1 Financial Management

Unit 3. capital. According to quantitative concept, the

amount of working capital refers to ‘total of current
assets’. Current assets are considered to be gross
WORKING CAPITAL MANAGEMENT working capital in this concept.

The qualitative concept gives an idea regarding

Capital required for a business can be source of financing capital. According to qualitative
classified under two main heads: concept the amount of working capital refers to
“excess of current assets over current liabilities.”
i. Fixed Capital
ii. Working Capital
Net working capital is positive when current assets
Fixed capital / Long term funds is required exceed current liabilities. It is negative when
to meet long term obligations namely purchase of current liabilities exceed current assets.
fixed assets such as plant & machinery, land,
building, furniture etc.
Working capital management is concerned
Any business requires funds to meet short-
with the problems that arise in attempting to
term purposes such as purchase of raw materials,
manage the current assets, current liabilities and the
payment of wages and other day-to-day expenses.
inter relationship that exist between them. The goal
These funds are called Working capital. In short,
of working capital management is to manage
Working Capital is the funds required to meet day-
firms current assets and current liabilities in
to-day operations of a business firm. And hence
such a way that a satisfactory level of working
study of Working capital is considered to be very
capital is maintained. This is so because, if the
significant. An inefficient management of working
firm can’t maintain a satisfactory level of working
capital leads to not only loss of profits but also to
capital, it is likely to become insolvent.
the closure of the business firm.

L.J. Guthmann defined working capital as “the Types of working capital

portion of a firm’s current assets which are financed Sometimes, working capital is divided into two
from long–term funds.” varieties as:
i) Permanent working capital
There are two concepts of Working capital namely, ii) Variable working capital
A. Balance Sheet Concept
B. Operating Cycle Or Circular Flow Concept Permanent Working Capital: (Fixed working
capital):- Though working capital has a limited
life and usually not exceeding a year, in actual
Balance Sheet Concept practice some part of the investment in that is
always permanent. Since firms have relatively
There are two interpretations of working capital longer life and production does not stop at the end
under balance sheet concept. of a particular accounting period some investment
is always locked up in the form of raw materials,
work-in-progress, finished stocks, book debts and
1. Gross Working Capital (GWC)
cash. The investment in these components of
2. Net Working Capital. working capital is simply carried forward to the
next year. This minimum level of investment in
The quantitative concept of Working Capital is current assets that is required to continue the
known as gross working capital while that under business without interruption is referred to as
qualitative concept is known as net working permanent working capital.

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2 Financial Management
to take care of the minimum investment in various
current assets, variable working capital is
expected to care for the peaks in the business
activity.

Need For Working Capital - Operating

Cycle.
The basic aim of Financial management
is to maximize the wealth of the share holders
and in order to achieve this; it is necessary to
generate sufficient sales and profit. However
sales do not convert in to cash instantly. The
time between purchase of inventory items (raw
material or merchandise) for the production and
their conversion into cash is known as operating
cycle or working capital cycle.

Fluctuating (Variable Working Capital): This is A study of the operating cycle would reveal
also known as the circulating or transitory working that the funds invested in operations are re-cycled
capital. This is the amount of investment required back into cash. The cycle, of course, takes some
to take care of the fluctuations in the business time to complete. The longer the period of this
activity. While permanent working capital is meant conversion the longer is the operating cycle.

If it were possible to complete the sequence Factors Determining the Working Capital
instantly, there would be no need for current assets( Requirements.
working capital). But since it is not possible, the
firm is forced to have current assets. Since cash
inflows and outflows do not match, the firm has to The total working capital requirement of a firm
keep cash for meeting short term obligations. is determined by a wide variety of factors. These
factors affect different organisations differently and
they also vary from time to time. In general the
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3 Financial Management
following factors are involved in a proper ie they will be purchased during certain months of
assessment of the amount of working capital needed. the year. Such companies may either produce goods
only when goods are purchased or they follow a
1. General nature of business. steady production policy through out the year. In the
former case there will be serious production problems.
The working capital requirements of an During offseason the firm will have to maintain its
enterprise are basically related to the conduct of those working force and physical facilities with out adequate
business. Enterprises fall in to some broad categories production and sales. A steady production through out
depending on the nature of their business. For instance, the year will cause large accumulation of finished goods.
public utilities have certain features which have a This will require additional working capital.
bearing on their walking capital needs. The two relevant
features are Cash nature of business; and Sale of
services than commodities. In view of these features 5. Credit Policy.
they do not maintain big inventories and have there fore, The level of walking capital is also determined
probably little or least requirement of working capital. by the credit policy which relates to sales and purchase.
At the other extreme are trading and financial enterprises. The credit sales will result in higher amount of debtors
The nature of their business is such that they have to and more working capital. On the other hand if
maintain a sufficient amount of cash, inventories liberal credit terms are available from the suppliers of
and book debts. They have necessarily to invest goods the need for working capital will be less. The
proportionately large amount in working capital. walking capital requirements of a business are, thus,
affected by the terms of purchase and sales.
2. Manufacturing process / Length of Production Cycle.
Another factor which affects is production 6. Growth and Expansion.
cycle. The term production cycle refers to the time As a Co grows it is logical to expect that a larger
involved in the manufacture of goods. It covers the time amount of working capital will be required. It is
span between the purchase of raw materials and the difficult to determine the relationship between the
completion of the manufacturing process leading to the growth in the volume of business of a Co and the increase
production of finished goods. Funds will have to be in the working capital. Other things being equal, growing
necessarily tied up during the process of manufacture, Go's need more working capital than those that are static.
necessitating enhanced working capital. The longer the
time span (production cycle), the larger will be the funds 7. Availability of Raw Material.
tied up and there fore, the larger the working capital
needed and vice versa. The availability of Raw material without
interruption would some times affect working capital.
There may be some material which cant be procured
3. Business cycle. easily either because their sources are few or irregular. To
The working capital requirements are also sustain smooth production the firm might be
determined by the nature of the business cycle. During the compelled to purchase and stock them in large
boom period the need for working capital is likely to grow quantities. This will result in excessive inventory of such
to cover the lag between increased sales and receipt of materials.
cash as well as to finance purchases of additional material
to face the expansion of the level of activity. The decline 8 Profit level.
stage in the business cycle will have exactly an opposite
effect on the level of working capital requirement. The Higher profit margin of a Co would generate
decline in the economy is associated with a fall in the more internal funds.. Net profit is a source of working
volume of sales, which will lead to a fall in the level of capital to the extent that it has been earned in cash. The
inventories and book debts. The need for working availability of such funds for working capital would
capital in recessionary condition is bound to decline. depend upon level of tax, dividend and reserves, and
depreciations.
a. Level of Tax:- The amount of tax to be paid is
4. Production policy.
determined by the prevailing tax regulations and very
The amount of working capital is also often taxes have to be paid in advance. An adequate
determined by production policy. In the case of certain provision for tax is an important aspect of working capital
lines of business, the demand for the product is seasonal
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4 Financial Management
planning. If tax liability increases, it will lead to an 6. Regular payment of salaries, wages and other
increase in the level of working capital and vice versa. day-to-day commitments: A company which has
b. Dividend Policy:- The payment of dividend ample working capital can make regular payment of
consumes cash resource and affects working capital. If salaries, wages and other day-to- day commitments
the firm does not pay dividend and but retains the profit, which raises the morale of its employees, increases
working capital will increase. their efficiency, reduces wastages and costs and
c. Depreciation Policy. :- as depreciation charges enhances production and profits.
do not involve any cash out flow, the amount so retained 7. Exploitation of favourable market conditions:
can be used as working capital. Only concerns with adequate working capital can
exploit favourable market conditions such as
9 Price Level Changes. purchasing its requirements in bulk when the prices
Changes in the price level also affect the are lower and by holding its inventories for higher
requirement of working capital. Rising prices would prices.
necessitate the use of more funds for maintaining an 8. Ability to face crisis: Adequate working capital
existing level of activity. For the same level of enables a concern to face business crisis in
materials and assets higher cash out flows are emergencies such as depression because during
required. The effect of rising prices will be that a such periods, generally, there is much pressure on
higher level of working capital is needed. working capital.
9. Quick and regular return on investments:
Importance or advantage of working capital Every Investor wants a quick and regular return on
his investments. Sufficiency of working capital
/ Adequacy of working capital enables a concern to pay quick and regular
dividends to its investors as there may not be much
The importance of adequacy of working capital can pressure to plough back profits. This gains the
hardly be over-emphasized. John L. O. Donnell and confidence of its investors and creates a favourable
Milton S.Gladberg observe “Many a times business market to raise additional funds i.e., the future.
failure takes place due to lack of working capital.”
Hence, working capital is considered as the life
10. High morale: Adequacy of working capital
blood and the controlling nerve centre of a
creates an environment of security, confidence, and
business. It should be adequate for the following
high morale and creates overall efficiency in a
reasons
business.

1. Solvency of the business: Adequate working

capital helps in maintaining solvency of the Disadvantages of redundant or excessive
business by providing uninterrupted flow of working capital
production.
1. Excessive Working Capital means idle funds
2. Goodwill: Sufficient working capital enables a which earn no profits for the business and hence the
business concern to make prompt payments and business cannot earn a proper rate of return on its
hence helps in creating and maintaining goodwill. investments.
2. When there is a redundant working capital, it
3. Easy loans: A concern having adequate working may lead to unnecessary purchasing and
capital, high solvency and good credit standing can accumulation of inventories causing more chances
of theft, waste and losses.
arrange loans from banks and other on easy and
favourable terms. 3. Excessive working capital implies excessive
4. Cash discounts: Adequate working capital also debtors and defective credit policy which may
cause higher incidence of bad debts.
enables a concern to avail cash discounts on the
purchases and hence it reduces costs. 4. It may result into overall inefficiency in the
organization.
5. Regular supply of raw materials: Sufficient
working capital ensures regular supply of raw
materials and continuous production.
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5 Financial Management
5. When there is excessive working capital, c. Redeemable debentures
relations with banks and other financial institutions d. Non-Redeemable debentures
may not be maintained. 3. Bonds
6. Due to low rate of return on investments, the 4. Loans from banks & financial institutions
value of shares may also fall.
5. Retained earnings
7. The redundant working capital gives rise to
speculative transactions.

B. Sources of Seasonal or Variable Working

Disadvantages or dangers of inadequate Capital
working capital
1. Bank credit
1. A concern which has inadequate working capital 2. Transaction credit
cannot pay its short-term liabilities in time. Thus, it
3. Advances from customers
will lose its reputation and shall not be able to get
good credit facilities. 4. Bank advances
2. It cannot buy its requirements in bulk and cannot 5. Loans
avail of discounts, etc. 6. Overdraft
3. It becomes difficult for the firm to exploit 7. Bills purchase and discounted
favourable market conditions and undertake 8. Advance against documents of title of goods
profitable projects due to lack of working capital. 9. Term loans by bank
4. The firm cannot pay day-to-day expenses of its 10. Commercial paper
operations and its creates inefficiencies, increases
costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the
fixed assets due to non-availability of liquid funds. MANAGEMENT OF CASH.
6. The rate of return on investments also falls with
the shortage of working capital. Cash is an important current asset for the
operations of business. Cash is the basic input that
keeps business running continuously and smoothly.
Sources Working Capital: Too much cash and too little cash will have a
negative impact on the overall profitability of the
A. Sources of Regular or Fixed or Core or firm as too much cash would mean cash remaining
Permanent Working Capital: idle and too less cash would destroy the smooth
running of the operations of the firm. Therefore,
Every firm has to anticipate at the time of planning there is need for the proper management of cash to
ensure high levels of profitability.
the initial capital structure of the company, the
minimum amount of working capital that it would It is a usual practice to include near cash
require to support is projected level of operation. items such as marketable securities and bank term
deposits in cash. The basic characteristics of near
cash items is that, they can be quickly and easily
This minimum working capital a firm has to converted into cash without any transaction cost or
provide out of long-term sources, such as: negligible transaction cost.

1. Share capital Motives for Holding Cash.

a. Equity share capital The firm’s need to hold cash may be
b. Preference share capital attributed to the three motives given below:
2. Debentures The transaction motive.
a. Convertible debentures The precautionary motive.
b. Non-convertible debentures The speculative motive.
The Compensation motive.
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6 Financial Management
Significance / Importance of Cash Management
1.Transaction Motive: The transaction
motive requires a firm to hold cash to conduct its 1. Cash planning - Cash is the most important as
business in the ordinary course and pay for well as the least unproductive of all current assets.
operating activities like purchases, wages and Though, it is necessary to meet the firm’s
salaries, other operating expenses, taxes, dividends, obligations, yet idle cash earns nothing. Therefore,
payments for utilities etc. The basic reason for it is essential to have a sound cash planning neither
holding cash is non-matching between cash excess nor inadequate.
inflows and cash outflows. Firms usually do not
hold large amounts of cash, instead the cash is
invested in market securities whose maturity 2. Management of cash flows - This is another
corresponds with some anticipated payments. important aspect of cash management. Matching of
Transaction motive mainly refers to holding cash to cash inflows and cash outflows rarely happens.
meet anticipated payments whose timing is not Sometimes, the cash inflows will be more than
perfectly matched with cash inflows. outflows because of receipts from debtors, and cash
sales in huge amounts. At other times, cash
2.Precautionary Motive: The precautionary
outflows exceed inflows due to payment of taxes,
motive is the need to hold cash to meet
interest and dividends etc. Hence, the cash flows
uncertainties and emergencies. In case cash flows should be managed for better cash management.
can be accurately estimated the cash held for
precautionary motive would be fairly low. Another
factor which influences the amount of cash to be 3. Maintaining optimum cash balance - Every
maintained for this motive is the firm’s ability to firm should maintain optimum cash balance. The
borrow at short notice. Precautionary balances are management should also consider the factors
usually kept in the form of cash and marketable determining and influencing the cash balances at
securities. The cash kept for precautionary motive various point of time. The cost of excess cash and
does not earn any return, therefore, the firms should danger of inadequate cash should be matched to
invest this cash in highly liquid and low risk determine the optimum level of cash balances.
marketable securities in order to earn some returns.
3. Speculative Motive. A firm also keeps 4. Investment of excess cash - The firm has to
cash balance to take advantage of unexpected invest the excess or idle funds in short term
opportunities, typically outside the normal course of securities or investments to earn profits as idle
business. Such motive is, there fore, of purely funds earn nothing. This is one of the important
speculative nature. For e.g., a firm may like to take aspects of management of cash.
advantage of an opportunity of purchase raw materials
at the reduced price on payment of immediate cash.
Similarly it may like to keep some cash balance to Thus, the aim of cash management is to maintain
make profit by buying securities in times when their adequate cash balances at one hand and to use
prices fall. excess cash in some profitable way on the other
hand.
4. Compensation Motive.
Another motive to hold cash balance is to
compensate banks for providing certain services Objectives of cash management.
and loans. Banks provide a variety of services to
business firms such as clearance of cheque, supply The basic objectives of cash management
of credit information, transfer of funds and so on. are two fold. Meeting payment schedule and
While for some of these services banks charge a minimising funds locked up as cash balance.
commission or fees, for others they seek indirect
compensation. Usually clients are required to
maintain a minimum balance of cash at the bank. A. Meeting Payment Schedule.
Since this balance cant be utilised by the firms for In t he normal course of business,
transaction purpose, the bank themselves can use firms have to make payment of cash on a regular
the amount to earn a return. Such balances are and continuous basis to suppliers of goods,
called as compensating balances. employees, and so on. A basic objective of cash
management is to meet the payment schedule, that
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7 Financial Management
is to have sufficient cash to meet the cash a) Inventory model (EOQ) to cash
disbursement needs of a firm. The firm can enjoy management
certain advantages associated with maintaining b) Stochastic model
adequate cash. They are:
c) Probability model
d)The BAT Model
a. Insolvency - The question of insolvency does
not arise as the firm will be able to meet its
obligations. 3. Strategy for economizing cash
a. Accelerating Cash Inflows / Speedy
Cash Collection.
b. Good relations - Adequate cash balance in the
business firm helps in developing good relations b. Strategy For Slowing Cash Outflows
with creditors and suppliers of raw materials. Delaying Payments.
c. Credit worthiness - The maintenance of
4. Investing Surplus Cash
adequate cash balances increase the credit
worthiness of the firm. Consequently it will be able
to purchase raw materials and procure credit with 1. Projection of cash flows and planning - Cash
favorable terms and conditions. Budgeting
The cash planning and the projection of cash flows
d. Availing discount facilities - The firm can avail is determined with the help of cash budget. The cash
the discounts offered by the creditors for payments budget is the most important tool in cash management. A
before the due date. cash budget is an estimation of the cash inflows and
outflows for a business over a specific period of time.
It gives a summary of cash flows over a period of time.
e. To meet unexpected facilities - The firm can The Finance Manager can plan the future cash
easily meet the unexpected cash expenditure in requirements of a firm based on the cash budgets.
situations like strikes, competition from customers The first element of a cash budget is the selection
etc. with little strain.
of the time period. Some firms may prefer to prepare
So, every firm should have adequate cash weekly budget while others may work out monthly
balances for effective cash management estimates while some others may be preparing quarterly or
yearly budgets.
B. Minimising Funds Locked up as Cash
Balance. The second element that has a bearing on cash
In minimising the cash balance, two budget preparation is the selection of factors that have a
conflicting aspects have to be reconciled. A higher bearing on cash flows. Only items of cash nature are to be
cash balance ensures proper payment with all its selected while noncash items such as depreciation and
advantages. But this will result in a large balance amortization are excluded.
of cash remaining idle. Low level of cash balance
may result in failure of the firm to meet the
2. Determining optimal level of cash holding in
payment schedule. The finance manager should,
the company - One of the important
there fore, try to have an optimum amount of cash responsibilities of a finance manager is to maintain
balance, keeping in view the above factors.
sufficient cash balances to meet the current
obligations of a company. Every business
Cash Management Techniques / Process. enterprise hold cash balances for transaction
purposes and to meet precautionary, speculative
and compensative motives. While determining the
The strategic aspect of an efficient cash management are: optimum level of cash balance (neither excess nor
- inadequate cash balances) the finance manager has
1. Projection of cash flows and planning- Preparation to bring a trade off between the liquidity and
of cash budget profitability of the firm.
2. Determining optimal level of cash holding in
the company
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8 Financial Management
The optimum level of cash balances of a company A = Monthly requirement = Rs. 36,000
can be determined in various ways : They are O = Fixed Cost for securing capital = Rs. 100
C = Cost of interest on marketable securities =
a) Inventory model (Economic Order Quantity) to 12% per year Per month: 1% or (0.1)
cash management
b) Stochastic model Therefore:
c) Probability model
d)The BAT Model

A) Baumol model of cash management /

Inventory model (EOQ) to cash management -

William J. Baumol developed a model (The Optimum transaction of cash: Rs. 8,485.28
Transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in B) Stochastic (irregular) Model - This model is
inventory management but has its application in developed to avoid the problems associated with
determining the optimal cash balance also. the EOQ model. This model was developed by
Economic Order Quantity (EOQ) model is used Miller and Orr. The basic assumption of this
in determination of optimal level of cash of a model is that cash balances are irregular.
company. In the model, the carrying cost of
holding cash-namely the interest forgone on
marketable securities is balanced against the The Miller and Orr (MO) model provides two
fixed cost of transferring marketable control limits-the upper control limit and the lower
securities to cash, or vice- versa. The Baumol control limit along-with a return point as shown in
model finds a correct balance by combining the figure below:
holding cost and transaction costs, so as to
minimize the total cost of holding cash. The
optimal cash balance is reached at a point where
the total cost is the minimum.

Optimum level of cash balance can be

determined as follows:

When the cash balance touches the upper control limit

(h), markable securities are purchased to the extent of
hz to return back to the normal cash balance of z.

In the same manner when the cash balance touches

lower control limit (o), the firm will sell the
marketable securities to the extent of oz to again return
to the normal cash balance.
For example : Teja & Company estimated cash
payments of Rs. 36,000 for a period of 30 days. The spread between the upper and lower cash
The average fixed cost for securing capital from balance limits (called z) can be computed using
the market (ordering cost) is Rs. 100 and the
carrying cost or interest rate on marketable Miller-Orr model as below:
securities is 12% per annum. Determine the
optimum quantity of cash balance?

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9 Financial Management
customers. To avail these facility, customers would be
eager to make payment early.

B. Early conversion of payment in to cash.

A firm can conserve cash and reduce its
requirements for cash balance, if it can speed up its
cash collections. Cash collection can be accelerated
C) Probability Model - This model was developed
by reducing the time gap between the time the
by William Beranek. Beranek observed that cash
customer pays the bill and the time the cheque is
flows of a firm are neither completely predictable
collected and funds become available for the firms
nor irregular (stochastic). The cash flows are
use.
predictable within a range.
Three steps are involved in this time interval.
1 Transit or Mailing time :- This is the lime taken
D) The BAT Model The Baumol-Allais-Tobin
by the post office too transfer the cheque from the
(BAT) model is a classic means of analyzing the
customers to the firm. This delay is referred to as
cash management problem. It is a straightforward
Postal Float.
model and very useful for illustrating the factors in
cash management and, more generally, current 2. Time taken in processing the cheque within the
asset management. firm before they are deposited in the Bank.
3. Collection time within the bank called Bank
Float.
III. Strategy For Economizing Cash - Once cash
flow projections are made and appropriate cash The early conversion of payment in to
balances are established, the finance manager cash, as a technique to speed up collection, is done
should take steps towards effective utilization of to reduce the time lag between depositing of the
available cash resources. A number of strategies cheque by the customer and the realisation of
have to be developed for this purpose they are: money by the firm. The collection of account
receivable can be accelerated, by reducing transit,
a) Strategy towards accelerating cash inflows, and
processing and collection time. An important cash
b) Strategy towards decelerating cash outflows
management technique adopted for this is
Decentralised Collection. The principal methods of
A. Accelerating Cash Inflows / Speedy Cash establishing a decentralised collection network are;
Collection.
A. Concentration Banking .
In managing cash efficiently, the cash inflow This is a system of operating through a number of
process can be accelerated through systematic collection centres, instead of a single collection
planning and refined techniques. There are two broad centre at the head office. Under this arrangement, the
approaches to do this. In the first place the customers are required to send their payments
customers should be encouraged to pay as quickly (cheques) to the collection centres covering their
as possible. Secondly the payment from the region. It reduces the mailing time, & time involved in
customers should be converted in to cash with out sending the bill to the customers.
any delay.
B. Lock Box System.
A. Prompt payment by customers.
Under this system, a firm arranges a Post office Lock
One way to ensure prompt payment by Box at important collection centres. The customers are
customers is prompt billing. What the customer has to required to remit payments to the Post office lock box.
pay and the dale and period of payment should be The firms local bank is given the authority to pick up
notified accurately and in advance. The use of the remittances directly from the Box. The bank pick
mechanical devises for billing along with a self ups the mail several times a day and deposits the
addressed return envelope will speed up the payment. cheques in the firms A/C. after crediting the A/C, the
Another technique is offering cash discount. bank sends a deposit slip along with the list of
The availability of discount implies savings to payments and other enclosures if any.

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10 Financial Management
Although the use of concentration banking presentation. So although the cheque has been
and lock box system accelerates the collection of issued, cash would be required later, when the
cash, they involve a cost, (cost in terms of cheque is presented for encashment. There fore a firm
maintenance of collection centres, compensation to can send remittance, although it does not have cash in
the bank for services etc.). If the income exceeds the its Bank A/C at the time of issue of cheque. There are
cost, the system is profitable. two ways of doing it.
a. Paying from a distant Bank:
C. Electronic Fund Transfer: Through electronic The firm may issue a cheque on banks away
fund transfer the collection float can be completely from the creditor's bank. This would involve
eliminated the other benefit of electronic fund relatively longer transit time for the creditor's
transfer is instant updation of accounts and bank to gel payment and t hus enable the firm to use
reporting of balances as and when required without its funds longer.
any delay. b. Cheque Encashment Analysis :
Another way is to analyse on the basis of past
B) Strategy For Slowing Cash Outflows experience, the time lag in the issue of cheques and
Delaying Payments. their encashment. For E.g.: Cheques issued to pay
wages and salary may not be cashed immediately, it
Apart from speedy collection of cash , the may be spread over a few days, say 25% on first
operating cash requirements can be reduced by day, 50% on the second day and balance 3r day. It
slow disbursement of A/C Payable. Slow would mean that the firm should keep in the bank,
disbursement represent a source of fund requiring not the entire amount of a pay roll, but only a
no interest payment. There are several techniques to fraction represented by actual withdrawal each
delay payment of A/C payable, namely day. This would enable to save operating cash.
1. Avoidance of early payment
2. Centralised disbursement 4. Accruals: -
3. Floats These are liabilities, that represent a
service/goods received by a firm, but not yet paid for.
4. Accruals For e.g.: Salary to employees who render service in
advance and receive payment later. They extend a
1.Avoidance of early payments. credit to the firm for a period at the end of which
One way to delay payments is to avoid early they are paid (a week or a month). The longer the
payments. According to the terms of credit, a firm period, the greater is the amount of free financing
is required to make payment within a stipulated and the smaller is the amount of cash balance
period. If the firm pays it accounts payable before required.
the due date, it has no special advantage. Thus a
firm would be well advised not to make payments Investing Surplus Cash
early, i.e. not before the due date.
There are sometimes , surplus funds with the
2.Centralised Disbursements. companies which are required after some time.
Since the excess cash balance is available only for a
All the payments should be made by the head
short period of time, it should be invested in highly
office from a centralised disbursement account.
safe and liquid securities.
Such an arrangement would delay payments,
because it involves increase in the transit time. The
The following short-term investment opportunities
remittance from the head office to the customers in
are available to companies in India to invest their
distant places would involve more mailing time.
temporary cash surplus.

3. Floats a) Treasury Bills: Treasury Bills are short-term

It refers to the amount of money tied up in government securities, they are sold at a discount to
cheques that have been written, but not yet en their face value and redeemed at par on maturity.
cashed It is due to transit and payment delays. There is They are highly liquid instruments and the default
a time lag between the issue of a cheque and its risk is negligible.
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11 Financial Management
b) Commercial Papers: Commercial papers are which involve extra cost in terms of interest.
short term, unsecured securities issued by highly Moreover increase in receivables also increases the
creditworthy and large companies. The maturity of chance of bad debts. Thus creation of account
these instruments ranges from 15 days to one year. receivable is beneficial as well as dangerous.
These instruments are marketable hence they are
liquid instruments.
Thus the objective of receivables management
c) Certificate of Deposits: Certificate of Deposits
is to promote sales and profits until that point is
are papers issued by banks acknowledging fixed
reached , where the return on investment in further
deposits for a specified period of time, they are
funding of receivables is less than the cost of funds
negotiable instruments, this makes them liquid. raised to finance that additional credit.
d) Bank Deposits: Firms can deposit
excess/surplus cash in a bank for a period of time.
The interest rate will depend upon the maturity Objectives of credit sales.
period. This is also a liquid instrument in the sense
that, in case of premature withdrawal only a part of The major objectives of credit sales are,
interest earned has to be foregone.
1. Achieving growth in sales:
e) Inter-corporate Deposit: Companies having
surplus cash can deposit its funds in a sister or If a firm sells goods on credit, it will generally be in
associate company or to other companies with high a position to sell more goods than if it insisted on
credit standing. immediate cash payment. This is because many
f) Money Market Mutual Funds: Money market customers are either not prepared or not in a position to
mutual funds invest in short term marketable pay cash when they purchase goods . the firm can sell
securities. These instruments have a minimum lock goods to such customers , in case it gives credit.
in period of 30 days and returns are usually two
percent above that of bank deposits with the same 2. Increasing Profits.
maturity. Increase in sales results in higher profits for the firm,
not only because of increase in the volume of sales
but also because of the firm charging a higher margin
MANAGEMENT OF RECEIVABLES. of profit on credit sales as compared to cash sales.
3. Meeting Competition.
Accounts receivables constitute a significant A firm may have give credit facilities to its
portion of the total current assets of the business. customers because of similar facilities being
They are a direct result of 'trade credit' which has granted by the competing firms to avoid the loss of
become an essential marketing tool in modern sales from customers who would buy else where if
business. When a firm sells goods for cash, they did not receive the expected credit.
payments are received immediately and there fore, The over all objective of committing funds to
no receivables are created How ever when a firm A/C receivable is to generate a large flow of
sells goods or services on credit, the payments are operating revenue and hence profit than what
postponed to future dates and receivables are created. would be achieved in the absence of no such
commitment.
Meaning of Receivables.
The term receivables is defined as "debt Cost of maintaining receivables.
owed to the firm by customers arising from sale of The costs with respect to maintenance of receivables
goods or service in the ordinary course of business." can be identified as follows.
Receivables are a direct result of credit sales. 1. Capital Costs
Credit sale is resorted to, by a firm to push up it s Maintenance of A/C receivables results in
sales which ult imat ely results in pushing up the blocking of the firms financial resources in them.
profits earned by the firm. At the same time, This is because there is a time lag between the sale
selling goods on credit result in blocking of funds of goods to customers and the payments by them.
in Accounts Receivables. The firm has, there fore, to arrange for additional
Additional funds are, there fore, funds to meet its own obligations, such as payment
necessary for the operational needs of the business, to employees, suppliers of raw materials, etc while
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12 Financial Management
awaiting for payments from its customers. i.e. investment in receivables. These include total
Additional funds may either be raised from outside amount of credit to be accepted, the length of the credit
or out of profits retained in the business. period to be extended, and the cash discount to be
given. If a firm has a liberal credit policy, it will
experience a higher level of receivables as compared to a
In both cases the firm incurs a cost. In the former
firm with rigid policy.
case, the firm has to pay the interest to the outsider,
while in the second case there is an opportunity
cost to the firm. - i.e. the money the firm could 3. Terms of Trade.
have earned otherwise by investing the funds else The size of receivables is also affected by the
where. terms of trade (or credit terms) offered by the firm,
the two important components are credit period and
2 Administrative Cost. cash discount.
The firm has to incur additional administrative
cost for maintaining Account Receivables in the A. Credit Period -
form of salaries to the staff kept for maintaining The term credit period refers to the time duration for
accounting records relating to customers, cost of which credit is extended to the customers. It is
conducting investigation regarding customers credit generally expressed in terms of "net date". For eg, if a
worthiness etc. firms credit terms are 'net 15' it means the customers
are expected to pay within 15 days from the date of
3. Collecting Cost. credit sale.
The firm has to incur costs for collecting
payments from its credit customers. Some times B. Cash Discount.
additional steps may have to be taken to recover Most of the firms offer cash discounts to their
money from defaulting customers. customers for encouraging them to pay their dues
4. Defaulting Cost. before the expiry of the credit period. Allowing
Some times after making all serious efforts to cash discounts results in a loss to the firm because
collect money from defaulting customers, the firm of recovery of less amount than what is due from the
may not be able to recover the over dues because of customer, but it reduces the volume of receivables
the in ability of the customers. Such debts are treated and puts extra funds at the disposal of the firm for
as bad debts and have to be written off since they alternative investment. The amount of loss thus
cant be realised. suffered is, there fore, compensated by the income
otherwise earned by the firm.'
Factors affecting the Size of Receivables.
4 Stability of sales.
The size of Account Receivables is determined by
a number of factors. Some are: In the business of seasonal character, total sales
and the credit sales will go up in the season and
therefore volume of receivables will also be large. If the
1. Size of Credit Sales: firm supplies goods on installment basis its balance in
The volume of credit sales is the first factor which increases receivables will be high.
or decreases the size of receivables. If a concern sells only on 5. Expansion Plans:
cash basis as in the case of Bata Shoe Company, then there
will be no receivables. The higher the part of credit sales out When a concern wants to expand its activities, it
will have to enter new markets. To attract customers, it
of total sales, figures of receivables will also be more or vice
will give incentives in the form of credit facilities. The
versa. This is the most important factor in
determining the size of receivables. Generally in the period of credit can be reduced when the firm is able to
get permanent customers. In the early stages of
same industry, a firm having a largo volume of sales
will be having u larger level of receivables as expansion more credit becomes essential and size of
receivables will be more.
computed to a firm with a small volume of sales.
2. Credit Policies.
The term credit policy refers to those decision 6. Credit Collection Efforts: The collection of credit
should be streamlined. The customers should be sent
variables that influence the amount of trade credit,
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13 Financial Management
periodical reminders if they fail to pay in time. On the procedure in a clear cut sequence. — i.e. polite letter,
other hand, if adequate attention is not paid towards strong worded reminders, personal visits and then legal
credit collection then the concern can land itself in a action.
serious financial problem. An efficient credit collection
machinery will reduce the size of receivables.
4. Analysing the Investments in Receivables.
7. Habits of Customers:
The last step is to analyse the amount of
The paying habits of customers also have bearing on receivables from time to time with the help of certain
the size of receivables. The customers may be in the ratios such as calculation of average collection period,
habit of delaying payments even though they are debtors turn over ratio, ratio of receivables to current
financially sound. The concern should remain in touch assets etc. A proper analysis of receivables will help
with such customers and should make them realise the the management in keeping the amount of receivables
urgency of their needs. within reasonable limits.

System of Control of Receivables. Dimensions of Receivables Management

It is in the interest of the enterprise to keep the Receivables management involves the careful
investment in receivables in a controllable limit. The consideration of the following aspects:
financial management should consider the following
four factors which control the receivables management
cost at a minimum point. 1. Forming of credit policy.
2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Deciding acceptable level of Risk.
The first consideration in this regard is to
decide to whom goods are to be sold bearing in 1. Forming of Credit Policy
mind the risk involved. Because every credit
transaction involves risk element, the financial For efficient management of receivables, a concern
management should consider the credit capacity of must adopt a credit policy. A credit policy is related
every customer before allowing any credit to him. to decisions such as credit standards, length of
Capacity of a customer can be judged by credit period, cash discount and discount period,
understanding his Character, Collateral Security etc. This aspect of receivables management is
offered and Conditions of sales. concerned with deciding about:

2. Terms of Credit Sales. 1. The quality of the trade accounts to be accepted

The next thing the company has to decide is the i.e., credit standards,
Credit Terms and the Level of Discount. In deciding 2. The length of the credit period,
upon the credit terms the firm should think over
3. Cash discount,
certain basic issues involved in it - such as cost of
capital, cash discount, volume of sales, period of 4. Discount period,
credit sales, and so on. By considering all these
factors, — i.e. the Cost and the Benefits— the (a) Quality of Trade - Credit Standards:
financial manager should fix the most desirable credit The volume of sales will be influenced by
terms. the credit policy of a concern. By liberalising credit
policy the volume of sales and profit can be
3. Credit Collection Policy. increased. But this will result in enhanced costs
After granting the credit sale, the Co. should try to and risks of bad debts and delayed receipts. The
get the amount collected from its customers as early as increase in number of customers will increase the
possible. It needs a sound and strict collection policy clerical wok and collecting of information about the
to keep bad debts and losses at the minimum. The credit worthiness of customers. There may be more
must also provide a certain amount as reserve for bad debt losses also.
bad debt. The company should follow a collection
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14 Financial Management
On the other hand, extending credit to discount and making payments as per earlier
only credit worthy customers will save costs like schedule will also delay their payments.
bad debt losses, collection costs, investigation
costs, etc but it reduces sales volume, thus resulting
2. Executing Credit Policy
in reduced profits.

After formulating the credit policy, its proper

A finance manager has to match the increased execution is very important.
revenue with additional costs. The credit should be
liberalised only to the level where incremental
revenue matches the additional costs. The optimum (a) Collecting Credit information:
level of investment in receivables should be where The first step in implementing credit policy
there is a trade off between the costs and will be to gather credit information about the
profitability. customers. The information may be available
from financial statements, credit rating agencies,
(b) Length of Credit Period: Credit terms or length reports from banks, firm’s records etc. Financial
of credit period means the period allowed to the reports of the customer for a number of years will
customers for making the payment. The customers be helpful in determining the financial position and
paying well in time may also be allowed certain profitability position. There are credit rating
cash discount. A concern fixes its own terms of agencies which can supply information about
credit depending upon its customers and the various concerns. Credit information may be
volume of sales. The competitive pressure from available with banks too. The banks have their
other firms compels to follow similar credit terms, credit departments to analyse the financial position
otherwise customers may feel inclined to purchase of a customer. In case of old customers, business
from a firm which allows more days for paying own records may help to know their credit
credit purchases. Sometimes more credit time is worthiness. The frequency of payments, cash
allowed to increase sales to existing customers and discounts availed, interest paid on over due
also to attract new customers. payments etc. may help to form an opinion about
the quality of credit.

The length of credit period and quantum of

discount allowed determine the magnitude of (b) Credit Analysis: After gathering the required
investment in receivables. information, the finance manager should analyse it
to find out the credit worthiness of potential
customers and also to see whether they satisfy the
(c) Cash Discount: Cash discount is allowed to standards of the concern or not. Thus, credit
accelerate the collection of receivables. The analysis involves the credit investigation of
concern will be able to use the additional funds potential customer to determine the degree of
received from speedy collections due to cash risk associated with giving credit to a firm. The
discount. The discount allowed involves cost. The credit analysis will determine the degree of risk
discount should be allowed only if its cost is less associated with the account, the capacity of the
than the earnings from additional funds. If the customer borrow and his ability and willingness to
funds cannot be profitably employed then discount pay.
should not be allowed.
(c) Credit Decision: After analysing the credit
(d) Discount Period: The collection of receivables worthiness of the customer, the finance manager
is influenced by the period allowed for availing the has to take a decision whether the credit is to be
discount. The additional period allowed for this extended and if yes then upto what level. He will
facility may prompt some more customers to avail match the creditworthiness of the customer with the
discount and make payments. This will mean credit standards of the company. If customer’s
additional funds released from receivables which creditworthiness is above the credit standards then
may be alternatively used. At the same time the there is no problem in taking a decision. In case the
extending of discount period will result in late customers are below the company credit standards
collection of funds because those who were getting

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15 Financial Management
then they should not be outrightly refused. b) The advance fiancé provided by factor firm
Rather they should be offered some alternative would be available at a higher interest costs than
facilities. usual rate of interest.

(d) Financing Investments in Receivables ( and Non-Monetary Costs

Factoring) : a) The factor firm doing the evaluation of credit
Accounts receivables block a part of worthiness of the customer will be primarily
working capital and hence the finance manager concerned with the minimization of risk of delays
should make efforts to get receivables collected so and defaults. In the process it may over look sales
that working capital needs are met in time. growth aspect.
Accounts receivable financing may include
pledging accounts receivable as collateral for a loan b) A factor is in fact a third party to the
from a bank or an outright sale (factoring) of customer who may not feel comfortable while
receivables. Banks in India provide loans against dealing with it.
accounts receivable.

c) The factoring of receivables may be

Another method of receivable financing is considered as a symptom of financial weakness.
factoring receivable. Factoring involves the direct
sale of receivables to a factoring firm / bank. In
the factoring of accounts receivable, title is
transferred to the factor who manages and collects 3. Formulating and Executing Collection Policy
the accounts.
The factor / bank will credit the amount to Proper management of receivables calls for
the party after deducting discount and will collect designing of suitable collection policy of the firm
the money from the customers later. The factoring and laying down collection procedures.
may be with or without recourse. It is without
recourse then any bad debt loss is taken up by the
factor but if it is with recourse then bad debts losses Collection Policy:
will be recovered from the seller. Basic objective while formulating collection policy
is to ensure the earliest possible payment of
receivable without any customer losses through ill
Benefits and Cost of Factoring
will. Prompt collection of accounts tends to reduce
investment required to carry receivables and the
A firm availing factoring services may have the costs associated with it. Percentage of bad debts is
following benefits: very likely to decrease.
i. Better Cash Flows
ii. Better Assets Management The collection policy can be termed as strict and
iii. Better Working Capital Management lenient. A strict policy of collection will involve
iv. Better Administration more efforts on collection. Such a policy has both
v. Better Evaluation positive and negative effects. This policy will
enable early collection of dues and will reduce bad
vi. Better Risk Management
debt losses. On the other hand a rigorous collection
policy will involve increased collection costs. It
may also reduce the volume of sales.
However, the factoring involves some monetary
and non-monetary costs as follows:
A relaxed or lenient collection policy may
increase the debt collection period and more bad
Monetary Costs
debt losses. A customer not clearing the dues for
a) The factor firm charges substantial fees and long may not repeat his order because he will have
commission for collection of receivables. to pay earlier dues first.

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16 Financial Management
The collection policy should also include steps to
be followed in collecting receivables. The steps
should be like
(i) sending a reminder for payments
(ii) Personal request through telephone etc.
(iii) Personal visits to the customers
(iv) Taking help of collecting agencies and lastly
(v) Taking legal action.

The last step should be taken only after exhausting

all other means because it will have a bad impact
on relations with customers.

The collection of receivables / debtors can be

monitored with the help of average collection
period and aging schedule. The actual collection
period may be compared with stated period to
evaluate the efficiency of collecting money from
debtors. It can help to take necessary corrective
actions. The aging schedule shows the Debtors
according to their period of debt. The aging
schedule can be used to identify the customers that
are extending the time to repay the amount.

NSS College. Rajakumari.