assignment

Appraise the importance of small scale business enterprise to a nation building

synopsis on credit and risk management

PRINCIPLES OF WORKING CAPITAL MANAGEMENT

The management of current assets is similar to that of fixed assets in the sense that in both cases the firm analyses their effects on its return and risk. The management of fixed and current assets, however, differs in three important ways: first, in managing fixed assts, time is a very important factor; consequently, discounting and compounding techniques play a significant role in capital budgeting and a minor one in the management of current assets. Second,, the large holding of current assets. Especially cash, strengthens firm’s liquidity position (and reduces riskness), but it also reduces the overall profitability. Third, levels of fixed as well as current assets depend upon expected sales, but it is only current assets which can be adjusted with sales fluctuations in the short run.

In examining the management of current assets, answers will be sought to the following questions:
- What is the need to invest funds in current assets?
- How much funds should be invested in each type of current assets?
- What should be the proportion of long-term and short-term funds to finance current assets?
- What appropriate sources of funds should be used to finance current assets?

CONCEPTS OF WORKING CAPAITAL
There are two concepts of working capital – gross concept and net concept:

v Gross Working Capital, simply called as working capital, refers to the firm’s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, bills receivables and stock (inventory).

v Net Working Capital, refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payable, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets.

The two concepts of working capital – gross and net – are not exclusive; rather they have equal significance from management viewpoint. The gross working capital concept focuses attention on two aspects of current assets management: (a) optimum investment in current assets and (b) financing of current assets. The consideration of the level of investment in current assets should avoid two danger points - excessive and inadequate investment in current assets. Investment in current assets should be just adequate, no more no less, to the needs of the business firm. Excessive investment in current assets should be avoided because it impairs firm’s profitability, as idle investment earns nothing. On the other hand, inadequate amount of working capital can threaten solvency of t he firm because of its inability to meet its current obligations. It should be realized that the working capital needs of the firm may be fluctuating with changing business activity. This may cause excess or shortage of working capital frequently. The management should be too prompt to initiate an action and correct imbalances.

Another aspect of the gross working capital points to the need of arranging funds to finance current assets. Whenever a need for working arranging funds to finance current assets. Whenever a need for working capital funds arises due to the increasing level of business activity or for any other reason, arrangement should be made quickly. Similarly, if suddenly some surplus funds arise, they should not be allowed to remain idle, but should have knowledge of the sources of working capital funds as well as investment avenues where idle funds may be temporarily invested.

Net working capital, being the difference between current assets and current liabilities, is a qualitative concept. It (a) indicates the liquidity position of the firm and (b) suggests the extent to which working capital needs may be financed by permanent sources of funds. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for maturing obligations within the ordinary operation cycle of a business. In order to protect their interests, short-term creditors always like a company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice of the level of current liabilities. However, the quality of current assets should be considered in determining the level of current assets vis-a-vis current liabilities. A weak liquidity position poses a threat to solvency of the company and current liabilities. A weak liquidity position poses a threat to solvency of the company and makes it unsafe and unsound. A negative working capital means a negative liquidity, and may prove to be harmful for the company. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm.

Networking capital concept also covers the question of judicious mix of long-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capital, which is permanent. Therefore, a portion of the working capital should be financed with the permanent sources of funds such as owner’s capital, debentures, long-terms debt, preference capital or retained earnings. Management must, therefore, decide the extent to which current assets should be financed with equity capital and/or borrowed capital.

In summary, it may be emphasized that both gross and net concepts of working capital are equally important for the efficient management of working capital. There is no precise way to determine the exact amount of gross, or net working capital for any firm. The data and problems of each company should be analysed to determine the amount of working capital. There is no specific rule as to how current assets should be financed. It is not feasible in practice to finance current assets by short-term sources only. Keeping in view the constraints of the individual company, a judicious mix of long-term finances should be invested in current assets. Since current assets involved cost of funds, they should be put to productive use.

NEED FOR WORKING CAPITAL
The need for working capital to run the day-to-day business activities cannot be overemphasized. We will hardly find a business firm, which does not require any amount of working capital. Indeed, firms differ in their requirements of the working capital.

We know that firms aim at maximizing the wealth of shareholders. In its endeavour to maximize shareholders’ wealth, a firm should earn sufficient return from its operations. Earning a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for the success of sales activity. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle involved in the conversion of sales into cash.

Operating Cycle
There is a difference between current and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investment in fixed assets such as plant and machinery or land and buildings. On the contrary, investment in current assets is turned over many times in a year. Investment in current assets such as inventories and book debts (accounts receivables) is realised during the firm’s operating cycles, which is usually less than a year1. What is an operating cycle?

Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases:

v Acquisition of resources such as raw material, labour, power and fuel etc.

v Manufacture of the product which includes conversion of raw materials into work-in-progress into finished goods.

v Sales of the product either for cash or on credit. Credit sale creates book debts for collection.

Permanent and Variable Working Capital
The operating cycle is a continuous process and, therefore, the need for current assets is felt constantly. But the magnitude of current assets needed is not always same, it increases and decreases over time. However, there is always a minimum level of current assets which is continuously required by the firm to carry on its business operations. This minimum level of current assets is referred to as permanent, or fixed working capital. It is permanent working capital, will fluctuate. For example, extra inventory of finished goods will have to be maintained to support the peak periods of the sale and investment in receivables may also increase during such periods. On the other hands, investment in raw material, work in process and finished goods will fall if the market is slack.

The extra working capital, needed to support the changing production and sales activities, is called fluctuating, or variable or temporary, working capital. Both kinds of working capital-permanent and temporary v- are necessary to facilitate production and sale through the operating cycle, but temporary-working capital is created by the firm to meet liquidity requirements that will last only, temporarily. Figure 2 illustrates requirements that will last only, temporarily. Figure 2 illustrates differences between permanent and temporary working capital. It is shown in Figure 2 that permanent working capital is stable over time, while temporary working capital is fluctuating - sometimes increasing and sometimes decreasing. However, the permanent working capital line need not be horizontal if the firm’s requirement for permanent capital is increasing (or decreasing) over periods. For a growing firm, the difference between permanent and temporary working capital can be depicted below:

Principles of Working Capital Management
Temporary or
Fluctuating

Permanent



Permanent and Temporary Working Time Capital


Temporary or
Fluctuating
Permanent



Permanent and Temporary Working Time Capital

Adequate of Working Capital
The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from the firm’s point of view. Excessive working capital means idle funds which earn no profits for the firm. Paucity of working capital not only impairs firm’s profitability but also results in production interruptions and inefficiencies. The dangers of excessive working capital are as follows:

v It results in necessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft and losses increase.

v It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts results, which adversely affects profits.

v Excessive working capital makes management complacent, which degenerates into managerial inefficiency.

v Tendencies of accumulating inventories to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits.

v Inadequate working capital is also bad and has the following dangers:

v It stagnates growth. It becomes difficult for the firm to undertake profitable projects for non-availability of working capital funds.

v It becomes difficult to implement operating plans and achieve the firm’s profit target.

v Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments.

v Fixed assets are not efficiently utilised for the lack of working capital funds. Thus, the firm’s profitability would deteriorate.

v Paucity of working capital funds renders the firm unable to avail attractive credit opportunities etc.

v The firm loses its reputation when it is not in position to honour its short-term obligations. As a result, the firm faces tight credit terms.

An enlightened management should, therefore, maintain a right amount of working capital on a continuous basis. Only ten a proper functioning of the business operations will be ensured. Sound financial and statistical techniques, supported by judgment, should be used to predict the quantum of working capital needed at different time periods.

A firm’s net working capital position is not only important as an index of liquidity but it is also used as a measure of the firm’s risk. Risk in this regard means chances of the firm being unable to meet its obligations on due date. Lender considers a positive net working as a measure of safety. Al other things being equal, the more the net working capital a firm has, the less likely that it will default in meeting its current financial obligations. Lenders such as commercial banks insist that the firm should maintain a minimum net working capital position.

DETERMINANTS OF WORKING CAPITAL
There are not set rules or formulae to determine working capital requirements of the firms. A large number of factors influence working capital needs of firms. All factors are of different importance. Also, the importance of factors changes of a firm over time; Therefore, an analysis of relevant factors should be made in order to determine total investment in working capital. The following is the description of factors which generally influence the working capital requirements of firms.

Nature and size of Business
Working capital requirements of a firm are basically influenced by the nature of its business. Trading and financial firms have a very small investment in fixed assets, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy varied and continuous demand of their customers. Some manufacturing business, such as, tobacco manufacturers and construction firms, also have to invest substantially in working capital and a normal amount in the fixed assets. In contrast, public utilities have a very limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they may have cash sales only and supply services, not product. Thus, no funds will be tied up in debtors and stock (inventories). Working capital needs of the most manufacturing concerns fall between two extreme requirements of trading firms and public utilities. Such concerns have to make adequate investment in current assets depending upon the total assets structure and other variables.

The size of the business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operation. A firm with larger scale of operation will need more working capital than a small firm.

Manufacturing Cycle
The manufacturing cycle comprises of the purchase and use of raw materials and the production of finished goods. Longer the manufacturing cycle, large will be the firm’s working capital requirements. For example, the manufacturing cycle in the case of a boiler, depending on its size, may range between six to twenty-four months. On the other hand, the manufacturing cycle of products such as detergent powders soaps, chocolate etc. may be few hours. An extended manufacturing time span means a larger tie-up of funds in inventories. Thus, if there are alternative ways of manufacturing a product, the process with the shortest manufacturing cycle should be chosen. Once a manufacturing process has been selected, it should be ensured that manufacturing cycle is completed within the specified period. This needs proper planning and coordination at all levels of activity. Any delay in manufacturing process will result in accumulation of work in process and waste of time. In order to minimise their investment in working capital, some firms, specifically firms manufacturing industrial products, have a policy of asking for advance payments from their customers. Non-manufacturing firms, service and financial enterprises do not have manufacturing cycle.

Sales Growth
The working capital needs of the firm increase as its sales grow. It is difficult to precisely determine the relationship between volume of sales and working capital needs. In practice current assets will have to be employed before growth takes place. It is, therefore, necessary to make advance planning of working capital for a growing firm on a continuous basis.

A growing firm may need to invest funds in fixed assets in order to sustain its growing production and sales. This will, in turn, increase investment in current assets to support enlarged scale of operations. It should be realised that a growing firm needs funds continuously. It uses external sources as well as internal sources to meet increasing needs of funds. Such a firm faces further financial problems when it retains substantial portion of its profits. It would not be able to pay dividends to shareholders. It is, therefore, imperative that proper planning be done b such companies to finance their increasing needs for working capital.

Demand Conditions
Most firms experience seasonal and cyclical fluctuations in the demand for their products and services. These business variations affect the working capital requirement, specially the temporary working capital requirement of the firm. When there is an upward swing in the economy, sales will increase; correspondingly, the firm’s investment in inventories and book debts will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase their productive capacity. This act of firms will require further additions of working capital. To meet their requirements of funds for fixed assets and current assets under boom period, firms generally resort to substantial borrowing. On the other hand, when there is a decline in the economy, sales will fall and consequently, levels of inventories and book debts will also fall. Under recessionary conditions, firms try to reduce their short-term borrowings.

Seasonally fluctuations not only affect working capital requirement but also create production problems for the firm. During periods of peak demand, increasing production may be expensive for the firm. Similarly, it will be more expensive during slack periods when the firm has to sustain its working force and physical facilities without adequate production and sales. A firm may, thus, follow a policy of steady production irrespective of seasonal changes in order to utilise its resources to the fullest extent. Such a policy will mean accumulation of inventories during off season and their quick disposal during the peak season.

The increasing level of inventories during the sack season will require increasing funds to be tied up in the working capital for some months. Unlike cyclical fluctuations, seasonal fluctuation generally conform to a steady pattern. Therefore, financial arrangements for seasonal working capital requirements can be made in advance. However, the financial plan or arrangement should be flexible enough to take care of some abrupt seasonal fluctuations.

Production Policy
We just noted that a strategy of constant production may be maintained in orders to resolve the working capital problems arising due to seasonal changes in the demand for the firm’s product. A steady production policy will cause inventories to accumulate during the off-season periods and the firm will be exposed to greater inventory costs and risks. Thus, if costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedules in accordance with changing demand. Those firms, whose productive capacities can be utilized for manufacturing varied products, can have the advantage of diversified activities and solve their working capital problems. They will manufacture the original product line during its increasing demand and when it has an off-season, other products may be manufactured to utilise physical resources and working force. Thus, production policies will differ from firm to firm, depending on circumstances of individual firm.

Price Level Changes
In increasing shifts in price level make functions of financial manager difficult. He should anticipate the effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require a firm to maintain higher amount of working capital. Same levels of current assets will need increased investment when prices are increasing. However, companies which can immediately revise their product prices with rising price levels will not face a sever working capital problem. Further, effects of increasing general price level will be felt differently by firms as individual prices may move differently. It is possible that some companies may to be affected by rising prices while others may be badly be hit by it. Thus, effect of rising prices will be different for different companies. Some will face no working capital problem, while working capital problems of others may be aggravated.

Operating Efficiency and Performance
The operating efficiency of the firm relates to the optimum utilisation of resources at minimum costs. The firm will be effectively contributing of its working capital if it is efficient in controlling operating costs. The use of working capital is improved and pace of cash cycle is accelerated with operating efficiency. Better utilization of resources improves profitability and, thus, helps in realizing the pressure on working capital. Although it may not be possible for a firm to control prices of materials or wages of labour, it can certainly ensure efficient and effective use of its materials, labour and other resources.

Firms differ in their capacity to generate profit from business operations. Some firms enjoy a dominant position due to quality product or good marketing management or monopoly power in the market and earn a high profit margin. Some other firms may have to operate in an environment of intense competition and may earn low margin of profits. A high net profit margin contributes towards the working capital pool. In fact, the net profit is a source of working capital to the extent it has been earned in cash. The cash profit can be found by adjusting non-cash items, such as depreciation, outstanding expenses, accumulated expenses and losses written-off, in the net profit. But, in practice, the net cash inflows from operations cannot be considered as cash available for use at the end of the period. Even as the company’s operations are in progress, cash is used up for augmenting stocks, book debts or fixed assts.1 The financial manager must see whether or not the cash generate has been used for rightful purposes. The application of cash should be well planned.

Even if net profits are earned in cash at the end of the period, whole of it is not available for working capital purposes. The contribution towards working capital would be affected by the way in which profits are appreciated. Higher the amount of dividends, less will be the contribution towards working capital funs The firm can enhance its working capital funds by saving taxes through appropriate tax planning. Depreciation as allowed under the income tax rules helps to save taxes The availability of cash generated from operations, thus, depends upon taxation, dividend and retention policy and depreciation policy.

Firm’s Credit Policy
The credit policy of the firm affects working capital by influencing the level of book debts. The credit terms to be granted to customers may depend upon norms of the industry to which the firm belongs. But a firm has the flexibility of shaping its credit policy within the constraint of industry norms and practices. The firm should be discretionary in granting credit terms to its customers. Depending upon the individual case, different terms may e given to different customers. A liberal credit policy, without rating the credit-worthiness of customers, will be detrimental to the firm and will create a problem of collecting funds later on. The firm should be prompt in making collections. A high collection period will mean tie-up of funds in book debts. Slack collection procedures can increase the chance of bad debts.

In order to ensure that unnecessary funds are not tied up in book debts, the firm should follow a rationalised credit policy based on the credit standing of customers and other relevant factors. The firm should evaluate the credit standing of new customers and periodically review credit-worthiness of the existing customers. The case of delayed payments should be thoroughly investigated.

Availability of Credit
The working capital requirements of a firm, also affected by credit terms granted by its creditors. A firm will need less working capital if liberal credit terms are available to it. Similarly, the availability of credit from banks also influences the working capital needs of the firm. A firm which can get bank credit easily on favourable conditions will operate with less working capital than a firm without such a facility.

DIMENSIONS OF WORKING CAPITAL MANAGEMENT
It has been emphasized that the firm should maintain a sound working capital position, and that there should be optimum investment in working capital. Thus, there is an unavoidable need to manage working capital well. Working capital management refers to the administration of all aspects of current assets, namely cash, marketable securities, debtors and stock (inventories) and current liabilities. The financial manager must determine levels and composition of current assets. He must see that right sources are tapped to finance current assets and that current liabilities are paid in time.

There are many aspects of working capital management which make it an important function of the financial manager:1

v Working capital management requires much of the financial manager’s time.

v Working capital represents a large portion of the total investment in assets.

v Working capital management has greater significance for small firms.

v The need for working capital in the best possible way to get maximum benefit.

Empirical observations show that the financial managers have to spend much of their time to the daily internal operations, relating to current assets and current liabilities of the firms. As the largest portion of the financial manager’s valuable time is devoted to working capital problems, it is necessary to manage working capital in the best possible way to get maximum benefits.

Investment in current assets represents a very significant portion of the total investment in assets. For example, in the case of the large and medium public limited companies, current assets constitutes about 60 percent of total net assets of total net assts or total capital employed. This dearly indicates that the financial manager should pay special attention to the management of current assets on a continuing basis. Actions should be taken to curtail unnecessary investment in current assets.

It is particularly very important for small firms to manage their current assets and current liabilities very carefully. A small firm may not have much investment in fixed assets, but it has to invest in current assets. Small firms face a severe problem of collecting their book debts (receivables). Further, the role of current liabilities in financing current assets is far more significant in cash of small firms, as, unlike large firms, they face difficulties in raising long-term finances.

There is a direct relationship between sales and working capital needs. As sales grow, the firm needs to invest more in inventories and debts. These needs become very frequent and fast when sales grow continuously. The financial manager should be aware of such needs and finance them quickly. Continuous growth in sales may also require additional investment in fixed assets, but they do not indicate same urgency as displayed by current assets.

In may, thus, be concluded that all precautions should be taken for the effective and efficient management of working capital. The finance manager should pay particular attention to the levels of current assets and the financing of current assets, the risk-return implications must be evaluated.

Ratio of Current Assets to Fixed Assets
The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximised. A firm needs fixed and current assets to support a particular level of output. However, to support the same level of output, the firm can have different levels of current assets. As the firm’s output and sales increase, the need for current assets increases. Generally, current assets do not increase in direct proportion to output; current assets increase at a decreasing rat with output. This relationship is based upon the notion that it takes a greater proportional investment in current assets when only a few units of output are produced than it does later on when the firm can use its current assets more efficiently.

The level of the current assets can be measured by relating current assets to fixed assets.3 Dividing current assets by fixed assets gives CA/FA ratio. Assuming a constant level of fixed assets, a higher CA/FA ratio indicates a conservative current assets policy and a lower CA/FA ratio means an aggressive current assets policy assuming other factors constant, a conservative policy (i.e., higher CA/FA ratio) implies greater liquidity and lower risk; while an aggressive policy (i.e., lower CVA/FA ratio) indicates higher risk and poor liquidity. The current assets policy of the most firms may fall between these two extreme policies. The alternative current assets policies may be shown with the help of Figure.



A
Conservative Policy
B
Average Policy
C
Aggressive Policy

Fixed Asset Level

Output
Alternative Current Asset Policies

In Figure 4, the most conservative policy is indicted by alternative a, where CA/FA ratio is greatest at every level of output. Alternative C is the most aggressive policy, as CA/FA ratio is lowest at all levels of output. Alternative B lies between the conservative and aggressive policies and is an average policy.

Liquidity vs. Profitability: Risk-Return Tangle
The firm would make just enough investment in current assets if it were possible t estimate working capital needs exactly. Under perfect certainty, current assets holdings would be at the minimum level. A larger investment in current assets under certainty would mean a low rate of return on investment for the firm, as excess investment in current assets will not earn enough return. A smaller investment in current assets, on the other hand, would mean interrupted production and sales, because of frequent stock-outs and inability to pay to creditors in time due to restrictive policy.

As it is not possible to estimate working capital needs accurately, the firm must decide about levels of current assets to be carried. The current assets holdings of the firm will depend upon its working capital policy. It may follow a conservative or an aggressive policy. These policies have different risk-return implications. A conservative policy means lower return and risk, while an aggressive policy produces higher return and risk.

The two important aims of the working capital management are: profitability and solvency. Solvency, used in the technical sense, refers to the firm’s continuous ability to meet maturing obligations. Lenders and creditors expect prompt settlements of their claims as and when due. To ensure solvency, the firm should be very liquid, which means larger current assets holdings. If the firm maintains a relatively large investment in current assets, it will have no difficulty in paying claims of creditor when they become due and will be able to fill all sales orders and ensure smooth production. Thus, a liquid firm has less risk of insolvency; that is, it will hardly experience a cash shortage or stock outs. However, there is a cost associated with maintaining a sound liquidity position. A considerable amount of the firm’s funds will be tied up in current assets, and to the extent this investment is idol, the firm’s profitability will suffer.

To have higher profitability, the firm may sacrifice solvency and maintain a relatively low level of current assets. When the firm does so, its profitability will improve as less funds are tied up in idle current assets, but its solvency would be threatened and would be exposed to greater risk of cash shortage and stock outs.

The risk-return tangle of the working capital management may further be illustrated with the help of an example.

Illustration 1. suppose, a firm has the following data for some future year:




N
Sales (1,000,000 units) 1,500,000
Earnings before interest and taxes 1,200,000
Fixed assets 500,000

The three possible current assets holdings of the firm are: N1,000,000, N400,000 and N300,000. It is assumed that fixed assets level is constant and profits do not very with current assets levels. The effect of the three alternative current asset policies is shown in Table below.

TABLE 5. EFFECT OF ALTERNATIVE WORKING CAPITAL POLICIES
A B C
N N N

Sales 1,500,000 1,500,000 1,500,000
Earnings before interest & taxes (EBIT) 150,000 150,000 150,000
Current assets 500,000 400,000 300,000
Fixed assets 1,000,000 900,000 800,000
Return on total assets (EBIT/Total assets) 15% 16.67% 18.75%
Current assets/Fixed assets 1.00 0.80 0.60

The Cost of Trade-off
A different way of looking into the risk-return trade-off is in terms of the cost of maintaining a particular level of current assets. There are two types of costs involved: the cost of liquidity and the cost of illiquidity. If the firm’s level of current assets is very high it has excessive liquidity. Its return on assets will be low, as funds tied up in idle cash and stocks earn nothing and high levels of debtors reduce profitability. Thus, the cost of liquidity (through low rates of return) increases with the level of current assets.












Minimum Total Total Cost
Cost




Cost of liquidity

Cost of Illiquidity




Optimum Level Level of Current
Of Current Assets Assets

Cost Trade-off
The cost of illiquidity is the cost of holding insufficient current assets. The firm will not be in a position to honour its obligations if it carries too little cash. This may force the firm to borrow at high rates of interest. This will also adversely affect the credit-worthiness of the firm and it will face difficulties in obtaining funds in future. All this may force the firm into insolvency. Similarly, the low level of stocks will result in loss of sales and customers may shift to competitors. Also, low level of book debts may be due to tight credit policy, which would impair sales further. Thus, the low level of current assets involves costs which increase as this level falls. In determining the optimum level of current assets, the firm should balance the profitability-solvency tangle by minimizing total costs-cost of liquidity and cost of illiquidity. This is illustrated in Figure above. It is indicated in the figure that with the level of current assets the cost of liquidity increases while the cot of illiquidity decreases and vice versa. The firm should maintain its current assets at that level where the sum of these two costs is minimized. The minimum cost point indicates the optimum level of current assets.

ESTIMATING WORKING CAPITAL NEEDS
A number of methods, in addition to the operating cycle concept, may be used to determine working capital needs in practice. We shall illustrate here three approaches which have been successfully applied in practice:

Current assets holding period: To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years.

Ratio of sales: To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales.

Ratio of fixed investment: To estimate working capital requirements as a percentage of fixed investment.

WORKING CAPITAL FINANCE:

TRADE CREDIT, BANK FINANCE AND COMMERCIAL PAPER

Funds available for a period of one ear or less are called short-term finance. In India, short-term funds are used to finance working capital. Two most significant short-term sources of finance for working capital are: trade credit and bank borrowing. The used of trade credit has been increasing over years. Trade credit as a ratio of current assets is about 40 percent.

Bank borrowing is next important source of working capital finance. In the past, bank credit was liberally available to firms. It has now become a scarce resource because of the change in the government policy. Besides, firms, new contenders such as farmers, common men, small-scale industry, public enterprises e.t.c. have emerged for the bank funds.

Two other short-term sources of working capital finance which are likely to develop in India are: (i) factoring of receivables and (ii) commercial paper. This chapter explains the most common short-term sources of working capital finance.

TRADE CREDIT
Trade credit refers to the credit that a customer gets from supplier of goods in the normal course of business. In practice, the buying firms do not have to pay cash immediately for the purchases made. This deferral of payments is a sort-term financing called trade credit. It is a major source of financing for firms. It contributes to about one-third of the short-term financing. Particularly small firms are heavily dependent on trade credit as a source of finance since they find it difficult to raise funds from banks or other sources in the capital markets.

Trade credit is mostly an information arrangement, and is granted on an open account basis. A supplier sends goods to the buyer on credit which the buyer accepts, and thus, in effect, agrees to pay the amount due as per sales terms in the invoice. However, he does not formally acknowledge it as a debt; he does not sign any legal instrument. Once the trade links have been established between the buyer and the seller, they have each others mutual confidence, and trade credit becomes a routing activity which may be periodically reviewed by the supplier. Open account trade credit appears as sundry creditors (known as account payable) on the buyer’s balance sheet.

Trade credit may also take the form of bills payable. When the buyer signs a bill-a negotiable instrument – to obtain trade credit, it appears on the buyer’s balance sheet as bills payable. The bill has a specified future date, and is usually used when the supplier is by discounting the bill from a bank. A bill is formal acknowledgment of an obligation to repay the outstanding amount, promissory notes – a formal acknowledgment of an obligation with a promise to pay on a specified date – are as an alternative to the open account, and they appear as notes payable in the buyer’s balance sheet.

Credit Terms
Credit terms refers to the conditions under which the suppliers sells on credit to the buyer, and the buyer is required to repay the credit. These conditions include the due date and the cash discount (if any) given for prompt payment. Due date (also called net date) is the date by which the supplier expects payment. Credit terms indicate the length and beginning date of the credit period. Cash discount is the concession offered to the buyer by the supplier to encourage him to make payment promptly the cash discount can be availed by the buyer if he pays by a certain date which is quite earlier than the due date. The typical way of expressing credit terms is, for example, as follows: 3/15, net 45’. This implies that a 3 percent discount is available if the credit is repaid on the 15th day, and in case the discount is not taken, the payment is due by the 45th day.

Benefits and Costs of Trade Credit
As stated earlier, trade credit is normally available to a firm; therefore, it is a spontaneous source of financing. As the volume of the firm’s purchase increase, trade credit also expands. Suppose that a firm increases its purchases from N 50,000 per day to N 60,000 per day. Assume that these purchases are made on credit terms of ‘net 45’, ad the firm makes payment on the 45th day. The average accounts payable outstanding (trade credit finance) will expand.

The major advantages of trade credit are as follows:-

v Easy availability:- Unlike other sources of finance, trade credit is relatively easy to obtain. Except in the case of financially very unsound firms, it is almost automatic and does not require any negotiations. The easy availability is particularly important to small firms which generally face difficulty in raising fund from the capital markets.

v Flexibility: Flexibility is another advantage of trade credit. Trade credit grows with the growth in firm’s sales. The expansion in the firm’s sales causes its purchases of goods and services to increase which is automatically financed by trade credit. In contrast, if the firm’s sales contract, purchases will decline and consequently trade credit will also decline.

v Informality: Trade credit is an informal, spontaneous source of finance. It does not require any negotiations and formal agreement. It does not have the restrictions which are usually parts of negotiated sources of finance.

Is trade credit a cost free source of finance? It appears to be cost free since it does not involve explicit interest charges. But in practice, it involves implicit cost. The cost of credit may be transferred to the buyer via the increased price of goods supplied to him. The user of trade credit, therefore, should be aware of the costs of trade credit to make its intelligent use. The reasoning that it is cost free can lead to incorrect financing decisions.

The supplier extending trade credit incurs costs in the form of the opportunity cost of funds invested in accounts receivables and cost of any cash discount taken by the buyer. Does the supplier bear these costs? Most of the time, he passes on all or part of these costs to the buyer implicitly in form of higher purchase price of goods and services supplied. How much of the costs can he really pass on depends on the market supply and demand conditions. Thus if the buyer is in a position to pay cash immediately, he should try to avoid implicit cost of trade credit by negotiating lower purchase price with the supplier.

Credit terms sometimes include cash discount if the payment is made within a specified period. The buyer should take a decision whether or not to avail it. A trade-off is involved. If the buyer takes discount, he benefits in terms of less cash outflow, but then he foregoes the credit granted by the supplier beyond the discount period. In contrast, if he does not take discount, he avails credit for extended period but pays more. The buyer incurs an opportunity cost when he does not avail cash discount Suppose that the NURA Company is extended N1,000,000 credit on terms of ‘2/15, net 45’, NURA can either pay less amount (1,000,000 – 02 x 1,000,000 = N98,000) by the end of the discount period viz the 15th day. If the firm foregoes cash discount and does not pay on the 15th day, it can use N98,000 for an additional period of 30 days, and implicitly paying N2,000 in interest. If a credit of N898,000 is available for 30 days by paying N2,000 as interest, how much is the annual rate of interest? It can be found as follows:-
2,000 360
Implicit interest rate = = .245 or 24.5%
98,000 30

We can also use the following formula to calculate the implicit rte of interests:

Credit Period Less Amount Due Full Amount Due
Begins N98,000 N1,000,000


ADDITIONAL PERIOD
Discount Period

Credit Period

Cost of Cash Discount







Implicit interest rate:
= % Discount x 360
100-% Discount Credit period – Discount period
Using data of our examples, we obtain:
= 2 x 360
100 – 2 45 – 15
= 2 x 360 = .245 or 24.5%
98 30

AS this example indicates, the annual opportunity cost of foregoing cash discount can be very high. Therefore, a firm should compare the opportunity cost of trade credit with the costs of other sources of credit while making its financing decisions.

For meeting its financing needs, should a company stretch its accounts payable. When a firm delays the payment of credit beyond the due date, it is called stretching account payable. Stretching accounts payable does generate additional short-term finances, but it can prove to be a very costly source. The firm will have to forgo the cash discount and may also be required to pay penalty interest charges. Thus the firm will not only charged higher implicit costs, but its creditworthiness will also be adversely affected. If the firm stretches accounts payable frequently, it may not be able to obtain any credit in future. It may also find it difficult to obtain finances from other sources once its creditworthiness is seriously damaged.

ACCRUED EXPENSES AND DEFERRED INCOME
In addition to trade credit, accrued expenses and deferred income are other spontaneous sources of short-term financing. Accrued expenses are more automatic source since by definition they permit the firm to receive services before paying or them.

Accrued Expenses
Accrued expenses represent a liability that a firm has to pay for the services which it has already received. Thus they represent a spontaneous, interest-freesources of financing. The most important component of accruals are wages and salaries, taxes and interest.

Accrued wages and salaries represent obligations payable by the firm to its employees. The firm incurs a liability the moment employees have rendered services. They are however paid afterwards, usually at some fixed interval like one month. The liability builds up between payables. The longer the payment intervals the greater the amount of funds provided by the employees. Legal and practical aspects constrain the flexibility of a firm in lengthening the payment interval.

Accrued taxes and interest constitute another source of financing. Corporate taxes are paid after the firm has earned profits. These taxes are paid quarterly during the year in which profits are earned. This is a differed payment of the firm’s obligation and thus, is a source of finance. Like taxes, interest is paid periodically during a year while the borrowed funds are continuously used by the firm. Thus accrued interest on borrowed funds requiring semiannually interest payments can be used as a source of financing for a period as long as six months. Note that these expenses are not postponeable for long and a firm does not have much control over their frequency and magnitude. It is a limited source of short-term financing.

Deferred Income
Deferred income represents funds received by the firm for goods and services which it has agreed to supply in future. These receipts increase the firm’s liquidity in the form of cash; therefore, they constitute an important source of financing.

Advance payments made by customers constitute the main item of deferred income. These payments are common in case of expensive products like boilers, turnkey projects, large contracts or where the product is in short supply and the seller has strong bargaining power as compared to the buyer. These payments are not recorded as revenue until goods and services have been delivered to the customers. They are, therefore, shown as a liability in the firm’s balance sheet.

BANK FINANCE FOR WORKING CAPITAL
Banks are the main institutional sources of working capital finance in India. After trade credit, bank credit is the most important source of financing working capital requirements of firms in India. A bank considers a firm’s sales and production plans and the desirable level of current assets in determining its working capital requirements. The amount approved by the maximum funds which a firm can obtain from the banking system. Banks may fix separate limits for the ‘peak level’ credit requirements and ‘normal non-peak level’ credit requirements indicating the periods during which the separate limits will be utilized by the borrower. In practice, banks do not lend 100 percent of the credit limit; the deduct margin money. Margin requirement is based on the principle of conservatism and is meant to ensure security. If the margin requirement is 30 percent, bank will lend only up to 70 percent of the value of the asset. This implies that the security of bank’s lending should be maintained even if the asset’s value falls by 30 percent.

Forms of Bank Finance
A firm can draw funds from a within the maximum credit limit sanctioned. It can draw funds in the following forms: (a) overdraft (b) cash credit (c) bill purchasing or discounting, and (d) working capital loan.

Overdraft:- Under the overdraft facility, the borrower is allowed to withdraw funds in excess of the balance in his current account up to a certain specified limit during a stipulated period. Though overdrawn amount is repayable on demand, they generally continue for a long period by annual renewals of the limits. It is a very flexible arrangement from the borrower’s point of view since he can withdraw and repay funds whenever he desires within the overall stipulations. Interest is charged on daily balances – on the amount actually withdrawn-subject to some minimum changes. The borrower operates the account trough cheques.

Cash Credit:- The cash credit facility is similar to the overdraft arrangement. It is the most popular method of bank finance for working capital in India. Under the cash credit facility, a borrower is allowed to withdraw funds from the bank up to the sanctioned credit limit. He is not required to borrow the entire sanctioned credit once, rather he can draw periodically to the extent of his requirements and repay by depositing surplus funds in his cash credit account. There is o commitment charge; therefore, interest is payable on the amount actually utilised by the borrower. Cash credit limits are sanctioned against the security of current assets. Though funds borrowed are repayable on demand, banks usually do not recall such advances unless they are compelled by adverse circumstances. Cash credit is a most flexible arrangement form the borrower’s point of view.

Purchasing or discounting of bills:- Under the purchase or discounting of bills, a borrower obtain credit from a bank against its bills. The bank purchases or discounts the borrower’s bills. The amount provided under this agreement is covered within the overall cash credit or overdraft limit. Before purchasing or discounting the bills, the bank satisfies itself as to the creditworthiness of the drawer. Though the term ‘bills purchased’ implies that t he bank becomes owner of the bills, in practice, bank hold bills as security for the credit. When a bills is discounted, the borrower is paid the discounted amount of the bills (viz, full amount of bills minus the discount charged by the bank). The bank collects the full amount on maturity.

To encourage bills as instruments of credit, the Reserve Bank of India introduced the new bills market scheme in 1970. The scheme was intended to reduce the borrowers’ reliance on the cash credit system which is susceptible to misuse. It was also envisaged that the scheme will facilitate banks to deploy their surpluses or deficits by rediscounting or selling the bills purchased or discounted by them. Bank with surplus funds could repurchase or rediscount bills in the possession of banks with deficits. There can be situation where every bank wants to sell its bills. Therefore, the reserve Bank f India plays the role of the lender of last resort under the new bill market scheme. Unfortunately, the scheme has not worked successfully so far.

Working capital loan:- A borrower may sometimes require ad hoc or temporary accommodation in excess of sanctioned credit limit to meet unforeseen contingencies. Banks provide such accommodation through a demand loan account or a separate ‘non-operable’ cash credit account. The borrower is required to pay a higher rate of interest above the normal rate of interest on such additional credit.

Security Required in Bank Finance
Banks generally do not provide working capital finance without adequate security. The following are the modes of security which a bank may require.

Hypothecation: Under this arrangement, the borrower is required to transfer the physical possession of t he properly offered as a security of moveable property, generally inventories. The borrower does not transfer the property to the bank; he remains in the possession of property made available as security for the debt. Thus hypothecation is a charge against property for an amount of debt where neither ownership nor possession is passed to the creditor. Banks generally grant credit hypothecation only to first class customers with highest integrity. They do not usually grant hypothecation facility to new borrowers.

Pledge: Under this arrangement, the borrower is required to transfer the physical possession of the property offered as a security to the bank to obtain credit. The bank has a right of lien and can retain possession of the goods pledged unless payment of the principal, interest and any other expenses is made. In case of default, the bank may either (a) sue the borrower for the amount due, or (b) sue for the sale of goods pledged or (c) after giving due notice, sell the goods.

MANAGEMENT OF CASH
The basic concepts involved in the working capital management in which the firm should manage its major components of cash, receivables (debtors) and inventories (stock). The basic focus in managing specific current assets should be to optimise the firm’s investment in them. Therefore, management of current assets involves the problem of determining the optimum level of investment in each assets.

FACETS OF CASH MANAGEMENT
Cash is the important current asset for the operations of the business. Cash is the basic input needed to keep the business running on a continuous basis; it is also the ultimate output expected to be realised by selling the serviced or product manufactured by the firm. The firm should keep sufficient cash, neither more nor less. Cash shortage will disrupt the firm’s manufacturing operation while excessive cash will simply remain idle, without contributing anything towards the firm’s profitability. Thus, a major function of the financial manager is to maintain a sound cash position.

Cash is the money which a firm can disburse immediately without any restriction. The term cash includes coins, currency and cheques held by the firm, and balances in its bank accounts. Sometimes near-cash items, such as marketable securities or bank time-deposits, are also included in cash. The basic characteristic of near-cash assets is that they can readily be converted into cash. Generally, when a firm has excess cash, it invests it in marketable securities. This kind of investment contributes some profit to the firm.

Cash management is concerned with the managing of: (i) cash flows into and out of the firm (ii) cash flows within the firm, and (iii) cash balances held by the firm at a point of time by financing deficit or investing surplus cash. It can be represented by a cash-management cycle as show in

COLLECTIONS
INFRMATION
AND CONTROL
BORROW OR
INVEST
PAYMENTS








Fig. 1. Cash Management Cycle

Figure 1. sales generate cash which has to be disbursed out. The surplus cash has to be invested while deficit has to be borrowed. Cash management seeks to accomplish this cycle at a minimum cost. At the same, it also seeks to achieve liquidity and control. Cash management assumes more importance than other current assets because cash is the most significant because it is used to pay the firm’s obligations. However, cash is unproductive. Unlike fixed assets of inventories, it does not produce goods for sale. Therefore, the aim of cash management is to maintain adequate control over cash position to keep the firm sufficiently liquid and to use excess cash in some profitable way.

The management of cash is also important because it is difficult to predict cash flows accurately, particularly the inflows, and that there is no perfect coincidence between the inflows and outflows of cash. During some periods, cash outflows will exceed cash inflows, because payments for taxes, dividends, or seasonal inventory build up. At other times, cash inflow will be more than cash payments because there may be large cash sales and debtors may be realized in large sums promptly. Cash management is also important because cash constitutes the smallest portion of the total current assets, yet management’s considerable time is devoted in managing it. In recent past, a number of innovations have been done in cash management techniques. An obvious aim of the firm now-a-days is to manage its cash affairs in such a way as to keep cash balance at a minimum level and to invest the surplus cash funds in profitable opportunities.

In order to resolve the uncertainty about cash flow prediction and lack of synchronization between cash receipts and payments, the firm should develop appropriate strategies for cash management. The firm should evolve strategies regarding the following four facets of cash management:
v Cash Planning: Cash inflows and outflows should be planned to project cash surplus or deficit for each period of the planning period. Cash budget should be prepared for this purpose.

v Managing the cash flows: The flow of cash should be properly managed. The cash inflows should be accelerated while, a far as possible, decelerating the cash outflows.

v Optimum cash level: The firm should decide about t he appropriate level of cash balances. The cost of excess cash and danger of cash deficiency should be matched to determine the optimum level of cash balances.

v Investing surplus cash: The surplus cash balances should be properly invested to earn profits. The firm should decide about the division of such cash balance between bank deposits, marketable securities, and interoperate lending.

The ideal cash management system will depend on the firm’s products, organization structure, competition, culture and options available. The task is complex, and decisions taken can affect important areas of the firm. For examples, to improve collections if the credit period is reduced, it may affect sales. However in certain cases, even without fundamental changes, it is possible to significantly reduce cost of cash management system by choosing a right bank and controlling the collections properly.

Before discussing these aspects of cash management in details, we explain the reasons for holding cash.

MOTIVES FOR HOLDING CASH
The firm’s need to hold cash may be attributed to the following three motives:

v The transactions motive
v The precautionary motive
v The speculative motive

Transactions motive
The transaction motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchases, wages and salaries, other operating expenses, taxes, dividends etc. The need to hold cash would not arise if there were perfect synchronization between cash receipts and cash payments, i.e., enough cash is received when the payment has to be made. But cash receipts and payments are not perfectly synchronised. For those periods, when cash payments exceed cash receipts, the firm should maintain some cash balance to be able to make required payments. For transactions purpose, a firm may invest its cash in marketable securities. Usually, the firm will purchase securities whose maturity corresponds with some anticipated payments, such as dividends, or taxes in future. Notice that the transactions motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash receipts.

Precautionary motive
The precautionary motive is the need to hold cash to meet contingencies in future. It provides a cushion or buffer to withstand some unexpected emergency. The precautionary amount of a cash depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will be maintained for an emergency. The amount of precautionary cash is also influenced by the firms ability to borrow at short notice when the need arises. Stronger the ability of the firm to borrow at short notice less the need for precautionary balance. The precautionary balance may be kept in cash and marketable securities. Marketable securities play an important role here. The amount of cash set aside for precautionary reasons is not expected to earn anything; therefore, the firm should attempt to earn some profit on it. Such funds should be invested in high-liquid and low-risk marketable securities.

Precautionary balance should, thus, be held more in marketable securities and relatively less in cash.

Speculative motive
The speculative motive relates to the holding of cash for investing in profit-making opportunities as and when they arise. The opportunity to make profit may arise when the security prices change. The firm old cash, when it is expected that interest rates will rise and security prices will fall. Securities can be purchased when the interest rate is expected to fall; the firm will benefit by the subsequent fall in interest rates and increase in security prices. The firm may also speculate on materials; prices. If it is expected that materials’ prices will fall, the firm can postpone materials’ purchasing and make purchases in future when price actually falls. Some firms may hold cash for speculative purposes. By the large, business firms do not engage in speculations. Thus, the primary motives to hold cash and marketable securities are: the transactions and the precautionary motives.

The firm must decide the quantum of transactions and precautionary balances to be held. This depends upon the following factors:

The expected cash inflows and outflows based on the cash budget and forecasts, encompassing long-and short-range cash needs of the firm.

v The degree of deviation between the expected and actual net cash flows.

v The maturity structure of the firm’s liabilities.

v The firm’s ability to borrow at short notice in the event of any emergency.

v The philosophy of management regarding liquidity and risk of insolvency.

v The efficient planning and control of cash.

All these factors, analysed together, will determine the appropriate level of the transactions and precautionary balances.

CASH PLANNING
Cash flows are inseparable parts of the business operations of all firms. The firm needs cash to invest in inventories, receivable and fixed assets and to make payment for operating expenses in order to maintain growth in sales and earnings. It is possible that a firm may be making adequate profits, but may suffer from the shortage of cash as its growing needs may be consuming cash very fast. The ‘cash poor’ position of the firm can be corrected if its cash needs are planned in advance. At times, a firm can have excess cash with it if its cash inflows exceed cash outflows. Such excess cash may remain idle. Again, such excess cash flows can be anticipated and properly invested if cash planning is resorted to. Thus, cash planning can help to anticipate future cash flows and needs of the firm and reduces the possibility of idle cash balances (which lowers firm’s profitability) and cash deficits (which can cause the firm’s failure).

Cash planning is a technique to plan and control the use of cash. It protects the financial condition of the firm by developing a projected cash statements from a forecast of expected cash inflows and outflows for a given period. The forecasts may be based on the present operations or the anticipated future operations. Cash plans are very crucial in developing the overall operating plans of the firm.

Cash planning may be done on daily, weekly or monthly basis. The period and frequency of cash planning generally depends upon the size of the firm and philosophy of management. Large firms prepare daily and weekly forecasts. Medium-size firms usually prepare weekly and monthly forecasts. Small firms may not prepare formal cash forecasts because of the non-availability of information and small scale operations. But, if the small firms prepare cash projections, it is done on monthly basis. As a firm grows and business operations become complex, cash planning becomes inevitable for its continuing success.

Cash forecasting and budgeting
Cash budget is the most significant device to plan for and control cash receipts and payments. A cash budget is a summary statement of the firm’s expected cash inflows and outflows over a projected time period. It gives information on the timing and magnitude of expected cash flows and cash balances over the projected period. This information helps the financial manager to determine the future cash needs of the firm, plan for the financing of these needs and exercise control over the cash and liquidity of the firm.

The time horizon of a cash budgets. Cash forecasting may be done on short or long-term basis. Generally, forecasts covering periods of one year or less are considered short-term; those extending beyond one year considered long-term.

Short-term forecasts: It is comparatively easy to make short-term forecasts. The important functions of carefully developed short-term cash forecasts are:

v To determine operating cash requirements
v To anticipate short-term financing
v To manage investment of surplus cash

The short-term forecast helps in determining the cash requirements for a predetermined period to run a business. If the cash requirements are not determined, it would not be possible for the management to know how much cash balance to keep in hand, t what extent bank financing be depended upon and whether surplus funds would be available to invest in marketable securities.

To know the operating cash requirements, cash flow projections, cash flow projections have to be made by a firm. As stated earlier, there is hardly a perfect matching between cash inflows and outflows. With the short-term cash forecasts, however, the financial manger is enabled to adjust these differences in favour of the firm.

It is well known that, for their temporary financing needs, most companies depend upon banks. One of the significant roles of the short-term forecasts is to pinpoint when the money will be needed and when it can be repaid. With such forecasts in hand, it will not be difficult for t he financial manager to negotiate short-term financing arrangements with banks. This in fact convinces banks about the ability of management to run its business.

The third function of the short-term cash forecasts is to help in managing the investment of surplus cash in marketable securities. A carefully and skillfully designed cash forecast helps a firm to: (i) select securities with appropriate maturities and reasonable risk (ii) avoid over and under-investing and (iii) maximize profits by investing idle money.

Short-run cash forecasts serve many other purposes. For example, multi-divisional firms use them as a tool to coordinate the flow of funds between their various divisions as well as to make financing arrangements for these operations. These forecasts may also be useful in determining the margins or minimum balances to be maintained with banks. Still other uses of these forecasts are:

v Planning reductions of short and long-term debt
v Scheduling payments in connection with capital expenditures programmes
v Planning forward purchases of inventories
v Checking accuracy of long-range cash forecasts
v Taking advantage of cash discounts offered by suppliers
v Guiding credit policies

Short-term forecasting methods: Two most commonly used methods of short-term cash forecasting are:

v The receipt and disbursements methods
v The adjusted net income method

The receipts and disbursements method is generally employed to forecast for limited periods, such as a week or a month. The adjusted net income method, on the other hand, is preferred for longer durations ranging between a few months to a year. Both methods have their pros and cons. The cash flows can be compared with budgeted income and expenses items if the receipts and disbursements approach is followed. On the other hand, the adjusted income approach is appropriate in showing a company’s working capital and future financing needs.

Receipts and disbursements method: Cash flows in and out in most companies on a continuous basis. The prime aim of receipts and disbursements forecasts is to summarise these flows during a predetermined period. In cash of those companies where each item of income and expenses involves flow of cash this method is favoured to keep a close control over cash.

Three broad sources of cash inflows can be identified: (i) operating (ii) non-operating and (iii) financial. Cash sales and collections from customers form the most important part of the operating cash inflows. Developing a sales forecast is the first step in preparing a cash forecast. All precautions should be taken to forecast sales as accurately as possible. In the case of cash sales, cash is received at the time of sale. On the other hand, cash is realized after sometimes if sale is on credit. The time in realizing cash on credit sales depends upon the firm’s credit policy reflected in the average collection period. Consider an example.

Illustration 1: Suppose that a firm’s standard collection period is 30 days, that is, payment is due within 30 days after the sale. The firm’s experience shows that 80 percent of book debts are realized after one month and 20 percent after two months after goods are sold. Also assume that credit sales generally are 80 percent of the firm’s total sales. With this information, the expected cash receipts from sales can be calculated if sales forecast are available. For example, sale receipts for January, February, March and April are calculated in Table 1 on the basis of assumed sales forecasts.

Table 1. Estimated sales receipts (‘000)
Actual Forecast
Nov. Dec. Jan. Feb. Mar. Apr.
Total sales 500 600 550 660 700 1,000
Credit sales (80%) 400 480 440 528 560 800
Collections:
One month - 320 384 352 422 448
Two months - - 80 96 88 106
Total collections 464 448 510 554
Cash sales 110 132 140 200
Total sales receipts 574 580 650 754

It can be seen from Table 1 that total sales for January are estimated to be N2,55,000 of which 80 percent (i.e. N4,40,000) are credit sales and 20 percent (i.e., N1,10,000) are cash sales. The 80 percent of credit sales of credit sales of N3,52,000 are expected to be received in February and 20 percent or N88,000 are expected to be realised in March. Sales of other months are also shown in the same way.

It can easily be noted that cash receipts from sales will be affected by changes in sales volume and the firm’s credit policy. To develop a realistic cash budget, these changes should be accounted for. If the demand for the firm’s products slackens, sales will fall and the average collection period is likely to be longer which increases the changes of bad debts. In preparing cash budget, account should be taken of sales discounts, returns and allowances and bad debts as they reduce the amount of cash collections from debtors.

Non-operating cash inflows include sales of old assets and dividend and interest income. The magnitude of these items is small. When internally generated cash flows are not sufficient, the firm resorts to external sources. Borrowings and issuance of securities are external financial sources.

The next step in the preparation of a cash budget is the estimate of cash outflows. Cash outflows include: (i) operating outflows: cash purchases, payments of payables, advances to suppliers, wages and salaries and other operating expenses (ii) capital expenditures (iii) contractual payments; repayment of loan and interest and tax payments; and (iv) discretionary payments: common and preference dividend. In case of credit purchases, a time lag will exist for cash payments. This will depend on the credit terms offered by the suppliers.

It is relatively easy to predict the expenses of the firm over the short run. Firms usually prepare capital expenditure budgets, therefore, capital expenditure are predictable for the purposes of cash budget. Similarly, payments of dividend do not fluctuate widely and are paid on specific dates. Cash outflow can also occur when the firm pays its long-term debt. Such payments are generally planned and, therefore, there is no difficulty in predicting them.

Once the forecasts for cash receipts and payments have been developed, they can be combined to obtain the net cash inflow or outflow for each month. The net balance for each month would indicate whether the firm has excess cash or deficit. The peak cash requirements would also be indicated. If the firm has a policy of maintaining some minimum cash balance, arrangements must be made to maintain this minimum balance in periods of deficit. The cash deficit can be met by borrowing from banks. Alternatively, the firm can delay its capital expenditures or payments to creditors or postpone payment of dividends.

Thus, one of the significant advantages of cash budget is to determine the net cash inflow or outflow so that the firm is enabled to arrange finances. However, the firm’s decision for appropriate sources of financing should depend upon factors such as cost and risk. Cash budget helps a firm to mange its cash position. It also helps to utilise ideal funds in better ways. On the basis of cash budget, the firm can decide to invest surplus cash n marketable securities and earn profits.

The preparation of a cash budget is explained in Illustration 2.

ILLUSTRATION 2: On the basis of the following information, prepare a cash budget for Kenny Manufacturing Company for the first six months of 2007.

1. Prices and costs are assumed to remain unchanged.
2. Credit sales a re 75 percent of total sales.
3. The 60 percent of credit sales are collected after one month, 30 percent after two months and 10 percent after three months.
4. Actual and forecast sales a re as follows:

Actual N Forecast N
Oct. 2006 1,20,000 Jan., 2007 60,000
Nov. 1993 1,40,000 Feb., 1994 80,000
Dec. 1993 1,60,000 Mar., 1994 80,000
Apr., 1994 1,20,000
May, 1994 1,00,000
June, 1994 80,000
July, 1994 1,20,000

5. The company expects a margin of 20 percent.
6. Anticipated sales of each month are purchased and paid in the preceding month.
7. The anticipated operating expenses are as below:

N N
Jan. 12,000 Apr. 20,000
Feb. 16,000 May 16,000
Mar. 20,000 June 14,000

8. Interest of 12 percent debenture N1,00,000 is to be paid in each quarter,
9. An advance tax of N20,000 is due in April.
10. A purchase of equipment of N12,000 is to be made in June.
11. The company has a cash balance of N40,000 at 31 December 2006, which is the minimum balance to be maintained. Funds can be borrowed in multiples of N2,000 on a monthly basis at 18 percent annum.
12. Interest is payable on the first of the month after the borrowing
13. Rent is N800 month.

In Table below, cash inflows are estimated in accordance with the company’s total sales and collection policy. For examples, of the total sales of N60,000 for January 25 percent (N15,000) are collected as cash sales in January: 60 percent of credit sales (60% of N45,000 = N27,000) are collected in February, 30% (13,500) in March and remaining 10 percent (N4,500) in April. Similarly, the sales of other months are broken.

Section B of the table 1 itemises all anticipated cash payments. Anticipated sales for each month are purchased and paid in the preceding month. As the profit margin is 20 percent, the cost of purchases will be 80 percent of sales. Thus, for the month of February, purchases equal to 80 percent of its anticipated sales of N 80,000 (i.e. N64,000 purchases) will be made and paid in January. Other items of cash outflows shown are rent, wages and salaries taxes, capital expenditures and interest on debt. The quarterly payment of interest will be made in March and June. In other to maintain a minimum cash balance of N40,000, N8,000 will have to be borrowed in the month of April. Interest at 18 percent on this amount will be paid only in May.

TABLE 2. CASH BUDGET
Actual 1993 Forecast 1994
Oct. Nov. Dec. Jan. Feb. Mar. Apri. May June
Total sales 1,20,000 1,40,000 1,60,000 60,000 80,000 80,000 1,20,000 1,00,000 80,000
Credit sales 90,000 1,05,000 1,20,000 45,000 60,000 60,0000 90,000 75,000 60,000
Cash sales 30,000 35,000 40,000 15,000 20,000 20,000 30,000 25,000 20,000
Collections:
One month 60% - 54,000 63,000 72,000 27,000 36,000 36,000 54,000 45,000
Two months 30% - - 27,000 31,500 36,000 13,500 18,000 18,000 27,000
Three months 10% - - - 9,000 10,500 12,000 4,500 6,000 6,000
Total Receipt (A) 1,27,500 93,500 81,500 88,500 1,03,000 98,000
B. Cash Payments
Purchases 64,000 64,000 96,000 80,000 64,000 96,000
Rent 800 800 800 800 800 800
Operating expenses 12,000 16,000 20,000 20,000 16,000 14,000
Equipment - - - - - 12,000
Interest - - - - - -
Advance tax - - - 20,000 - -
76,800 80,800 1,19,800 1,20,800 80,800 1,25,800
C. Cash Payments
Net Cash balance (A) – (B) 50,700 12,700 (38,300) (32,300) 22,200 (27,800)
Beginning of month cash balance 40,000 90,700 1,30,400 65,100 40,800 54,880
Total cash 90,700 1,03,400 65,100 32,800 63,000 27,080
Beginning of month borrowings - - - 8,000 - 14,000
Interest on borrowings - - - - (120) -
Repayment of borrowings - - - - (8,000) -
Total end of month cash balance 90,700 1,03,400 65,100 40,800 54,880 41,080

*To maintain minimum cash balance of N40,000, the company will borrow.
The difference between total receipts and total payments gives us the net cash flow. To this is added the beginning of month’s balance to get the total cash balance in a particular month. In April the total balance is N32,800, therefore, to maintain the minimum requirements of N40,000, a borrowing of N8,000 will be made. In Ma, there is a cash balance of N62,880 after paying interest of N120, therefore N8,000 can be repaid without impairing the minimum cash balance requirement. Again, N14,000 will have to be borrowed in June to maintain cash balance at N40,000.

The virtue of the receipts and disbursements method is its capability to give a complete picture of expected cash flows. It is also a sound tool to manage day-to-day cash operations. The method, however, does suffer from some limitations. Because of uncertainty, its reliability may be reduced. For example, collections may be delayed, or there may be an unanticipated demand for large disbursements. Another limitation of this approach is that it fails to highlight the significant movements in the company’s working capital.

Adjust net income method. This method of cash forecasting involves the tracing of working capital flows. It is sometimes called the sources and uses approach. Two objectives of the adjusted net income approach are: (i) to project the company’s need for cash at some future date and (ii) to show whether the company generates this money internally, and if not, how much will have to be borrowed or raised in the capital market.

As regards the form and content of the adjusted net income forecast, it resembles the cash flow statement. It is, in fact, a projected cash flow statement based on proforma financial statements. It generally has three sections: sources of cash, uses of cash and the adjusted cash balance. This procedure helps in adjusting estimated earnings on an accrual basis to a cash basis. It also helps in anticipating the working capital movements.

In preparing the adjusted net income forecasts items such as net income, depreciation, taxes, dividends etc., can easily be determined from the company’s annual operating budget. Normally, difficulty is faced in estimating working capital changes; specially the estimates of receivables ad inventories pose problem because they are influenced by factors such as fluctuations in raw-material costs, changing demand for the company’s products and possible delays I collection. Any error n predicting these items can make the reliability of forecast doubtful.

One popularly used method of projecting working capital is to use ratios relating receivables and inventories to sales. For example, if the past experience tells that receivables of a company range between 32 percent to 36 percent of sales, an average rate of 34 percent can be used. The difference between the projected figure and that on the books will indicate the expected increase or decrease in cash attributable to receivables.

The major benefit of the adjusted net income method is that it helps n keeping a control on working capital and anticipating financial requirements. The main limitation of the method is that it fails to trace the flows of cash. Thus this method is not useful in controlling the day-to-day cash transactions.

Sensitive Analysis: The example on cash budget in Table 2 is not entirely meaningful since it is based on only one set of assumptions about cash flows. The estimates of cash flows in the example may be considered based on expected or most probable values. In practice, many alternatives are possible because of uncertainty. One useful method of getting insights about the variability of cash flows is sensitivity analysis. A firm can for example, prepare cash budget based on three forecasts; optimistic, most probable and pessimistic. On the basis of its experience, the firm would know that sales can decrease at the most by 20 percent under unfavourable conditions as compared to the most probable estimate. Thus cash budget can be prepared under three sales conditions. Acknowledge of the outcome of extreme expectations will help the form to be prepared with contingency plans. A cash budget prepared under worst conditions will prove to be useful to the management to face those circumstances.

Long-term cash forecasting: Long-term cash forecasts are prepared to give an idea of the company’s financial requirements in distant future. They are not as detailed as the short-term forecasts are. Once a company has developed long-term cash forecast, it can be used to evaluate the impact of, say, new-product developments or plant acquisitions on the firm’s financial condition three, five or more years in the future. Te major uses of the long-term cash forecasts are:

v It indicates as company’s future financial needs, especially for its working capital requirements

v It help to evaluate proposed capital projects. It pinpoints the cash required to finance these projects as well as the cash to be generated by the company to support them.

v It helps to improve corporate planning. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully.

Long-term cash forecasts may be made for two, three or five years. As with the short-term forecasts, company’s practice may differ on the duration of long-term forecasting Long-term cash forecasting reflects the impact of growth, expansion or acquisitions; it also indicates financing problems arising from these developments.

MANAGING THE CASH FLOWS
Once the cash budget has been prepared and appropriate net cash flow established, the financial manager should ensure that there does not exist a significant deviation between projected cash flows and actual cash flows. To achieve this, cash management efficiency will have to be improved through a proper control of cash collection and disbursement. The twin objectives in managing the cash flows should be to accelerate cash collections as much as possible and to decelerate or delay cash disbursements as much as possible.

Accelerating Cash Collections
A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash collections. The first hurdle in accelerating the cash collection could be the firm itself. It may take long time to process the invoice. The days taken to get the invoice to the buyer is called order processing float. Yet another problem is with regard to the extra time enjoyed by the buyers in clearing of bills. Particularly the government agencies take time beyond what is allowed by the seller in paying bills. This is called buyer float. Cash collections can be accelerated by reducing the lag or gap between the time a customer pays bill and the time the cheque is collected and funds become available for the firm’s use. Within this time gap the delay is caused by the mailing time, i.e., the time taken by cheque in transit and the processing time, i.e., the time taken by the firm in processing cheque for internal accounting purposes. The amount of cheques sent by customer not yet collected is called deposit float. This also depends on the processing time taken by the bank as well as the inter bank system to get credit in the desired account. The greater will be the firm’s deposit float, the longer the time to get realized than in most countries. An efficient financial manager will attempt to reduce the firm’s deposit float by speeding up the mailing, processing ad collection times.

Decentralised Collections
A large firm operating over wide geographical areas can speed up its collections by following a decentralised collection procedure. A decentralized collection procedure, called concentration banking in the U.S.A. is a system of operating through a number of collection centres, instead of a single collection centre centralised at the firm’s head office. The basic purpose of the decentralized collections is to minimise the lag between the mailing time from customers to the firm and the time when the firm can make the use of funds. Under decentralized collections, the firm will have a large number of bank accounts operated in the areas where the firm has its branches. All branches may not have the collection centres. The selection of the collection centre will depend upon the volume of billing. The collection centres will be required to collect cheques from customers and deposit in their local bank accounts. The collection centre will transfer funds above some predetermined minimum to a central or concentration bank account, generally at the firm’s head office, each day. A concentration bank is one where the firm has a major account – usually disbursement account. Funds can be transferred to a central or concentration bank b wire transfer or telex or fax or electronic mail. Decentralised collection procedure is, thus, useful way to reduce float.

Decentralised collection system saves mailing and processing times and, thus, reduces the financing requirements. Thus, decentralised collection’s system results in potential savings which should be compared with the cost of maintaining the system results in potential savings which should be compared with the cost of maintained the system. The system should be adopted only when the savings are greater than the cost.

Lock-box System.
Another technique of speeding up the mailing, processing and collection times which is quite popular in the U.S.A. and European countries is lock-box system. Some foreign banks in India have started providing this service to firms in India. In case of the concentration banking, cheques are received by a collection centre and after processing, are deposited in the bank. Lock-box system helps the firm to eliminate the time between the receipt of cheques and their deposit in the bank. In a lock-box system, the firm establishes a number of collection centres, considering customer locations and volume of remittances At each centre, the firm hires a post office box and instructs its customers to mail their remittances to the box. The firm’s local bank is given the authority to pick up the remittances directly from the local-box. The bank picks up the mail several times a day and deposits the cheques in the firm’s account. For the internal accounting purposes of the firm, the bank prepares detailed records of the cheques picked up.

Two main advantages of the lock-box system are: First, the bank handles the remittances prior to deposit at a lower cost. Second, the cheques are deposited immediately upon receipt of remittances and their collection process starts sooner than if the firm would have processed them for internal accounting purposes prior to their deposit. The firm can still process the cheques on the basis of the records supplied by the bank without delaying the collection. Thus lock-box system eliminates the period between the time cheques are received by the firm and the time they are deposited in the bank for collection.

The lock-box system involves cost. For the services provided under a lock-box arrangement, banks charge a fee or require a minimum balance to be maintained. Whether a lock-box system should be sued or not will depend upon the comparison between its cost and benefits. Generally the benefits will exceed if the average remittances are very large and the firm’s cost of financing is high.

Instruments Used for Collection
The main instruments of collection used in India are: (i) cheques (ii) dafts (iii) documentary bills (iv) trade bills and (v) letter of credit. (see Table 3 below).




















TABLE 3. FEATURES OF INSTRUMENTS OF COLLECTION IN INDIA


Instrument
Pros
Cons
1.
Cheques
No charge
Can bounce


Payable through clearing
Collection times can be long


Can be discounted after receipt
Collection charge


Low discounting charge
Requires customer limits which are inter-changeable with overdraft limits.


2.
Draft
Payable in local clearing
Cost


Chances of bouncing are less.
Buyers account debited on
day one.




3.
Documentary Bills
Theoretically, goods are not released
till payment is made or the bills
Accepted.
Low discounting charge
Not payable through clearing.
Collection cost
Long delays

4.




5.
Trade Bills




Letters of Credit
No charge except stamp duty can be
Discounted.
Discipline of payment of due date


Good credit control as goods released
On payment or acceptance of bill.
Seller forced to meet delivery schedule
Because of expiry date.
Procedure is relatively
Cumbersome.
Buyers are reluctant to
Accept the due date discipline.

Opening charges
Transit period interest
Negotiation charges
Need bank lines to open LC.
Stamp duty on insurance bills.

Clearing: The instruments of exchange (e.g. cheques, drafts, etc.) are used to receive or pay claims. Before the amount is credited or debited to any account it has to pass through the clearing system. Therefore, the understanding of the clearing system is important for efficient collection system. The clearing process refers to the exchange of instruments by banks drawn on them through a clearing house. Instruments like cheques, demand drafts, interest and dividend warrants and refund orders can go through clearing. Documentary bills, promissory notes, etc. cannot go through clearing.

The clearing process has been highly automated in quite a few countries. Electronic data is used instead of paper. In India, foreign banks such as Citi Bank have started using MICR to automate the clearing process. They maintain an account with the Reserve Bank of India (RBI) which is debited for inward clearing (items drawn on other banks plus inward returns).

The clearing house covers banks located within a defined geographic area. Thus, when we say a cheque is payable in local clearing in Bobay then it must be drawn on a bank located within the geographic area covered by Bombay clearing house.

Clearing operations are based on time limits. There is a time by which the cheques have to be give to t clearing house and a time by which returned cheques have to be given back. A cheque which is not returned is treated as paid.

Credit is given to the customer as soon as the banks get credit through the clearing. This credit is with a hold for the time it takes to get returns back ad debt them. Thus, the customer cannot draw on these funds till the hold is removed. Some banks credit customers only after funds are cleared. This creates a problem for customers with advances accounts as they continue paying interest for the clearing period.

Cheques deposited by customers drawn on other banks go for outward clearing. In the manual process which applies for non-MICR cheques, the cheques have to be sorted by bank, listed and tallied before presenting them to the clearing house. For MICR cheques, the cheques have to be encoded and then presented to the clearing house. Physical sorting of cheques is avoided. The MICR code line on the cheques has information on the city, bank branch, cheque number, type of cheque (transaction code), the account number and amount. Using this, the clearing house is able to sort the cheques by city, bank and branch and deliver the cheques to the drawee bank. RBI own operates national clearing between a few major cities.

In inward clearing the banks receive instruments that have been issued by them. In case a customer does nothave fujnds in his account or his lines are exceeded, the cheque is returned unless appropriate approvals are obtained. The cheques have also to be scrutinized for signature, forgery or other defects (post dated, unauthorised alterations, etc).

Cheques must be returned within a tight deadline, so quick processing is essential. Returned within a tight deadline, so quick processing is essential. Returned cheques can be divided into two categories: (a) inward returns (cheques presented by other banks, and returned), and (b) outward returns (cheques returned by other banks). Return cheques have to be processed independently from the people handling clearing. In the case of outward returns, it is essential that the presenting department is stamped on the cheque as otherwise the clearing department will not know the area to debit.

To conclude this section on collections, it may be stated that the major advantage of accelerating collections is to reduce the firm’s total financing requirements. Other advantages also follow. By transferring clerical function to the bank, the firm may reduce its costs, improve internal control and reduce the possibility of fraud.

Controlling Disbursements
The effective control of disbursement can also help the firm in conserving cash and reducing the financial requirements. Disbursements arise due to trade credit, which is a source of funds The firm should make payments using credit terms to the fullest extent. There is no advantage in paying sooner than agreed. By delaying payments as much as possible, the firm makes maximum use of trade credit as a source of funds – a source which is interest free. To illustrate the point, suppose that a company purchased raw materials worth Rs 73 crore in 1994 and followed the policy of paying within credit terms offered by the supplier. If the company paid one day earlier, creditors’ balance would decline buy one day’s purchase. Trade credit would decrease by Rs 20 lakh (Rs 72 crore 365) and financing requirement from other sources will increase by this amount. If the interest rate is 18 percent, the company’ interest costs will increase by Rs 3.6 lakh on an annual basis.

Delaying disbursements results in maximum availability of funds. However, the firm that delays in making payments may endanger its credit standing. This can put the firm in difficulties in obtaining enough trade credit. On the other hand, paying early may not result in any substantial advantage to the firm unless cash discounts are offered. Thus, keeping in view the norms of the industry, the firm should pay within the terms offered by the suppliers.

While, for accelerated collections a decentralised collection procedure should be followed, for a proper control of disbursements, a centralised system is advantageous. The payments of bills will be made from a single central account. For the local payees, who are far from the central account, the transit time will increase and the firm will gain by this delay.

Playing the float: Some firms use the techniques of “paying the float” to maximise use the availability of funds. When the firm’s actual bank balance is greater than the balance shown in the firm’s books, the difference is called payment float. The difference between the total amount of cheques drawn on a bank account and the balance show on the bank’s books is caused by transit and processing delays. If the financial manager can accurately estimate when the cheques issued will be deposited and collected, he can invest the “float” during the float period to earn a return. However, it is a risky game and should be played very cautiously.

DETERMINING THE OPTIMUM CASH BALANCE
One of the primary responsibilities of the financial manger is to maintain a sound liquidity position of the firm so that dues may be settled in time. The firm needs cash not only to purchase raw materials and pay wages, but also for payments of dividend, interest, taxes and countless other purposes. The test of liquidity is really the availability of cash to meet the firm’s obligations when they become due.

The operating cash balance is maintained for transaction purposes and an additional amount may be maintained as a buffer or safety stock. The financial manager should determine the appropriate amount of cash balance. Such a decision is influenced by a trade-off between risk and return. If the firm maintains a small cash balance, its liquidity position weakens and it suffers from a paucity of cash to make payments. But a higher profitability can be attained by investing realised funds in some profitable opportunities. When the firm runs out of cash, it may have to sell its marketable securities, if available, or borrow. This involves transaction cost. On the other hand, if the firm maintains a high level of cash balance, it will have a sound liquidity position but forego the opportunities to earn interests. The potential interest lost on holding large cash balance involves an opportunity cost to the firm. Thus, the firm should maintain an optimum cash balance, the transaction costs and risk of too small a balance should be matched with the opportunity costs of too large a balance. Figure 2 shows this trade-off graphically. If the firm maintains larger cash balances, its transaction costs would decline, but the opportunity costs would increase. At point x the sum of the two costs is minimum. This is the point of optimum cash balance which a firm should seek to achieve.










Fig. 2. Optimum Cash Balance

Uncertainty
Receipts and disbursements of cash are hardly in perfect synchronization. Despite the absence of synchronization, it is not difficult to determine the optimum level of cash balance if cash flows are predictable. It is simply a problem of minimising the total costs-the transaction costs ad the opportunity costs.

Cash flows, in practice, are not completely predictable. At times, they may be completely random. Under such a situation, a different model, based on the technique of control theory, is needed to solve the problem of appropriate level of operating cash balance. When the optimum cash balance has to be determined under the situation of unpredictable variations in cash flows, the firm will have to consider a trade-off between transaction costs and opportunity costs, given the degree of cash flows variability. Given such a date, the minimum ad maximum limits of the cash balances should be set. Greater the degree of variability, higher the minimum cash balance. Whenever the cash balance reaches the maximum level, the difference between maximum and minimum levels should be invested in marketable securities. When the balance falls to zero, marketable securities should be sold and the proceeds should be transferred to working cash balances. Formal mathematical models can be used to resolve the problem of fluctuating cash flows.

On the question of the appropriate level of cash balance, a firm arrives at reasonable solution, by combining formal cash management models and the techniques of cash budgeting with its experience and experiments. The extent to which analysis should be carried would be governed by the cost of analysis. In case of most of the firms, the use of formal mathematical models is not likely to be beneficial. The cost of obtaining the necessary information for using such models may far exceed the savings expected from the solutions. The results on the basis of experience and experiment may prove to be more economical.

INVESTMENT IN MARKETABLE SECURITIES
There is a close relationship between cash and marketable securities. Therefore, the investment in marketable securities should be properly manger. Excess cash should formally be invested in marketable securities which can be conveniently and promptly converted into cash. Cash in excess of the requirement of operating cash balance may be held for two reasons. First, the working capital requirements of firm fluctuate because of the elements of seasonality and business cycles. The excess cash may build up during slack seasons but it would be needed when the demand picks up. Thus, excess cash during slack reason is idle temporarily, but has a predictable requirement later on. Second, excess cash may be held as a buffer to meet unpredictable financial needs. A firm holds extra cash because cash flows cannot be predicted with certainty. Cash balance held to cover the future exigencies is called the precautionary balance and usually is invested in marketable securities until needed. Instead of holding excess cash for the above mentioned purpose, the firm may meet its precautionary requirements as and when they arise by making short-term borrowings. The choice between the short-term borrowings and liquid assets holding will depend upon the firm’s policy regarding them of short-term financing.

The excess amount of cash held by the firm to meet its variable cash requirements and future contingencies should be temporarily invested in marketable securities, which can be regarded as near moneys. A number of marketable securities may be available in the market. The financial manager must decide about the portfolio of marketable securities in which the firm’s surplus cash should be invested.

Selecting Securities
A firm can invest its excess cash in many types of securities. As the firm invests its temporary transaction balances or precautionary balances or both, its primary criterion is selecting a security will be its quickest convertibility into cash, when the need for cash arises. Besides this, the firm would also be interested the fact that when it sells the security, it, at least, gets the amount of cash equal to the cost of security. Thus, in choosing among alternative securities, the firm should examine three basic features f security: safety, maturity and marketability.

Safety: Usually, a firm would be interested in receiving as high a return on its investment in marketable securities as is possible. But the higher return yielding securities are relatively more risky. The firm would invest in very safe securities, as the transaction or precautionary balance invested in them are needed in near future. Thus, the firm would tend to invest in the highest yielding marketable securities subject to the constraint that the securities have acceptable level of risk. The risk referred here is the default risk. The default risk means the possibility of default in the payment of interest or principal on time and in the amount promised. The default in payment may mean more than one thing in an extreme case, the security may not be redeemed at all. In a less severe case, the security may be sold at a loss, when the firm needs cash. To minimize the chances of default risk and ensure safety of principal or interest, the firm should invest in safe securities. Other things remaining constant, higher the default risk, higher the return from security. Low-risk securities will earn low return.

Maturity: Maturity refers to the time period over which interest and principal are to be made. The price of long-term security fluctuates more widely with the interest rate changes than the price of short-term security. Overtime, interest rates have a tendency to change. Because of these two factors, the long-term securities are relatively more risky. For safety reasons, therefore, short-term securities are preferred by the firm for the purpose of investing excess cash.

Marketability: Marketability refers to convenience and speed with which a security ca be converted into cash. The two important aspects of marketability are price and time. If the security can be sold quickly without loss of price, it is highly liquid or marketable. The government treasury bills fall under this category. If the security need time to sell without loss, it is considered illiquid. As the funds invested in marketable securities which are readily marketable. The securities which have low marketability usually have higher yields in order to attract investment. Thus, differences in marketability also cause differences in the security yields.

ILLUSTRATIVE PROBLEMS
Problem 1. From the information and the assumption that the cash balance in hand on 1 January, 19 x 1 is N72,500, prepare a cash budget.


Sales
Materials
Purchases
Salaries &
Wages
Production
Overheads
Office & Selling
Overheads
Month
N
N
N
N
N
January
February
March
April
May
June
72,000
97,000
86,000
88,600
1,02,500
1,08,700
25,000
31,000
25,500
30,600
37,000
38,800
10,000
12,100
10,600
25,000
22,000
23,000
6,000
6,300
6,000
6,500
8,000
8,200
5,500
6,700
7,500
8,900
11,000
11,500

Assume that 50 percent of total sales are sales. Assets are to be acquired in the months of February and April. Therefore, provisions should be made for the payment of N8,000 and N25,00 for the same. And application has been made to the bank for the grant of a loan of N30,000 and it is hoped that the loan amount will be received I the month of May.

It is anticipated that a dividend of N35,000 will be paid in June. Debtors are allowed one month’s credit. Creditors for materials purchases and overheads grant one month’s credit. Creditors for materials purchases and overheads grant one month’s credit. Sales commission at 3 percent on sales is paid to the salesman each month.












Solution:

Cash Budget


Jan.
Feb.
March
April
May
June
Total
Receipts


43,000
44,300
51,250
54,350
2,77,400
Cash sales
36,000
48,500
48,500
43,000
44,300
51,250
2,23,050
Collections
From debtors
-
36,000





Bank loan
-
-
-
-
30,000
-
30,000
Total
36,000
84,500
91,500
87,300
1,25,550
1,05,600
5,30,450
Payments







Materials
-
25,000
31,00
25,600
30,,600
37,000
1,49,100
Salaries and
wages
10,000
12,100
10,600
25,000
22,000
23,000
1,02,700
Production
Overheads
-
6,000
6,300
6,000
6,500
8,000
32,800
Office and
selling
-
-
-
-
-
-
-
Overheads
-
5,500
6,700
7,500
8,900
11,000
39,600
Sales
commission
2,160
2,910
2,580
2,658
3,075
3,261
16,644
Capital
Expenditure
Dividend
-

-
8,000

-
-

-
2,658

-
3,075

-
3,261

35,00
16,644

35,000
Total
12,160
59,510
57,180
91,658
71,075
1,17,261
4,08,844
Net cash flow
23,840
24,99
34,320
(4,358)
54,475
(11,661)
1,21,606
Balance,
Beginning of
month
72,500
96,340
1,21,330
1,55,650
1,51,292
2,05,767
1,94,106
Balance, end
Of month
96,340
1,21,330
1,55,292
2,05,767
1,94,106
1,94,106
3,15,712

PROBLEM 2. The Dauda Paints Limited is currently following a centralised collection system. Most of its customers are located in the cities of Northern Nigeria. The remittances mailed by customer to the central location take four days to reach. Before depositing the remittances in the bank, the firm loses two days in processing them. The daily average collection of the firm is N1,00,000.

The company is thinking of establishing a lock-box system. It is expected that such a system will reduce mailing time by one day and processing time by on day.
(i) Find out the reduction in cash balances expected to result from the adoption of the lock-box system.
(ii) Determine the opportunity cost of the present centralized collection system if the interest rate is assumed to be 18 percent.
(iii) Should the lock-box system be established if its annual cost is N24,500?

Solution:
(1) The total time saved by the firm by established the lock-box system is 2 days Reduction in cash balances = Times saved x daily average collection 2 x N1,00,000 = N2,00,000
(2) Opportunity cost = 18% x N2,00,000 = N26,000
(3) The lock-box system should be established because the opportunity cost of the present system N36,000) is higher than the cost of the lock-box system (N24,500).

RISK AND RETURN OF A SINGLE SECURITY
To review, we said the return on a security (especially common stock) is given by:
P1-P1-D1
R1 =
P1

Where: R1 = Return on a security (common stock or ordinary shares).

P1 = Market price of the security at the end of period
1.
P1 = Market price of the security at the beginning of the period (i.e. current price).
D1 = Dividend paid during period 1

Example:
Uncle bought the common stock of Adex Plc when the market price is N2,60. He expects the stock will appreciate to N3.50 in one year’s time when he will later sell it. Calculate the expected return on the stock if

a. No dividend will be paid during the period.
b. A dividend of 30k will be paid during the period.


Solution:
a. Expectd return - N3.50 – N 2.60 = 0.3461
N 2.60
= 34.61%.

b. Expected return - N8.50 – N2.60 - N0.4
N2.60

= 0.5395

= 53.85%

In a world of uncertainty, expected return as give in Example 7.1 may not be realised. There is a possibility that the actual return from holding the security will be different from expectations. If the actual return of a security deviates from expectations, there is risk associated with the return of that security.

If it is possible to find out the probability of occurrence of possible. The probability distribution the assessment of risk can be summarized in terms of two parameters, the expected value and the standard deviation. The expected value of returns is given by:

n
E(R) = E R1P1
T=I

Where: E(R) is the expected value of returns on security i.
R1 is the return associated with an event I (or a possibility) i.
R1 is the probability associated with event i.
n is the total number of events.

The standard deviation is given by:

n
ơ = E [R1 – E(R)2P1]

t=I

The square of the standard deviation, Ơ2 is known as the variance of the distribution.

Example:
The return on Security P for a one-year holding period is not certain. However, the probability distribution of possible returns of Security P is given as follows:

Event 1 Possible Probability of
Returns % event
1 18 0.3
2 20 0.2
3 24 0.5

Calculate the expected value and standard deviation of the return of Security P.

Return (R) Probability Ri x Pi Ri - E(R) (Ri-B(Ri)
(a) (Pi) (c) = (a) x (d) (e)
(b) (b)
0.18 0.3 0.054 -0.034 0.000347
0.20 0.2 0.04 -0.014 0.000059
0.24 0.5 0.12 0.026 0.000638
E(R) = 0.214 Ơ2=0.000724

Expected value of returns = 21.4%
Standard deviation of return = 2.69%

PORTFOLIO RISK AND RETURN
Portfolio describes the collection of various investments that make up an investor’s total investments. The investments. The investment might be in securities or projects. In the previous chapter and preceding section, we have discussed how to calculate the risk and return of a single investment (or security). When an investor has a portfolio of securities, he will expect the portfolio to obtain a certain return. The expected return on a portfolio is the weighted average of the expected return of each investment in the portfolio where the weights represent the proportion of total funds of each investment in the portfolio. Mathematically, the expected return on a portfolio is given by:

n
RP = E WjRj
j=1

Where: Rj = Expected return on security j.
Wj = Proportion of portfolio funds invested in security
j.
Rp = Expected return on portfolio P.

Example:
Ade is considering investment in two securities, which have the following random returns.

Security A Security B
Return Probability Return Probability
24% 0.3 12% 0.6
15% 0.5 13% 0.3
12% 0.2 14% 0.1

Calculate the expected return on portfolio P consisting of 60% of security
A and 40% security B.

Solution:
RA = (0.24)(0.3) + (0.15)(0.5) + (0.12)(0.2) = 0.171.
RB = (0.12)(0.6) + (0.13)(0.3) + (0.14)(0.1) = 0.125
= (0.6)RA + (0.4)RB
= 0.6(0.171) + 0.4(0.125)
= 0.1526
= 15.26%

PORTFOLIO RISK
We measured the risk of a single security by calculating the standard deviation (or the variance) of the return. The risk of a portfolio depends not only on the riskiness of the securities making up the portfolio but also on the relationship among those securities. This must be considered in calculating the standard deviation (or the variance) of a portfolio return.

An investor can reduce relative risk by selecting securities that have little relationship with each other. Diversification is the process of combining securities in a way that reduces risk. The standard deviation of possible portfolio returns is give by:

n n
ƠP = E E WjWj Ơij
i=j j=1
Where: ƠP is the standard deviation of portfolio p.
Wj is the proportion of total funds invested in security i.
Wj is the proportion of total funds invested in security j.
Ơj is the covariance between possible returns for security I and j.

The two Es mean that the covariances for all possible pair wise combinations of securities in the portfolio will be considered. The number of covariances will get larger as the number of securities in the portfolio increases. For this book, we will restrict our discussions to a two-security case.

For a two-security case, the standard deviation of portfolio return is given by:

For instance, the means of covariances in a situation when a = 3 is as follows:

Ơ1.1 Ơ1.2 Ơ1.3

Ơ2.1 Ơ2.2 Ơ2.3

Ơ3.1 Ơ3.2 Ơ3.3

The combination in the diagonal that shows that j = k represent the variance terms. The rest are covariance terms for n - 4, the covariance terms are 12 in number.

ƠP = WA2 ƠA2 + WB2 ƠB2 + 2w AWB cov(A,B)

Where: WA is the proportion of total funds invested in security A.
Ơ2 is the variance of return on security A.
WB is the proportion of total funds invested in security B.
Ơ2B is the variance of return on security B.
COV(A,B) = ƠAB is the covariance between returns on security A and B.

Calculating covariance is not straightforward. Statistically, covariance is given by:
1
COV(A,B) = n-1 E (RA – RAXRB – RB)

If the returns between securities A and B are subjected to the same event, then.

COV(A,B) = E P1(RA – RAxRB – RB)

Where P1 is the probability associated with event i.

Example
Calculate the standard deviation of the return on a portfolio consisting of 50% of security A and 50% of security B. the random returns of the two securities are given as follows:

Event Probability Return on Security Return on Security
A B
1 0.3 23% 14%
2 0.5 18% 15%
3 0.2 15% 16%

Solution:

RA R1 RAP1 RA – RA (RA – RA)2 P1
0.23 0.3 0.069 0.041 0.000504
0.18 0.5 0.09 -0.009 0.000041
0.15 0.2 0.03 -0.039 0.000304
RA=0.189 Ơ2A = 0.000849

RB R1 RBP1 RB – RB (RB – RB)2P1
0.14 0.3 0.042 -0.009 0.000024
0.15 0.5 0.075 0.001 0.000001
0.16 0.2 0.032 0.011 0.000024
RB = 0.149 Ơ2B = 0.000049

COV(A,B) is calculated as follows:

P1 RA – RA RB – RB P1(RA – RA)(RB – RB)
0.3 0.041 -0.009 -0.000111
0.5 -0.009 0.001 -0.000005
0.2 -0.039 0.011 -0.000086
-0.000202

ƠP = WA 2 ƠA2 + WB 2ƠB2 + 2WA WB COV (A-B
= (0.5)2(0.000849) + (0.5)2(0.000049) + 2(0.5)(-0.000202
= 0.011113
= 1.11%

The covariance of the possible return of two securities is a measure of the extent to which they are expected to vary together rather than independently of each other. We can also restate the covariance term in Equation (7.6) as:

COV(A,B) = rAB ƠA ƠB

Where: rAB is the correlation between possible returns for securities A and B
ƠA is the standard deviation of security A.
ƠB is the standard deviation of security B.

This we can restate Equation as:

ƠP = WA2 ƠA2 + WB2 ƠB2 + 2WA WB ƠA ƠB

Correlation coefficient can be positive, negative or zero. If the value of correlation coefficient is positive, the returns on two securities vary along the same direction. If the value of correlation coefficient is negative, the returns vary along different direction. If the value of correlation coefficient is zero, there is no relationship between returns on two securities.

The value of a correlation coefficient always lies between – 1 and + 1. If the value of correlation coefficient is strictly 1, it is called perfect positive correlation while it is called perfect negative correlation if the value is strictly – 1.

The lower the correlation coefficient of securities in a portfolio, the more effective will be diversification in reducing overall risk of the portfolio. Diversification will be strictly more effective in reducing overall risk of a portfolio if securities in the portfolio are perfect negatively correlated.






Example:
For portfolio P in example calculate standard deviation of the portfolio if:

a. rAB = 1
b. rAB = 0
c. rAB = -1

Solution:
a. ƠP = WA 2 ƠA2 + WB 2 ƠB2 + 2WAWB - AB ơa ƠB

For example Ơ2A = 0.000849 and Ơ2B = 0.000049
Thus, ƠA = 0.029138; and
ƠB = 0.007.

ƠP = (0.5)2(0.000849) – (0.5)2(0.000049) + 2(0.5)(1)
(0.029139)(0.007)

= 0.018069

= 1.81%

ii. ƠP = (0.5)2(0.000849) – (0.5)2(0.000049) + 2(0.5)(0)
(0.029139)(0.007)

= 0.014983

= 1.50%

iii. ƠP = (0.5)2(0.000849) – (0.5)2(0.000049) + 2(0.50(0.5)
(-1)(0.029138)(0.007)

= 0.011069

= 1.11%

We could see that standard deviation (or risk) is lowest when the correlation between return on securities A and B is – 1.

WORKING CAPITAL DECISIONS
Working capital management involves the management of current assts (cash, debtors and cash) and current liabilities (creditors). An important consideration in working capital management is determining the amount of investment in working capital and how working capital should be financed.

FINANCIAL WORKING CAPITAL
Current assets may be financed either by long-term finance or short-term finance (current liabilities). We have discussed the sources of long-term financing in previous chapters. Short-term financing (current liabilities) is a cheap source of finance. For instance, trade creditors do not carry interest cost. However, short-term financing is risky. They create the danger of insolvency through insufficient liquidity For instance, a company might suddenly find that it is unable to renew its short-term financing. A bank might suspend its overdraft facilities or creditors may start to demand earlier payments. Unless the company can realise sufficient of its assets quickly into cash, there will be a danger of insolvency. A going concern profitable business might be faced with liquidation because of insufficient liquidity. In financing working capital, the following guides can be taken into consideration:

(i) Liquidity ratios
We said that the normal current ratio (i.e., current assets/current liabilities) is 2:1. This implies that 50% of current assets should be financed with long-term funds. However, this can vary depending on the situation of individual organisation. We also mentioned that the normal quick or acid test ratio is 1:1. A current ratio of 2:1 and a quick ratio of 1:1 appear to indicate that a company is reasonably well protected against the dangers of insolvency through insufficient liquidity.

(ii) Permanent an fluctuating current assets
Permanent current assets are current assets that can be regard as fixed over time. For example, a company might always carry certain base stock levels, cash balance never falls below a particular level and certain level of debtors are always carried.

Fluctuating or variable current assets are extra current assets needed above the permanent current assets. They are needed to support changing production and sales in peak periods.

It has been argued that given that because of the permanent nature of a large proportion of current assets, it is prudent to fund some current assets wit long-term finance. The question is to what extent will permanent current assets be financed with long-term finance? The possible options are:

(a) All permanent current assts are financed with long-term finance.
(b) Some permanent current assets are financed short-term finance.
(c) Fluctuating current assets can be financed with short or longer-term finance.

Financing fixed assets with short-term finance appears imprudent.

The final choice in financing working capital is managerial judgment. Management must balance the requirement for a higher return by using short-term debts to finance current assets against the risk of illiquidity that can result in insolvency. Thus, the decision on working capital financing varies with management’s attitude towards risk.

INVESTMENT IN WORKING CAPITAL
The volume of working capital or net current assets required will depend on the nature of the company’s business. For example, some companies (e.g.), manufacturing) may require more stocks than other companies (e.g., service industry). As a company expands or grows and its output increase, the volume of its working capital or net current assets will also increase. The volume of net current assets will also depend on policies adopted by a company for managing individual current asset items. A company with no stock, no debtors and no creditors will have little or no investment in working capital. This would result in few sales and therefore little profit. Cash is an important ingredient of any business. It is essential that investment in working capital is effectively and efficiently managed to maintain control of business cash flows. Management should be aware of the trade off between liquidity and profitability.

Thus, overall, investment in working capital must consider the trade off between liquidity (risk) and profitability. The benefits of investing in working capital must be compared with the cost of investing in working capital.






Example
Comment on the working capital management of the following three companies:

Company Company Company
A B C
N’000 N’000 N’000
Fixed Assets 900 900 900
Current Assets 900 900 900

Total Assets 1,800 1,800 1,800
Equity 900 900 900
Long-term debt - 450 150
Current Liabilities 900 450 150

1,800 1,800 1,800
Profit before interest and tax 300 300 300
Return on capital employed 33.33% 22.22% 18.18%
Current ratio 1:10 2:1 6:1

Solution:
In comparison with companies B and C’s working capital policy offers the highest return. The costs of holding extra net current assets in companies B and C are the profit s foregone on the investment of these extra funds elsewhere.

Company A faces a greater risk of illiquidity problem should occur, the company would be obliged to cash its liquid assets at short notice.

Thus, the trade off between risk and return varies among the three companies. Company A’s working capital management policy could be regarded as aggressive (high returns with high risk of illiquidity). Company C’s working capital management policy could be regarded as defensive (flow returns with low risk of illiquidity). While company B’s working capital management could be regarded as average (moderate returns with moderate or reasonable risk of illiquidity).

Working Capital and Overcapitalisation
Overcapitalisation is an inefficient working capital management that results in excessive stocks, debtors and cash very few creditors. This implies that working capital will be excessive. The return on capital employed would be lowered than it should be as long-term funds would be unnecessarily tied up. The long-term funds could have been invested elsewhere to earn profits.

The symptoms of overcapitalisation include high working capital turnover (Sales/working capital), high liquidity ratios (a current ratio in excess of 2:1 or a quick ratio in excess of 1:1), low stock turnover, high average collection period and low creditors’ payment period.

A good management should watch these signals to see whether they are out of line.

Working Capital and Overtrading
Overtrading occurs if a business is trying to support large volume of trading with little long-tem capital at its disposal. An overtrading business might be a profitable going concern but it could easily run into a serious problem because of illiquidity. The illiquidity system from the fact that it does not have enough capital to provide cash to pa its debt as thy fall due. Thus, an overtrading business runs the risk of liquidation. The symptoms of overtrading include:

i. A rapid growth in turnover
ii. High stock turnover and low average collection period
iii. A rapid growth in current and fixed assets
iv. Low liquidity ratios
v. Liquidity deficits
vi. Creditors’ payment period is getting higher
vii. Bank overdraft reaches or exceeds the limit of the facilities agreed
viii. with the bank
ix. Proportion of total assets financed by credit will increase while the
x. proportion financed with equity capital decline
An overtrading could be caused by the following:
i. Repayment of long-term loans without refinancing
ii. Inflation, which increases the amount of funds needed to finance current assets

The solution to an overtrading situation if it arises is to inject more equity capital and better control of stock and debtors.


Working Capital and Cash Operating Cycle
The cash operating cycle is the period that takes place between payments for raw material purchases and the eventual payment for the goods made from the raw materials by the company’s customers. This implies that the cash operating cycle equal average collection period plus the length of time stocks are held less the creditors’ payment period. The longer the operating cycle of a business the higher will be the investment in working capital.

Example
The following information relates to Alake Plc:

N
Sales 100,000
Costs of Goods sold 84,000
Purchases 56,000
Raw materials stock 14,000
Work-in-progress 7,000
Finished goods stock 16,000
Debtors 12,500
Creditors 8,400

Assume all sales and purchases are on credit. Calculate the length of the cash operating cycle.

Solution:

Cost of goods sold
Finished goods stock turnover = Finished goods stock

N84,000
= N16,000

= 5.25 times

1
= x 365
525

= 70 days

Cost of goods sold
Work-in-progress stock turnover = ­­------------
Work-in-progress stock

N84,000
= N7,000

= 12 times

1
x 365
12

= 30 days

Purchases
Raw materials stock turnover = ---------
Raw materials stock

N56,000
= N14,000

= 4 times

1
= ----- x 365
4

= 91 days

Debtors
Average collection period = -------- x 365
Sales

N12,500
= x 365
N84,000

= 54 days


Credits
Creditors payment period = --------- x 365
Purchases

N8,400 x 365
N56,000

= N16,000

= 55 days

Length of cash operating cycle = 70 + 30 + 91 + 54 - 55
= 190 days
Forecasting Working Capital Requirements
A company may occasionally require a forecast of the amount of working capital needed to finance an increase in output or introduction of a new product. In preparing a working capital forecast, the factors to be considered include: anticipated production level and production costs, length of production cycle, planned stock level and credit erms.

Example
From the following information of Ajala Plc, prepare a statement of working capital needed to finance an activity level of 7,800 units of output

Per unit
--------
N
Raw Materials 12
Direct Labour 3
Overhead (variable) 3
Variable Production Cost 18

Notes:

(a) Selling price per unit is N30
(b) Fixed overheads will amount to 15% of sales while selling and distribution overheads will amount to 5% of sales
(c) Raw materials are in stock on average two months
(d) Each unit of production is expected to be in process for 1 month and on average 50% complete
(e) Finished goods will stay in the warehouse awaiting dispatch to customers for 1½ months
(f) Credit given to debtors is 2 months from the date of dispatch
(g) Credit is taken as follows:
(i) raw materials - 1½ months
(ii) direct labour - 1 week
(iii) variable overhead - 1 month
(iv) fixed overhead - 1 month
(v) Selling and distribution overhead - ¾ month

Work-in progress and finished goods are valued at variable production cost. Assume that the labour force is paid for 52 working weeks.

Solution:
Workings:
The costs will be as follows:

N
Raw materials 7,800 x N12 93,600
Director labour 7,800 x N3 23,400
Variable overhead 7,800 x N3 23,400
Fixed overhead 7,800 x N30 x 15% 35,100
Selling and distributionoverhead N7,800 x N 30 x 5% 11,700

Ajala Plc
The statement of Working Capital Requirements
Production: 7,800 units

N N
Average value of current assets: -----------------------
Raw materials: 2/12 x N93,600 15,600
Work-in-progress:
Materials (100% complete) 1/12 x N93,600 7,800
Direct labour (50% complete) ½/12 x N23,400 975
Variable overhead (59% complete) ½/12 x N23,400 975

Finished goods: 9,750
Materials ½/12 x N93,600 11,700
Direct labour ½/12 x N23,400 2,925
Variable overhead ½/12 x N23,400 2,925

17,550 Debtors 2/12 x N30 x 7,800 39,000

81,900

Less:
Average value of current liabilities:
Raw materials: 1½ x N93,600 11,700
Direct labour 1/52 x N23,400 450
Variable Overhead: 1/12 x N35,100 2,925
Selling and Distribution Overhead ¾/12 x N11,700 731.25

17,756.25
64,143.75

DEBTORS MANAGEMENT
Debtors management is concerned with the efficient management of debtors to achieve an optimum level of debtors in the firm’s working capital investment. The optimum level of debtors represents a balance between two factors namely:

(i) Increase in sales and profits associated with extending credit
(iii) Costs of trade credit, which include:
- interest and administrative cost of carrying debtors
- cost of bad debt.

These two factors will enable management to determine the profitability of a credit policy.

A company’s management in deciding a policy for optimum level of debtors should consider the following:

i. Establish a credit policy in relation to normal credit periods and over all credit control
ii. Establish a policy on individual credit limits
iii. Debt collection management

CREDIT POLICY
The following factors should be considered in a credit policy:

i. Credit terms offered by competitors
ii. The procedures for controlling credit to individual customers and debt collection
iii. Elasticity of demand for the company’s products
iv. The availability of finance required to fund an extension of total
credit. An increase in debtors might require, for instance, an increase in stock.
v. The cost of additional finance required for an increase in debtors. The implied cost might be interest on a bank overdraft used to fund the increase in debtors or it might be the cost of long-term funds. If there is a reduction in volume of debtors, this will represent a savings
vi. The savings of additional expenses in administering the credit policy
vii. The considered risk of bad debts resulting from extension of credit period
viii. The discount policy to be adopted. Discounts can be offered for early payment.

The credit policy should be flexible to reflect changes in economic conditions. Competitors’ actions and marketing strategy.

CREDIT CONTROL OF INDIVIDUAL ACCOUNTS
Having established a credit policy, a company should have a procedure for extending credit to individual customers and controlling outstanding accounts of their customers.
The following points should be taken into consideration:

a. There should be a procedure laid down for accepting new customers. The creditworthiness of a potential customer should be assessed to decide whether the customer would be allowed credit at all and the maximum amount that should be allowed. The assessment would involve analysis of the prospective customer’s current business situation and past credit record. Information can be obtained from the following sources:

i. Trade reference
The potential customer can be asked to give names of two existing suppliers that will testify to the firm’s credit standing

ii. Bank reference
With the permission of the customer, the firm can obtain information from the customer’s bank about his creditworthiness.

iii. Credit rating agencies
iv. Reports from salesmen
v. Information from competitors
vi. Financial statements

The annual report and accounts of the customer can be analysed to determine his ability to pay.

b. The credit limits of a new customer should be fixed at a low level and should only be increased if his payment record warrants it.
c. The company should look out for any press comments about a potential customer. This may give an up-to-date information about the company
d. The company could send a member of its staff to visit the potential customer’s business. This will enable the company to asses on the spot the customer’s business and its prospects
e. For existing customers, their credit limits should be reviewed periodically. The credit limits should be increased at the request of customers and if their credit standing is good.
f. Report on age analysis of outstanding debts should be produced and reviewed at regular intervals.

DEBT COLLECTION MANAGEMENT
The following points should be considered for an effective debt collection management:

(1) Prompt Invoicing
The customer’s credit period will commence from the date of receipt of an accurate invoice. Thus, it is necessary to reduce the time between delivery of goods and invoicing. The company should ensure that:

a. Invoices are sent out immediately after delivery of goods
b. Checks are carried to ensure that invoices are accurate
c. Issues of credit notes arising from any complaints from customers are carried out promptly

2. Monthly Statements
Monthly statements should be issued early so that payments to be made by the customer will include all items in the statements.

3. There should be effective debt collection and credit control system
4. Collection of overdue debts

A debt that runs for a long time might eventually turn bad except an effective action in taken. There should be a procedure for a systematic follow-up that should be done as not to offend a valued customer. The following techniques can be adopted for chasing overdue debts:

i. Send monthly statements to draw attention to unpaid debts
ii. Send reminder letters
iii. Make telephone calls to extract promise of payment
iv. Send a telex/fax reminder
v. Send sales staff to visit the customer
vi. Make use of external agencies such as debt collection agencies, factoring companies etc. to take over the responsibility of collecting the debt. The agencies will charge a fee for their services
vii. The company can threaten to withdraw normal credit facilities and cash discounts unless payments are made
viii. The company can threaten to withhold future supplies until payments are made
ix. The company’s solicitor writes the customer threatening legal action.
x. Legal action in court.

5. Debt Collection Policy
There is not optimal debt collection policy that all companies ca adopt. Debt collection policies differ depending on the nature of the company, its product, industry ad competition. However, a good debt collection policy should posses the following factors:

i. There should be a good quality well-trained credit staff.
ii. There should be a procedure (as previously discussed) for collection overdue debt. However, the procedure should ensure that the cost of collecting the debt does not exceed the debts to be collected. The procedure should also not offend a valued customer.
iii. Debt collection policies should be modified as circumstances changes.
iv. The overall costs of a debt collection policy should not exceed the benefits.

DISCOUNT POLICIES
A company can sometimes offer a discount to its customers to encourage early payment. The discount will shorten the average collection period, thus, reducing the volume of debtors. The discount can also affect the volume of demand.

For a company to consider whether the offer of a discount is worthwhile, it is necessary to compare the cost of the discount with the savings from reduced investment in debtors.

EVALUATING CREDIT POLICIES
In evaluating any credit policy, the benefits of the policy should be compared with the costs of the policy. For instance, the benefits of a proposed policy to ease credit terms include increases in sales and profit form sales, while the costs of the policy include:

i. Interest charges on an additional increase in debtors.
ii. Increase in bad debt.

Example
Fatade Limited with a turnover of N3 million and N500,000 is current contemplating changing in debt collection policy while N250,000 and N50,000 are option A & B respectively. It currently incurs administrative cost N100,000 in debt collection, and average collection period is 2 months. Bad debt also currently amounts to 2½ of sales. The company is considering two options as follows:

Option A Option B
Administrative cost of bad debt N150,000 N10,000
Bad debt losses (% of sales) 1½% -
Average collection period 1 month 1/5
Factoring fee (% of sales) - 3%

The company currently requires a 16% return on its investment. Advise the company on the best option.





Solution:
Current Option Option
Policy A B
N N N
Debtors 500,000 250,000 50,000
Reduction in debtors - 250,000 450,000
Interest savings – 16% of
reduction in debtors (i) - 40,000 72,000
Bad debt losses 75,000 45,000 -
Reduction in bad debt losses (ii) - 30,000 75,000
Reduction in administrative cost (iii) - - 90,000

Total benefits (i) + (ii) + (iii) 70,000 237,000

Increase in administrative cost (iv) 50,000 -
Factoring fee (v) - 90,000

Net benefits [(i) + (ii) + (iii) – [(iv) + 9v)] 20,000 147,000

Options A and B are better than the current policy. But Option B is the preferable policy because it has the highest net benefit.

Example
Falak Limited is contemplating on changing its current credit policy to increase turnover. The new policy will increase average collection period from 1½ months to 2½ months while bad debt losses as a percentage of sales will increase from 2% of sales to 3% of sales. With the new policy, sales turnover will increase from N2.5 million to N3.2 million. The increase in sales would result in additional stocks of N180,000 and additional creditors of N30,000. The company currently earns a contribution of 20% on sales while it requires a return of at least 22% on its investment. Advise the company on whether or not the new credit policy is worthwhile if:

i. all the customers take the new credit period.
ii. Only the new customers take the new credit period while credit period to existing customers remain unchanged.





Solution:
i. Increase in sales = N3,200,000 - N2,500,000
= N700,000
Contribution from increase in sales = 30% x N700,000

= N210,000

1½
Current level of debtors = ----- x N2,500,000
12
= N312,500
= 2½
New level of debtors = ----- x N3,200,000
= 12
= N666,666.67
Increase in debtors = N666,666.67 – N312,500
= 354,166.67

Extra investment in working capital is as follows:

N
Increase in debtors 354,166.67
Increase in stock 180,000

53,166.67
Less: Increase in creditors 30,000

504,166.67

Cost of extra investment in working capital = 22% x N504,166.67
= N110,916.67
Current level of bad debt losses = 2% x N2,500,000
= N50,000
New level of bad debt losses = 3% x N3,200,000
= N96,000
Increase in bad debt losses = N96,000 – N50,000

= N46,000


The net benefit/cost of the policy is, thus, as follows:

N N
Contribution from increase in sales 210,000
Less: Cost of extra investment in working capital 110,916.67
Increase in bad debt losses 46,000
156,916.67

53,083.33

The new policy is worthwhile if all the customers take the new credit period.

(ii) Extra investment in working capital will be as follows:

N
Increase in debtors (2½/12 x N700,000) 145,833.33
Increase in stock 180,000

325,833.33
Less: Increase in creditors 30,000

295,833.33

Cost of extra investment in working
capital is 22% x N295,833.33 = N65,083.33

The net benefit/cost will be as follows:

N N
Contribution from increase in sales 210,000
Less: Cost of extra investment in working capital 65,083.33
Increase in bad debt losses (3% x N700,000) 21,000

86,083.33

123,916.67




The new credit policy is also worthwhile in this situation.

Example
Phillip Limited is considering introducing a discount of 2% so as to reduce the debtors level. The company currently has annual sales of N4 million with an average collection period of 2½ months. If the discount is introduced, the average collection period would be reduced to 1½ months.

Example
Salako Limited which produced and sells one product plans to increase production and sales next year. The plan for the next nine months is as follows:
Month
Production (units)
Sales (units)
October
975
975
November
1,050
1,050
December
1,200
1,200
January
1,500
1,200
February
1,800
1,500
March
1800
1,800
April
2,100
1,950
May
2,250
2,100
June
2,250
2,400

Notes:
a. The selling price per unit is expected to be N15. The raw materials will cost N6 per unit, wages will cost N3 per unit and other variable costs will cost N1.50 per unit.

b. Salaries and other fixed overheads are expected to amount to N2,100 per month during October, November and December, to rise to N2,400 per month from January to March, and to increase to N3,000 per month from April to June.


c. Sales collections are to be made as follows:

%
During the month of sales 60
In first subsequent month 30
In second subsequent month 9
Uncollectible 1

d. Payment is planned to be made for raw materials purchases one month after delivery and materials are expected to be held in stock for one month before they are used in production.

e. Delay in payment of wages is 1/8 month while variable costs of production are expected to be paid for during the month of production.

f. Salaries and fixed overheads are planned to be paid 85 percent in the month in which they are incurred and 15 percent in the following month.

g. The company plans to spend N1,500 in January and N2,250 in April on advertisements.

h. In order to cope with increased production, a new machine has been ordered and it should be delivered in February. The agreement is to pa the N9,000 for the machine in three equal installments of N3,000 each in March, April and May.

i. The firm intends to pay a dividend of N900 to its shareholders in April.

j. The firm expects to have a bank balance of N7,500 on 1 January.

You are required to prepare cash budget for Salako Limited for the first six months of next year, showing the set cash position at the end of each month.














Solution:
Workings

1. Receipts from Debtors

Month Received



Jan.
Feb.
Mar.
Apr.
May
June

N
N
N
N
N
N
N
Sales







Oct.
14,625
-
-
-
-
-
-
Nov.
15,750
1,417.5
-
-
-
-
-
Dec.
18,000
5,400
1,620
-
-
-
-
Jan.
18,000
10,800
5,400
1,620
-
-
-
Feb.
18,500
-
13,500
6,750
2,025
-
-
Mar.
27,000
-
-
16,200
8,100
2,430
-
Apr.
29,250
-
-
-
17,550
8,775
2,632.5
May
31,500
-
-
-
-
18,900
8,775
June
36,000
-
-
-
-
-
21,600