Working Capital concept

7/28/2019 Working Capital concept

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Meaning:-

Capital required for a business can be classified into 2 categories.

Fixed (L&B, P&M). Working (wages, salaries, RM).

Every business needs capitals for its establishment & also for its day to day

operations. Long-term funds are required to create production facilities through

purchase of fixed assets like P&M, L&B etc. Investments in these assets represent

that part offirms capital which is blocked on permanent or fixed basis is called

fixed capital.

Funds needed for short-term purposes for purchase of raw material,

payment of wages known as working capital. That is part of the firms capital

which is required for financing short-term or current assets. Funds invested in

current assets keep revolving fast & converted into cash & these cash flows out

again in exchange for other current assets. Hence it is also known as revolving or

circulating or short-term capital.

Definition:-

According to shubin, working capital is the amount of funds necessary tocover to cost of operating the enterprise.

According to genstenberg, circulating capital means current assets of a

company that are changed in the ordinary course of business form one form to

another

Concepts of working capital:-

The concept of working capital is of 2 types. They are:

Gross working capital. Net working capital.


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Gross working capital:-

It refers the total amount of funds invested in current asset. It is a

financial concept. Cash, B/R, sundry debtors (less provision for bad debts), short-

term loans & advances, inventories like RM, WIP, FG, temporary investment ofsurplus funds, prepaid expenses, accrued incomes.

Net working capital:-

It is the excess of current assets over current liabilities. Net working

capital may be positive or negative. Net working capital is an accounting concept.

N.W.C = current assets current liabilities.

Ex of C.L:-

B/P, sundry creditors, accrued or outstanding expenses, and short term

loans advances & deposit, dividend payable, bank overdraft, provision for

taxation.

Kinds of working capital:-

On the basis of

conpect

Gross workingcapital

Net workingcaptial

On the basis oftime(or)

behavious

Permanent (or)fixed working

capital

Temporary (or)variable

working capital

Regular working capital

Reserve working capital

Seasonal working

Special working capital


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On the basis of time or behavior:-

Permanent or fixed working capital:-This is the minimum amount which is required to ensure effective

utilization of fixed facilities & for maintaining the circulation of current assets.

This part of the capital is permanently blocked in current assets. The permanent

working future is classified into:

Regular working capital. Reserve working capital.

Regular working capital required to ensue circulation of current assets from

cash inventories form inventories to receivables & from receivable to cash & so

on.

Reserve working capital is excess amount over the requirement for regular

working capital for regular working which may be provided for contingencies that

may arise at strikes, rise in prices, depression etc.

Temporary or variable working capital:-

This is required to meet the seasonal demands & some special

exigencies. It is classified into 2 types. They are:

Seasonal working capital.The capital is required to meet the seasonal needs of

enterprise is called seasonal working capital.

Special working capital.This is the part of working capital which is required to meet

special exigencies such as launching of extensive marking campaigns for

conducting research etc.


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Importance of working capital:-

Solvency of business: - Working capital helps in maintaining the solvencybusiness.

Good will: - It enables to make prompt payments & helps increasing &maintaining goodwill.

Easy loans: - High solvency & good credit standing can arrange easy loansfrom banks & other financial institutions.

Cash discounts: - Working capital enables to available cash discounts on thepurchase & hence it reduces costs.

Regular supply of raw materials: - Working capital ensures regular supplyof raw material & continuous production.

Regular payment of salaries, wages & day to day commitment: - Employeeworking capital can make regular payments & it raises the morale of

employees, increases their efficiency, reduces wastage & cost & enhances

production & profits.

Exploitation of favorable market conditions: - Concerns with adequateworking capital can exploit favorable market conditions such as purchasing

its requirements in bulk when the prices are lower & by holding its

inventories for higher prices.

Ability to face crisis: - Adequate working capital enables a firm to facebusiness crisis in emergencies.

Quick & regular return on investments: - Sufficient working capital enablesa firm to pay quick & regular return to its investors.

High morale: - It creates security, confidence, high morale & overallefficiency in a business.

Operating cycles:-

This starts wi9th the purchase of raw material & ends with the

realization of cash from the sale of finished products. This involves purchase of

RM & its conversion into stocks of finished goods through WIP, conversion

finished stock into sales, debtors & receivable & ultimately realization of cash &

this cycle continues again form cash to purchase of RM.


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Factors determining working capital requirements:-

Cash

RawMaterial

Working InProcess

FinishedProduct

Debtors,sales, Billsreceivables

Workingcapital

Nature ofbusiness

Size ofbusiness

Productionpolicy

Manufacturingprocess

Seasonalvariation

Workingcapital cycle

Rate of stockturnover

Credit policy

Business cycle

Rate of growthof business

Earningcapacity &

dividend policy

Price levelcharges

Other factors


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Nature of business:-

The working capital requirements of a firm basically depend upon the

nature of business. Public utility undertakings like electricity, railways need very

limited working capital because they offer cash sales only. But the trading &financial firms require huge amounts to invest in current assets. The

manufacturing requires sizable working capital along with fixed investments.

Size of business operations:-

Greater the size of a business unit requires large amount of working

capital.

Production policy:-

The requirement of working capital depends on production policy.

The production could keep steady by accumulating inventories in slack period to

meet high demand in peak seasons or production could be curtailed in slack &

increased in peak seasons. If the policy is to keep production steady by

accumulating inventories if requires higher working capital.

Manufacturing process/length of production cycle:-

In manufacturing business, the required working capital directly

proportioned to length of manufacturing process. Longer the process gives large

amount of working capital needed to meet the labour & service cost for long

period.

Seasonal variations:-

In certain industries raw material is not available throughout the year.

They have to buy bulk raw material in unreason to ensure uninterrupted flow

throughout the years. So, a huge amount is blocked in the form of material

inventories during such seasons given rise to more working capital requirements.


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Working capitals cycle/operating cycle:-

The speed with which the working capital completes one cycle determines

the required working capital. Longer the period gives larger amount of working

capital.

Rate of stock turn over:-

There is a high degree of inverse co-relation between sales & amount

of working capital. A firm has a high rate of stock turnover need lower amount of

working capital as compared to firm having a low rate of turnover.

Credit policy:-

A firm make it purchases on credit & sells on cash needs less amount of

working capital. On the other hand if it makes it purchases on cash & sells on

credit it needs high amount of working capital.

Business cycles:-

This refers to alternate expansion & contraction in general business

activity. In a period of boom, large amount of W.C is needed due to increase in

sales. In times of depression i.e., when there is a down swing in business, sales

Cash

RawMaterial

Working InProcess

FinishedProduct

Debtors,sales, Bills

receivables


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decline, difficulties arise in collection from debtors may have large amount of

W.C.

Rate of growth of business:-

The w.c requirement increase with growth & expansion of

business activities for normal expansion gives the firms provide retained earnings

for W.C. fast growing company requires large amount of w.c.

Earning capacity & dividend policy:-

High earning capacity firms may generate cash profits from

operations & contribute W.C. the dividend policy also influences the W.C. if a firm

maintains steady high rate of cash divided irrespective of its earnings needs more

w.c than the firms that retain large part of profits & does not pay high rate of cash

dividend.

Price level changes:-

Rising prices will requires maintaining larger amount of w.c as more

funds will be required to maintain the same current assets.

Other factors:-

Operating efficiency management ability, irregularities in supply, import

policy asset structure, importance of labour, banking facilities also influence the

w.c requirements.

Estimation of w.c requirements:-

No business cab run successfully without adequate amount of W.C.

to avoid the shortage, an estimate of w.c requirement should be made in

advance. But estimation of w.c requirement is not an easy task & large no. of

factors has to be considered. Those are:


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Total cash incurred on material, wages & overheads. Length of time for which raw material are to remain in store before they

are issued for production.

Length of production or operating cycle. Length of sales cycle during which finished goods & to be kept waiting for

sales.

The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of business. Average amount of cash requirements to make advance payments. Average credit period expected to be allowed by suppliers. Time lag in the payment of wages & other expenses.The total amount blocked in current assets estimated on the basis of first seven

items, the last two items are total amount of current liabilities. From first seven

items, the last two items deducted to find out the requirements of w.c. in case of

purely trading origin 1, 2,3 points would not arise, but all other factors 4to9 are to

be taken into consideration.

Importance:-

Profits should be ignored while calculating w.c required. because: Profits may or may not be used as w.c. Even if profits are to be used for w.c it has to be reduced by the

amount of income tax, drawings, and dividend paid etc.

Calculation WIP depends upon its degree of completion. If nothing is given100% consumption of raw material & 50% in case of labour & overheads.

Calculation of finished goods & debtors should be made at cost unlessotherwise asked in the question.

Financing of working capital requirements:-

The w.c requirements can be classified as:-

Permanent or fixed working capital requirements. Temporary or variable working capital requirements.


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The fixed proportion of w.c should be financed from fixed capital sources

while the temporary w.c required may be met from short term source of w.c.

Sources of working capital

Sources of fixed orlongterm or

permaent w.c

Shares

Debentures

Publicdeposits

Ploughingback ofprofits

Loans fromfinancial

institutions

Sources of tempararyor short term or

variable w.c

Indifenousbankers

Tradecreditors

Instalmentcredit

Advances

Accountsreceivable

credit

Accured

expenses

Commercialpapers

Differedincomes

Commercialbanks


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Sources of fixed w.c:-

Shares:-Issue of shares is the most important source for raising the permanent

or long term capital. a company can issue various types of shares accordingto companies act 1956, a public company cannot issue deferred shares.

Preference shares carry preferential rights in respect of dividend at t fixed

rate & in regard to the payment of capital at the time of winding up the

company.

Equity shares do not have any fixed amount of charge & dividend on

these shares is to be paid subject to the availability of sufficient profits. As

far as possible, a company should raise the maximum amount of

permanent capital by the issue of shares.Debentures:-

It is an instrument issued by the company acknowledging its debt

to its holder. The debenture holders are the creditors of the company. a

fixed rate of interest is paid on debentures. The interest on debentures is a

charge against P&L account. When the debentures are secured they are

paid on priority to other creditors.

The debentures are may be of various kinds. The debentures as a

source of finance have a no. of advantages both to the investors & the

company interest on debentures can be paid on predetermined intervals at

the time of liquidation. They are well suited to cautious investors.

The firm also enjoys no. of benefits like trading on equity, retention of

control, tax benefits etc.

Public deposits:-These are the fixed deposits accepted by a company directly from

the public. This source of raising short-term & medium-term finance was

very popular in the absence of banking facilities. In the past public deposits

were accepted by textile industries in Ahmadabad & Bombay for

6months/1year. But now long-term deposits for 5to7 years are accepted by

the business houses.


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Advantages:-Very simple & convenient source of finance.Taxation benefits.Trading on equity.No need of securities.In expensive source of finance.

Disadvantages:-Uncertain.Unreliable.Unsound & inelastic source of finance.

RBI laid down certain limits on public deposits. Non banking concerns

cannot borrow by way of public deposits more than 25% of its paid up capital &

free reserves.

Ploughing back of profits:-This means reinvestments by concerns of its surplus earnings

in its business. It is an internal source of finance & most suitable for an

established firm for its expansion, modernization & replacement etc.

Advantages:-Cheapest rather cost free source of finance.No need to keep securities.No dilution of control.Ensures stable dividend policy.Gains confidence on the public.

Disadvantages:-

Excessive resort to ploughing back of profits may lead tomonopolies.

Misuse of funds.Overcapitalization & speculation etc.


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Loans from financial institutions:-Financial institutions such as commercial banks, LIC, industrial

finance corporation of India, state financial corporation (SFC), state

industrial development corporation, industrial development bank of India

provide short-term, medium term & long-term loans.

This is more suitable to meet the medium term demands of W.C.

interest is charged on such loans at a fixed rate & amount of loan is too

repaid by way of installments in a no. of years.

Sources of short-term w.c:-

Indigenous bankers:-Private money lenders & other country bankers used to be the

only source of finance prior to the establishment of commercial banks.

They change high interest & exploited the customers now a days with the

development of commercial banks they have lost their monopoly.

Trade credit:-This refers to the credit extended by the suppliers of goods in the

normal source of business. The credit worthiness of a firm & the confidence

of its suppliers are the main basis of securing trade credit. It may also take

the form of bills payable where by the buyer signs a bill of exchangepayable on a specified future date.

If a firm delays its payment beyond the due date as per terms of sales

invoice, it is called stretching accounts payable. A firm may generate

additional short-term finances by stretching accounts charges as well as to

forgo cash discount. If a firm delays the payment frequently if affects the

credit worthiness of the firm & it may not be allowed such credit facilities in

future.

Advantages:-Easy & convenient method finance.Flexible.Informal & spontaneous source of finance.


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Disadvantages:-Charging of higher prices by suppliers.Loss of cash discount.

Installment credit:-Under this, the assets are purchased & the possession of goods in

taken immediately but the payment is making in installments over a pre

determined period of time. Generally, interest is charged on the unpaid

price or it may be adjusted in the price.

Advances:-Some business houses get advances from their customers & agents

against orders. It is a cheap source of finance & in order to minimize their

investment in w.c.Ex: - some manufacturing firm prefers to take advances from their

customers.

Factoring/accounts receivable credit:-Accounts receivable credit is offered by commercial banks

or factors. A commercial bank may provide finance by discounting the bills

or invoices of its customers. Thus a firm gets immediate payment for sales

made on credit. A factor is a financial institution which offers services

relating to management & financing of debts arising out of credit sales.Factors renders services varying from bill discounting facilities offered

by commercial banks to a total takeover of administration of credit sales

including maintenance of sales ledger, collection of accounts receivables

credit control & protection from bad debts, provisions of finance &

rendering of advisory services to their clients.

At present factoring in India is rendered by only a few financial

institutions. However, vaghul committee recommended that banks should

be encouraged to setup factoring divisions to provide speedy finance to the

corporate entities.


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Limitations of factoring:-High cost of factoring as compared to other sources of short

term finance.

The perception of financial weakness about the firm availingfactoring services.

Adverse impact of tough stances taken by facto, against adefaulting buyer.

Accrued expenses:-These are the expenses which have been incurred but not yet due

& hence not yet paid also. These represent a liability that a firm has to pay

for the services already received by it.

These are paid on monthly fortnightly or weekly basis for the servicesrendered by employees. The longer the payment period, the greater is the

amount of liability towards employees. This is same in all cases of interest

& tax etc. thus, all accrued expenses can be used as a source of finance.

The amount of accruals various with the change in the level of activity

of firm. Activity level expands accruals increases gives increase in finance.

But it may not be desirable to postpone these expenses for a long period.

Deferred incomes:-These are the incomes received in advance before supplying

goods or services. These funds increase the liquidity of a firm & constitute

important sources of short-term finance. However, firms having great

demand for its products & services & those having good reputation in the

market can demand deferred incomes.

Commercial paper:-It represents unsecured promissory note issued by firms to raise

short-tem funds. It is an important money market instrument in advanced

countries. In India RBI introduced this by the recommendations of vaghul

committee. Only large companies enjoyed high credit rating & sound

financial health can issue this to raise short-term funds.


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RBI laid down no. of restrictions to issue this paper i.e. only a

company which is listed on stock exchange has a net worth of at least

10crores & a maximum per missible bank finance of 25crores can issue

commercial paper not exceeding 30% of its w.c limit.

Disadvantages:-It can be used only large companies enjoying high company

rating & sound financial health.

It cannot be redeemed before the maturity date even if theissuing firm has surplus funds to pay back.

Commercial banks:-Commercial banks are the most important source of short-term

capital. the mahor portion of w.c provided bu commercial banks. theyprovide a wide variety of loans tailored to meet the specific requirements

of a concern. Those are:

Loans:-When a bank makes an advance in lump-sum against some security, it

is called a loan. The entire amount of loan is paid to the borrower in cash or

by credit to his account. The borrowers required to pay interest on the

entire amount of loan from the date of sanction. A loan may be repayable

in lump-sum or installments.

COmmercialloans

Loans

Cash credits Overdrafts

Purchasing& discountin

of bills


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Cash credits:-It is an arrangement by which a bank allows his customer to borrow

money up to a certain limit against same tangible securities. The customer

can withdraw from his credit limit according to his needs & he can also

deposit any surplus amount with him. The interest is charged on the daily

balance & not on the entire amount of account.

RBI issued a directive to all scheduled commercial banks on 28th

march

1970, prescribing a commitment charge which banks should levy on the

utilized portion of credit limits.

Overdrafts:-That is agreement with a bank by its current account holder to with

draw more than the balance to his credit up to a certain limit. The interest

is charged on daily overdrawn balances. Main difference in between cash

credit & O.D is allowed for a short period & is temporary accommodation

where as the cash credit is allowed for a longer period.

Purchasing & discounting of bills:-It is most important in which a bank lands without any collateral

security. The seller drew a bill of exchange on the buyer of goods on credit.

The bank purchases the bills payable on demand & credits the customers

account with the amount of bill less discount. At the maturity of the bills,bank presents the bill to its acceptor for payment. In case the bill

discounted in dishonored by non-payment, the bank recovers the full

amount of bill from the customer along with expenses in that connection.

Norms of bank finance:-

It is also called as security required in bank finance. Banks do not

provide finance without obtaining adequate security. The following are most

important modes of security required by a bank.


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Hypothecation:-Under this bank provides w.c finance against the security of

movable property, usually inventories. The borrower does not give the

possession of property to bank. It remains with the borrower &

hypothecation in a charge against property for the amount of debt. If the

borrower fails to pay hid due to the banker may file a case to realize his

dues by sale of goods/property hypothecated. Pledge:-

Under this, the borrower is required to transfer the physical possession

of property or goods to the bank as security. The bank will have the right of

lien & can retain the possession goods unless the claim of bank is met. In

case of default, the bank can even sell the goods after giving due notice.

Mortgage:-In addition to the hypothecation or pledge, banks usually ask for

mortgages as collateral or additional security. Mortgage is the transfer of alegal or equitable interest in a specific immovable property for the payment

of a debt. Although the possession of property remains with the borrower,

the full legal title is transferred to the lender.

In case of default, the bank can obtain decree from the court to sell

the immovable property mortgage so as to realize its dues.

Normsof bankfinance

Hypothecation

Pledge

Mortgage


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Management of cash:-

Cash is one of important current assets of business. It is needed to all

times to keep the business going any shortage of cash will hamper the operations

of a concern & any excess of it will be unproductive.

Nature of cash:-

For some persons cash means only currency. For some other persons

cash means both cash in hand & cash at bank. Some even includes near cash

assets to it. Cash is a medium to acquire other assets. The assets acquired by cash

again help the business in producing cash. A financial manager tries to

synchronize the cash inflows & outflows. Perfectly synchronization of receipts &

payments of cash is only an ideal situation.

Motives for holding cash:-

Cash forecast & budgeting:-Cash budget is the most important device for the control of

receipts & payments of cash. This is an estimate of cash receipts &

disbursements during a future period of time. It is a forecast of expected

cash in take & outlay. Short term fore cast can be made with the help of

cash flow projections.

The long-term forecast is also essential for proper cash pledge. These

estimates may be for 3, 4,5or more years. Long-term forecast indicate

companies future financial needs for w.c, capital projects. Both short-term

& long-term cash forecast may be made with the help of following

methods.

Receipts & disbursements method.Adjusted net income method.

Receipts & disbursement methods:-

In this the receipts & payments of cash are estimated. Receipts

may be from cash sales, collection from debtors, sale of fixed assets,

receipts of dividends & other. It is difficult to forecast sales because the

sales may be either for cash or for credit.


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Adjusted net income method:-

This is also known as sources & uses approach. This helps in

projecting the companies need for cash are some future date & to see

whether the company will be able to generate sufficient cash. It has

generally 3 sections:

Sources of cash.Uses of cash.Adjusted.

In preparing its statement, dividend, net income, depreciation, tax can

easily be determined from companys annual operating budget. But the

estimation of w.c movement becomes difficult because receivables, inventories

are influenced by fluctuations in raw material cost, changing demand for

companies products & delays in collections.

Cash inflows (accelerating):-

Quick conversion of payment in cash:-Cash inflows can be accelerated by improving the cash

collecting process. There is a time gap between the cheque sent by

customer & the amount collected against it. This is due to many factors.

Managingcash flows

Cash inflows(accelerating)

Promptpayment

bycustomers

Quickconversionof payment

in cash

Decentralised collection

Lock boxsystem

Slowing cashoutflow

Payingon lastdate

Paymentthroughdrafts

Adjustingpayrollfunds

Centralisation of

payment

Interbank

transfer

Makuseflo


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1. Mailing time is taken by post office for transfer cheque from customer tofirm Postal float.

2. Time taken in processing cheque within the organization & sending it bankfor collections Lethargy.

3. Collection time taken within the bank Bank float.Postal float, lethargy & bank float are collectively referred as deposit float.

Deposit float refers to the cheque written by customers but the amount not yet

usable by the firm. Efficient management will be possible only if the time taken in

deposit float is reduced & make the money available for use. This can be done by

decentralizing collections.

Decentralized collections:-No. of collecting centers are opened in different areas

instead of collecting receipts at one place. That reduces the mailing time

from customers dispatch of cheque & its receipt in the firm & then

reducing the time in collecting these cheques. On the receipt of cheque it is

immediately sent for collection. Since the party may have issued the

cheque on a local bank, it will not take much time in collecting it.

The amount so collected will be sent in the central office at the

earliest. Decentralized collection system mailing & processing time &reduces the financial requirements.

Lock box system:-This is another technique of reducing mailing, processing & collecting

time. Under this the firm selects some collecting centers at different places.

The places are selected on the basis of a no. of consumers & the

remittances to be received form a particular place.

The firm hires a post box in a post office & the parties are asked to

send the cheques on the post box number. A local bank is authorized tooperate the post box. The bank will collect the post a no. of times in a day

& start the collection process of cheques. The amount so collected is

credited to the firms account.


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The bank will prepare a detailed account of cheques received which

will be used by the firm for processing purpose. This system of collecting

cheques expedites the collection process & avoids delays due to mailing &

processing time at the accounting department. By transferring clerical

function to the bank, the firm may reduce it costs improve internal control

& reduce the possibility of fraud.

slowing cash outflows:-

Paying on last date:-The disbursements can be delayed on making payments on the

last due date only. If the credit is for 10days then payment should be made

on 10th

day only. It can help in using the money for short periods & the firm

can make use of cash discount also.

Payments through drafts:-A company can make payments by issuing drafts to the

suppliers instead of cheques will have to keep a balance in its account so

the cheque is paid whenever it comes. On the other hand a draft is payable

only on presentation to the issues.

The receiver will give the draft to its bank for presenting it to the

buyers bank. It takes a no. of days before it is actually paid. The companycan economize large resources by using this method. The funds so saved

can be invested in highly liquid low risk securities to earn income there on.

Adjusting payroll funds:-Some economy can be exercised on payroll funds. it can be

done by reducing the frequency of payments. If the payments are made

weekly then this period can be extended to a month. Secondly the financial

manager can play the issuing of salary cheques &their disbursements. If the

cheques are issued on Saturday then only a few cheques may be presentedfor payment, even on Monday all cheques may not be presented.

On the basis of his post experience finance manager can clear to him

about the average time taken by employees in encashing their pay

cheques.


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Centralization of payments:-The payments should be centralized make through drafts or

cheques. When cheques are issued from the main office then it will take

time for cheques to be cleared through post. The benefit of cheque

collecting time in availed.

Interbank transfer:-An efficient use of cash also possible by interbank transfer. If the

company has accounts with more than one bank then amounts can be

transferred to the bank where disbursements are to be made. It will help in

avoiding excess amount in one bank.

Making use of float:-Float is a difference between the balance shown in companies

cash book & balance in passbook of bank. Whenever a cheque is issued the

balance at bank in cash book is reduced. The party to whom the cheque is

issue may not present it for payment immediately. If the party is at some

other station then the cheque will come through post & it may take a no. of

days before it is presented.

Until the time, the cheques are not presented to bank for payment

there will be a balance in the bank. The company can make use of this float

if it is able to estimate it correctly.

Receivables management:-

A sound managerial control requires proper management of liquid assets

& inventory. These assets are a part of w.c of the business. An efficient use of

financial resources is necessary to avoid financial distress. Receivables results

from credit Saks.

Meaning of receivables:-

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 & form part of its current assets. Receivables are also known

as accounts receivables, trade receivable, customer receivables or book debts.

The period of credit & extent of receivables depends upon the credit policy


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followed by the firm. The purpose of maintain in receivables is to meet

competition & to increase the sales & profits.

Costs of maintaining receivables:-

Cost of financing receivables:-When goods & services are provided on credit then the

concerns capital is allowed to be used by the customers. The receivables

are financed from the funds supplied by shareholders for long-term

financing & through retained earnings. The concern incurs some cost for

collecting funds which finance receivables.

Cost of collection:-Proper collection of receivables is essential for receivables

management. The firm may send reminders or persons for collecting the

amounts. In some cases legal resource may have to be taken for collection.

All these costs are known as collection costs which a concern is generallyrequired to incur.

Bad Debts:-The amounts which the customers fail to pay are known as bad debts.

Though a concern may be able to reduce bad debts through efficient

collection machinery but one cannot altogether rule out this cost.

Cost ofmaintainingreceivables

Costs offinancing

receivables

Costs ofcollection

Bad Debts


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Factors influencing the size of receivables:-

Size of credit sales:-The volume of credit sales is the first factors which increases or

decreases the size of receivables. Credit policies:-

A firm with conservative credit policy will have a low size of

receivables while a firm with liberal credit policy will be increasing this

figure.

Terms of trade:-The period of credit allowed & rates of discount given are linked

with receivables. If credit period allowed is more than receivables will be

more.

Expansions of plans:-When a firm entering into new markets to attract customers it will

give incentives in the form of credit facilities. The periods of credit can be

reduced when the firm is able to get permanent orders. In the early stages

of expansion more credit becomes essential & size of receivables will be

more.

Relation with profits:-More sales bring more profits. The increase in profits will be

followed by an increase in the size of receivables.

Credit collection efforts:-The paying habits of customers also have a bearing on the size of

receivables. If the customers delaying payments receivables will be more.

Factors help in forecasting receivables:-

Credit period allowed:-Longer the amount remains due the higher will be the size ofreceivables; the higher will be the size of receivables.


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Effect of cost of goods sold:-Sometimes an increase in sales results in decrease in cost of

goods sold. If this is so sales should be increased to that extent where costs

are low. The increase in sales will also increase the amount of receivable.

The estimate for sales will enables the estimation of receivables too.

Forecasting expenses:-Administrative expenses on collection amounts, costs of funds

tied down in receivables, bad debts are associated with receivables. if the

costs are more, further credit sales will not be allowed. On the other hand,

revenue increased, sales should be expanded.

Average size of receivables:-The determination of average size of receivables will also be

helpful in forecasting receivables. This is calculated as

Average size of receivables = estimated annual sales X average collection

period.

Meaning of receivables management:-

Receivables management is the process of making decisions relating

investment in trade debtors. Investment in receivables is necessary to increase

the sales & the profits of a firm. But at the same time investment in this assetinvolves cost consideration also further there is a risk of bad debts too.

The objective of receivables management is to take a sound decision as

regards investment in debtors.


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Dimensions:-

Receivables management involves the following considerations.

A. Forming of credit policy:-For efficiency management of receivables, a concern must adopt

a credit policy. A credit policy is related to decisions such as credit

standards.

Length of credit period.Cash discount.Discount period.

Credit standards:-The volume of sales will be influenced by credit policy of concerns.

Liberalized sales policy increases the sales volume resulting into increased

profits. This is associated with certain risks like enhancing costs, risks of bad

debts & delayed receipts. The increase in no. of customers will increase the

clerical work in maintaining additional accounts & collecting information

about credit worthiness of customers.

There may be more bad debts due to extension of credit to less

worthy creditors. On the other hand, extending credit to only credit worthy

Dimensions

Forming ofcredit policy

Executing thecredit policy

Formulating &executing

collection policy


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customers will save costs like bad debt losses, collection costs, investigation

costs etc. the restrictions of credit to such customers only will certainly

reduce sales volume, thus resulting in reduced profits.

A finance manager has to match the increased revenue with

additional costs. Credit should be liberalized only to the level where

incremental revenue matches the additional costs. The optimum level of

investment in receivables should be where there is a tradeoff between the

costs & profitability.


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Working Capital concept

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