Ba7202 financial management (unit4) notes

Financial Management Semester II

S.N.Selvaraj, Assistant Professor, E-mail: [email protected]

UNIT – IV: WORKING CAPITAL MANAGEMENT

Principles of Working Capital: Concepts – Needs – Determinants – Issues and

Estimation of Working Capital – Accounts Receivables Management and Factoring

– Inventory Management – Cash Management – Working Capital Finance: Trade

Credit – Bank Finance and Commercial Paper

PRINCIPLES OF WORKING CAPITAL

Working Capital refers to the cash a business requires for day-to-day operations or

more specifically, for financing the conversion of raw materials into finished goods,

which the company sells for payment. Among the most important items of working

capital are levels of inventory, debtors and creditors. These items are looked at for

signs of a company‟s efficiency and financial strength.

There are four principles of working capital:

Definitions of Working Capital

According to Shubin, “Working capital is the amount of funds necessary to cover the

cost of operating the enterprise”

According to Gerestenberg, “Circulating capital means current assets of a company

that are changed in the ordinary course of business from one form to another, as for

example, from cash to inventories, inventories to receivable, receivables into cash”.

Working capital, in general practice, refers to the excess of current assets over current

liabilities. Management of working capital therefore, is concerned with the problems

that arise in attempting to manage the current assets, the current liabilities and the

inter-relationship that exists between them. In other words it refers to all aspects of

administration of both current assets and current liabilities. It is also known as

revolving or circulating capital or short-term capital.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital:

1) Gross Working Capital

2) New Working Capital

Principles of Working Capital

Principal of Risk Variation Principle of Cost Capital

Principal of Equity Position Principle of Maturity Payment



Gross Working Capital

In broad sense, the term working capital refers to the gross working capital and

represents the amount of funds invested in current assets. Thus, the gross working

capital is the capital invested in total current assets of the enterprise. Current assets are

those which in the ordinary course of business can be converted into cash within short

period of normally one accounting year.

Components of Current Assets

1) Cash in hand

2) Cash at bank

3) Bills receivables

4) Sundry debtors (or) Accounts receivable

5) Short-term loans and advances

6) Inventories of stocks

7) Temporary investment of surplus funds

8) Prepaid expenses

9) Accrued incomes

Net Working Capital

In a narrow sense, the term working capital refers to the net working capital is the

excess of current assets over current liabilities.

Net Working Capital = Current Assets – Current Liabilities.

New working capital may be positive or negative. When the current assets exceeds the

current liabilities the working capital is positive and vice versa.

Current liabilities are those which are intended to be paid in the ordinary course of

business within a short period of normally one accounting year out of the current

assets or the income of the business.

Components of Current Liabilities

1) Bills payable

2) Sundry creditors (or) Accounts payable

3) Accrued or Outstanding expenses

4) Short-term loans, advances and deposits

5) Dividends payable

6) Bank overdraft

7) Prepaid expenses

8) Provision for taxation



NEEDS OF WORKING CAPITAL

Working capital is needed for the following purposes:

DETERMINANTS OF WORKING CAPITAL

Following are the determinants generally influencing the working capital

requirements.

Needs for Working Capital

Replenishment of Inventory Provision for Operating Expenses

Support of Credit Sales Provision of a Safety Margin

Factors Determining Working Capital

Nature or Character of Business Size of Business

Production Policy Manufacturing Process

Seasonal Variations Working Capital Cycle

Rate of Stock Turnover Credit Policy

Business Cycles Rate of Growth of Business

Dividend Policy

Price Level Changes

Tax Level Other Factors



ISSUES OF WORKING CAPITAL

The financial manager must determine levels and composition of current assets. He

must see the right sources are tapped to fiancé current assets, and that current

liabilities are paid in time. There are many aspects of working capital management

which make it an important function of the financial manager:

1) Components: Components such as cash, marketable securities, receivables and

inventories.

2) Time: Working capital management requires much of the financial manager‟s

time. Time as either permanent or temporary working capital.

3) Investment: Working capital represents a large portion of the total investment in

assets.

4) Criticality: Working capital management has great significance for all firms but

it is very critical for small firms.

5) Growth: The need for working capital is directly related to the firm‟s growth.

Profitability-Liquidity Trade-Off

To maximize shareholder‟s wealth, optimal level of current assets should be

determined. There is always a conflict between the liquidity and the profitability

objectives. If current assets are held at a level more than the required one, profitability

is eroded; though there is enough liquidity. If current assets are maintained at a level

less than required, the solvency of the firm is threatened.

Therefore, a proper balance is to be maintained between these two so that profitability

is maximized without sacrificing solvency. Thus, a trade-off between risk and return is

attempted to be struck off. The optimum level is the point where the total cost is the

minimum.

Policies/Strategies to Working Capital

So far the banks were the sole source of funds for working capital needs of business

sector. At present more finance options are available to a finance manager to see the

operations of his firm go smoothly. Depending on the risk exposure of business, the

following strategies are evolved to manage the working capital.

Matching

Policy

Policies/Strategies Working Capital

Aggressive

Policy

Conservative

Policy

Zero Working Capital

Policy



Matching Strategy

The firm can adopt a financial plan which involves the matching of the expected life

of assets with the expected life of the source of funds raised to finance assets. Thus, a

ten year loan may be raised to finance a plant with an expected life of ten years; stock

of goods to be sold in thirty days may be financed with a thirty-day bank loan and

soon.

Financing Strategy of Matching Strategy

Long-term funds = Fixed assets + Total permanent current assets

Short-term funds = Total temporary current assets

Conservative Strategy

Under a conservative plan, the firm finances its permanent current assets and a part of

temporary current assets with long term finance; it stores liability by investing surplus

funds into marketable securities. The conservative plan relies heavily on long-term

financing and therefore, is less risky.

Financing Strategy of Conservative Strategy

Long-term funds = Fixed assets + Total permanent current assets + Part of

temporary current assets

Short-term funds = Part of temporary current assets

Aggressive Strategy

A firm may be aggressive in financing its assets. An aggressive policy is said to be

followed by the firm when it uses short-term financing than warranted by the

matching plan. Under an aggressive policy, the firm finances a part of its permanent

current assets with short-term financing; some extremely aggressive firms may even

finance a part of their fixed assets with short-term financing. The relatively more use

of short-term financing makes the firm more risky.

Financing Strategy of Aggressive Strategy

Long-term funds = Fixed assets + Part of temporary current assets

Short-term funds = Part of temporary current assets + Total temporary

current assets

Zero Working Capital Strategy

This is one of the latest trends in working capital management. The idea is to have

zero working capital, i.e. at all times the current assets shall equal the current

liabilities. Excess investment in current assets is avoided and firm meets its current

liabilities out of the matching current assets.

Financing Strategy of Zero Working Capital Strategy

Total Current Assets = Total current liabilities (or)

Total Current Assets minusTotal current liabilities = Zero



ESTIMATION OF WORKING CAPITAL

A firm must estimate in advance as to how much net working capital will be required

for the smooth operations of the business. Only then, it can be bifurcated into

permanent working capital and temporary working capital. This bifurcation will help

in deciding the financing pattern i.e. how much working capital should be financed

from long term sources and how much be financed from short term sources.

There are different approaches available to estimate the working capital requirements

of a firm as follows:

1) Working Capital as a Percentage of Net Sales: This approach is based on the

assumption that higher the sales level, the greater would be the need for working

capital.

(a) To estimate total current assets as a % of estimated net sales.

(b) To estimate current liabilities as a % of estimated net sales and

(c) The difference between the two above is the net working capital as a % of

net sales.

2) Working Capital as Percentage of Total Assets or Fixed Assets: This approach of

estimation of working capital requirement is based on the fact that the total assets of

the firm are consisting of fixed assets and current assets. On the basis of past

experience, a relationship between

(a) Total current assets i.e. gross working capital; or net working capital,

i.e. current assets – current liabilities.

(b) Total fixed assets or a total asset of the firm is established. For example, a

firm is maintaining 20% of its total assets in the form of current assets and

expects to have total assets of Rs.50,00,000 next year. Thus, the current assets

of the firm would be Rs.10,00,000 (i.e. 20% of Rs.50,00,000).

3) Working Capital Based on Operating Cycle: The concept of operating cycle, helps

determining the time scale over which the current assets are maintained. The

operating cycle for different components of working capital gives the time for which

an asset is maintained, once it is acquired. However, the concept of operating cycle

does not talk of the funds invested in maintaining these current assets. It can

definitely be used to estimate the working capital requirements for any firm.

The different components of working capital may be enumerated as follows:

Current Assets Current Liabilities

Cash and Bank balances Creditors for purchases

Inventory of raw material Creditors for expenses

Inventory of work-in-progress

Inventory of finished goods

Receivables



Proforma for Assessment and Computation of Working Capital

(For Trading Concern) Statement of Working Capital Requirements

Amount Rs.

Current Assets: i) Cash - - ii) Debtors or Receivables (for …. month‟s sale) - - iii) Stocks (for …. month‟s sale) - - iv) Advance payments, if any - - v) Others - - Less: Current Liabilities - -

i) Creditors (for …. month‟s sale) - -

ii) Lag in payment of expenses

(outstanding expenses, if any) - -

Working Capital (CA – CL) - - Add: Provision / Margin for contingencies - - Net Working Capital Required - -

Proforma for Assessment and Computation of Working Capital

(For Manufacturing Concern) Statement of Working Capital Requirements

Amount Rs.

Current Assets: 1) Stock of raw material (for ….. month‟s consumption) - 2) Work-in-progress (for …… months): -

i) Raw materials - -

ii) Direct labour -

iii) Overheads - 3) Stock of finished goods (for …. month‟s sale) -

i) Raw materials - -

ii) Labour -

iii) Overheads - 4) Sundry Debtors or Receivables (for …. month‟s sale) -

i) Raw materials - - ii) Labour -

iii) Overheads - 5) Payments in Advance (if any) - 6) Balance of Cash (Required to meet day-to-day expenses) - 7) Any other (if any) - Less: Current Liabilities -

i) Creditors (for …. month‟s purchases of raw material) -

ii) Lag in payment of expenses (outstanding expenses) -

iii) Others (if any) - Add: Provision / Margin for Contingencies - Net Working Capital Required -



Problem: EXE Ltd. is engaged in large-scale consumer retailing. From the following

information, you are required to forecast their working capital requirement:

a) Project annual sales – Rs.65 lacs.

b) Percentage of net profit on cost of sales – 25 percent

c) Average credit period allowed to debtors – 10 weeks

d) Average credit period allowed by creditors – 4 weeks

e) Average stock carrying (in terms of sales requirement) – 8 weeks

f) Add 10 percent to compute figures to allow for contingencies.

Solution

Rs.

Project annual sales 65,00,000

Project sales per week 1,25,000

Less: Net profit (25% on cost = 20% on sales) 25,000

Projected cost of goods per week 1,00,000

Working Capital Requirement Forecast

1) Current Assets: Rs. Rs.

Stock (1,00,000×8) 8,00,000

Debtors (1,25,000×10) 12,50,000 20,50,000

2) Current Liabilities

Creditors (1,00,000×4) 4,00,000 4,00,000

3) Working Capital (1 – 2) 16,50,000

Add: 10 percent for contingencies 1,65,000

4) Total requirement 18,15,000

Problem: The Board of Directors of Ruby Ltd. requests you to prepare a statement

showing the working capital requirements forecasts for a level of activity of 1,56,000

units of production. The following information is available for your calculation.

(Rs. Per Unit)

Raw material 90

Direct labour 40

Overheads 75

205

Profit 60

Selling pricing per unit 265

a) Raw materials are in stock on average one month

b) Materials are in process, on average 2 weeks

c) Finished goods are in stock, on average one month

d) Credit allowed by supplier – one month

e) Time lag in payment from debtors – 2 months

f) Lag in payment of wages – 1½ weeks

g) Lag in payment of overheads – one month



20% of the output is sold against cash. Cash in hand and at bank is expected to be

Rs.60,000. It is to be assumed that production is carried on evenly throughout the

year. Wages and overheads accrue similarly and a time period of 4 weeks is

equivalent to a month.

Solution

Statement of Working Capital Required

Current Assets: Rs. Rs.

Cash in hand and cash at bank 60,000 Stock in hand

Raw material 10,80,000

Work-in-process 8,85,000

Finished goods 24,60,000 44,25,000

Sundry Debtors 39,36,000

84,21,000 Current Liabilities:

Sundry creditors 10,80,000

Wages payable 1,80,000

Expenses payable 9,00,000 21,60,000

Net working capital employed (CA–CL) 62,61,000

Working Notes

1) Raw material = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000

52 weeks

2) Work-in-progress= 1,56,000 units × 2weeks = 6,000 units

52 weeks

Raw materials (6,000 units @ Rs.90) 5,40,000

Wages (6,000 units @ Rs.40×½) 1,20,000

Overheads (6,000 units @ Rs.75×½) 2,25,000

Total value of WIP 8,85,000

3) Finished goods = 1,56,000 units × 4 weeks×Rs.205 = Rs.24,60,000

52 weeks

4) Debtors = 1,56,000 units × 8 weeks×Rs.205×80 = Rs.39,36,000

52 weeks 100

5) Creditors = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000

52 weeks

6) Wages = 1,56,000 units × 1.5 weeks×Rs.40 = Rs.1,80,000

52 weeks

7) Expenses = 1,56,000 units × 4 weeks×Rs.75 = Rs.9,00,000

52 weeks



ACCOUNTS RECEIVABLES MANAGEMENT

Receivables represent amounts owed to the firm as a result of sale of goods or services

in the ordinary course of business. These are claims of the firm against its customers

and form part of its current assets. Receivables are also known as accounts

receivable, trade receivables, customer receivables or book debts.

Meaning of Receivables

Receivables management is the process of making decisions relating to investment in

trade debtors. Certain investment in receivables is necessary to increase the sales and

the profits of a firm. But at the same time investment in this asset involves cost

considerations also. Further, there is always a risk of bad debts too.

Definition of Receivables

According to Hampton, “Receivables are asset accounts representing amount owned

to firm as a result of sale of goods or services in ordinary course of business.”

Objectives of Receivables Management

The objectives of receivables management are to improve sales, eliminate bad debts

and reduce transaction costs incidental to maintenance of accounts and collection of

sales proceeds and finally enhance profits of the firm. Credit sales help the

organization to make extra profit. It is a known fact; firms charge a higher price,

when sold on credit, compared to normal price.

Cost of Maintaining Receivables

Cost of Financing:

Administration Cost:

Delinquency Costs:

Cost of Default by Customers: Factors Affecting the Size of Receivables

Besides sales, a number of other factors also influence the size of receivables. The

following factors directly and indirectly affect the size of receivables.

a) Size of Credit Sales:

b) Credit Policies: c) Terms of Trade: d) Relation with Profits: e) Credit Collection Efforts

f) Stability of Sales:

g) Size and Policy of Cash Discount: h) Bill Discounting and Endorsement:



Importance of Receivables Management

FACTORING

The word „factoring’ has its origin from Latin „factor‟ which means „doer‟. The

Webster‟s New Collegiate Dictionary defines a factor as “one who lends money to

producers and dealers on the security of accounts receivables”.

Factoring is a financial transaction whereby a business sells its accounts receivables

(i.e. invoices) to a third party (called a factor) at a discount in exchange for immediate

money with which to finance continued business.

Definition of Factoring

According to C.S.Kalyanasundaram, “Factoring is the outright purchase of credit

approved account receivables with the factor assuming bad debt losses”.

According to AlamCalpin, “Factoring is a system designated to eliminate payment risk

in overseas sales and ensure that the seller receives prompt settlements”.

A factor is thus a financial institution which manages the collection of account

receivables of the companies on their behalf and bears the credit risk associated with

those accounts. In general, factoring means selling, with or without recourse, the

receivables by the firm to a factor. By factoring, the company relieves itself of the

organization, procedures and internal expenses of collecting its receivables.

There are three main parties in factoring arrangements:

1) The Factor

2) The Client (seller)

3) The Customer (buyer)

The arrangements are governed by a contract between the factor and the client, and

this contract is for a fixed period, usually a year, which is normally renewed

automatically. The contract can be cancelled only with sufficient prior notice.

Importance of Receivables Management

Determining Credit Policy

Determining Credit Terms

Evaluating the Credit Application

Determining Collection Policies and Methods

Control and Analysis of Receivables



Features of Factoring

a) The period for factoring is 90 to 150 days. Some factoring companies allow

even more than 150 days.

b) Factoring is considered to be a costly source of finance compared to other

sources of short-term borrowings.

c) Factoring receivables is an ideal financial solution for new and emerging firms

without strong financials.

d) Bad debts will not be considered for factoring.

e) Credit rating is not mandatory but factoring companies carry out credit risk

analysis.

f) Factoring is a method of off balance sheet financing.

g) Cost of factoring =Finance cost + Operating cost.

h) Indian firms offer factoring for invoices as low as Rs.1000.

i) For delayed payments beyond the approved credit period, penal charge of

around 1%-2% per month over and above the normal cost is charged.

Types of Factoring

ing

Working/Mechanism of Factoring

Factoring business is generated by credit sales in the normal course of business. The

main function of factor is realization of sales. One the transaction takes place, the role

of factor steps, is to realize the sales/collect receivables. Thus, factor acts as an

intermediary between the seller and sometimes along with the seller‟s bank together.

When the payment is received by the factor, the account of the firm is credited by the

factor after deducting its fees, charges, interest, etc. as agreed.

Types of Factoring

Recourse Factoring Non-Recourse Factoring

Advance Factoring Bank Participation Factoring

Maturing Factoring Notified and Undisclosed

Factoring

Full Factoring Invoicing Factoring

Buyer-based, Seller-based, and

Selective Factoring Export Factoring



The mechanism of factoring is described in the following figure:

1) Customer places an order with the client for goods and or service on credit;

client delivers the goods and sends invoice to customers.

2) Client assigns invoice to factor.

3) Factor makes pre-payment up to 80 percent and sends periodical statements.

4) Monthly statement of accounts to customer and follow-up.

5) Customer makes payment to factor.

6) Factor makes balance 20 percent payment on realization to the client.

1

2 3 Send invoice

Assign Payment 6 to customer

Invoice up to 80% Balance 20% on realization

to factor 4 Statement to customer

5 Payment to factor

Figure: Working of Factoring

INVENTORY MANAGEMENT

The word „Inventory‟ is understood differently by various authors. In accounting

language it may mean stock of finished goods only. In a manufacturing concern, it

may include raw materials, work in process and stores, etc.

International Accounting Standard Committeedefines inventories as „Tangible property‟

Held for sale in the ordinary course of business

In the process of production for such sale or,

To be consumed in the process of production of goods or services for sale

The American Institute of Certified Public Account (AICPA) defines “Inventory in the

sense of tangible goods, which are held for sale, in process of production and available

for ready consumption”.

According to Bolten S.E., “Inventory refers to stock-pile of product, a firm is offering

for sale and components that make up the product”.

Meaning of Inventory Management

The investment in inventory is very high in most of the undertaking engaged

manufacturing, whole-sale and retail trade. The amount of investment is sometimes

more in inventory than in other assets. About 90 percent part of the working capital

invested in inventories. It is necessary for every management to give proper attention

CLIENT

FACTOR CUSTOMER



to inventory management. A proper planning of purchasing, handling, storing and

accounting should form a part of inventory management. An efficient system of

inventory manager will determine (a) What to purchase? (b) How much to purchase?

(c) From where to purchase? (d) Where to store? etc.

Objectives of Inventory Management

The objectives of inventory management may be discussed under two heads:

Operating Objectives

Financial Objectives

Operational objectives refer to material and other parts which are available in

sufficient quantity. It includes:

(a) Availability of Materials

(b) Minimizing the Wastages

(c) Promotion of Manufacturing Efficiency

(d) Better Service to Customers

(e) Control of Production Level

(f) Optimal Level of Inventories

Financial objectives mean that investment in inventories must not remain idle and

minimum capital must be locked in it. It includes:

(a) Economy in Purchasing

(b) Optimum Investment and Efficient

(c) Reasonable Price

(d) Minimizing Costs

Elements of Inventory

Inventory includes the following things:

1) Raw Materials: It includes the materials used in the manufacture of a product.

The purpose of holding raw material is to ensure uninterrupted production in

the event of delaying delivery.

(a) Direct Materials: It is the primary classification for raw materials in

manufacturing operations. It is directly related to the final product.

(b) Indirect Materials: It is the class of materials in the manufacturing process

that does not actually ship to the customer as part of the final product. For

example, the gas used to heat the furnaces that melt the steel in the

manufacture of hammers, is an indirect material.

2) Work-in-progress: It includes partly finished goods and material held between

manufacturing stages. It can also be stated that those raw materials which are

used in production process but are not finally converted into final product are

work-in-progress.

3) Consumables: Consumables are products that consumers buy recurrently, i.e.

items which „get used-up‟ or discarded. For example, consumable office

supplies are such products as paper, pens, file, folders computer disks, etc.



4) Finished Goods: The goods ready for sale or distribution comes under this class.

It helps to reduce the risk associated with stoppage in output on account of

strikes, breakdowns, shortage of materials, etc.

5) Stores and Spares: This category includes those products which are accessories

to the main products produced for the purpose of sale. For example, bolts and

nuts, clamps, screws, etc.

The following are a few examples of the type of inventory held by various

organizations. Since the final product (output) of a service organization such as bank,

hospital, etc. cannot be stored for use in the near future; the concept of inventory

control for them is associated with the various forms of productive capacity.

Type of Organizations Type of Inventories Held

Manufacturer Raw materials, spare parts, semi-finished goods,

finished goods

Hospital Number of beds, stock of drugs, specialized personnel

Bank Cash reserves, tellers

Airline company Seating capacity, spare parts, special maintenance crew

Motives of Holding Inventories

There are three main purposes of motives of holding inventories:

Transaction Motive: Precautionary Motive: Speculative Motive:

Types of Inventory

Movement Inventories:

Buffer Inventories:

Anticipation Inventories:

Decoupling Inventories:

Cycle Inventories:

Independent Demand Inventory:

Dependent Demand Inventories:

Costs of Inventory

In determining an optimal inventory policy, the criterion most often is the cost

function. The classical inventory analysis identifies four major cost components:



Inventory Management Techniques

Several Techniques of inventory control are in use and it depends on the convenience

of the firm to adopt any of the techniques. What should be stressed, however, is the

need to cover all items of inventory and all stages, i.e. from the stage of receipt from

suppliers to the stage of their use. The techniques most commonly used are the

following:

Economic Order Quantity

Levels of Stock

Perpetual Inventory System

ABC Analysis

Just in Time

Inventory Turnover

Inventory Control of Spares and Slow Moving Items

Economic Order Quantity:

EOQ is an important factor in controlling the inventory. It is a quantity of inventory

which can reasonably be ordered economically at a time. It is also known as

“Standard Order Quantity”, “Economic Lot Size” or “Economic Ordering Quantity”.

In determining this point ordering costs and carrying costs are taken into

consideration.

The quantity may be calculated with the help of the following formula:

EOQ = √2AC † h

where, A = Annual quantity used (in units), C = Cost of placing an order

(fixed cost) and h = Cost of holding one unit.

For example, calculate EOQ from the following data.

Estimated requirement for the year 600 units

Cost per unit Rs.20

Ordering cost (per order) Rs.12

Carrying cost (% of average inventory) 20%

EOQ = √2AC † h = √(2×600×12)÷ (20×20%) = 60 units

Cost of Inventory

Purchase Cost Ordering Cost / Set-up Cost

Carrying Cost Stock out Cost



CASH MANAGEMENT

Cash is one of the currents of a business. It is needed at all times to keep the business

going. A business concern should always keep sufficient cash for meeting its

obligations. Any shortage of cash will hamper the operation of a concern and any

excess of it will be unproductive. Idle cash is the most unproductive of all the assets.

The fixed assets like machinery, plant, etc. and current assets such as inventory will

help the business in increasing its earnings capacity. But cash in hand idle will not

add anything to the concern.

Motives for holding cash

The firm‟s needs for cash may be attributed to the following needs: Transactions

motive, Precautionary motive and Speculative motive. Some people are of the view

that a business requires cash only for the first two motives while others feel that

speculative motive also remains. o Transaction Motive: o Precautionary Motive: o Speculative Motive: o Compensation Motive

Determining Cash Needs

The amount of cash for transaction requirements is predictable and depends upon a

variety of factors which are as follows:

Credit position of the firm

Status of firm‟s receivable

Status of firm‟s inventory account

Nature of business enterprise

Management‟s attitude towards risk

Amount of sales in relation to assets

Cash inflows and Cash outflows

Cost of Cash Balance

Meaning of Cash Management

Cash management refers to management of cash balance and the bank balance

including the short term deposits. For cash management purpose, the term cash is used

in this broader sense i.e. it covers cash, cash equivalents and those assets which are

immediately convertible into cash.

Objectives of Cash Management

The basic objectives of cash management are two-fold:

1) Meeting the Payment Schedule: 2) Minimizing Funds Committed to Cash Balance:

Advantages of Adequate Cash

It prevents insolvency or bankruptcy arising out of the inability of a firm to

meet its obligation.

The relationship with the bank is not strained



It helps in fostering good relations with trade creditors and suppliers of raw

materials as prompt payment may help their own cash management.

A trade discount can be availed, if payment is made within the due date.

It leads to a strong credit rating which enables the firm to purchase goods on

favourable terms.

The firm can meet unanticipated cash expenditure with a minimum of strain

during emergencies, such as strikes, fires or a new marketing campaign by

competitors.

Keeping large cash balances however, implies a high cost. The advantage of prompt

payment of cash can well be realized by sufficient cash and not excessive cash.

Importance of Cash Management

Cash management consists of taking the necessary actions to maintain adequate levels

of cash to meet operational and capital requirements and to obtain the maximum yield

on short-term investment of pooled, idle cash. A good management program is a very

significant component of the overall financial management of a municipality. Such a

program benefits the city or town by increasing non-tax revenues, improving the

control and superintendence of cash. Also increasing contacts with members of the

financial community and lowering borrowing costs, while at the same time

maintaining the safety of the municipality‟s funds.

Basic strategies for Cash Management

The broad cash management strategies are essentially related to the cash turnover

process, that is, the cash cycle together with the cash turnover. The cash cycle refers to

the process by which cash is used to purchase materials from which goods are

produced, which are then sold to customers, who later pay the bills.

Details of Cash Cycle

A B C D E F GH I

A = Materials ordered; B = Materials received; C = Payments;

D = Cheque clearance; E = Goods sold; F = Customer‟s payments

G = Payment received H = Cheques deposited I = Funds collected

Tools /Techniques of Cash Management

There are some specific techniques and processes for speedy collection of receivables

from customers and slowing disbursements.

1) Cash Management Planning

2) Cash Management Control

(i) Accelerating Cash Flows,

(ii) Controlling Cash Flows

3) Determining Optimum Cash Balance



Problem

Prepare cash budget for the months of June, July, August, 2011 from the following

information:

a) Opening cash balance in June Rs.7000/-

b) Cash sales for June Rs.20,000; July Rs.30,000; and August Rs.40,000

c) Wages payable Rs.6000 per month.

d) Interest receivable Rs.500 in the month of August

e) Purchase of furniture for Rs.16,000 in July.

f) Cash purchases for June Rs.10,000; July Rs.9000; and August Rs.14,000

Solution Cash Budget for the period June to August 2011

Particulars June July August

Opening Cash Balance

Add: Estimated Cash Receipts

Cash Sales

Interest receivable

Total Receipts

Less: Estimated Cash Payments

Cash Purchases

Payment of Wages

Purchase of Furniture

Total Payments

Closing Balance (surplus/deficit)

7,000

20,000

--

27,000

10,000

6,000

--

16,000

11,000

11,000

30,000

41,000

9,000

6,000

16,000

31,000

10,000

10,000

40.000

500

50,500

14,000

6,000

--

20,000

30,500

Cash Management Models

Two important cash management models which lead to determination of optimum

cash balance.

Optimum Cash Balance under Certainty: Baumol’s Model

The Baumol cash management model provides a formal approach for determining a

firm‟s optimumcash balance under certainty. It considers cash management similar to

an inventory management problem. As such, the firm attempts to minimize the sum of

Cash Management Models

Optimum Cash Balance under

Certainty: Baumol‟s Model Optimum Cash Balance under

Uncertainty

Miller-Orr Model Stone Model



the cost of holding cash (inventory of cash) and the cost of converting marketable

securities to cash.

Assumptions of Baumol’s Model

1) The firm is able to forecast its cash needs with certainty.

2) The firm‟s cash payment occurs uniformly over a period of time.

3) The opportunity cost of holding cash is known and it does not change over

time.

4) The firm will incur the same transaction cost whenever it converts securities to

cash.

Let us assume that the firm sells securities and starts with a cash balance of C rupees.

As the firm spends cash, its cash balance decreases steadily and reaches to zero. The

firm replenishes its cash balance to C rupees by selling marketable securities. This

pattern continues over time. Since the cash balance decreases steadily, the average

cash balance will be: C/2. The pattern is shown in the following figure:

Figure: Baumol’s Model for Cash Balance

Cash Balance

C

C/2 Average

Time

0 T1 T2 T3

The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost;

that is, the return foregone on the marketable securities. If the opportunity cost is k,

then the firm‟s holding cost for maintaining an average cash balance is as:

Holding Cost = k(C/2)

The firm incurs a transaction cost whenever it converts its marketable securities to

cash. Total number of transactions during the year will be total funds requirement, T,

divided by the cash balance, C, i.e. T/C. The per-transaction cost is assumed to be

constant. If per transaction cost is c, then the total transaction cost will be:

Transaction cost = c(T/C)

The total annual cost of the demand for cash will be:

Total Cost = k(C/2) + c(T/C)

The holding cost increases as demand for cash, C, increases. However, the transaction

cost reduces because with increasing C the number of transactions will decline. Thus,



there is a trade-off between the holding cost and the transaction cost. The following

figure depicts this trade-off.

Figure: Cost Trade-off Baumol’s Model

Cost Total

Cost

Holding Cost

Transaction Cost

Cash

Balance

The optimum cash balance, C*, is obtained when the total cost is minimum. The

formula for the optimum cash balance is as:

C* = √2cT /k Where,

C* is the optimum cash balance

c is the cost per transaction

T is the total cash needed during the year

k is the opportunity cost of holding cash balance

The optimum cash balance will increase with increase in per-transaction cost and total

funds required and decrease with the opportunity cost.

Limitations of the Baumol Model

1. Assumes a constant disbursement rate.

2. Ignores cash receipts during the period

3. Does not allow for safety cash reserves.

In spite of limitations, the model has a theoretical value. It gives an idea as to how the

holding cost and transaction cost should optimized by the firm. The cash balance

being maintained by the firm should be a level close to optimum level as given by the

model so that the total cost is minimized.

Optimum Cash Balance under Uncertainty

There are two optimum cash balance under uncertainty.

1) Miller-Orr Model

2) Stone Model



Miller-Orr Model

The Miller-Orr (MO) model is also known as stochastic model. This model overcome

the shortcoming of Baumol’s model and allows for daily cash flow variation. It

assumes that net cash flows are normally distributed with a zero value of mean and a

standard deviation. The MO model provides for two control limits – the upper control

limit and the lower control limit as well as a return point. If the firm‟s cash flows

fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities

to come back to normal level of cash balance (the return point).

Similarly, when the firm‟s cash flows wander and hit the lower limit, it sells sufficient

marketable securities to bring the cash balance back to the normal level i.e. the return

point. Figure: Miller-Orr Model

Cash Balance Upper Limit

Purchase of securities

Return point

Sale of securities

Lower Limit

Time

The firm sets the lower control limit as per its requirement of maintaining minimum

cash balance. At what distance the upper control limit will be set? The difference

between the upper limit and the lower limit depends on the following factors:

(1) Transaction Cost (c); (2) Interest Rate (i); (3) standard deviation (σ) of net cash

flows.

The formula for determining the distance between upper and lower control limits

(called Z) is as follows:

Upper Limit – Lower Limit)

= (¾ × Transaction Cost × Cash Flow Variance /Interest Rate)⅓

= (¾ × cσ2 /i)

⅓

Stone Model

Like the Miller-Orr model, the Stone model takes a control limits approach; when

cash balances fall outside the control limits, the firm is signaled to do something. But

in the Stone model, the signal does not automatically result in an investment or

disinvestment; the recommended action depends on management‟s estimates of future

cash flows; i.e. the model signals an evaluation by management rather than an action.



To do this, the Stone model uses two sets of control limits, the inner control limits

(UCL1 and LCL1) and the outer control limits (UCL2 and LCL2).

The transactions are the same as those in the Miller-Orr model. Investments are made

sufficient to bring the cash balance back to the return point if the upper control limit is

exceeded; corresponding disinvestments are made if the lower control limit is

exceeded. Optimal procedures for setting the return point, the two sets of control

limits and the number of days a firm looks ahead are net specific; the outer control

limits could be set by the Miller-Orr model or could be based on the cash manager‟s

feeling for the best limits. Figure: Control Limits for the Stone Model

400 UCL2

300UCL1

200 Return Point

LCL1

LCL2

100

0 1 2 3 4 5

WORKING CAPITAL FINANCE: TRADE CREDIT

Working capital financing concerns how a firm finances its current assets. It is very

essential to any growing business. It helps to keep the business efficient and

competitive in the market.

Trade Credit

Trade Credit refers to the credit extended by the suppliers of goods in the normal

course of business. As present day commerce is build upon credit, the trade credit

arrangement of a firm with its suppliers in an important source of short-term finance.

The credit-worthiness of a firm and the confidence of its suppliers are the main basis

of securing trade credit.

Management of Trade Credit

The firm should exploit the possibilities of trade credit to the full extent, because it is

an important source of financing working capital needs of the firm. To facilitate the

management‟s decision-making the following financial ratios can be of great use.

Trade Credit to Total Current Assets Ratio: This ratio indicates the magnitude of the use

of trade credit in financing total current assets of a firm. The lower the ratio, the better

will be liquidity position of the firm.



Trade Credit to Total Current Assets Ratio

= Trade Credit / Total Current Assets

Trade Credit to Total Current Liabilities Ratio: This ratio indicates the proportion of

trade credit to total current liabilities. It speaks on the financing mix adopted by the

company. A high ratio means increased dependence on spontaneous sources and

difficult in getting funds from negotiated sources.


= Trade Credit / Total Current Liabilities

Trade Credit to Sales Ratio: This ratio is also very useful form the


= Trade Credit / Total Current Liabilities

Percentage Change in Trade Credit to Percentage Change in Sales Ratio: This ratio

indicates the behavioral relationship between sales and trade credit. Generally

speaking, increasing sales demand increasing use of trade credit facilities. The rate of

change in sales must always be higher than the rate of change in trade credit.

Percentage Change in Trade Credit to Percentage Change in Sales Ratio = (% Change in Trade Credit) / (% Change in Sales)

BANK FINANCE AND COMMERCIAL PAPER

Banks are the main institutional sources of working capital finance in India. After

trade credit, bank credit is the most important source of financing working capital

requirements of firms in India. The amount approved by the bank for the firm‟s

working capital is called credit limit. Credit limit is the maximum funds which a firm

can obtain from the banking system. Banks are required to fix separate limits, for the

„peak level‟ credit requirements and „normal non-peak level‟ credit requirements

indicating the periods during which the separate limits will be utilized by the

borrower.

In practice, banks do not lend 100% of the credit limit; they deduct margin money.

Margin requirement is based on the principle of conservatism and is meant to ensure

security. If the margin requirement is 25%, bank will lend only up to 75% of the value

of the asset. This implies that the security of bank‟s lending should be maintained

even if the asset‟s value falls by 25%.

Forms of Bank Credit

A firm can draw funds from a bank within the maximum credit limit sanctioned. It can

draw funds in the following forms:

Secured Term Loans/ Bank Loans: Cash Credit: Overdrafts:



Commercial Paper

Commercial paper (CP) is an important money market instrument in advanced

countries like U.S.A. to raise short-term funds. In India, on the recommendation of the

Vaghul Working Group, the Reserve Bank of India introduced commercial paper in

the Indian money market. Commercial paper, as it is known in the advanced countries,

is a form of unsecured promissory note issued by firms to raise short-term funds. The

commercial papermarket in USA is a blue-chip market where financially sound and

highest rated companies are able to issue commercial papers.

o Duration:

o Denomination and Size:

o Maximum Amount:

Advantages of Commercial Paper

It is an alternative source of raising short-term finance, and proves to be handy

during periods of tight bank credit.

It is a cheaper source of finance in comparison to the bank credit. Usually,

interest yield of commercial paper is less than the prime rate of interest.

Disadvantages of Commercial Paper

It is impersonal method of financing.

It is available always to financially sound and highest rated companies.

It cannot be redeemed until maturity.

Text Books

1. M.Y.Khan and P.K.Jain, “Financial Management” Tata McGraw Hill, 6th

Edition, 2011.

2. I.M.Pandey, “Financial Management” Vikas Publishing House Pvt. Ltd., 10th

Education 2012. References

1. AswatDamodaran, Corporate Finance Theory and Practice, John Wiley &

Sons, 2011.

2. James C Vanhorne, Fundamentals of Financial Management, PHI Learning,

11th

Edition, 2012.

3. Brigham Ehrhardt, Financial Management Theory and Practice, Cengage

Learning, 12th

Edition, 2010.

4. Prasanna Chandra, Financial Management, Tata McGraw Hill, 9th

Edition,

2012.

5. Srivatsava, Mishra, Financial Management, Oxford University Press, 2011.

Ba7202 financial management (unit4) notes

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