer does business;

(c) Bank references - these may not give a lot of information but they tend to use a series of standardised replies, and experience of these will indicate the relative credit grading of the customer in question;

(d) Reports published in trade journals or the financial press dealing either with the customer company or with the type of business in which it is engaged.

In assessing the creditworthiness of overseas customers, reports from bankers are an important source of information. It is also necessary to weigh up the risks of the customer being prevented from paying either through political or exchange control restrictions. On all these matters the Export Credits Guarantee Department can usually give guidance.

If the customer's creditworthiness appears to be established, the next stage is to decide the amount of credit to be given.

Theoretically there are three possible ways of doing this:

(a) The income or cash flow method, which requires knowledge of the amounts of cash becoming available to the customer, and how he proposes spending them, thus indicating his ability to pay the supplier's invoices - this method is possible between a bank manager and his client seeking an overdraft or loan, but seldom in business life;

(b) The capital structure method, under which the value of uncharged assets in the customer's last balance sheet is established, and the credit limit will be a percentage of this value. This is a necessary calculation when the proposed value of future transactions will involve a major increase in the customer's total indebtedness, but it is not an indicator of liquidity, and is not particularly relevant to small transactions in the ordinary course of trade;

(c) The requirement method, which is almost always used in practice. If the customer is creditworthy then we should be able to rely on him to pay any amounts arising from the ordinary course of business. The amount of credit granted, therefore, is based on the value of business which the customer expects to place with the supplier each month. The forecast monthly sales to the customer are multiplied by a number of months' credit laid down as company policy to give that customer's credit limit. If, for example, a customer proposed placing orders totalling Rs.1,500 per month with a supplier whose credit terms required payment by the end of the month following the date of invoice (say, two month's credit) the credit limit granted him might be 2xRs.1,500 = Rs.3,000 outstanding on the ledger accounts at any time.

For customers of international repute it may be decided that no limitation of credit is necessary, but the financial difficulties faced by several major companies in recent years must be a warning against the automatic granting of unlimited credit.

Vetting Incoming Orders
The amount appearing on the customer's ledger account at any time will, of course, result from invoicing the orders he has placed, so that if the value of orders in any period were to exceed the original forecast this might not become apparent until after invoicing. At that time the outstanding balance on the ledger would suddenly be found to be in excess of the agreed limit.

To safeguard against this possibility an order register may be kept for each customer, showing the value of orders placed for delivery in particular months. Each incoming order will then be checked against the register to confirm that it will not cause the credit limit to be exceeded. This could be a cumbersome procedure, and normally it would only be used in respect of:

(a) New customers' whose compliance with credit limits has not been established;

(b) Customers who had consistently failed to adhere to their credit limits in the past. (It might be better in such cases to withdraw credit facilities completely).

All incoming orders should be checked to ensure that are placed on the customer's official order form and authorised by somebody purporting to have the power to place that type of order. Computerisation has made this task very easy.

Sales Invoicing
So far as the customer is concerned, the company's credit period does not begin until he receives an invoice. Even then his accounting procedures probably involve a monthly cut off date for the receipt of invoices, so that any invoice received after, say, the 28th day of the month will be treated as belonging to the succeeding month.

It is important, therefore, that delays in invoicing be kept to a minimum. The causes of delay are nearly all within the control of the company, and may include:

(a) An inflexible routine in the sales invoicing department (perhaps invoices are issued only on certain days in the month);

(b) A requirement for approval or signature of sales invoices by members of the sales staff who are often away from the office;

(c) Failure to agree prices for special work; and

(d) For job work, and in other cases where prices are linked with costs, excessively slow procedures for calculating costs.

Debt Collection
There must be no slackness in pursuing the collection of debts. In most business purely formal reminders are ineffective, and therefore a waste of money, when an account has passed its due date there should be early personal contact with the customer either by telephone or a salesman's visit or by a letter addressed to a named person in the customer company. If necessary, there may be a follow up at the higher level of authority. And this should be followed by a threat to cut off supplies.

The value of legal action against debtors needs to be assessed. When this stage is reached, the likelihood of the customer's paying is sharply reduced, and additional legal costs may never be recouped. On the other hand, the action may deter potential future defaulters.

From the point of view of the salesman every customer is valuable. From the financial director's standpoint the marginal contribution from goods sold to a late payer will be more profitable without sales to that particular customer.

Overdue debts should be the subject of formal discussion between the sales and financial managers. The reasons for delayed payment should be noted, and decisions should be minuted on the action to be taken in each case and the people responsible for taking it.

Although the salesman's job is not complete until his customer has paid the money due, it is often advantageous for the more rigorous collection procedures to be handled by finance staff, leaving the salesman free to exercise his persuasive influence with the customer's buying department.

Cost of Credit Control

The costs of credit control include the cost of:

• assessing and reviewing creditworthiness;

• checking incoming orders;

• sales ledger keeping, and invoicing

• debt collection.

These costs may occur in various departments of the business, but there should be some means of identifying them and collecting the total cost, which will have to be taken into account in reviewing the benefits of the credit policy.
Cash Discount
An alternative or supplement of a formal credit policy is to offer discount for prompt payment. In considering this possibility it is important to bear in mind that:

(a) customers who normally pay promptly will now become entitled to discount, although there will be no improvement in the timing of their payments'.

(b) some late payers will nevertheless deduct discount from their settlements, and there may be some practical difficulty in recovering these incorrect deductions.

There are various other ways in which a business can speed up its collection of cash without requiring the customer to pay any earlier. The most common examples are by using bills discounting or factoring both of which have been mentioned earlier.
Personal Guarantees

An alternative form of protection against bad debts is to take a personal guarantee in support of the customer's account. The value of personal guarantees varies considerably and they are likely to present two problems.

• it may be more difficult to assess the creditworthiness of an individual guarantor than of the trade customer;

• the guarantor does not normally expect to be called upon to pay, and there may be difficulties in obtaining money from him when the need arises.

These problems do not occur to the same extent when the guarantor is another company, often the parent company in the customer's group.

So the objective of the receivables management remains as the most effective way to receive the cash back without sacrificing the sales and future prospects of the company.

Payables Management
When the company gets the trade credit, it would like to pay back as late as possible, because these are the funds that require no interest payments and are free of cost. Right. Wrong, these funds are not free of cost because the sale price of these already includes the cost of the time for which the credit is given.

Cost of Trade Credit
For purposes of measuring the true cost, or the effective annual rate of interest associated with use of trade credit as a discretionary source of short-term business funds, it is necessary to consider the effects of its use both when :

(1) a company fails to take its cash discounts but nevertheless pays within the net period, and

(2) a company fails to take its discounts and allows its payable to become overdue.

These two situations are the only ones that involve an actual cost to the debtor. If no cash discount is offered, then there is no cost for the use of credit during the "net" period, however long it may be. By the same token, if a discount is available and the buyer takes it, there is also no cost for the use of credit during the discount period. However, if a cash discount is offered and is not taken, there is an explicit opportunity cost for the use of third credit.

For example, the Road Company purchases it raw materials on terms of 2/10 net 30. It thus has the option of using the funds for 20 days after the discount period if it "passes" the discount but pays on the final day of the net period. Road Co., however, must pay 2 % of the privilege of using the funds for 20 days. It is given by the equation:

R = C(365 D)
D (100-C)
C = the cash discount
D = the number of extra days Road has the use of the
supplier’s funds
R = the annual interest rate for the use of these funds

In our example, C = 2 percent, D = 20: the effective annual interest rate for the company would be
R = 2 (365) 37.24 per cent
20 (100-2)

Thus, we see that passed discounts can transform trade credit from a normally easy sources of funds into a very expensive form of short-term financing. Therefore, if other financing is available even though with high interest rates, say 20 or 24%, Road's financial administrator would be well advised to borrow in sufficient time so that it can take advantage of any cash discounts offered by its suppliers.

Sometimes companies that are short of cash and lack reserve borrowing power may be forced to not only pass up cash discounts but also postpone payment beyond the net period. This practice is referred to as "stretching" accounts payable or "riding" trade creditors.

There are two types of costs incurred by a company that stretches its accounts payable

(1) the explicit cost of discounts foregone, as outlined above, and

(2) the implicit cost of permitting its trade credit rating to deteriorate.

If a company rides its creditors excessively, so that its trade payable become noticeably delinquent, its credit rating among all suppliers in the trade will surely suffer. They will view the company as increasingly risky to sell to and may quickly begin to impose rather strict terms of sale, upto and including COD or CBD.

Proper Use of Trade Credit
As compared with other kinds of short-term business credit -- bank loans, for example-trade credit is almost automatic. And because it may be much more readily acquired, business companies must exercise continuing care to avoid falling into the habit of using trade credit to excess.

Because suppliers regard the extension of trade credit as a part of their overall sales promotion programs, they often extend trade credit to many marginally creditworthy companies-small, new companies and old, declining companies-that do not qualify for and consequently cannot obtain credit from other sources of short-term funds. It is also quite easy to get into debt through the use of trade credit.

A company needs only to order additional goods from its suppliers; and if it is occasionally late in making payment, the sales promotion aspect of trade credit extension may prompt suppliers to "look the other way," so that the company's credit reputation may suffer no immediate harm.

Finally, trade credit is exceedingly useful and valuable precisely because business companies can usually obtain it when, as, and to the extent that it is needed. When inventory should be increased to anticipate the seasonal expansion of sales, for example trade credit will automatically finance a part of the increase. Then, as the seasonal sales convert into cash through collections, the company may use the funds to reduce trade payable. For this reason, trade credit is often termed a "spontaneous" source of funds.

Thus, a company's financial officer while assuring that his company benefits from the availability of trade credit in every legitimate way, should always maintain the business liquidity required to pay all his company's bills as they come due. Beyond this, even considering the extremely high cost of passing discounts, he should certainly plan to pay all of his company's trade bills within the discount period. Doing so will have favourable results, not only on the company's credit reputation in the trade but, more important, on its current and long-run profitability as well.

In a negative but equally significant sense, doing so will automatically avoid the possible financial over extension of the company that could result from its succumbing to the temptation to use trade credit excessively "because it is there".

Inventory Management
The financial decisions relating to stockholding have certain special features, but looking first at saleable stocks (finished goods) we can postulate that the object of holding stocks is to increase sales, and that the object of increasing sales is to increase profit. We can then create a simple model similar to that for debtors.

The Retail Company Ltd makes cash sales from stock and obtains an average rate of marginal contribution of 25% on sales value. When it holds stocks equivalent to one month’s cost of sales it achieves sales of Rs.10,000 per annum.
It is estimated that by doubling the stock available an increase of 25% in sales value could be achieved; alternatively, if three months’ stocks were held then sales could be increased by 35% from the present level. The effect on profits of these two alternatives, including any relevant changes in costs, is illustrated on the following page.
This somewhat exaggerated example draws attention to three points which are relevant to any further discussion of the financial implications of stockholding policy:
Rs. No credit One month’s Credit Two month’s Credit

Sales 120,000 160,000 240,000
Debtors 13,333 40,000
Stocks (less creditors (Say, 1/12 of sales value) 10,000 13,333 20,000
Total 10,000 26,666 60,000
Increase in working capital through granting credit 16,666 50,000
Marginal contribution 30,000 40,000 60,000
Less: Cost of:
Credit control (6,000) (6,000)
Bad debts (1,600) (4,800)
Relevant comparable profits 30,000 32,400 49,000
Increase in profits 2,400 19,200

But the company requires a return of 15% on the increase in capital employed; i.e. 2,500 7,500

The net advantage (or disadvantage) of the proposed changes in credit policy is therefore (Rs.100) Rs.11,700

There are some points that you need to note here:
• There may be a point beyond which further increase in stock will not give rise to sufficient additional sales and gross profit to justify the additional costs involved.
• Purchase order processing costs per unit or Rs. value of purchases ( and possibly even in total as shown) are likely to diminish as stock holdings are increased, because instead of having to frequent orders for the renewal of stocks, the company is now placing less frequent bulk orders i.e. one negotiation, one order and one progress action cover a large quantity of any particular item;
• Stock holding costs naturally increase with the size of stockholdings because:
1. stocks occupy space which has to be purchased, rented or converted from some other use - that space has to be equipped with racks or containers;
2. people are required to put the stocks into the warehouse, to withdraw them when needed (picking and packing), to record them, check their conditions and ensure they are not lost;
3. stocks lose value if they deteriorate, are wasted in handling, pilfered, destroyed or allowed to become obsolete - it may be desirable to insure against some of these risks;
4. stocks tie up money, involving interest charges or opportunity costs.
Why should increased stocks give rise to increased sales? One reason would be that the business may offer a wider range of goods and it diversifies its range. Another could be that with the existing range the business was offering a better level of service; i.e. it was less frequently out of stock of an item when it was required.
Stock Service Levels

In deciding on an inventory policy it is necessary to define the level of service to be offered to the customer, in the sense of the percentage of order which can be satisfied immediately from stock. This will depend on the nature of the business.
In some cases the company may be the monopoly supplier of certain goods, or may offer particular advantages of quality, reputation., reliability or after-sales services. Where such distinguishing features exist, it is possible that the customers will be prepared to endure occasional delays in meeting their requirements, and it would not be necessary to hold sufficient stocks to ensure immediate delivery.
In other cases quick delivery may be an essential feature of success in achieving sales. This would be the case, for example, if there was strong competition for a limited market, or if the failure to supply a spare part for installed equipment would cause significant loss to the customer while the equipment was out of use.
When the required level of service has been defined, the next problem is to decide how much stock is needed to meet that requirement. This will be the minimum holding, and not the average holding which will be influenced by the stockholding costs illustrated in the previous paragraph.
Pattern of Procurement and Stockholding
Assuming that an item is in constant demand there are no difficulties in obtaining supplies, it would be normal to take a supply into stock and then use it up steadily until it was exhausted, when a new supply would be obtained. Taking the example from the paragraph on control of stock where sales were to be Rs.1,35,000 per annum, assume, that this represents 1,35,000 units of an item of stock at Rs.1 each. If demand is steady, the monthly usage of this item would be 11,250 units.

Now it would be possible to buy all 1,35,000 units at the beginning of the year and to use them progressively as shown in the following diagram:

If this was done then:

• there would be only one purchase, so the related costs in the buying department would be low;

• the average stock holding would be 62,500 units, so there would be 62,500x12 = 7,50,000 unit-months to influence the costs of stock-holding.

An alternative action would be to buy twice during the year, as shown in the next diagram. This would double the procurement costs, but would reduce the average stockholding to 31,250 units so that stockholding costs would be determined by only half the previous number of unit-months.

There is obviously a very large choice of procurement and stockholding patterns; what is needed is to find that pattern which keeps total procurement and holding costs at the lowest possible level.

This means that carrying costs increase with the quantity of inventory on hand and as the inventory go down the carrying costs also go down. But with the declining amount of inventory held restocking costs go up as there are more number of orders and more number of receipts of orders. As total costs are the sum of the carrying and restocking costs we need to find a level where it is minimum. This is depicted graphically in the figure 18.5 above.

Mathematically speaking carrying costs are given by:

Here Q/2 is the average inventory, I the interest rate and P the price per unit.
Similarly Restocking Costs are given by

Here S = total quantity consumed in a year.
As we know that total costs are a sum of these two individual costs. We can say
But this doesn't give us the optimum size of the inventory order. For finding the minimum costs we need to find the 'economic order quantity' for the particular item of stock under review. The effect of the combination of the various items of stock into the total business inventory will be discussed later.

Economic Order Quantity (EOQ)
The economic order quantity is defined as a point where the total costs of restocking and carrying costs are the lowest.

EOQ is usually calculated by a formula based on differential calculus. Though we will not derive the formula we need to understand its working.

There are four assumptions that we make in the EOQ model:

1. Sales can be forecasted perfectly,
2. Sales are evenly distributed throughout the year, and
3. Orders are received as soon as they are placed.

This set of assumptions mean is pretty restrictive and we will relax these assumptions slowly. Before we relax these assumptions there are two important things to note about the EOQ:

1. Although a mathematically precise EOQ can be calculated, in practice there is likely to be a range of order quantities within which total costs remain at a low level. The choice of order quantity within this low-cost range may not significantly affect the overall financial plan.

2. The key factor in the calculations is usually the cost of capital (interest on stockholdings). In times of high interest rates this is likely to outweigh all the other variables. The inventory holding costs will go up very steeply, and one's conclusion will be that stockholdings should be kept to the lowest figure possible having regard to any practical difficulties in obtaining frequent replacement supplies.

Optimum Order Quantity (OOQ)
The last comment above is a reminder that suppliers do not like handling small orders. The purchase price per unit, therefore, may vary with the size of the purchase order, and this will require a modification to our EOQ calculation.

The supplier might, for example, impose a 'minimum order value' so that for quantities below this limit the cost per unit would, in effect, be higher than normal. This would either impose a lower cut-off limit on the size of order placed, or would introduce an upward curve at the lower end of the holding cost line on the EOQ chart, since insurance and interest charges per unit would be relatively high until the small order limit was reached. For larger orders, on the contrary, there might be quantity discounts, and these would cause one or more downward steps at those points on the holding cost line where they began to operate.

This possibility can result in minimum total cost which differs from the position of the EOQ as originally calculated. This point is sometimes distinguished as the 'optimum order quantity'.

Safety Margins in Stockholding
So far we have assumed that a company will he placing purchase orders at regular intervals of time for a fixed quantity (the economic or optimal order quantity) of any particular item. The possibility of doing this depends on demand remaining constant from period to period and on supplies being available as and when required.

Sales demand, however, could show fluctuations around the normal level, so that in a period of high demand the available stock could be used up before fresh supplies are due. Similarly, in some periods deliveries from suppliers could be delayed so that even the normal sales demand could not be satisfied.

Against both these contingencies, it is necessary to hold a safety margin of stock. If it were necessary to hold a safety margin sufficiently large to cover the simultaneous occurrence of a peak in demand and a delay in supplies, then the minimum stockholding would form the greater part of the total stockholding.
Very little can be done to correct for random delays in supply, but it may be possible to anticipate changes in the trend of demand and to modify the purchasing procedure to meet them in one of the following ways:

• to order in economic order quantities but at varying time intervals according to the rate of demand currently being experienced, or anticipated in the near future - this is known as the fixed order quantity or re-order level system (for reasons which will be explained below);

• to order at regular intervals but in varying quantities determined by the current rate of demand - this is the fixed interval, or periodic review

Modified Ordering Systems
The re-order level system involves deciding a level of stockholding at which new purchase orders shall be placed. This will be decided in relation to the normal rate of issues during the normal purchasing lead time. The quantity to be ordered is constant, and an order for that quantity will be placed whenever stock falls to the pre-determined order level. The system thus responds quickly to variations in demand though there is a danger that in doing so it may reflect purely short term or random fluctuations in sales.

The operation of re-order level system include the use of:

• A maximum stock level. This would correspond to the normal peak holding under stable conditions. If the stockholding exceeds the peak level this provides a warning that demand has been running below the rate expected when the EOQ was fixed. The stock controller should then review the correctness of his standard purchase order quantity

• a minimum stock level which, as suggested above, is probably the amount of the safety margin.

The minimum stock level provides a warning of a potential out-of-stock position. When a stockholding falls to that level the stock controller will review his outstanding purchase orders and their due dates, and also the current trend of demand, and can then decide whether additional emergency procurement is necessary.

Under the periodic review system purchase orders are placed at fixed intervals of time but the quantity ordered can be modified to meet the rate of demand indicated by current experience. This gives an opportunity for analysing the trend of demand, and various techniques such as 'exponential smoothing' can be used in forecasting this trend. The system does not respond rapidly to immediate needs, and it may therefore necessitate a larger safety margin than the re-order level system.

It is, in fact, a common experience that the re-order level system gives slightly lower average stock levels, and it is sometimes thought to be the cheaper system to operate because reordering is triggered automatically at the re-order levels, however, requires reviewing in the light of changes in the rate of demand. Any system can appear cheap in the short run if it is operated in a slovenly manner.

Infrequent and Seasonal Demand
In most inventories it will be necessary to carry items which are slow moving in the sense that units of demand are separated by significant intervals of time. These items may have high individual value but because they are demanded infrequently they will probably contribute only a small percentage of the total annual value of sales. The normal distribution of stockholdings would show that about 20% of the line items carried would contribute 80% of the total annual usage, though this relationship will vary between different types of business.

It may be decided not to hold stocks of some slow-moving items, but to procure them as and when they are required. If a stock is needed however the amount held will probably be limited to the quantity most likely to be next demanded, the occurrence of the demand being the signal for further procurement action. The quantity held may, however, be increased if the purchase price per unit is sufficiently lower for large quantities so as to offset any increase in holding costs for a larger stock holding. This could occur for example when the supplier imposed a minimum order value.

There should be a regular review of slow-moving items to identify stocks which have become technically obsolete or for which the demand has diminished to the point where stock holding is no longer justified.

In some businesses (for example, ladies fashion wear), it is necessary to place orders for the full seasonal requirement well in advance of the demand occurring, with a high probability that repeat orders will not be obtainable. In such instances the purchase and sale of each batch will be a separate project or venture dependent heavily on accurate forecasting of demand quantities and selling prices. In this case, the evaluation procedure applicable to stock holding for continuous demand will not apply.

Of a similar nature will be decisions like the following:

• to purchase goods in bulk in advance of demand arising in order to protect the business against anticipated price rises or shortages of supply;

• to purchase commodities forward at a fixed price for future delivery;

• to combine forward purchase options with forward sales options, so as to limit losses arising from price changes (including changes in currency exchange rates);

• to purchase foreign currency forward against specific overseas purchases, so as to minimise the effect of changes in exchange rates.

These are financial decisions quite separate from the routine problems of inventory control, and would be evaluated as investment projects.

The Total Inventory
The techniques described in the foregoing paragraphs all relate to single line items of stock; the assumption has been made that if each item is held at its own economic level then the overall holding of stock will be correctly balanced. This would be true provided that two conditions were satisfied.

• that there was enough space available to hold all the stocks required; and

• that enough money could be found to finance them.

Neither condition is likely to be fulfilled in practice, so some form of mathematical programme might be used to constrain the ideal unit quantities within the limiting factors. There are, however, a number of simple pragmatic approaches to inventory reduction, and these include:

• modifying the service level offered, either generally or in relation to selected items;

• letting the company's suppliers act as stockholders (possibly by placing bulk orders with schedules of call-off dates linked to sales demand);

• discontinuing those items which are the least profitable having regard to their marginal contribution and relevant fixed costs per unit of the limiting factor.

Raw Material Stocks and Work-In-Progress
So far, in considering inventory control we have been discussing saleable stocks, but the same principles apply to stocks of raw materials. The main difference is that demand for raw materials is not direct from the outside customers but indirect through the production plans of the factory using the raw materials.

In considering the scheduling of production the 'Economic Batch Quantity' (EBQ) corresponds to the EOQ for purchased items. Manufacture in small batches will be more costly than in larger batches because there will be greater repetition of planning and progress actions and of the setting up and breaking-down of machine tooling, and also because there will be less opportunity for an efficient momentum of work to be established. However, these batch processing costs (like procurement costs of stocks) will change inversely to the holding costs of the work-in-progress (floor space, insurance, interest on capital, etc.).

A big problem with work-in-progress is that work passes in sequence through a series of operations. What is an economic batch for lathe work may not be economic for drilling, milling or assembly operations. Applying EBQ calculation to one operation in isolation can cause bottlenecks in the flow or production - creating excessive holdings of partly-completed work because it could be produced cheaply in a large batch, even though there will be no demand for that work for some time ahead.

A similar problem is that of keeping skilled work people steadily occupied, since their wages are basically fixed in relation to time, even though outside customer demand may be seasonal or erratic.

Because these problems are concerned with the uneven timing of cash flows they are best solved by the use of discounted cash flow techniques. If, however, there is a capability of a rate of production which is in excess of a steady rate of demand (internal or external) then the problem is to decide what is the economic length of a production run, the facilities then being switched to other work until the next run is required.

As the number of items could be very large in case of raw materials it is necessary to find ways to selectively pay attention to those items that represent the highest value. A categorisation method known as ABC analysis is used for the same purpose. The idea behind ABC analysis is that attention is focussed on the highest value items that are usually small in number categorised as A-category items and the lowest value items are categorised as C and are ordered in more quantities so that less attention is required there.

For example in the figure 18.6 below, the A category items represent only 10 % of total inventory items but represent 57 % of the total value. While C category items represent 50 % of the total items but only 16 % of the value. By concentrating more on the A category items the company is able to manage its raw material inventory better.

Integrated Short Term Funds Planning
Short-term financial planning is concerned with the management of the company's short-term, or current assets and liabilities. The most important current assets are cash, marketable securities, inventories and accounts
receivable. The most important current liabilities are bank loans and accounts payable.
Current assets and liabilities are turned over much more rapidly than the other items on the balance sheet. Short-term financing and investment decisions are more quickly and easily reversed than long term decisions. Consequently, the financial manager does not need to look too far into the future when making them.

The nature of company's short term financial planning problem is determined by the amount of long term capital it raises. A company that issues large amounts of long term debt or equity, or which retains a large part of its earnings, may find that it has permanent excess cash. In such cases there is never any problem paying bills, and short term financial planning consists of managing the company's portfolio of marketable securities. Companies with permanent excess cash should look at the cost of funds and pay them out to the shareholders if they are earning less than the cost of funds.

Other companies raise relatively little long term capital and end up as permanent short term debtors. Most companies attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long term debt. This may even be required by the bank to be so. Such companies may invest cash surpluses during part of the year and borrow during the rest of the year.

The starting point for short term financial planning is an understanding of sources and uses of cash. Companies forecast their net cash requirements by forecasting collections on accounts receivable, adding other cash inflows, and subtracting all forecasted cash outlays.

If the forecasted cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, you will need to find additional finance. It may make sense to raise long term finance if the deficiency is permanent and large. Otherwise you may choose from a variety of sources of short term finance.

In addition to the explicit costs of short term financing, there are often implicit costs. The financial manager must choose the financing package that has lowest total cost (explicit and implicit costs combined) and yet leaves the company with sufficient flexibility to cover contingencies.

Short Term Financial Planning Model
Working out a consistent short term plan requires burdensome calculations. Fortunately much of the arithmetic can be delegated to a computer. Many large companies have built models to do this. Smaller companies do not face so much detail and complexity and find it easier to work with a spreadsheet programme on a personal computer.

In either case the financial manager specifies forecasted cash requirements or surpluses, interest rates, credit limits, etc. and the model grinds out a plan. The computer also produces balance sheets, income statements, and whatever special reports the financial manager may require.

Smaller companies that do not want custom built models can buy general purpose models offered by accounting companies, management consultants or specialised computer software companies.

Most of these models are simulation programmes. They simply work out the consequences of the assumptions and policies specified by the financial manager. Optimisation models for short term financial planning are also available. These models are usually linear programming models. They search for the best plan from a range of alternative policies identified by the financial manager.

Optimisation helps when the company faces complex problems with many interdependent alternatives and restrictions for which trial and error might never identify the best combination of alternatives.

Of course the best plan for one set of assumptions may prove disastrous if the assumptions are wrong. Thus, the financial manager has to explore the implications of alternative assumptions about future cash flows, interest rates and so on. Linear programming can help identify good strategies, but even with an optimisation model the financial plan is still sought by trial and error.

In defining short term finance, we focus on the cash flows connected with the operations of a company. Short term financial management thus encompasses decisions about activities that affect cash inflows, cash outflows, liquidity, backup liquidity, and internal cash flows. Many decisions of a company have a short term financial management aspect.
Components of Working Capital include: Cash, Short term investments, Trade Debtors, Inventory and Trade Creditors. Bank Overdraft or Cash Credit and Short Term Borrowings are tow of the major ways of financing working capital.
Working parameters of a company influence the composition mix of various components of working capital. Whether the company does made to order work or it keeps stock in inventory? Whether it is manufacturing company or a trading company? Single product companies normally operate with a lower quantum of working capital than a multi-product or multi-process companies.
The size of the company’s investment in current assets is determined by its short-term financial policies. A company keeping a flexible working capital policy means that the company is very liberal in its trade terms and has invested a large amount of funds in its operations. This means that the company borrows as the seasonal needs grow to fund its working capital needs. Flexible policy means that company is carrying excess cash and hence bearing higher carrying costs than the other two policies. As the level of working capital increases, shortage costs go down while the carrying costs increases.
There are other factors Influencing Working Capital including: Profit levels, Tax Levels & Planning, Depreciation Policy and Operating Efficiency of the company.
Operating efficiency of an company plays a major role in working capital management. An efficient company will have a shorter manufacturing period, long credit terms available from suppliers and minimal customers credit outstanding.
If we are getting trade credit to fund our needs, we also have to extend trade credit to our customers. This involves various costs including:
1. Cost effects: Extending credit means that the company has to maintain a credit department. This

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