Working capital refers the cash a company requires in order to finance its day-to-day business

operations or in other words, working capital refers to the amount of capital which is readily available to
an organization. Working capital is basically an indicator of the short-term financial position of an
organization and is also the measure of its overall efficiency.

Working capital is one of the most fundamental measures of a company’s financial strength. If a
company possesses a significant value of liquid assets, it can easily fund its day-to-day business
obligations. If, however, a company is under cash crunch, whether by way of a lack of cash, trouble in
collecting its account receivable, or a dearth of inventory, it may face difficulties keeping up with
demand for its products/services.

Working capital can be obtained by subtracting the current liabilities from the current asset

The importance of working capital management

Since we know that working capital is a daily necessity for every business, they need a regular amount of
cash to make the routine payments day-to-day, cover unexpected costs, and purchase basic materials
used in the production of goods. The primary purpose of working capital management is to make sure
the company always maintains sufficient cash flow to meet its short-term operating costs and short-
term debt obligation. So that means working capital management is a vital part of a business. The main
objectives of working capital management include maintaining the working capital operating cycle and
ensuring its ordered operation, minimizing the cost of capital spent on the working capital, and
maximizing the return on current asset investments.

Because working capital is a metric for companies to calculate the efficiency, liquidity, and overall health
of a company, which reflects various company activities such as inventory management, debt
management, and revenue collection. And any type of business must need working capital management
because it is essentially an accounting strategy with a focus on the maintenance of a sufficient balance
between a company’s current assets and liabilities.

 Dangers of too much working capital  

>> High investment in working capital denotes idling of funds which earns no returns on its investment. 

>> High level of inventory and receivable demands more supervision and good amount of control which
has its cost too. 
>> Chances of wastages in inventory and bad debt losses are more when the level of working capital is
very high. 

>> Idling and accumulation of funds may bring inefficiencies in the system. 

>> High liquidity in the business results in low profitability which can shake the confidence of
shareholders and the market price of share may fall.

 Dangers of too little working capital 

>> Illiquidity is the biggest danger of inadequate working capital. A firm, which is not able to meet its
short-term obligations, endangers its goodwill and long-term survival. 

>> Inadequacy of working capital leads to frequent and regular stoppages in the production. 

>> A firm short of liquidity cannot take short-term environmental opportunities due to lack of funds. -
Advantages of bulk purchases are forgone. 

>> In case of emergency, the firm must resort to external borrowing which has a very high cost. 
For the characteristics of working capital, we have:

- Short lifespan: normally working capital is less than one year since they are current assets like cash,
bank balance, marketable securities, account receivable and inventories.

- Swift transformation: Current assets can transform into other assets. For example: cash is used for
acquiring raw materials, then raw materials is transform into finished goods, finished goods generally
sold on credit thus converted into account receivables, and finally account receivables generate cash.

- Short-term focus: Working capital is an indication of a company’s short-term financial health and the
present value of money is not significant for the purpose of analyzing financial condition.

- Repetitive and frequent: Working capital is constantly converted into cash which again turns into
working capital. This process of conversion goes on continuously. The cash is used to purchase current
assets and when the goods are produced and sold out; those current assets are transformed into cash.
Thus, it moves in a circular away. That is why working capital is also described as the involvement of
repetitive and frequent activities.

- Liquidity: Working capital is more liquid than fixed capital. If need arises, working capital can be
converted into cash within a short period and without much loss. A company in need of cash can get it
through the conversion of its working capital by insisting on quick recovery of its bills receivable and by
expediting sales of its product. It is due to this trait of working capital that the companies with a larger
amount of working capital feel more secure. It is very liquid for it can be converted as cash at any time
without losing anything.

- Inter-relation among assets: Current assets cannot be viewed in isolation.

For the statement: The most important characteristic of working capital is its quick liquidity

The statement is true. Because working capital, by definition, must be comprised of highly liquid assets
that can be easily turned into cash, acting as a source of payment for short-term debt obligations and a
"insurance" for short-term survival against a few failed years (profit decrease). If a company does not
generate cash for years (even if it is lucrative), it will struggle to continue trading, pay its suppliers, and
will finally have to declare bankruptcy. However, to avoid the trade-off between liquidity and
profitability, a desirable level of liquidity for working capital must be sustainably high but not excessively
so.
  Similarities:

Operating cycle and cash cycle are measures of how effective a company is at managing its cash. Money
is tied up in inventory until it can be sold. As a result, cash invested in the inventory is not available for
alternative uses. Maintaining a short operating cycle and cash conversion cycle are ways that businesses
minimize inventory storage and depreciation costs and keep their liquidity high.

 Differences:

Operating cycle Cash cycle

Definition The length of time between when The length of time between when the firm
a firm originally purchases its pays cash to purchase its initial inventory
inventory and when it receives the and when it receives cash from the sale of
cash back from selling its product. the output 

Formula Operating cycle = Day of Cash cycle = Day of Inventory

Inventory outstanding + Day sales outstanding + Day sales outstanding –
outstanding Day payable outstanding
Purpose An operating cycle represents the a cash cycle represents the amount of time
amount of time it takes a company it takes a company to convert resources to
to acquire inventory, sell that cash. The cash cycle calculates the time
inventory, and receive cash from during which each dollar is committed to
its customers in exchange for the various production and sales processes
inventory sold.  before it is then converted to cash in the
form of accounts receivable, or paid
invoices.
For the statement: The operating cycle is always longer than the cash cycle

Yes. Unlike the cash flow cycle, the operating cycle does not include the length of time it takes to pay
suppliers. The longer it takes to pay suppliers the shorter your cash flow cycle. This is because trade
credit represents a source of cash, which shortens the cash flow cycle. So the operating cycle can be
longer than the cash cycle. Since the cash cycle equals the operating cycle minus the accounts payable
period, it is not possible for the cash cycle to be longer than the operating cycle if the accounts payable
period is positive. Moreover, it is unlikely that the accounts payable period would ever be negative since
that implies the firm pays its bills before they are incurred.
The components of working capital:

 Cash: it is one of the most important components of current assets as well as the most
liquid form of current assets. It is needed for performing all the activities of a firm, i.e.,
from acquisition of raw materials to marketing of finished goods. After this, in order of
liquidity, come cash equivalents.
 Inventory: is kept in many forms - raw materials, work in progress and finished goods,
which purchased by company with a view to resell in the market and earn profits. The
turnover of inventory determines how the successful the business is.
 Accounts receivable is the balance of money owed to a firm for goods or services
delivered or used but not yet paid for by customers. You will find account receivables on
the company’s balance sheet under the current assets. The important point is that they
are classified as assets but in real, they are not available for usage until realized in more
liquid form.
 Payable: is divided into Accounts Payable and Notes Payable.
- Accounts Payable are the suppliers of goods/services whose invoices have not yet been
paid. comes under the head of current liabilities and one of the major components of
working capital management. Accounts payable can be managing through negotiations
with creditors to extend the payment period.
- Notes payable: is a liability account where a borrower records a written promise to
repay the lender. When carrying out and accounting for notes payable, "the maker" of
the note creates liability by borrowing from another entity, promising to repay the
payee with interest. Then, the maker records the loan as a note payable on the balance
sheet.
The most important component of working capital:
In my opinion, it is impossible to choose one of those to be the most important component of
working capital since each of them has their own costs and benefits. Cash and cash equivalents
are the most liquidity current assets that are used to handle the daily operations, unexpected
expenses and the financial stability of the company. While the inventory determines how
successful a business is. The inventory helps the management reduce the risk of running out of
stocks and losing customers. Similarly, if the inventory is not available on time, it is a loss of
sales. Therefore, inventory management involves the control of stock that is purchased for sale
in the normal course of business. In connection with the company’s accounts receivable, there
are two conflicting views: On the one hand, granting credit can enhance the sales rate, whereas
the increase in credit sales may cause bad debts. Hence, the working capital components
should be analyzed according to their costs and benefits.
Working Capital Requirement is the amount of money needed to finance the gap between
disbursements (payments to suppliers) and receipts (payments from customers).

WCR = Inventory + Accounts Receivable - Accounts Payable - Pre-paid Expenses

WC = Inventory + Accounts Receivable + Cash - Accounts Payable - Pre-paid Expenses - Short-term Loans

=> WC = Current Assets-Current Liabilities

Factors influencing working capital requirements:

+ Nature of business: The nature of business is usually of two types: Manufacturing Business and Trading
Business. In the case of manufacturing business, it takes a lot of time to convert raw material into
finished goods. Consequently, more working capital is required. On the contrary, in case of trading
business the goods are sold immediately after purchasing or sometimes the sale is affected even before
the purchase itself. Therefore, very little working capital is required. Moreover, in case of service
businesses, the working capital is almost nil since there is nothing in stock.

+ Seasonality of operations: During the busy season, more working capital is required while during the
slack (less busy) season less working capital is required.

+ Level of activity: The firms operating at large scale need to maintain more inventory, capital. So, they
generally require large working capital whereas firms operating at small scale require less working
capital.
+ Market conditions: The working capital requirements of a company depends on the degree of
competition in the market. If the competition is intense, then the company has to spend a lot of money
on running advertising campaigns and sales promotion. It will also have to keep more stock and sell on
credit. So, it will require more working capital.

+ Supply conditions: The working capital requirements of the company depends on the conditions of
supply:

1. If the supply of raw materials is regular, then the company can keep less inventory (stock). So, it
will require less working capital.

2. But if the supply is irregular then the company has to hold more stock. Therefore, in such a case,
it will need more working capital.

Statement: Managing working capital is to manage factors affecting working capital requirements.

Working capital management refers to a company’s strategies to monitor and utilize the components of
working capital to ensure the most financially efficient operation of the company. The primary purpose
of working capital management is to make sure the company always maintains sufficient cash flow to
meet its short-term operating costs and short-term debt obligation. And the working capital
requirements that I have already mentioned is the denominator of three elements essential to the
proper functioning of any business (cash, profitability, and the business efficiency).
The instruments used to finance working capital requirements:

 Commercial paper: is a money-market security issued by large corporations to obtain funds to

meet short-term debt obligations and is backed only by an issuing bank or company promises to
pay the face amount on the maturity date specified on the note.
 Inter-corporate deposits is an unsecured borrowing by corporates and financial institutions from
other corporate entities. The corporate having surplus funds would lend to another corporate in
need of funds.
 Accounts receivable financing:

- Pledging: A pledge of accounts receivable is the use of a firm’s receivables to secure a short-term loan.
- Factoring: Factoring accounts receivable is a financial transaction and a type of debtor finance in which
a business sells its accounts receivable to a third party (called a factor) at a discount.

 Spontaneous financing:  is the financing that arises from the normal operating cycle.

- Accrued expenses: Accrued expenses are periodically recurring short-term liabilities such as wages
accrued but not yet paid to employees and taxes owned but not yet paid. A firm can use all the accruals
it can since there is no actual cost involved.

- Accounts payable (Trade credit): Trade credit allows a firm to defer cash payments to its suppliers in
exchange for its promise to pay them in the future. The purchasing firm pays for the goods as per the
supplier’s credit terms. Credit terms usually express the amount of the cash discount, the date of its
expiration, and the due date.

 Bank credit:

- Line of credit is an agreement between a commercial bank and a business that states an amount of
short-term borrowing the bank will make available to the firm over a given period of time.
- Revolving credit: is a guaranteed line of credit.

- Bank overdraft: The account holder withdraws more money from a bank account than has been
deposited in it.

Statement: Bank credit is the most important instruments to finance working capital requirements.

In my opinion, bank credit is not the most important instruments to finance working capital
requirements when comparing to other instruments. Most of the time, funds from banks have higher
borrowing costs when having a low credit rating or no collaterals, which make small business finds it
difficult to lend a large amount of money.
Permanent working capital: refers to the level of current assets that have to be maintained and are
important for the firm to run its business regardless of the level of operations. It has fixed working
capital. Permanent working capital usually financed with long-term debt and equity.

Permanent working capital will always be the reserve capital for uncertain situations like lockout, strike,
or depression.

Temporary working capital: refers to the working capital which is over & above the permanent working
capital. It is necessary to meet seasonal needs and temporary needs. It has fluctuating or variable
working-capital. Temporary working capital usually financed with short-term loans.

Temporary working capital will be only for special needs like advertising of a product etc.

How can these concepts be used to analyze the working capital financing approach?

Through 3 types of approach:

Hedging (or Maturity approach)

- Fixed assets and the non-seasonal portion of current assets are financed with long-term debt and
equity.

- Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is
expected to cover the short-term financing cost).

Conservative approach

Long-term financing benefits

- Less worry in refinancing short-term obligations.

- Less uncertainty regarding future interest costs.

Long-term financing risks

- Borrowing more than what is necessary.

- Borrowing at a higher overall cost.

=> Results: Managers accept less expected profits in exchange for taking less risk.

Aggressive approach

Short-term financing benefits

- Financing long-term needs with a lower interest cost by short-term debt.

- Borrowing only what is necessary.

Short-term financing risks

- Refinancing short-term obligations in the future.

- Uncertain future interest costs.

=> Result: Managers accept greater expected profits in exchange for taking greater risk.
How can we use the ratio…

To use the ratio analysis in working capital management, we need to use the ratios (such as liquidity,
solvency, or efficiency ratios) to compare with the industry’s statistics or the result from previous years.
The general rule when using industry comparisons is that any result within the interquartile range is
considered normal, and that any result outside of that range is unusual and worthy of further analysis.

Statement: A company with a long cash conversion cycle will have higher firm value.

For this statement, I believe that the length of a good cash conversion cycle depends on the situation or
the size of the business. A long CCC can improve a company's performance and value by increasing sales
and profitability for a variety of reasons. A long CCC indicates that a company can make more sales
because it is now providing more credit to its customers and also providing more time for the credit.
Furthermore, larger inventories can prevent interruptions in the manufacturing process and loss of
business due to product’s scarcity. In terms of accounts payables, companies that reduce supplier
financing may be able to take advantage of critical discounts for early payments. A firm's business and
profitability can be expanded in this manner, but the firm may run out of working capital.

However, almost all small businesses are unable to easily find external financing sources, and a short
CCC is preferable for them because it has been documented that a long CCC may be a primary cause of
bankruptcy. If the accounts receivable collection period is too long, the company may face liquidity and
payment recovery issues. Because of the high cost of borrowing, they would have to seek outside
financing, which would reduce their profit margin. As a result, several studies have found that reducing
the cash conversion cycle (CCC) can improve operating performance.
Reasons for holding cash:

 Transactions: A firm needs cash for making transactions in the day-to-day operations. The cash
is needed to make purchases, pay expenses, taxes, dividend, etc. The cash needs arise due to
the fact that there is no complete synchronization between cash receipts and payments.
Sometimes cash receipts exceed cash payments or vice-versa.
 Precaution: A firm is required to keep cash for meeting various contingencies. Though cash
inflows and cash outflows are anticipated but there may be variations in these estimates. If the
firm maintains too small a cash balance, it may run out of cash. If so, it must sell marketable
securities or borrow, which involve trading costs. Hence, it is necessary for a firm to hold a
certain level of cash on hand.
 Compensating balances: Cash balances are kept at commercial banks to compensate for loans
and/or banking services rendered to the firm. A minimum required compensating balance at
banks providing credit services to the firm may impose a lower limit on the level of cash a firm
holds.
 Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line,
marketable securities. These opportunities cannot be scientifically predicted but only
conjectures can be made about their occurrence.

Cash budget:

The cash budget is an important tool for short-run financial planning. The cash budget depicts the
company's projected cash inflows and outflows over a given time period. It will also inform the manager
of the short-term borrowing requirements. Firms typically use a monthly cash budget forecasted over
the next year, as well as a more detailed daily or weekly cash budget for the coming month. Monthly
cash budgets are used for planning, while daily or weekly cash budgets are used for actual cash control.
In other words, the cash budget keeps track of the estimated cash receipts and disbursements on a
regular basis.
Baumol model

The Baumol is closely related to the Economic Order Quantity (EOQ), which relates to inventory
management. In EOQ, the optimal level of inventory is determined by considering the carrying and
ordering costs of inventory. In this model, cash balances are considered similar to inventory levels of a
business. Therefore, the same concept is applied to cash management to determine the optimal level of
cash that businesses can inject into a current account or transfer to short-term investments at one time. 

Formula: C=
√ 2 TF which: C represents the optimal cash level. T represents the demand for cash over
K
time. F represents fixed transaction costs for cash transfer, R represents the alternative cost of
maintaining cash.

Miller-Orr model

The Miller-Orr Model is not concerned with optimal levels of cash like the Baumol Model. Instead, the
Miller-Orr Model helps businesses with uncertain or irregular cash flows. It allows businesses to
establish an upper (H) and a lower limit (L) for cash balance and determine a target cash balance, which
is known as the return point. When the cash balance reaches the upper control limit H, cash is invested
elsewhere to get us to the target cash balance Z. When the cash balance reaches the lower control limit,
L, investments are sold to raise cash to get us up to the target cash balance.
Formula:

Statement: Miller-Or model is the best model of managing cash

I believe the statement is true. When we look at the Baumol model, it predicts an optimal level of cash.
But in practice, maintaining an optimal level of cash may not be possible. Similarly, the model requires
businesses to forecast demand for financial resources. In practice, demands are very difficult to predict
and can result in inaccurate results. Similarly, the model requires transaction costs and the costs of
holding cash. It may be difficult for businesses to determine these. Furthermore, all these required
figures can easily change with time, thus, resulting in inaccurate calculations. While we look at the Miller
Orr model, it allows businesses to consider cash flows that occur randomly or unpredictably. Second, it
considers transfers that take place at any time. Finally, it produces control limits that businesses can use
as a basis for cash management.
Factors that influence the target cash balance:

 Costs of holding cash: firms need to pay for trading cost and the forgone income creates
opportunity cost.
 Borrowing

- Borrowing is likely to be more expensive than selling marketable securities.

- The need to borrow will depend on management’s desire to hold low cash balances.

 Compensating balance

- Firms have cash in the back as a compensation for banking services.

- Large corporations have thousands of accounts with several dozen banks

- Sometimes it makes more sense to leave cash alone than to manage each account on a daily basis.

Statement: A company will always buy marketable securities when it has surplus cash.

I don’t think that a company will always buy marketable securities when it has surplus cash. Firms have
excess cash for three reasons: to finance seasonal or cyclical activities, to cover planned expenses, and
to cover unanticipated contingencies. As a result of seasonal cash demand, they have a variety of actions
in different time periods. When there is a deficit and a high demand for money to operate, firms will
convert securities back to cash. They frequently limit the maturity of short-term investments to 90 days
in order to avoid principal loss due to changing interest rates and to avoid default risk.
When there are deficits and a significant demand for money to function, firms will convert securities
back to cash. They must keep a balance between the amounts of cash in the cash account and the
amounts of cash invested in securities. Transactions are carried out when the cash balance meets the
firm's lower or upper control limits. They frequently limit the maturity of short-term investments to 90
days in order to avoid principal loss owing to changing interest rates and to avoid default risk.
Float refers to ‘the amount of money tied up between the time a payment is initiated and cleared funds
become available in the company’s bank account’. The efficiency of firm’s cash management can be
enhanced by having knowledge and use of various procedures aiming at accelerating cash inflows and
controlling cash outflows. Float management involves keeping a large number of shares available for
trading. A large float creates a significant level of liquidity, which means that investors can easily buy
and sell shares without any undue delays to find counterparties. Also, a large float means that investors
can buy and sell large blocks of stock without having their actions negatively impact the stock price.

There are a few methods for a company to accelerate cash collection and delay cash disbursements
along side float

a. Accelerate cash collections:

 Lockbox processing: Lock box system is a technique of reducing mailing, processing and
collecting time. Under this system the firm selects some collecting centres at different places.
The places are selected on the basis of number of consumers and the remittances to be received
from a particular place. The firm hires a Post Box in a post office and the parties are asked to
send the cheques on that post box number. A local bank is authorized to operate the post box.
The bank will collect the post a number of times in a day and start the collection process of
cheques.
 Wire transfers: Wire transfers are electronic transfers of funds via a network that is
administered by hundreds of banks and transfer agencies around the world. Wire transfers take
place electronically, from one computer to another, and eliminate the mailing and
checkingclearing times associated with other cash-transfer methods.
b. Delay cash disbursements

It is through increasing the mail time.

A firm's credit policy is the set of principles on the basis of which it determines who it will lend money to
or gives credit (the ability to pay for goods or services at a later date). Credit policy is determined by 5Cs:
Character, Capacity, Capital, Collateral, Conditions. It is composed of:

 Credit extension
 Collection policy: is the set of procedures a company uses to ensure payment of accounts
receivables.
 Terms of sale: 
- Credit period: vary across industries, lengthening the credit period generally increases sales. Generally,
a firm must consider three factors in setting a credit period: (the probability that the customer will not
pay, the size of the account and the extent to which goods are perishable)
- Cash discounts: is often the part of the terms of sales. It is also the tradeoff between the size of the
discount and the increased speed and rate of collection of receivables. (Example: a 3/10 net 30- which
means that the customer can take a 3% discount if he pays within 10 days. In any event, he must pay
within 30 days)
- Credit instruments: most is offered on open account, where the goods are shipped and delivered
before payment is due. They are:
+ Promissory notes: are IOUs that are signed after the delivery of goods
+ Commercial drafts: call for a customer to pay a specific amount by a specific date. The draft is sent to
the customer’s bank, when the customer signs the draft, the goods are sent.
+ Banker’s acceptance allows a bank to substitute its creditworthiness for the customer for a fee
+ Conditional sales contracts let the seller retain legal ownership of the goods until the customer has
completed payment
Statement: The only purpose of trade credit is to increase sales:
The statement is false. Although trade credit can often be used to encourage sales (since it is a form of
credit with no interest), there are many other purposes. Trade credit can be a good way for businesses
to free up cash flow and finance short-term growth. This sort of financing is useful for minimizing and
controlling a company's capital requirements. Furthermore, it aids in the development of strong client
relationships, increasing consumer loyalty and, as a result, repeat business. Trade financing increases
competitiveness while also driving efficiency in markets and supply chains, resulting in increasing trade
volumes within a safer framework. Furthermore, trade-related credit facilities can alleviate this pressure
and keep businesses from encountering difficulties as a result of these risks.
For the credit term “1/10, net 30”, it is a type of cash discount. It is the tradeoff between the size of the
discount and the increased speed and rate of collection of receivables. With 1/10, it means that the
customer can take a 1% discount if he/she pays within 10 days. The discount will be unavailable at the
start of day 11. For the net 30, it means that in any event, he/she must pay within 30 days.

The importance of credit management department:

A company will need to start departmentalizing when it begins to grow or has grown. A credit
management department is one of the first departments which will become needed as revenue grows
and credit is extended to clients new and old. For a small business, they do not need the department
since the task of keeping the account receivable low can be assigned to the CFO of the business. When
this occurs, a company needs to create a credit management department. Credit management
departments work in conjunction with the sales department to make sure that the sales extended on
credit are going to credit worthy customers who will pay in a timely manner. Often times friction is
created between these two departments – sales want the sale no matter what, and credit departments
are tasked with only allowing sales that will end up being paid. The department helps to reduce the bad
debt and to increase the timely payments by new and current customers. With this, the department can
ensure you are trading with the right customers at the right level. Other goals of the credit department
include stream-lined payment and billing processes making it easier for clients to pay and pay timely.
This can be helped by automating client reminders to pay when a debt is past due.
Credit policy effects
a. Sales
- Credit policy varies from firm to firm and is based on the particular business, cash flow
circumstances, industry standards, current economic conditions and the degree of risk involved.
It also has impact on performance, as a relaxed credit policy boosts sales but also increases
defaults and bad debts whereas a conservative credit policy may restrict sales but will also
minimize defaults.
- With credit policy, it helps companies to ensure a consistence approach among customers,
reducing the chance of personal bias affecting the decision-making process.
b. Costs
- Cost of sale is still incurred even though the cash from the sale has not been received.
- if the policy is too loose, the chance that the cost of debt increases is higher, companies have
to finance their receivables.
- While accepting credit can attract good customers, the need to constantly hound a late-paying
client can make for a stressful situation. Everyone falls into tough financial times, and while no
one wants to repeatedly ask for payment or charge late fees, it’s a part of business. Those
companies will have to decide if repeat business with a late-paying customer is worth the
hassle.
- Sometimes to attract more customers, companies will offer some discounts on their services
to entice customers to spend their money with those companies by paying cash only, or for
early payment on their credit accounts. While the tactic may in fact bring in more business,
they run the risk of losing money if too many customers take advantage of their generosity. It is
a gamble, and most of the time they have to decide if the payoff is actually worth it.
Trade credit vs standard loans
Firms offer trade credit because:
- Providing financing at below-market rates is an indirect way to lower prices for only certain
customers, which standard loans do not offer to them.
- A supplier may have an ongoing relationship with its customers, it may have more information
about the credit quality of the customer than a traditional outside lender such as a bank would
have
- moreover, if the buyer defaults, the supplier may be seizing the inventory as collateral.
In my opinion, there are several reasons why repeat customers more valuable than one-time
customers:
Repeat customers are easier to sell to: Since there is an established between you and your
existing customers, they are easier to convert to repeat customers. Also, repeat customers are
also much easier to cross-sell to without spending much on marketing. Most likely, they will
purchase from you over and over again since you have lived up to their expectation with
regards to the products, payment method, shipping, and customer service that you offer.
Repeat customers will keep on purchasing: Repeat customers are those who have made more
than one purchase. These repeat clients will most likely purchase from you again and again,
which makes your NPV is higher than one-time sales (which is explained by the formulas below:
+ For one time sale: NPV = -v + (1 - π) * P / (1 + R)
+ For repeat customers: NPV = -v + (1-π) * (P – v)/R
V: variable cost per unit
P: current price
π: probability of default
R: monthly required return
New customers will cost you more: Keeping existing customers is much less expensive and has
greater advantages than finding new ones. Because the more money you are using for
marketing, the more the profit is cut down. If you’re a small business, you should save cost and
channel your marketing efforts into ensuring customer retention. 
Statement: A company will give trade credit to a new customer if the net present value from
this trade credit is positive:
I do not think this statement is fully correct. In theory, a company will give trade credit to a new
customer if the net present value from this trade credit is positive because no one wants to sell
their product for a loss. But in reality, only a few businesses will approach this strategy. Most of
the time, many firms will sacrifice some of their sales at a loss to attract more customers.
Because they know that customer loyalty is very important. For example, Shopee offers huge
promotions every month when the day has the same number as the month (in 7/7 or 8/8) but
they still earn a lot of profit every year. Because in order to collect those promotions, buyers
have to accumulate “coin” (a system of bonus points for every time a customer purchase a
product through Shopee).
The practice of ensuring that consumers pay their bills on time is known as accounts receivable
management. It assists firms in preventing themselves from running out of working capital at
any time. It also prohibits consumers from being late or not paying their pending sums. Credit
management is the function of extending credit terms and collecting money when it becomes
due. Credit policy is made up of three parts: conditions of sale, credit analysis, and collection
policy. When we talk about credit analysis in the context of managing accounts receivable, it is
a process refers to evaluating a borrower's loan application to determine the financial health of
an entity and its ability to generate sufficient cash flows to service the debt.
Credit analysis is the method by which one calculates the creditworthiness of a business or
organization. In other words, it is the evaluation of the ability of a company to honor its
financial obligations. Lenders use these criteria to decide whether a loan applicant is eligible for
credit and to determine related interest rates and credit limits. The risk rating is derived by
estimating the probability of default by the borrower at a given confidence level over the life of
the facility, and by estimating the amount of loss that the lender would suffer in the event of
default. They also help determine the riskiness of a borrower or the likelihood that the loan's
principal and interest will be repaid in a full and timely manner.
The analysis process is divided into 2 parts:
- Credit information: the firm will analyze the information provided from financial statements,
credit reports on customer’s payment history with other firms, banks or even customer’s
payment history with the firm.
- Credit scoring: most firms use the system of 5Cs (Character, Capacity, Capital, Collateral,
Condition). It is a system used by lenders to gauge the creditworthiness of potential borrowers.
The system weighs five characteristics of the borrower and conditions of the loan, attempting
to estimate the chance of default and, consequently, the risk of a financial loss for the lender.
Tools monitoring account receivable:
- Accounts receivable days: The average number of days that it takes a firm to collect on its
sales. The point of the measurement is to determine the effectiveness of a company's credit
and collection efforts in allowing credit to reputable customers, as well as its ability to collect
cash from them in a timely manner.
- Aging schedule: is an accounting table that shows a company’s accounts receivables, ordered by their
due dates. 

+ Categorizes accounts by the number of days they have been on the firm’s books.

+ Can be prepared using either the number of accounts or the dollar amount of the accounts receivable
outstanding.

+ Aging schedules are accounting tables companies use to see whether payments are being made or
received in a timely fashion. These schedules can be customized to include whatever time frame the
company wants to track, but commonly include under 30 days, 1-30 days past due, 30-60 days past due,
and more than 90 days past due.

+ Using aging schedules can help companies spot cash flow problems so that firms can prepare for a
suitable policy before they become an even bigger issue.

- Payments patterns: Provides information on the percentage of monthly sales that the firm collects in
each month after the sale

How can a company use these tools to set up a penalty and reward system to accelerate cash
collections?
  Collection effort: Most firms follow a protocol for customers that are past due, the longer the
time that customers do not pay the debt, the more intense actions will be performed by the
firms through these steps:

- First the company will send a delinquency letter to remind the customer about passing the due date. 

- If the customer does not response, the firm will make a telephone call to the customer about the
problem.

- If these two steps are not effective, the company can employ a collection agency to do the collection
form them. 

- And even that the customer does not pay the money, the company has to take legal action against
that customer.

 Late payment fees and prompt payment discounts are incentives designed to encourage
customers to pay according to terms. Prompt payment discounts offer a reward for paying
“early”, and late payment fees are a penalty for paying late.

 Factoring: The sale of a firm’s accounts receivable to a third party (known as a factor). The firm
and the factor agree on the basic credit terms for each customer. The customer sends payment
directly to the factor, and the factor bears the risk of nonpaying customers.
Factoring: The sale of a firm’s accounts receivable to a third party (known as a factor). The firm
and the factor agree on the basic credit terms for each customer. The customer sends payment
directly to the factor, and the factor bears the risk of nonpaying customers.
Factoring account receivables is an economic decision whereby a specialized firm assumes the
responsibility for the administration and control of a company’s debtor portfolio. It can be
considered to be a method of raising short-term capital based on the selling of trade debts at a
discount, or for a prescribed fee plus interest.
Stretching account payables: When a firm ignores a payment due period and pays later. In
periods of excess capacity, firms may be able to get away with deliberately paying late or
stretching accounts payable. Suppliers may react to a firm whose payments are always late by
imposing late fees or terms of Cash on delivery (COD) or Cash before delivery (CBD).
Potential consequences: by using the example: ‘What is the effective annual cost of credit
terms of 1/15, net 40, if the firm stretches the accounts payable to 60 days?
First, we need to compute the interest rate per period. The 1% discount means that on $100
purchases, you can either pay $99 in the discount period, or keep $99 and pay $100 later. Thus,
you pay $1 interest on the $99. If you pay on time, then this $1 in interest is over the 25-day
period between the 15th day and the 40th day. If you stretch, then this $1 in interest is over the
45-day period between the 15th day and the 60th day.
The interest rate per period is $1/$99 = 1.01%. If the firm delays payment until the sixtieth day,
it has use of the funds for 45 days beyond the discount period. There are 365/45 = 8.11 45- day
periods in one year. Thus, the effective annual cost is (1.0101)8.11 - 1 = 0.0849, or 8.49%.
Paying on time corresponds to a 25- day credit period and there are 365/25 = 14.6 25-day
periods in a year. Thus, if it pays on the 40th day, the effective annual cost is (1.0101)14.6 - 1 =
0.158, or 15.8%.
So, By stretching its payables, the firm substantially reduces its effective cost of credit. They
will also suffer a variety of problems associated with being branded a “slow payer.”
Benefits

Inventory equals money: The simple truth behind any business is that it must make money to survive.
While some companies – those that provide services only – can operate without inventory concerns,
most businesses rely on selling a product to make money. Not only is having inventory essential to
making sales, but it is also crucial for companies to plan and budget financial expenditures effectively.
And no inventory means no sale, which lead to money and can make firm goes bankrupt.

Customer satisfaction and loyalty: Maintaining a proper inventory level ensures that when customers
want a product, the company can provide it. Customers don't care about the logistics behind inventory
management; their concern is that a company has whatever they want when they want it. When a
company sells out of a product a customer wants, that customer will likely take their business
elsewhere. While this may only result in one lost sale, a company runs the high risk of losing that
customer permanently to a competitor.

Measuring the company efficiency: Maintaining consistent levels of inventory gives companies a good
idea of how their businesses is running. Cash flow measures the money coming in and going out of a
business and is a good indicator of how efficiently the business is operating.

Reducing order cost: By ordering in large numbers, a firm can reduce the cost it incurs. Some of the cost
involved when making an order is forms that must be completed, approvals needed to be obtained and
the goods arrived must be accepted, inspected, and counted. Then an invoice must be issued, and
payment must be made.

Costs

Carrying cost: Inventory carrying involves Inventory storage and management either using in house
facilities or external warehouses owned and managed by third party vendors. In both cases, inventory
management and process involve extensive use of Building, Material Handling equipment, IT Software
applications and Hardware equipment coupled managed by Operations and Management Staff
resources. The cost usually takes 20 - 40% of inventory value per year and their losses are due to
obsolescence, deterioration, or theft.

Shortage cost: also known as stock-out costs, occurs when businesses become out of stock for various
reasons (emergency shipments costs, disrupted production costs, customer loyalty and reputation, …)

Ordering cost: are the expenses incurred to create and process an order to a supplier. These costs are
included in the determination of the economic order quantity for an inventory item. Include payroll
taxes, benefits and the wages of the procurement department, labor costs etc. These costs are typically
included in an overhead cost pool and allocated to the number of units produced in each period.

 Inventory holding costs: The amount of rent a business pays for the storage area where they hold the
inventory. This can be either the direct rent the company pays for all the warehouses put together or a
percentage of the total rent of the office aura utilized for storing inventory.

  Inventory carrying costs: Requires a certain amount of calculation to understand the extent of its
impacts on your P&L statement. Refers to the amount of interest a business loses out of unsold stock
value lying in the warehouses.

Statement: A company should hold a level of inventory where the benefits of holding cash equals the
cost

Critically evaluate:

TIC = Total carrying costs + Total ordering costs

TIC = C*P*(Q/2) + F*(S/Q)

where

C = Annual carrying costs (% of inventory)

P = Purchase price per unit

Q = Number of units per order

F = Fixed costs per order

S = Annual usage in units

Minimizing these total costs involves some trade-offs. For example, if we assume no quantity discounts
are available, the lower the level of inventory a firm carries, the lower its carrying cost, but the higher its
annual order costs, because it needs to place more orders during the year.

-> A company should hold a level of inventory where the benefits of holding cash equal the costs.
Objective:

To

Having sufficient supply: Inventories should be readily stored beforehand, from raw materials to the
finished product. To prevent manufacturing from suffering when a consumer needs it, you need to
supply the material in sufficient volume. Inventory management helps maintain the availability of
materials whenever and wherever required in enough quantity.

Minimizing costs: maintain minimum working capital as required for operational and sales activities. To
be financially correct, you should minimize the unnecessary money. After all, money is a key constraint.
You should keep the inventory expenditure to a low level and also monitor the cost of material to
reduce the cost of production.

Reduce losses due to theft, wastage, etc.: Another main goal of inventory management is this. The sum
of inventory, from the raw material to the finished product, is handled in most of the organization. All
this inventory needs to be carefully handled so that fraud, waste, etc. causes minimal loss. On the other
hand, incidents of robbery and other unwanted activities are not recorded by anyone because the
inventory is not properly managed.

Optimizing product sales: The analysis of commodity pricing trends is another thing that is considered
an inventory management objective. Sales are an essential and crucial step of the whole operation. It
helps to understand the current situation and to build on the review of potential predictions. For
example, you can detect and remove slow-moving goods.

Statement: EOQ is the best model to manage inventory.

In my opinion, the statement is incorrect. The EOQ assumes your rate of demand, ordering costs and
unit price of inventory is constant. This fact makes it difficult or impossible for the formula to account for
business events such as changing consumer demand, seasonal changes in inventory costs, lost sales
revenue due to inventory shortages, or purchase discounts a company might realize for buying inventory
in larger quantities. So, if you tend to have periods of time where the demand for your products is a lot
lower or higher than other periods, the EOQ number will be meaningless. Moreover, in some cases, with
the existence of just-in-time system, the need for using EOQ will be eliminated. Although EOQ is not the
best model to manage inventory, we can still acknowledge the model for its benefits such as minimizing
inventory cost, stockouts or improving overall efficiency.
In deterministic model, the demand and lead time are known (constant). The output of the model is
fully determined by the parameter values and the initial conditions. A Deterministic Model allows you to
calculate a future event exactly, without the involvement of randomness. If something is deterministic,
you have all of the data necessary to predict (determine) the outcome with certainty

In stochastic model, demand and lead time is treated as random (unknown). A Stochastic Model has the
capacity to handle uncertainties in the inputs applied Stochastic models possess some inherent
randomness. The same set of parameter values and initial conditions will lead to an ensemble of
different outputs.

Define the safety stock and reorder point of two models.

- Deterministic model:

 for a deterministic model, you do not need to have the safety stock because no demand rate
during the lead time is certain
 the reorder point is the inventory level at which a new order is placed. Order must be made
while there is enough stock in place to cover demand during lead time. Formulation: R = d*L
where d = demand rate per time period L = lead time
 Under deterministic conditions, when both demand and lead time are constant, the reorder
point is set equal to lead time demand.

- Stochastic model:

 When demand is uncertain, safety stock is added as a hedge against stockout

 Under probabilistic conditions, when demand and/or lead time varies, the reorder point often
includes safety stock.
 Safety stock is the amount by which the reorder point exceeds the expected (average) lead time
demand.
Objective:

To

Having sufficient supply: Inventories should be readily stored beforehand, from raw materials to the
finished product. To prevent manufacturing from suffering when a consumer needs it, you need to
supply the material in sufficient volume. Inventory management helps maintain the availability of
materials whenever and wherever required in enough quantity.

Minimizing costs: maintain minimum working capital as required for operational and sales activities. To
be financially correct, you should minimize the unnecessary money. After all, money is a key constraint.
You should keep the inventory expenditure to a low level and also monitor the cost of material to
reduce the cost of production.

Reduce losses due to theft, wastage, etc.: Another main goal of inventory management is this. The sum
of inventory, from the raw material to the finished product, is handled in most of the organization. All
this inventory needs to be carefully handled so that fraud, waste, etc. causes minimal loss. On the other
hand, incidents of robbery and other unwanted activities are not recorded by anyone because the
inventory is not properly managed.

Optimizing product sales: The analysis of commodity pricing trends is another thing that is considered
an inventory management objective. Sales are an essential and crucial step of the whole operation. It
helps to understand the current situation and to build on the review of potential predictions. For
example, you can detect and remove slow-moving goods.

Statement: Working capital management has the most important role in corporate finance
The statement is incorrect. Working capital management refers to a company’s strategies to monitor
and utilize the components of working capital to ensure the most financially efficient operation of the
company. Although working capital management is vital because of its impact on a firm’s profitability
and risk, and consequently its value, it has received less attention than the other aforementioned
categories. Finance theory discussion is generally related to one of the following categories: Capital
budgeting, capital structure, dividend policy, or working capital management.
Roles of financial planning:

-Plan for future funding needs.

-Examine interactions - help management see the interactions between decisions.

-Explore options - give management a systematic framework for exploring its opportunities.

-Avoid surprises - help management identify possible outcomes and plan accordingly.

- Ensure feasibility and internal consistency - help management determine if goals can be accomplished
and if the various stated goals of the firm are consistent with one another.

Long-term and short-term financial planning

Compare and contrast long-term and short-term financial planning.

Long – term financing is typically raised for a longer length of time, and it includes all types of financing
that last longer than a year, as well as any search finance for long-term aims. 

Short - term finance is concerned with achieving short-term goals and involves borrowing money for a
period of less than a year. Short-term loans have higher interest rate than long-term loans, and short-
term loans are typically used for working capital needs.
To calculate External Financing Needed, management should make the balance: Net New Financing.
First, he or she must choose new funding: Debt or equity. If debt is chosen, it will change the interest
assumption on the pro forma income statement.

Step 1: calculate full capacity sales

Step 2: compare full capacity sales with estimated sales

Step 3: Calculate Total Assets

Step 4: External Financing Needed will equal Total Assets minus Total liabilities and Equity

Statement: Issuing new debt is always better than issuing new equity because new debt can generate
a tax shield for the company.

It is said that issuing new debt is always better than issuing new equity because new debt can
generate a tax shield for the company. This statement is false, since the smaller or newer businesses
may be endangered when issuing new debt. Debt finance is capital obtained by the borrowing of funds
to be repaid at a later period. Loans and credit cards are two common types of debt. Equity finance
refers to monies raised through the selling of stock. The advantage of debt financing is that it allows a
company to leverage a small sum of money into a much bigger number, allowing for faster expansion
than would otherwise be possible. In addition, loan payments are often tax deductible. The
disadvantage of debt financing is that lenders want interest payments, which means that the total
amount repaid exceeds the beginning investment. Furthermore, debt payments must be made
regardless of business revenue. This can be especially problematic for smaller or newer businesses.

This statement is only correct when the company that choose to issue new debt over new equity is a
large and prestigious one. When issuing a new debt, these companies can generate a tax shield since
they are big companies with reputations, stable assets, or even guarantee loan. And most of the time,
financial institutions will definitely choose the customer that have the highest chance to repay the debt
on time (low risk of default). Moreover, most of them are matured firms that is well-established in the
industry, issuing new equity may alter the balance of power in the company.
Determinants of the growth of a company are profit margin, total asset turnover, financial leverage,
and dividend policy. 

 Profit margin: is one of the commonly used profitability ratios to gauge the degree to which a
company or a business activity makes money. It represents what percentage of sales has turned
into profits. The three main profit margin metrics are gross profit margin (total revenue minus
cost of goods sold (COGS), operating profit margin (revenue minus COGS and operating
expenses), and net profit margin (revenue minus all expenses, including interest and taxes).
There are several types of profit margin:

- Gross profit margin: (efficiency to manage cost of goods sold)

- Operating profit margin (efficiency to manage operating expenses)

- Net income (efficiency to manage depreciation and tax)

 Total asset turnover: The asset turnover ratio measures the value of a company's sales or
revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator
of the efficiency with which a company is using its assets to generate revenue. The higher the
asset turnover ratio, the more efficient a company is at generating revenue from its assets.
Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its
assets to generate sales.
 Financial leverage which is also known as leverage or trading on equity, refers to the use of debt
to acquire additional assets. The use of financial leverage to control a greater amount of assets
(by borrowing money) will cause the returns on the owner's cash investment to be amplified.
  A dividend policy is the policy a company uses to structure its dividend payout to shareholders.

Statement: the internal growth rate is always smaller than the sustainable growth rate.

As the SGR is a leveraged ratio that contains debt, SGR is expected to be higher than the IGR
which is unleveraged. In addition, the equation of IGR, SGR will be explained below: 

Internal growth rate = retention rate *ROA

Sustainable growth rate = retention rate*ROE
Equity = Asset + Liability (Liability >=0)
Equity <= Asset
ROE >= ROA
Sustainable growth rate>= Internal growth rate
Since little firms operate without any liability => It is true that the internal growth rate is always
smaller than the sustainable growth rate.
The purpose of short-term financing is to forecast the company’s future cash flows to discover if the
company has cash surplus or cash deficit. The firm also needs to figure out whether that surplus or
deficit is temporary or permanent. If it is permanent, it may affect the firm’s long-term financial
decisions.

There are three reasons for short-term financing: negative cash flow shocks, Positive cash flow shocks,
and seasonality. A negative cash flow shock is a circumstance in which cash flows are temporarily
negative for an unexpected reason. Positive cash flow shocks mean increased expected sales often
require increased short-term financing for items like marketing and production. Short-term financing is
needed for seasonality. When sales are concentrated during a few months, sources and uses of cash are
also likely to be seasonal.

It is said that a company should not hold surplus cash in all situations. This statement is true. High
levels of cash on the balance sheet can signal danger ahead. If cash is more or less a permanent feature
of the company's balance sheet, investors need to ask why the money is not being put to use. Cash
could be there because management has run out of investment opportunities or is too short-sighted and
doesn't know what to do with the money.The excess cash could be invested in suitable projects that
would generate additional income. By keeping the cash idle, the business loses an opportunity to
generate additional returns. Therefore, the major disadvantage of too much cash on hand is that it
lowers the return on assets.

Sitting on cash can be an expensive luxury because it has an opportunity cost, which amounts to the
difference between the interest earned on holding cash and the price paid for having the cash as
measured by the company's cost of capital.