MCM606_Financial Management-converted

UNIT-8 WORKING CAPITAL MANAGEMENT AND L FINANCE M Structure C P earning Objectives F I F ntroduction S K eaning of Working Capital lassification of Working Capital Permanent working capital: rinciples of Working Capital actors Determining Working Capital inancing of Working Capital. Types of Long-Term Financing Funding the growth of a business ummary eywords Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the basic concepts of Working Capital Management and Finance • Assess the principles of working capital • Describe how to finance working capital • State classification of working capital 98 CU IDOL SELF LEARNING MATERIAL (SLM)

INTRODUCTION The management and control of working capital is of vital importance to companies and forms a major workload function of the finance manager and accountant. By working capital, the commonly accepted descriptive term for these resources, we mean the company’s investment in short-term assets; traditionally these relate to items coming under the balance- sheet heading of current assets (in practice, of course, all capital is working, whether invested in fixed or current assets). Thus inventories (stocks), accounts receivable (debtors), short- term investments and cash balances all come within the term working capital. Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash and accounts receivable (customers’ unpaid bills), and its current liabilities, such as accounts payable or short-term debt obligations. Furthermore, working capital is a measure of a company’s liquidity, operational efficiency, and its short- term financial health. Positive working capital indicates that a company can fund its current operations and invest in future activities and growth. In every business an optimum level of Working Capital is to be maintained for the purpose of day to day remittances. Any Business cannot grow in absence of satisfactory working capital level. In case of shortage of working capital the business may suffer scarcity of resources. But it should also be kept in mind that even working capital in excessive quantity, possibly will result into superfluous cost. Therefore, the management of business firm should goal an optimal level of working capital. Working capital should be ample enough to carry out the current liabilities but should not be much more than the genuine requirement. It must be ensured by the firm’s managing people that the return yield through the funds engrossed in structuring working capital is no less than the return earned from other investment alternatives. In the circumstances, when the financial resources are insufficient and as a consequent capital cost is to be enlarged, management of working capital becomes even more crucial and significant due to its profound influence on liquidity and profitability of the business. The basic objective of Working Capital Management is to avoid over investment or under investment in Current Assets, as both the extremes involve adverse consequences. Over investment in Current Assets may lead to the reduced profitability due to cost of funds. Working capital management is considered to be one of the most important functions of finance, as a very large amount of funds are blocked in current assets in practical circumstances. Unless working capital is managed properly, it may lead to the failure of business. MEANING OF WORKING CAPITAL Working Capital is basically an indicator of the short-term financial position of an organization and is also a measure of its overall efficiency. Working Capital is obtained by subtracting the current liabilities from the current assets. This ratio indicates whether the company possesses sufficient assets to cover its short-term debt. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

Working Capital indicates the liquidity levels of companies for managing day-to-day expenses and covers inventory, cash, accounts payable, accounts receivable and short-term debt that is due. Working capital is derived from several company operations such as debt and inventory management, supplier payments and collection of revenues. According to Shubin “Working capital is the amount of funds necessary to cover the cost of operating the enterprise. According to Gerstenberg, “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example from cash to inventories, inventories to receivable into cash. In financial speak, working capital is the difference between current assets and current liabilities. Current assets are the money you have in the bank as well as any assets you can quickly convert to cash if you needed it. Current liabilities are debts that you will repay within the year. So, working capital is what’s left over when you subtract your current liabilities from what you have in the bank. In broader terms, working capital is also a gauge of a company’s financial health. The larger the difference between what you own and what you owe short-term, the healthier the business. Unless, of course, what you owe far exceeds what you own. Then you have negative working capital and are close to being out of business. CLASSIFICATION OF WORKING CAPITAL: The working capital admits of two broad classifications, viz: (a) Regular or Fixed or Core or Permanent Working Capital; (b) Variable or Seasonal or Temporary Working Capital. (a) Regular or Fixed or Core or Permanent Working Capital: The amount of current assets which are kept by a firm in hand day-in and day out, i.e., throughout the year is designated as Regular or Fixed Working Capital. In other words, in order to maintain the normal day-to-day activities, a certain minimum level of working capital is required on a continuous and uninterrupted basis which will have to be met permanently along with other fixed assets; they are considered as fixed working capital. On the other hand, due to seasonal variation/fluctuation, investment in raw materials, W-I-P, finished products will fluctuate or fall in consequence, this portion of the working capital is required in order to meet such fluctuation. It can also be stated that any amount over and above the permanent level of working capital is Variable or Seasonal or Temporary Working Capital. We know that both fixed and variable working capital is required to maintain the production 100 CU IDOL SELF LEARNING MATERIAL (SLM)

and sales activities. Practically, variable working capital is required to meet the liquidity requirements for short-term obligation. It is quite clear from the Fig. 8.1 that permanent working capital is constant but variable working capital fluctuates i.e., sometimes increasing or sometimes decreasing according to seasonal demands of the product. For a growing/expanding firm, the permanent working capital line may not be horizontal since demand for permanent current assets is increasing or decreasing. Thus, the difference between the permanent and temporary working capital for an expanding firm can be depicted as under: 8.3.1 Permanent working capital: It represents the current assets required on continuing basis over the entire year. A fixed amount of current assets are required to operate the business. Every business organization must maintain minimum current assets to ensure effective utilization of fixed facilities and for maintaining the circulating of current assets. Thus, minimum level of current assets is called is called permanent or fixed working capital. Permanent working capital or fixed working capital consists of minimum stock, minimum cash and bank balance and minimum other current assets. Temporary working capital represents additional current assets required during the operation of the year. It is the extra working capital needed to support the changing production and sales activities of the firm. Any excess amount of working capital over the permanent working capital is called temporary working capital. It is required to meet the seasonal demands and contingencies. Temporary working capital is fluctuating, sometimes decreasing and sometimes increasing. Generally, temporary working capital is financed from short term sources of funds. PRINCIPLES OF WORKING CAPITAL 1. P rinciple of Risk Variation (Current Assets Policies): Risk here refers to the inability of a firm to meet its obligations as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases the opportunity for gain or loss. On the other hand, less investment in current assets with greater dependence on short-term borrowings, reduces liquidity and increases profitability. In other words, there is a definite inverse relationship between the degree of risk and 101 CU IDOL SELF LEARNING MATERIAL (SLM)

profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. However, the goal of the management should be to establish a suitable tradeoff between profitability and risk. The various working capital policies indicating the relationship between current assets and sales are depicted below: Figure 8.1 Various working capital policies The effect of working capital policies on the profitability of a firm is illustrated below: Figure 8.2 Risk and Return (Costs of Liquidity and Illiquidity) Trade off We have discussed earlier that there is a definite inverse relationship between the degree of risk and profitability. Risk here refers to the level of current assets or the cost of liquidity. Higher the investment in current assets, higher is the cost and lower the profitability, and vice-versa. Thus,” a firm has to reach a balance (trade off) between the cost of liquidity and cost of illiquidity. 102 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 8.3 Levels of Current Assets P P 2. rinciple of Cost of Capital: P The various sources of raising working capital finance have different cost of capital and the degree of risk involved. Generally, higher the risk lower is the cost and lower the risk higher is the cost. A sound working capital management should always try to achieve a proper balance between these two. 3. rinciple of Equity Position: This principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the current assets should contribute to the net worth of the firm. As per this principle every investment in the current assets should contribute to the net worth of the firm. The position of current assets can be well judged by the two ratios; current assets to total asset and current asset to total sales. The level of current assets may be measured with the help of two ratios: (i) Current assets as a percentage of total assets and (ii) Current assets as a percentage of total sales. While deciding about the composition of current assets, the financial manager may consider the relevant industrial averages. 4. rinciple of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital. According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an important factor in risk assumptions and 103 CU IDOL SELF LEARNING MATERIAL (SLM)

risk assessments. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater the inability to meet its obligations in time. To sum up, working capital management should be considered as an integral part of overall corporate management. In the words of Louis Brand, “We need to know when to look for working capital funds, how to use them and how to measure, plan and control them”. 1) Principle of equity position: as per this principle every investment in the current assets should contribute to the net worth of the firm. The position of current assets can be well judged by the two ratios; current assets to total asset and current asset to total sales. 2) Principle of cost of capital: different sources of working capital finance have different cost of capital. Generally there is strong relationship between the risk and cost of capital, which means more the risk less will be the cost and less the risk more will be the cost. So there should be balance between the two. MAIN FACTORS AFFECTING WORKING CAPITAL Main factors affecting the working capital are as follows: (1) Nature of Business: The requirement of working capital depends on the nature of business. The nature of business is usually of two types: Manufacturing Business and Trading Business. In the case of manufacturing business it takes a lot of time in converting raw material into finished goods. Therefore, capital remains invested for a long time in raw material, semi-finished goods and the stocking of the finished goods. Consequently, more working capital is required. On the contrary, in case of trading business the goods are sold immediately after purchasing or sometimes the sale is affected even before the purchase itself. Therefore, very little working capital is required. Moreover, in case of service businesses, the working capital is almost nil since there is nothing in stock. (2) Scale of Operations: There is a direct link between the working capital and the scale of operations. In other words, more working capital is required in case of big organizations while less working capital is needed in case of small organizations. (3) Business Cycle: The need for the working capital is affected by various stages of the business cycle. During the boom period, the demand of a product increases and sales also increase. Therefore, more working capital is needed. On the contrary, during the period of depression, the demand declines and it affects both the production and sales of goods. Therefore, in such a situation less working capital is required. (4) Seasonal Factors: 104 CU IDOL SELF LEARNING MATERIAL (SLM)

Some goods are demanded throughout the year while others have seasonal demand. Goods which have uniform demand the whole year their production and sale are continuous. Consequently, such enterprises need little working capital. On the other hand, some goods have seasonal demand but the same are produced almost the whole year so that their supply is available readily when demanded. Such enterprises have to maintain large stocks of raw material and finished products and so they need large amount of working capital for this purpose. Woollen mills are a good example of it. (5) Production Cycle: Production cycle means the time involved in converting raw material into finished product. The longer this period, the more will be the time for which the capital remains blocked in raw material and semi-manufactured products. Thus, more working capital will be needed. On the contrary, where period of production cycle is little, less working capital will be needed. (6) Credit Allowed: Those enterprises which sell goods on cash payment basis need little working capital but those who provide credit facilities to the customers need more working capital. (7) Credit Availed: If raw material and other inputs are easily available on credit, less working capital is needed. On the contrary, if these things are not available on credit then to make cash payment quickly large amount of working capital will be needed. (8) Operating Efficiency: Operating efficiency means efficiently completing the various business operations. Operating efficiency of every organisation happens to be different. Some such examples are: (i) converting raw material into finished goods at the earliest, (ii) selling the finished goods quickly, and (iii) quickly getting payments from the debtors. A company which has a better operating efficiency has to invest less in stock and the debtors. Therefore, it requires less working capital, while the case is different in respect of companies with less operating efficiency. (9) Availability of Raw Material: Availability of raw material also influences the amount of working capital. If the enterprise makes use of such raw material which is available easily throughout the year, then less working capital will be required, because there will be no need to stock it in large quantity. On the contrary, if the enterprise makes use of such raw material which is available only in some particular months of the year whereas for continuous production it is needed all the year round, then large quantity of it will be stocked. Under the circumstances, more working capital will be required. (10) Growth Prospects: 105 CU IDOL SELF LEARNING MATERIAL (SLM)

Growth means the development of the scale of business operations (production, sales, etc.). The organizations which have sufficient possibilities of growth require more working capital, while the case is different in respect of companies with less growth prospects. (11) Level of Competition: High level of competition increases the need for more working capital. In order to face competition, more stock is required for quick delivery and credit facility for a long period has to be made available. (12) Inflation: Inflation means rise in prices. In such a situation more capital is required than before in order to maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a corresponding increase in the working capital. FINANCING OF WORKING CAPITAL Working capital finance is business finance designed to boost the working capital available to a business. It's often used for specific growth projects, such as taking on a bigger contract or investing in a new market. A constant flow of working capital is an intrinsic component of a successful business. This is especially true considering the outflow that is a part and parcel of every cycle: salaries and wages need to be paid; raw materials need to be purchased and equipment needs to be serviced; funds are needed for marketing, advertising, and other general overhead costs; reserves are required till the customers make their payment. Working capital is truly the lifeline for any company. Banks can be an invaluable source of short term working capital finance. 1. O verdraft Agreement A By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a certain limit without the need for further discussion. The bank might ask for security in the form of collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if the business is confident of making the repayments quickly, then an overdraft agreement is a valuable source of financing and one that many companies resort to. 2. ccounts Receivable Financing Many banks and non-banking financial institutions provide invoice discounting facilities. The company takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date, the bank collects the money from the customer. This is another popular method of financing, especially among small traders. Businesses that offer large 106 CU IDOL SELF LEARNING MATERIAL (SLM)

terms of credit can carry on their operations without having to wait for the customers to settle C their bills. S 3. L ustomer Advances R There are many companies that insist on the customer making an advance payment before selling them goods or providing a service. This is especially true while dealing with large orders that take a long time to fulfill. This method also ensures that the company has some funds to channelize into its operations for fulfilling those orders. 4. elling Goods on Instalment Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles, and so on, allow customers to make their payments in installments. Since many of these items have become modern-day essentials, their customers might not come from well-to-do backgrounds or the cost of the product might be too prohibitive for immediate payment. In such a case, instead of waiting for a large payment at the end, they allow the customers to make regular monthly payments. This ensures that there is a constant flow of funds coming into the business that does not choke up the accounts receivable numbers. Types of Long-Term Financing Relying purely on short-term funds to meet working capital needs is not always prudent, especially for industries where the manufacture of the product itself takes a long time: automobiles, aircraft, refrigerators, and computers. Such companies need their working capital to last for a long time, and hence they have to think about long term financing. 1. ong-Term Loan from a Bank Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their working capital needs for two, three, or more years. 2. etain Profits Rather than making dividend payments to shareholders or investing in new ventures, many businesses retain a portion of their profits so that they may use it for working capital. This way they do not have to take loans, pay interest, incur losses on discounted bills, and they can be self-sufficient in their financing. 3.I ssue Equities and Debentures 107 CU IDOL SELF LEARNING MATERIAL (SLM)

In extreme cases when the business is really short of funds, or when the company is investing in a large-scale venture, they might decide to issue debentures or bonds to the general public or in some cases even equity stock. Of course, this will be done only by conglomerates and only in cases when there is a need for a huge quantum of funds. Different businesses use working capital finance for a variety of purposes, but the general idea is that using working capital finance frees up cash for growing the business which will be recouped in the short- to medium-term. There are many different types of lending that could be considered working capital finance. Some are explicitly designed to help working capital (whatever industry you’re in), while others are useful for specific sectors or requirements. As one of the most overused and misunderstood terms in commercial lending and finance, “working capital” means different things to different people. By definition, working capital is defined as current assets minus current liabilities, but in commercial lending, working capital financing is often considered by many to be any financing that is not real estate and/or equipment related. The biggest challenge in working capital financing is in designing a structure to best meet the working capital needs and cash cycle of the business borrower. Many banks and borrowers automatically think that all working capital financing should be structured in the form of a revolving line of credit. This is often the appropriate structure when the working capital needs are truly short term in nature and when borrowing is needed to fund temporary cash gaps. However, there are also a number of circumstances wherein working capital financing should be done on a longer term installment basis when the working capital needs are longer term or “permanent” such as when: Funding the start-up costs and initial losses associated with the ramp up of a new business Funding the growth of a business Making long term investments in personnel, systems or infrastructure Funding growth in the business that will help in accounts receivable and inventory in a business. All too often, business owners end up falling into the trap of funding permanent working needs as described above on their revolving line of credit, only to then limit their line availability for short term working capital needs, be unable to revolve the line as intended or required by their Bank and perpetually pay a variable rate of interest on the portion of the line used for permanent working capital needs. In the worst cases, these businesses also face non- renewal of their line of demand for payment when their lines are used improperly. 108 CU IDOL SELF LEARNING MATERIAL (SLM)

SUMMARY W • C orking capital management involves balancing movements related to five main M items – cash, trade receivables, trade payables, short-term financing, and inventory – to make sure a business possesses adequate resources to operate efficiently. Ensuring that the company possesses appropriate resources for its daily activities means protecting the company’s existence and ensuring it can keep operating as a going concern. Scarce availability of cash, uncontrolled commercial credit policies, or limited access to short-term financing can lead to the need for restructuring, asset sales, and even liquidation of the company. The levels of cash should be enough to deal with ordinary or small unexpected needs, but not so high to determine an inefficient allocation of capital. • ommercial credit should be used properly to balance the need to maintain sales and healthy business relationships with the need to limit exposure to customers with low creditworthiness. • anaging short-term debt and accounts payable should allow the company to achieve enough liquidity for ordinary operations and unexpected needs, without an excessive increase in financial risk. •I nventory management should make sure there are enough products to sell and materials for its production processes while avoiding excessive accumulation and obsolescence. Working capital may be classified as follows: (1) On the basis of concept Working capital may be classified as: (i) Gross working capital. (ii) Net working capital. These terms have been discussed above. (2) On the basis of periodicity of requirement: • W 109 CU IDOL SELF LEARNING MATERIAL (SLM)

orking capital is the amount of cash a business can safely spend. It’s commonly W defined as current assets minus current liabilities. Usually working capital is T calculated based on cash, assets that can quickly be converted to cash (such as invoices from debtors), and expenses that will be due within a year. W G For example, if a business has £5,000 in the bank, a customer that owes them £4,000, an N invoice from a supplier payable for £2,000, and a VAT bill worth £4,000, its working capital would be £3,000 = (5,000 + 4,000) - (2,000 + 4,000). • orking capital financing is done by various modes such as trade credit, cash credit/bank overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of credit, factoring, commercial paper, inter-corporate deposits etc. • he arrangement of working capital financing forms a major part of the day to day activities of a finance manager. It is a very crucial activity and requires continuous attention because working capital is the money which keeps the day to day business operations smooth. Without appropriate and sufficient working capital financing, a firm may get into troubles. Insufficient working capital may result in nonpayment of certain dues on time. Inappropriate mode of financing would result in loss of interest which directly hits the profits of the firm. KEY WORDS /ABBREVIATIONS • orking Capital: Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable • ross Working Capital : Gross working capital is the sum of a company's current assets (assets that are convertible to cash within a year or less • et Working Capital: Net working capital (NWC) is the difference between a company's current assets and current liabilities LEARNING ACTIVITY 1. What would be the working capital requirements for a newly set up company? 110 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Explain the role of working capital for a large manufacturing concern. UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions 1. Explain the meaning of the term “Working Capital”. Also give its formula. 2. Mention the different situations when an asset is classified as current and when a liability is classified as current liability 3. Mention the different categories into which current assets and current liabilities can be grouped for the purpose of working capital management. 4. Explain the concept of working Capital from the point of view of value. 5. Explain why is it essential to maintain working capital in short term as well as long term in an organisation. B. Multiple Choice Questions 1. In finance, \"working capital\" means the same thing as a. total assets b. fixed assets c. current assets d. current assets minus current liabilities 2. Which of the following would be consistent with a more aggressive approach to financing F working capital? F F a. F inancing short-term needs with short-term funds. b. inancing permanent inventory buildup with long-term debt. c. inancing seasonal needs with short-term funds. d. 111 CU IDOL SELF LEARNING MATERIAL (SLM)

inancing some long-term needs with short-term fund 3. Permanent working capital refers too a.v aries with seasonal needs. b. i ncludes fixed assets. c.I s the amount of current assets required to meet a firm's long-term minimum needs? d. i ncludes accounts payable 4. Net working capital refers to t c a. c otal assets minus fixed assets. c b. L urrent assets minus current liabilities. R B c. F urrent assets minus inventories. d. urrent assets. 5. varies inversely with profitability. a. iquidity. b. isk. c. lue. d. alse. Answers 3. c) 4. b) 5. a) 1. b) 2. c) 112 CU IDOL SELF LEARNING MATERIAL (SLM)

REFERENCES J • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Brigham and Houston, Fundamentals of Financial Management, Thomson ONE, 2009. • eff Madura, International Financial Management, South-Western College Pub., 2010 113 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-9 METHODS OF WORKING CAPITAL L Structure C R earning Objectives O I P ntroduction S V K arious methods to estimate Working Capital Requirements like Sales Forecast Method L ash Forecasting egression Analysis perating Cycle Method rojected Balance Sheet Method ummary eywords earning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit, you will be able to • Describe the basic concepts of method of working capital • Explain Regression Analysis • Learn methods of working capital • State Projected Balance sheet Method INTRODUCTION Working capital levels are important in determining the value of a company. Typically, an analyst considers three methods to determine value: the income approach, the market approach, and the asset approach. An asset approach considers the assets and liabilities of the company. There are broadly three methods of estimating or analyzing the requirement of 114 CU IDOL SELF LEARNING MATERIAL (SLM)

working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because the planning of working capital would be based on these estimates and bank and other financial institutes finance the working capital needs to be based on such estimates only. Percentage of Sales Method is the easiest of the methods for calculating the working capital requirement of a company. This method is based on the principle of ‘history repeats itself’. For estimating, a relationship of sales and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales are 500 million dollars, 200 million dollars would be required as working capital. Regression Analysis method of statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue) Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. Net operating working capital is a measure of a company's liquidity and refers to the difference between operating current assets and operating current liabilities. In many cases these calculations are the same and are derived from company cash plus accounts receivable plus inventories, less accounts payable and less accrued expenses. Working capital is a measure of a company's liquidity, operational efficiency and its short- term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt. FORECASTING METHODS OF WORKING CAPITAL REQUIREMENTS Working capital forecasting is a difficult task. The reason is that the total current assets requirements should be forecasted in estimating the working capital requirements. Working capital forecasting is based on the overall financial requirements and financial policies of the concern. The basic objective of working capital forecasting is either to measure the cash position of the concern or to exercise control over the liquidity position of the concern. In this context, any one of the following methods can be adopted for working capital forecasting. Working capital forecasting methods: C • 115 CU IDOL SELF LEARNING MATERIAL (SLM)

ash Forecasting Method. B A • P alance Sheet Method. O R • djusted Profit and Loss Method. • ercent of Sales Method. • perating Cycle Method. • egression Analysis Method 1. Cash Forecasting Method Total cash receipts and cash disbursement for a particular period are taken into consideration lender cash forecasting method. Cash receipts may be estimated cash sales, cash collected from debtors, and bills receivables, other miscellaneous cash receipts and sale of fixed assets and investments. Delay in cash receipts is taken into consideration. Cash disbursement may be relating to estimated cash purchases, payment to sundry creditors, repayment of loan, payment over bills payable, payment of wages, salaries, bonus, advances, payable to suppliers, repayment of loans and advances interest and principal amount and the like. The minimum cash balance designed to be maintained is added with the required disbursements and provision is also made for additional borrowings and the like. Both cash receipts and cash disbursements are recorded in a format. In this way, working capital is forecasted under cash forecasting method. 2. Balance Sheet Method A balance sheet is prepared by adjusting the anticipated transactions for the ensuring year in the opening balances. The closing balances of all accounts are arrived other than cash and bank balances. The accountant has confirmed that all the assets and liabilities are balanced and recorded in the balance sheet. Lastly, closing cash and bank balances are arrived to find the working capital. A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders. The balance sheet is used alongside other important financial statements such as the income 116 CU IDOL SELF LEARNING MATERIAL (SLM)

statement and statement of cash flows in conducting fundamental analysis or calculating financial ratios. The balance sheet adheres to the following accounting equation, where assets on one side, and liabilities plus shareholders' equity on the other, balance out: Assets = Liabilities + Shareholder’s equity This formula is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity). For example, if a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long- term debt account) will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders' equity. All revenues the company generates in excess of its expenses will go into the shareholders' equity account. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or some other asset. Assets, liabilities and shareholders' equity each consist of several smaller accounts that break down the specifics of a company's finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. Broadly, however, there are a few common components investors are likely to come across. The balance sheet is a snapshot representing the state of a company's finances at a moment in time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For this reason, the balance sheet should be compared with those of previous periods. It should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing. A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company's finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet. Assets Within the assets segment, accounts are listed from top to bottom in order of their liquidity – that is, the ease with which they can be converted into cash. They are divided into current assets, which can be converted to cash in one year or less; and non-current or long-term assets, which cannot. Here is the general order of accounts within current assets: 117 CU IDOL SELF LEARNING MATERIAL (SLM)

Cash and cash equivalents are the most liquid assets and can include Treasury bills and short- term certificates of deposit, as well as hard currency. Marketable securities are equity and debt securities for which there is a liquid market. Accounts receivable refers to money that customers owe the company, perhaps including an allowance for doubtful accounts since a certain proportion of customers can be expected not to pay. Inventory is goods available for sale, valued at the lower of the cost or market price. Prepaid expenses represent the value that has already been paid for, such as insurance, advertising contracts or rent. Long-term assets include the following: Long-term investments are securities that will not or cannot be liquidated in the next year. Fixed assets include land, machinery, equipment, buildings and other durable, generally capital-intensive assets. Intangible assets include non-physical (but still valuable) assets such as intellectual property and goodwill. In general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house. Their value may thus be wildly understated – by not including a globally recognized logo, for example – or just as wildly overstated. Liabilities Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long- term liabilities are due at any point after one year. Current liabilities accounts might include: current portion of long-term debt bank indebtedness interest payable wages payable customer prepayments dividends payable and others earned and unearned premiums accounts payable 118 CU IDOL SELF LEARNING MATERIAL (SLM)

Long-term liabilities can include: Long-term debt: interest and principal on bonds issued Pension fund liability: the money a company is required to pay into its employees' retirement accounts Deferred tax liability: taxes that have been accrued but will not be paid for another year (Besides timing, this figure reconciles differences between requirements for financial reporting and the way tax is assessed, such as depreciation calculations.) Some liabilities are considered off the balance sheet, meaning that they will not appear on the balance sheet. Shareholders' Equity Shareholders' equity is the money attributable to a business' owners, meaning its shareholders. It is also known as \"net assets,\" since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders. Retained earnings are the net earnings a company either reinvests in the business or use to pay off debt; the rest is distributed to shareholders in the form of dividends. Treasury stock is the stock a company has repurchased. It can be sold at a later date to raise cash or reserved to repel a hostile takeover. Some companies issue preferred stock, which will be listed separately from common stock under shareholders' equity. Preferred stock is assigned an arbitrary par value – as is common stock, in some cases – that has no bearing on the market value of the shares (often, par value is just $0.01). The \"common stock\" and \"preferred stock\" accounts are calculated by multiplying the par value by the number of shares issued. Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the \"common stock\" or \"preferred stock\" accounts, which are based on par value rather than market price. Shareholders' equity is not directly related to a company's market capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price. 3. Adjusted Profit and Loss Method Working capital is forecasted on the basis of opening cash and bank balances. Under this method, some of the items are added and some of the items are deducted to arrive closing cash and bank balances i.e. working capital. The items like depreciation, preliminary expenses written off, deferred revenue expenses, goodwill written off, reduction in closing stock, decrease in sundry debtors and bills receivable, decrease in investments and 119 CU IDOL SELF LEARNING MATERIAL (SLM)

marketable securities, increase in sundry creditors and other liabilities, increase in loans and accrued expenses are added with opening cash and bank balances. The items like accrued rent, accrued interest/Dividend/ Royalty, increase in closing stock, increase in sundry debtors, increase in investments, increase in bills receivables, decrease in sundry creditors, bills payable and other liabilities, payment of expenses of last year and payment of dividend are deducted from opening cash and bank balances. The net amount will be required working capital. 4. Percent of Sales Method The existing relationship between sales and working capital is identified for one or two years. If the relationship is steady over a period of time, certain percent is fixed to determine working capital over the forecasted sales. The relationship between sales and working capital and its various components may be expressed in three ways: • as number of days of sales; • as turnover; • as percentage of sales. This method is suitable for short period since the relationship does not vary for short period. Moreover, this method is not suitable for public limited companies and Multinational Corporation. Percentage of sales method is the simplest and easiest way of finding future working capital. First, each component of working capital as a percentage of sales is calculated. Like, accounts payable are 20 million, and sales are 100 million, accounts payable as a percentage of sales would be 20%. Secondly, the coming year sales forecast is taken as a base and the component is calculated as per the percentage. In our instant example, if forecasted sales are 150 million, accounts payable should be 30 million. This is as simple as that. Let us see a practical example with formula and example. Percentage of Sales Method Formula = Component of Working Capital * 100 / Sales of the Year PERCENTAGE OF SALES METHOD EXAMPLE The existing relationship between sales and working capital is identified for one or two years. If the relationship is steady over a period of time, then certain percent is fixed to determine the working capital over forecasted sales. This method is suitable only for short period. CASH FORECASTING METHOD Normally, the main sources of cash inflows to a business are receipts from sales, increases in 120 CU IDOL SELF LEARNING MATERIAL (SLM)

bank loans, proceeds of share issues and assets disposals v, and other income such as interest earned. Cash outflows includes payments to suppliers and staff, capital and interest repayments for loans, dividends, taxation and capital expenditure. Net cash flow is the difference between the inflows and outflows within a given period. A projected cumulative positive net cash flow over several periods highlights the capacity of a business to generate surplus cash and a cumulative negative cash flow indicates the amount of additional cash required to sustain the business. Cash flow planning entails forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received and then analyzing in detail the detail timing of expected payments relating to suppliers, wages other expenses, capital expenditure, loan repayments, dividends, tax, interest payments. The difference between the cash inflow and outflow indicates the net cash flow. REGRESSION ANALYSIS METHOD In this method, statistical formula will be used to find out the value of estimated working capital. For this purpose, the average relationship of sales and working capital of the past years are established for the current assets Current Assets Raw Material In this method, statistical formula will be used to find out the value of estimated working capital. For this purpose, the average relationship of sales and working capital of the past years are established for the current assets Procedure of calculating the working capital Current Assets Raw Material xx Work in Progress xx Finished Goods xx Debtors’ x In this method, statistical formula will be used to find out the value of estimated working capital. For this purpose, the average relationship of sales and working capital of the past years are established for the current assets. Procedure of calculating the working capital: Current Assets Raw Material xx 121 CU IDOL SELF LEARNING MATERIAL (SLM)

Work in Progress xx Finished Goods xx Debtors’ xx Cash xx Total Current Assets xx Less: Current Liabilities xx Creditors’ Wages xx Any Other Expenses xx Total Current Liabilities [TCA – TCL] xx Working Capital xx Add: Contingencies xx Amount of Working Capital required xx Workings: For the computation of cost of all elements, we have to find out numbers of units. Computation of Finished Goods: Raw Material Cost xx Labour Cost xx Overhead Cost xx Finished Goods xx As the work in progress and its finished goods remains the same, this means the production occurs uniformly throughout the year. In this case, we have to find out the value of work in progress separately. Raw Material Cost xx Labor Cost xx Overhead Cost xx Work in Progress xx Hence, the value of debtors will be calculated. This value either include profit element or not for the calculation process. 122 CU IDOL SELF LEARNING MATERIAL (SLM)

OPERATING CYCLE METHOD Operating cycle method for estimating working capital is based on the duration of the operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash. Operating cycle time is the time taken starting from raw material purchases to its conversion into cash. For calculating the working capital using this method, we would need 3 important things and they are the estimated cost of goods sold, operating cycle time, and desired cash levels. The time of cycle can be calculated using the operating cycle formula. FORMULA Working Capital = {Estimated Cost of Goods Sold * (Operating Cycle/ 365)} +Desired Cash and Bank Balance Calculating the total working capital will not suffice the purpose. How this working capital is formed is also important. It means each component of working capital will have to be known. For that, we would first need to review the activity level of the company. Let us see how to calculate each item of working capital below: RAW MATERIAL (RM) STOCK The formula for determining the RM stock is mentioned below. RM and many other calculations are based on estimated production units and therefore it should be calculated with utmost accuracy. Estimated Production Units * Per Unit Cost of RM * (RM Holding Period / 365 Days) WORK IN PROGRESS (WIP) In calculating the WIP, special care has to be taken of the percentage of labor and overheads. These may vary depending on the stage of the product and completion percentage. We have taken the percentage for an example. Estimated Production * {Per Unit Cost of — RM (100%) + Labor (50%) + Overheads (50%)} * (Work In Progress Period / 365 Days) FINISHED GOODS STOCK In Finished Goods workings, we have to know the cost of production with the help of the previous year cost sheets or budgeted cost sheets of the company’s products. Estimated Production * Per Unit Cost of Goods Produced * (Finished Goods Holding Period / 365 Days) ACCOUNTS RECEIVABLES 123 CU IDOL SELF LEARNING MATERIAL (SLM)

This calculation is simple and we just need to put the estimates and average collection period right. Estimated Production * Selling Price * (Collection Period / 365 Days) ACCOUNTS PAYABLES The calculation of accounts payable is similar but the major difference is of raw material cost. We take finished goods selling price in accounts receivable calculation whereas raw material cost in case of accounts payable. Estimated Production * Per Unit RM Cost * (Payment Period / 365 Days) PROJECTED BALANCE SHEET METHOD The excess of estimated total current assets over estimated current liabilities, as shown in the projected balance sheet, is computed to indicate the estimated amount of working capital required. A projected balance sheet, also referred to as pro forma balance sheet, lists specific account balances on a business' assets, liabilities and equity for a specified future time. A forecasting balance sheet is a useful tool for business planning in general, and it particularly benefits those individuals responsible for arranging and bringing in additional financing. Using a projected balance sheet, financial personnel can present lenders and investors with detailed financial information about planned future asset expansion, making it easier to persuade capital providers to supply the required financing. Unlike a past balance sheet that shows a business's actual, historical financial positions, a projected balance sheet communicates expected changes in future asset investments, outstanding liabilities and equity financing. Businesses may consider the creation of a projected balance sheet as a way to facilitate long-term, strategic planning. A business' long- term plans often concern future asset growth and how it may be supported by increased financing through both debt and equity. A projected balance sheet provides the most relevant financial information needed in the business planning process. SUMMARY • T here are broadly three methods of estimating or analyzing the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because the planning of working capital would be based on these estimates and bank and other financial institutes finance the working capital needs to be based on such estimates only. The top five methods for 124 CU IDOL SELF LEARNING MATERIAL (SLM)

estimating working capital requirements, i.e., 1. Percentage of Sales Method 2. C Regression Analysis Method 3. Cash Forecasting Method 4. Operating Cycle Method R 5. Projected Balance Sheet Method. O • W ash Flow Forecasting is the process of obtaining an estimate or forecast of a company’s future financial position and is a core planning component of financial W management within a company. It might sound obvious but the main output or P deliverable of a cash flow forecasting process is a cash flow forecast. S • egression analysis is a powerful statistical method that allows you to examine the relationship between two or more variables of interest. While there are many types of regression analysis, at their core they all examine the influence of one or more independent variables on a dependent variable. • perating cycle method for estimating working capital is based on the duration of the operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash. • orking capital is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. KEY WORDS/ABBREVIATIONS • orking Capital: Working capital, also known as net working capital (NWC), is the difference between a company's current assets, such as cash, accounts receivable (customers' unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable • ercentage Sales Method: The percentage of sales method is used to calculate how much financing is needed to increase sales. The method allows for the creation of a balance sheet and an income statement • ales forecasting: ales forecasting is the process of estimating future sales. Accurate sales forecasts enable companies to make informed business decisions and predict short-term and long-term performance. ... It is easier for established 125 CU IDOL SELF LEARNING MATERIAL (SLM)

companies to predict future sales based on years of past business data R O • egression Analysis: Regression analysis is a powerful statistical method that W allows you to examine the relationship between two or more variables of interest. While there are many types of regression analysis • perating Cycle: Operating cycle method for estimating working capital is based on the duration of the operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash LEARNING ACTIVITY 1. hich method of working capital will be followed for a large organization? Explain detail. 2. E xplain a suitable method of working capital for an industrial organization. UNIT END QUESTIONS (DESCRIPTIVE AND MCQ) A. Descriptive Questions 1. Explain the concept of cash management in a real life 2. What is an Operating Cycle in a restaurant? 3. Explain the concept of regression analysis 4. Analyze sales forecast method of working capital to forecast the sales of laptop in the month of November when the sales of prevision three months were 1000, 2000,3000 units 5. Evaluate briefly the management of working capital to avoid insolvency in the business B. Multiple Choice Questions 1. Operating Cycle Method: Operating cycle is the time duration required to convert sales, 126 CU IDOL SELF LEARNING MATERIAL (SLM)

after the conversion of resources into inventories and cash. Which one is applicable as the A suitable one? M The operating cycle of a manufacturing co involves 3 segments: S C a. cquisition of resources like raw labor, material, fuel and power b. anufacture of the product that includes conversion of raw material into work in process and into finished goods, and c. ales of the product either for cash or credit. d. redit sales create book debts for collection (debtors). 2. Which of the following is a basic principle of finance as it relates to the management of P working capital? L P a. P rofitability varies inversely with risk. b. iquidity moves together with risk. c. rofitability moves together with risk. d. rofitability moves together with liquid 3. The amount of current assets required to meet a firm's long-term minimum needs is referred to as working capital. a. p ermanent t n b. g emporary c. et d. ross 127 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Having defined working capital as current assets, it can be further classified according to f . r t a. A inancing method and time t b. f ate of return and financing method c c c. ime and rate of return d. ll of these 5. \"Net working capital\" means the same thing as . 5. d) a. otal assets b. ixed assets c. urrent assets d. urrent assets minus current liabilities. Answer 1. c) 2. a) 3. c) 4. a) REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. 128 CU IDOL SELF LEARNING MATERIAL (SLM)

• Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • Khan and Jain, Financial Management, Tata McGraw-Hill, 2009 Prasanna Chandra, Financial Management, McGraw Hill 129 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-10 WORKING CAPITAL MANAGEMENT AND FINANCE II Structure Learning Objectives Introduction Management of Cash and Receivables Meaning of Cash Management Receivables Cash Management Payables Cash Management Objectives of Cash Management Models for Cash Management Functions of Cash Management Cash Management Strategies Cash Flow Management Techniques Limitations of Cash Management Importance of cash management Functions of cash management Receivables Management, Factors Affecting Receivables Management Summary Keywords Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit you will be able to • Explain the basic concept of working capital management • State factors affecting receivables management • Describes models of cash management INTRODUCTION Most of the business growth depends upon its management, planning of working capital. And if any business has any problem, or any obstacle, this is dependent on company’s poor management. And this poor management includes management of different things 130 CU IDOL SELF LEARNING MATERIAL (SLM)

like…current assets, inventory management production policies, credit policy. Thus a F business’ success depends on better management, better manager knowledge of working P capital is very essential. We can say a business’ backbone is better working capital management. If a business does not have more cash fund but have better management, it will easily maintain its working capital. On the other hand, if a business has more funds but doesn’t have better credit polices then that business requires much fund but have much working capital required. This second business condition is not is good but though the first business has less fund, better credit policies, and then it will be in good condition. Thus we can say from a better management, a business can achieve its business goal and can easily stand in the market for a long time. Cash Management refers to the collection, handling, control and investment of the organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound cash flow position in the organization. Any amount which the company has earned however not yet received, i.e. its outstanding and is expected to be received in future, is known as receivables. An organization must manage its receivables to maintain the surplus cash inflow. It helps the firm to fulfil its immediate cash requirements. The cash receivables must be planned in such a way that the organization can realize its debts quickly and should allow a short credit period to the debtors. Payables Cash Management The payables refer to the payment which is unpaid by the organization and is to be paid off shortly. The organization should plan its cash outflow in such a manner that it can acquire an extended credit period from the creditors. This helps the firm to retain its cash resources for a longer duration to meet the short term requirements and sudden expenses. Even the organization can invest this cash in a profitable opportunity for that particular credit period to generate additional income. 1. ulfil Working Capital Requirement: The organization needs to maintain ample liquid cash to meet its routine expenses which possible only through effective cash management. 2. lanning Capital Expenditure: It helps in planning the capital expenditure and determining the ratio of debt and equity to acquire finance for this purpose. 131 CU IDOL SELF LEARNING MATERIAL (SLM)

3. H andling Unorganized Costs: There are times when the company encounters unexpected circumstances like the breakdown of machinery. These are unforeseen B expenses to cope up with; cash surplus is a lifesaver in such conditions. A 4.I nitiates Investment: The other aim of cash management is to invest the idle funds in the right opportunity and the correct proportion. 5. etter Utilization of Funds: It ensures the optimum utilization of the available funds by creating a proper balance between the cash in hand and investment. 6. voiding Insolvency: If the business does not plan for efficient cash management, the situation of insolvency may arise. It is either due to lack of liquid cash or not making a profit out of the money available. MANAGEMENT OF CASH & RECEIVABLES Management of Cash Cash is considered as vital asset and its proper management support company development and financial strength. An effective cash management program designed by companies can help to realize this growth and strength. Cash is vital element of any company needed to acquire supply resources, equipment and other assets used in generating the products and services. Marketable securities also come under near cash, serve as back pool of liquidity which provides quick cash when needed. Cash management is associated with management of cash in such a way as to realize the generally accepted objectives of the firm, maximum productivity with maximum liquidity. It is the management's capability to identify cash problems before they ascend, to solve them when they arise and having made solution available to delegate someone carry them out. Cash is one of the current assets of the business and it is needed for all times to keep the business going. The business concern should keep sufficient cash for meeting its obligations and any shortage of cash will hamper the operation of the concern and excess of it will be unproductive. Management of Receivables Receivables management is the process of making decisions relating to the investment in trade debtors. Certain investment in receivables is necessary to increase the sales and the profits of the firm and at the same time investment in these assets involves the cost consideration. Also there is a risk of bad debts. So the objective of receivable management is 132 CU IDOL SELF LEARNING MATERIAL (SLM)

to take sound decision. The objective of receivables management is to promote sales and profit where the return on investment is funding of receivables lesser than the cost of funds raised in finance and additional credit. MEANING OF CASH MANAGEMENT Cash management as the word suggests is the optimum utilization of cash realize to ensure maximum liquidity and maximum profitability. It refers to the proper collection, disbursement, and investment of cash. Cash Management refers to the collection, handling, control and investment of the organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound cash flow position in the organization. Receivables Cash Management Any amount which the company has earned however not yet received, i.e. its outstanding and is expected to be received in future, is known as receivables. An organization must manage its receivables to maintain the surplus cash inflow. It helps the firm to fulfil its immediate cash requirements. The cash receivables must be planned in such a way that the organization can realize its debts quickly and should allow a short credit period to the debtors. Payables Cash Management The payables refer to the payment which is unpaid by the organization and is to be paid off shortly. The organization should plan its cash outflow in such a manner that it can acquire an extended credit period from the creditors. This helps the firm to retain its cash resources for a longer duration to meet the short term requirements and sudden expenses. Even the organization can invest this cash in a profitable opportunity for that particular credit period to generate additional income. Objectives of Cash Management Why do we need to manage cash flow in the organization? What is the use of cash management in the business? Following purposes of cash management will resolve the above queries: • Fulfil Working Capital Requirement: The organization needs to maintain ample liquid cash to meet its routine expenses which possible only through effective cash management. 133 CU IDOL SELF LEARNING MATERIAL (SLM)

• Planning Capital Expenditure: It helps in planning the capital expenditure and determining the ratio of debt and equity to acquire finance for this purpose. • Handling Unorganized Costs: There are times when the company encounters unexpected circumstances like the breakdown of machinery. These are unforeseen expenses to cope up with; cash surplus is a lifesaver in such conditions. • Initiates Investment: The other aim of cash management is to invest the idle funds in the right opportunity and the correct proportion. • Better Utilization of Funds: It ensures the optimum utilization of the available funds by creating a proper balance between the cash in hand and investment. Avoiding Insolvency: If the business does not plan for efficient cash management, the situation of insolvency may arise. It is either due to lack of liquid cash or not making a profit out of the money available. Different types of companies have very different needs for cash management activities. Here are several examples: Telecom operators, utility companies, and tax authorities deal with large numbers of relatively small payments in local markets. The full integration of the systems that send out bills, generate bank statements, and connect the two (through an accounting process known as “reconciliation”) has to be automated. The cash manager plays an essential role in the integration of these systems and in their operation. For example, banks often charge fees on a per-transaction basis. As a cash manager at a company that processes many bulk payments, negotiating low transaction fees is very important. International e-commerce companies with a focus on consumers will want to offer the most convenient payment infrastructure possible. They do not want to lose customers in the payment process. Each country has its own standards, such as credit card networks like Visa or Mastercard, or bank transfer schemes like IDEAL in the Netherlands or SOFORT in Germany. Cash management should be involved in choosing and implementing these standards. Companies with many different subsidiaries often have complex and fragmented bank account structures. As a result, available cash is often spread out over many accounts. Corporate banking services, such as cash pooling, concentrate this dispersed cash into a small number of accounts. From these centralized accounts, sometimes called “concentration accounts”, it is much easier to organize internal funding for expenditures. Thus, cash pooling sometimes allows companies to avoid tapping external sources of funding, which are typically more costly. Companies that aim to expand evermore internationally wish to be able to make payments anywhere in the world, and yet there are no banks that are present in each and every country 134 CU IDOL SELF LEARNING MATERIAL (SLM)

on the globe. For this reason, many companies hold accounts with multiple banks, and it is the cash manager’s job to manage these complex international payments. Simultaneously operating the electronic banking solutions offered by each bank can be an elaborate process, not to mention the security procedures that must be followed. Recent Payment Services Directive (PSD2) regulatory adjustments have made it possible to manage (or at least screen) accounts from different banks through a single bank. Alternatively, there exists specialized software that brings all accounts together into a single application that can be used for screening and transaction purposes. Cash managers are keenly CASH MANAGEMENT MODELS Cash management requires a practical approach and a strong base to determine the requirement of cash by the organization to meet its daily expenses. For this purpose, some models were designed to determine the level of money on different parameters. The two most important models are discussed in detail below: Figure 10.1 Cash Management Models Let us now elaborate on each of these models: 1. The Baumol’s EOQ Model Based on the Economic Order Quantity (EOQ), in the year 1952, William J. Baumol gave the Baumol’s EOQ model, which influences the cash management of the company. This model emphasizes on maintaining the optimum cash balance in a year to meet the business expenses on the one hand and grab the profitable investment opportunities on the other side. The following formula of the Baumol’s EOQ Model determines the level of cash which is to be maintained by the organization: 135 CU IDOL SELF LEARNING MATERIAL (SLM)

Where, ‘C’ is the optimum cash balance; ‘F’ is the fixed transaction cost; ‘T’ is the total cash requirement for that period; ‘i’ is the rate of interest during the period 2. The Miller – Orr’ Model According to Merton H. Miller and Daniel Orr, Baumol’s model only determines the cash withdrawal; however, cash is the most uncertain element of the business. There may be times when the organization will have surplus cash, thus discouraging withdrawals; instead, it may require to make investments. Therefore, the company needs to decide the return point or the level of money to be maintained, instead of determining the withdrawal amount. This model emphasizes on withdrawing the cash only if the available fund is below the return point of money whereas investing the surplus amount exceeding this level. Given below is the graphical representation of this model: Figure 10.2 136 Where, ‘Z’ is the spread of cash; ‘UL’ is the upper limit or maximum level ‘LL’ is the lower limit or the minimum level ‘RP’ is the Return Point of cash CU IDOL SELF LEARNING MATERIAL (SLM)

We can see that the above graph indicates a lower limit which is the minimum cash a business requires to function. Adding up the spread of cash (Z) to this lower limit gives us the return point or the average cash requirement. However, the company should not invest the sum until it reaches the upper limit to ensure maximum return on investment. This upper limit is derived by adding the lower limit to the three times of spread (Z). The movement of cash is generally seen across the lower limit and the upper limit. Let us now discuss the formula of the Miller – Orr’ model to find out the return point of cash and the spread across the minimum level and the maximum level: Where, ‘Return Point’ is the point at which money is to be invested or withdrawn; ‘Minimum Level’ is the minimum cash required for business sustainability; ‘Z’ is the spread across the minimum level and the maximum level; ‘T’ is the transaction cost per transfer; ‘V’ is the variance of daily cash flow per annum; ‘i’ is the daily interest rate Functions of Cash Management Cash management is required by all kinds of organizations irrespective of their size, type and location. Following are the multiple managerial functions related to cash management: Figure 10.3 Functions of Cash Management 137 Investing Idle Cash: The company needs to look for various short-term investment CU IDOL SELF LEARNING MATERIAL (SLM)

alternatives to utilize surplus funds. Controlling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is an essential function of the business. Planning of Cash: Cash management is all about planning and decision making in terms of maintaining sufficient cash in hand and making wise investments. Managing Cash Flows: Maintaining the proper flow of cash in the organization through cost-cutting and profit generation from investments is necessary to attain a positive cash flow. Optimizing Cash Level: The organization should continuously function to maintain the required level of liquidity and cash for business operations. Cash Management Strategies Cash management involves decision making at every step. It is not an immediate solution but a strategical approach to financial problems. Following are the strategies of cash management: Figure 10.4 Cash Management Strategies Business Line of Credit: The organization should opt for a business line of credit at an initial stage to meet the urgent cash requirements and unexpected expenses. Money Market Fund: While carrying on a business, the surplus fund should be invested in the money market funds. These are readily convertible into cash whenever required and yield a considerable profit over the period. Lockbox Account: This facility provided by the banks enable the companies to get their payments mailed to its post office box. This lockbox is managed by the banks to avoid manual deposit of cash regularly. Sweep Account: The organizations should avail the facility of sweep accounts which is a mix of savings and fixed deposit account. Thus, the minimum balance of the savings account is automatically maintained, and the excess sum is transferred to the fixed deposit account. 138 CU IDOL SELF LEARNING MATERIAL (SLM)

Cash Deposits (CDs): If the company has a sound financial position and can predict the expenses well along with availing of a lengthy period, it can invest the surplus cash in the cash deposits. These CDs yield good interest, but early withdrawals are liable to penalties. Cash Flow Management Techniques Managing cash flow is a contemplative process and requires a lot of analytical thinking. The various techniques or tools used by the managers to practice cash flow management are as follows: Figure 10.5 Cash Flow management techniques • Accelerating Collection of Accounts Receivable: One of the best ways to improve cash inflow and increase liquid cash by collecting the debts and dues from the debtors readily. • Stretching of Accounts Payable: On the other hand, the company should try to extend the payment of dues by acquiring an extended credit period from the creditors. • Cost Cutting: The Company must look for the ways of reducing its operating cost to main a good cash flow in the business and improve profitability. • Regular Cash Flow Monitoring: Keeping an eye on the cash inflow and outflow, prioritizing the expenses and reducing the debts to be recovered, makes the organization’s financial position sound. • Wisely Using Banking Services: The services such as a business line of credit, cash deposits, lockbox account and sweep account should be used efficiently and intelligently. 139 CU IDOL SELF LEARNING MATERIAL (SLM)

• U pgrading with Technology: Digitalization makes it convenient for the organizations to maintain the financial database and spreadsheets to be assessed from anywhere anytime. Limitations of Cash Management Cash management is an inevitable part of business organizations. However, it has a few shortcomings which make it unsuitable for small organizations; these are as follows: Figure 10. 6 Limitations of Cash Management Cash management is a very time consuming and skillful activity which is required to be performed regularly. As it requires financial expertise, the company may need to hire consultants or other experts to perform the task by paying administrative and consultation charges. Small business entities which are managed solely, face problems such as lack of skills, knowledge, For a small business, proper utilization of cash ensures solvency. Hence, cash management is a vital business function; it is a function that manages the collection and utilization of cash. Importance of cash management Just like a ‘no cash situation’ in our day to day lives can be a nightmare, for a business it can be devastating. Especially for small businesses, it can lead to a point of no return. It affects the credibility of the business and can lead to them shutting down. Hence, the most important task for business managers is to manage cash. Management needs to ensure that there is adequate cash to meet the current obligations while making sure that there are no idle funds. This is very important as businesses depend on the recovery of receivables. If a debt turns bad (irrecoverable debt) it can jeopardize the cash flow. Therefore, cash management is also about being cautious and making enough provision for contingencies like bad debts, economic slowdown, etc. 140 CU IDOL SELF LEARNING MATERIAL (SLM)

Functions of cash management C P In an ideal scenario, an organization should be able to match its cash inflows to its cash M outflows. Cash inflows majorly include account receivables and cash outflows majorly include account payables. O Practically, while cash outflows like payment to suppliers, operational expenses, payment to regulators are more or less certain, cash inflows can be tricky. So the functions of cash management can be explained as follows: •I nvesting Idle Cash: The Company needs to look for various short term investment alternatives to utilize surplus funds. • ontrolling Cash Flows: Restricting the cash outflow and accelerating the cash inflow is an essential function of the business. • lanning of Cash: Cash management is all about planning and decision making in terms of maintaining sufficient cash in hand and making wise investments. • anaging Cash Flows: Maintaining the proper flow of cash in the organization through cost-cutting and profit generation from investments is necessary to attain a positive cash flow. • ptimizing Cash Level: The organization should continuously function to maintain the required level of liquidity and cash for business operations. RECEIVABLES MANAGEMENT Receivables, also commonly known as collections, are often the most challenging part of working capital management. After all, it is hard to control your customers' payment behaviors. For treasurers, receivables reconciliation can be a challenge due to incomplete information on incoming payments, missing remittance advices, and inadequate technological support. Receivable Management or Managing Accounts Receivables means collecting the payments due for Sales in a timely manner. When we sell any services, products or solutions to our clients or customers, they owe us the money. Collecting that money is called Receivables Management. In Accounting terms Our Customers who owe us money are called as “Sundry Debtors”. Yes, they are called Debtors, because they owe us money. 141 CU IDOL SELF LEARNING MATERIAL (SLM)

In India, Management of Receivables is also known as: P C • A ayment Collection. R • M ollection Management. C • ccounts Receivables. At the working capital level, receivables management requires a holistic effort across sales and logistics functions to ensure that the following objectives are achieved: • ealistic and consistent payment terms, • inimum invoicing errors, and • ash flow incentives to ensure optimal collection and credit management. Working capital studies have shown that invoicing errors, in particular, are a major source of overdue receivables. This is because customers commonly leverage on invoicing errors, for example, by waiting until the invoice due date to communicate the error, and then start the payment term from receipt of corrected invoices, resulting in a delay. There are very few businesses, which have the luxury of receiving money before selling, i.e. Selling for advance payments. Most of the Companies sell their offerings on a credit. Which means that they will collect the money after selling. Although it looks very simple on the face of it, Managing receivables from Debtors can be a very complex task depending on the nature of our business. As our business grows and as our offering gets complex the process of collecting the payments needs to be designed accordingly. So the entire process of defining the Credit Policy, Setting Payment Terms, Payment Follow ups and finally timely collection of the due payments can be defined as Receivables Management. Objectives of Receivable Management •I n order to keep business running, we need cash. The whole purpose or objective of Receivables Management is to keep inflow of cash healthy. •I 142 CU IDOL SELF LEARNING MATERIAL (SLM)

n other words, these are the objectives of Payment Collection. C • M H ollect receivables from our sundry debtors. A • aintain a healthy cash flow for the company, so that it can pay our creditors. • ave proper Policy for Credit management. • working process and mechanism for managing payment follow ups and timely collection. It’s Importance Why Receivables management is so important? Cash flow is always considered as bloodline of any business organization. Badly managed Receivables can break the company. Most of the companies that go bankrupt have Cash flow problems. Companies with lack of profit can survive, but lack of cash flow is fatal. Working Capital is one the costliest form of capital. One of the ways of calculating working capital requirement can be defined as the difference between Sales and Receivables. Bad collections can mean higher working capital requirements. Which means higher interest costs for the company? A reliable and predictable Receivables will ensure steady cash flow management of the organization. Amounts receivables with no due dates are useless. Benefits of Accounts Receivable Management Better Cash Flow. All our Budgets and projections depends on how much we can spend. Predictable cash flow enables us to manage our operations and expansion plans. Lower Working Capital Requirements. Effective receivables management ensures that our Working Capital requirements are kept at minimum. Lowered Interest costs. Working capital is also fixed capital, which attracts interest. Lower Debtors will reduce our Interest burden. 143 CU IDOL SELF LEARNING MATERIAL (SLM)

Better Bargaining with Sellers. When we are buying any goods or services, we can bargain mainly on quantity or Payment terms. Having a good receivable management provides us with enough cash flow to bargain effectively with our Suppliers. Stop profit leakages In case of thin margins, just imagine how much more sales we have to do to recover and adjust just one small bad-debt. Non receipt or delayed receipt is the biggest profit leakage any company can have. FACTORS AFFECTING RECEIVABLE MANAGEMENT Factors affecting size of Receivables Factor 1. Level of Sales: The primary factor in determining the volume of debtors/receivables is the level of credit sales. Increase in credit sales means a corresponding increase in debtors, and vice versa. No doubt the level of sales can be used to forecast changes in receivables, i.e., if a firm predicts an increase of 50% in its credit sales for the next period, it will probably experience also an increase of 50% in debtors/receivables. Factor 2. Terms of Trade: A change in credit policy has a direct impact on debtors. Thus, if credit terms are relaxed, it will lead to increase in the amount of debtors, and vice versa. Factor 3. Credit Policies: The level of debtors/receivables balance is closely related with the collection policy of the firm. Practically, credit policy determines the amount of risk that a firm is to undertake in its sales activities. Policies for Managing Accounts Receivables Accounts receivable consist of the credit a business grants its customers when selling goods or services.1They take the form of either trade credit, which the company extends to other companies, or consumer credit, which the company extends to its ultimate consumers. The effectiveness of a company’s credit policies can have a significant impact on its total performance. For example, Monsanto’s credit manager has estimated that a reduction of only one day in the average collection period for the company’s receivables increases its cash flow by $10 million and improves pretax profits by $1 million. For a business to grant credit to its customers, it has to do the following: Establish credit and collection policies. 144 CU IDOL SELF LEARNING MATERIAL (SLM)

Evaluate individual credit applicants. Receivables management involves the following aspects: Forming of credit policy: Every company must adopt a credit policy. Credit policy relates to (a) Quality of Trade accounts or credit standards: Volume of sales will be influenced by the credit policy of a concern. By liberalizing credit policy, the sales will be increased, The increased volume of sales will be increased the cost and risk of bad debts Credit to only creditworthy customers will save costs like bad debt losses, collection costs and investigation costs etc Quality of trade accounts should be decided so that credit facilities are extended only up to the optimum level. (b) Length of credit period: It means the period allowed to the customers for making the payment Customers paying well in time also be allowed certain cash discount. Concern fixes its own terms of credit depending upon its customers and volume of sales. (c) Cash discount: Cash discount is allowed to immediate payment of customers Discount allowed involves cost Financial manager compare the cost of discount and the amount of fund realized Discount should be allowed only if its cost is less than the earnings. (d) Discount period: Collection of receivables influenced by the period allowed for availing discount Additional period allowed for this facility may prompt some more customers to avail discount and make payments. Executing credit policy: After formulating credit policy proper execution is important. Evaluation of credit applications and finding out the credit worthiness of customers should be undertaken 145 CU IDOL SELF LEARNING MATERIAL (SLM)

(a) Collecting credit information: Collecting credit information about the customers is the first step in implementing credit policy. Information should be adequate and proper analysis about the financial position of the customers is possible. Sources of collecting credit information are financial statements, credit rating agencies, reports from banks etc. (b) Credit analysis: After gathering information, analyze the creditworthiness of the customer Credit analysis will determine the degree of risk associated, the capacity of the customer to borrow and his ability and willingness to pay. (c) Credit decision: After analyzing the creditworthiness of the customer, decision has to take whether the credit is to be extended and then up to what level. Match the creditworthiness of the customer with the credit standard of the company. If customer’s creditworthiness is above the credit standards then the credit is allowed. Formulating and executing collection policy: Collection policy is termed as Strict and Lenient. Strict policy of collection will involve more efforts on collection Such policy will enable early collection of dues and will reduce bad debts losses. It may also reduce the volume of sales. Some customers may not appreciate the efforts of the concern and may shift to another concern thus causing reduced sales and profits. A lenient policy may increase the debt collection period and more bad debt losses. SUMMARY • C ash management involves using the firm’s cash as efficiently as possible. Given the daily uncertainties of business, firms must maintain some liquid resources. Liquid assets are those that are readily spent. Cash is the most liquid asset. But since cash (and the traditional checking account) earns no interest, the firm has a strong incentive to minimize its holdings of cash. There are highly liquid short-term securities that 146 CU IDOL SELF LEARNING MATERIAL (SLM)

serve as good substitutes for actual cash balances and yet pay interest. The corporate R treasurer is concerned with maintaining the correct level of liquidity at the minimum possible cost. R • A eceivable management is one of the most important aspects of the organization, as it A deals with the management of the outstanding. The profit of the company mainly T depends on the accounts receivables They are the outcome of rapid growth of trade T credit granted by the firms to their customers. T •I T nventory serves a useful purpose in the supply chain. The two classic systems for managing independent demand inventory are periodic review and perpetual review systems. ... The economic order quantity (EOQ) is the order quantity that minimizes total holding and ordering costs for the year. •I nventory management is a systematic approach to sourcing, storing, and selling inventory—both raw materials (components) and finished goods (products). •I n business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost as well as price. • eceivable management is one of the most important aspects of the organization, as it deals with the management of the outstanding. The profit of the company mainly depends on the accounts receivables. • ny amount which the company has earned however not yet received, i.e. its outstanding and is expected to be received in future, is known as receivables. • n organization must manage its receivables to maintain the surplus cash inflow. It helps the firm to fulfil its immediate cash requirements. • he cash receivables must be planned in such a way that the organization can realize its debts quickly and should allow a short credit period to the debtors. • he payables refer to the payment which is unpaid by the organization and is to be paid off shortly. • he organization should plan its cash outflow in such a manner that it can acquire an extended credit period from the creditors. • 147 CU IDOL SELF LEARNING MATERIAL (SLM)