Here CF1, CF2, and so forth represent the net cash flows; k is the firm’s cost of capital; I0 is the initial cost of the project; and n is the project’s expected life. The net present value of Project C in Table 5.2 is calculated below by multiplying each cash flow by the appropriate discount factor (PVIF), assuming that the cost of capital, k, is 10 per cent. Year Cash Flow X PVIF = PV 0 -1,500 1.000 -1,500.00 1 150 .909 136.35 2 300 .826 247.80 3 450 .751 337.95 4 600 .683 409.80 5 1,875 .621 1,164.38 NPV = 796.28 The net present value of all four projects in Table 5.2 are: Project A NPV = Rs. –610.95. Project B NPV = Rs. 766.05. Project C NPV = Rs. 796.28. Project D NPV = Rs. 778.80 If these projects were independent instead of mutually exclusive, we would reject A and accept B, C, and D. Why? Since they are mutually exclusive, we select the project with the greatest NPV, Project C. The NPV of the project is exactly the same as the increase in shareholders’ wealth. This fact makes it the correct decision rule for capital budgeting purposes. The NPV rule also meets the other three general principles required for an optimal capital budgeting criterion. It takes all cash flows into account. All cash flows are discounted at the appropriate market-determined opportunity cost of capital in order to determine their present values. Also, the NPV rule obeys the value additivity principle. The net present value of a project is exactly the same as the increase in shareholders’ wealth. To see why, start by assuming a project has zero net present value. In this case, the project returns enough cash flow to do three things: 100 CU IDOL SELF LEARNING MATERIAL (SLM)
1. To pay off all interest payments to creditors who have lent money to finance the project. 2. To pay all expected returns (dividends and capital gains) to shareholders who have put up equity for the project, and 3. To pay off the original principal, I0, which was invested in the project. Thus, a zero net present value project is one which earns a fair return to compensate both debt holders and equity holders, each according to the returns which they expect for the risk they take. A positive NPV project earns more than the required rate of return, and equity holders receive all excess cash flows because debt holders have a fixed claim on the firm. Consequently, equity holders’ wealth increases by exactly the NPV of the project. It is this direct link between shareholders’ wealth and the NPV definition which makes the net present value criterion so important in decision making. Internal Rate of Return Method The internal rate of return (IRR) is defined as the interest rate that equates the present value of the expected future cash flows, or receipts, to the initial cost outlay. The equation for calculating the internal rate of return is: Here we know the value of Io and also the values of CF1, CF2, CFn, but we do not know the value of IRR. Thus, we have an equation withone unknown, and we can solve for the value of IRR. Some value of IRR will cause the sum of the discounted receipts to equal the initial cost of the project, making the equation equal to zero, and that value of IRR is defined as the internal rate of return. The internal rate of return may be found by trial and error. First, compute the present value of the cash flows from an investment, using an arbitrarily selected interest rate - for example, 10 percent. Then compare the present value so obtained with the investment’s cost. If the present value is higher than the cost figure, try a higher interest rate and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. Continue until the present value of the flows from the investment is 101 CU IDOL SELF LEARNING MATERIAL (SLM)
approximately equal to its cost. The interest rate that brings about this equality is defined as the internal rate of return. Table 4.3 shows computation for the IRR for Project D in Table 4,2 and Figure4.1 graphs the relationship between the discount rate and the NPV of the project Figure 4.1 In Figure 4.1 the NPV of Project D’s cash flows decreases as the discount rate is increased. If the discount rate is zero, there is no time value of money and the NPV of a project is simply the sum of its cash flows.For Project D, the NPV equals Rs.1, 650 when the discount rate is zero. At the opposite extreme, if the discount rate is infinite, then the future cash flows are valueless and the NPV of Project D is its current cash flow, –Rs.1,500. Somewhere between these two extremes is a discount rate which makes the NPV equal to zero. In Figure 5.1, we see that the IRR for Project D is 25.4 per cent. The IRR’s for each of the four projects in Table 1 are given below 102 CU IDOL SELF LEARNING MATERIAL (SLM)
Project A IRR = - 200% Project B IRR = 20.9% Project C IRR = 22.8% Project D IRR = 25.4% If we use the IRR criterion and the projects are independent, we accept any project which has an IRR greater than the opportunity cost of capital, which is10 percent. Therefore, we would accept Projects B, C, and D. However, since these projects are mutually exclusive, the IRR rule leads us to accept Project D as best Profitability Index (PI) Another method that is used to evaluate projects is the profitability index (PI), or the benefit/cost ratio, as it is sometimes called: Present value methods had the merit of simplicity in as much as it helps the management in choosing the most profitable proposal. Further, while evaluating and ranking projects it focuses on one of the primary objectives of a firm, i.e., increasing value of the firm. However, main drawback of this approach is that it does not take into consideration size of investment outlay and net cash benefits together while ranking projects. This may at times lead to faulty decisions. Profitability Index (PI) method has come to be employed to overcome the above drawback and to ensure rational investment decision by establishing relationship between the present values of the net cash inflows and net investment outlay. The equation to compute ‘PI’ of a project is: Here CIFt represents the expected cash inflows, or benefits, and COFt represents the expected cash outflows, or costs. The PI shows the relative profitability of any project, or the present value of benefits per rupee costs. The PI for Project C, based on a 10 percent cost of capital is: 103 CU IDOL SELF LEARNING MATERIAL (SLM)
Similarly: Project A PI = 0.59 Project B PI = 1.51 Project D PI = 1.52 A project is acceptable if its PI is greater than 1.0, and the higher the PI, the higher the project ranking. Mathematically, the NPV, the IRR, and the PI methods must always reach the same accept/reject decisions for independent projects: If a project’s NPV is positive, its IRR must exceed k and its PI must be greater than 1.0. However, NPV, IRR, and PI can give different rankings for pairs of projects. This can lead to conflicts between the three methods when mutually exclusive projects are being compared. TOOLS/ TECHNIQUES OF CAPITAL BUDGETING The above discussion leads us to conclude that IRR, NPV and PI methods will result in the same decision, except in certain cases involving mutually exclusive projects or non-normal cash flows. The question that arises which capital budgeting techniques do firm actually use in practice. Lawrence Gitmanand John Forester conducted a survey to help answer this question. Gitman and Forester received 103 usable responses from a survey sent to 268 major companies known to make large capital expenditures. They found that the responsibility for capital budgeting analysis generally rests with the finance department. The respondents also stated that defining projects and estimating their cash flows were the most difficult and the most critical steps in the capital budgeting process. Table – 5.4 summarizes the capital budgeting methods used by the respondent firms. The results indicate a strong preference for discounted cash flow (DCF) capital budgeting techniques, that is, NPV, IRR, and PI, with the dominant method being IRR. However, the heavy use of ROA and payback as primary ranking techniques indicates that not all U.S. firms were technologically up to part in an economic sense. Method Number Percent Number Percent IRR 60 53.6% 13 14.0% ROA 28 25.0 13 14.0 NPV 11 9.8 24 25.8 Payback period 10 8.9 41 44.0 PI 3 2.7 2 2.2 104 CU IDOL SELF LEARNING MATERIAL (SLM)
Total 112 100.0% 93 100.0% It may also be noted that almost all the respondents used at least two methods in their analysis, and as evidenced by the 112 primary methods from 103 respondents, some firms use more than one primary method. Although the questionnaire did not bring this point out, we suspect that many of the analysts of firms which use the IRR as the primary method recognize its drawbacks, yet use it anyway because it is easy to explain to non-financial executives but use NPV as a check on IRR when evaluating mutually exclusive or non- normal projects. It is also doubtful the payback method can be used as a liquidity and/ or risk indicator, hence to help choose among competing projects whose NPVs and/or IRRs are close together. One interesting, and encouraging note is that when compared with earlier surveys, Gitman and Forester found that the discounted cash flow methods are gaining in usage. As regards the use of assessment methods employed by Indian corporates, study of 100 medium and large scale companies conducted in 1994, reveals that Indian Companies have started using discounting techniques more than non- discounting approaches. Although some companies are still using payback period approach, it is the net present value technique which is used quite widely, particularly by companies which have high sales volume and large-paid- up capital. Small and new companies are still relying on traditional approach like pay-back period. CONCEPT OF COST OF CAPITAL The cost of capital is an important financial concept. It links the company's long- term decisions with the wealth of the shareholders as determined in the market place. Whenever, a business organization raises funds, it has to keep in mind its cost. Hence computation of cost of capital is very important and finance managers must have a close look on it. In this unit, we shall discuss the concept, classification, and importance of cost of capital the process of computing cost of capital of individual components, weighted cost of capital, importance of cost of capital and a few misconceptions. The term cost of capital refers to the minimum rate of return which a firm must earn on its investments so that the market value of the company's equity shares does not fall Hampton, John defines the term as \"the rate of return the firm requires from investment in order to increase the value of the firm in the market place\". The following are the basic characteristics of cost of capital: i) Cost of capital is a rate of return; it is not a cost as such. ii) This return, however, is calculated on the basis of actual cost of different components of capital. 105 CU IDOL SELF LEARNING MATERIAL (SLM)
iii) A firm's cost of capital represents minimum rate of return that will result in at least maintaining (If not increasing) the value of its equity shares. iv) It is related to long term capital funds. v) Cost of capital consists of three components: a) Return at Zero Risk Level. (r0) b) Premium for Business Risk (b) c) Premium for Financial Risk (f) vi) The cost of capital may be put in the form of the following equation: K = ro + b + f Where K = Cost of Capital ro = Return at Zero Risk Level b = Premium for Business Risk f = Premium for Financial Risk. Importance of cost control The determination of the firm's cost of capital is important from the point of view of the following: i) It is the basis of appraising new capital expenditure proposals. This gives the acceptance / rejection criterion for capital expenditure projects. ii) The finance manager must raise capital from different sources in a way that it optimizes the risk and cost factors. The source of funds which have less cost involve high risk. Cost of capital helps the managers in determining the optimal capital structure. iii) It is the basis for evaluating the financial performance of top management. iv) It helps in formulating appropriate dividend policy. v) It also helps the organization in developing an appropriate working capital policy. Classification of Cost of Capital There is no fixed base of classification of cost of capital. It varies according to need, process and purpose. It may be classified as follows: i) Explicit Cost and Implicit Cost: Explicit cost is the discount rate that equates the present value of the funds received by the firm net of underwriting costs, with the present value of expected cash outflows. Thus, it is `the rate of return of the cash flows of financing opportunity’. On the other hand, the implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted. In the other words, explicit cost 106 CU IDOL SELF LEARNING MATERIAL (SLM)
relates to raising of funds and implicit costs relate to usage of funds. ii) Average Cost and Marginal Cost: The average cost is the weighted average of the costs of each components of funds. After ascertaining costs of each source of capital, appropriate weights are assigned to each component of capital. Marginal cost of capital is the weighted average cost of new funds raised by the firms. iii) Future Cost and Historical Cost: In financial decision making, the relevant costs are future costs. Future cost i.e. expected cost of funds to finance the projects is ascertained with the help of historical costs. iv) Specific Cost and Combined Cost: The costs of individual components of capital are specific costs of capital. The combined cost of capital is the average cost of capital as it is inclusive of cost of capital from all sources. In capitalbudgeting decisions, combined cost of capital is used for accepting / rejecting the proposals MEASUREMENT OF COST OF CAPITAL There are four basic sources of long term funds for a business firm : (i) Long-term Debt and Debentures (ii) Preferences share capital, (iii) Equity share capital, (iv) Retained Earnings. Through all of these sources may not be tapped by the firm for funding its activities, each firm will have some of these sources in its capital structure. The specific cost of each source of funds is the after-tax cost of financing. It can be before- tax, provided the basis is the same for all the sources of finance being considered for calculating the cost of capital. The procedure for determining the costs of debt, procedure for determining the costs of debt, preferences and equity capital as well as retained earnings is discussed in the following sub-sections. Cost of Long Term Debt Debt may be issued at par, or at premium or at of discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained in the following paragraphs. (a) The formula for computing the Cost of Long Term debt at par is Kd = (1 – T) R where Kd = Cost pf long term debt T = Marginal Tax Rate R = Debenture Interest Rate 107 CU IDOL SELF LEARNING MATERIAL (SLM)
For example, if a company has issued 10% debentures and the tax rate is 50%, the cost of debt will be (1 - .5) 10 = 5% (a) In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized. The formula will be as follows : Cost of Preference Capital The preference share represents a special type of ownership interest in the firm. Preference shareholders must receive their stated dividends prior to the distribution of any earnings to the equity shareholders. In this respect preference shares are very much like bonds or debentures with fixed interest payment. The cost of preference shares can be estimated by dividing the preference dividend per share by the current price per share, as the dividend can be considered a continuous level payment. For example, a company is planning to issue 9% preference shares expected to sell at Rs. 85 per share. The costs of issuing and selling the shares are expected to be Rs. 3 per share. The first step in finding out the cost of the preference capital is to determine the rupee amount of preference dividends, which are stated as 9% of the share of Rs. 85 per share. Thus 9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs, the net proceeds are Rs. 82 per 108 CU IDOL SELF LEARNING MATERIAL (SLM)
share. Thus the cost of preference capital: Now, the companies can issue only redeemable preference shares. Cost of capital for such shares is that discount rate which equates the funds available from the issue of preference shares with the present values of all dividends and repayment of preference share capital. This present value method for cost of preference share capital is similar to that used for cost of debt capital, the only difference is that in place of `interest’ stated dividend on preference share is used. Cost of Equity Capital “Cost of equity capital is the cost of the estimated stream of net capital outlays desired from equity sources” E.W. Walker. James C. Van Horne defines the cost of equity capital can be thought of as the rate of discount that equates the present value of all expected future dividends per share, as perceived by investors. The cost of equity capital is the most difficult to measure. A few problems in this regard are as follows: i. The cost of equity is not the out of pocket cost of using equity capital. ii. The cost of equity is based upon the stream of future dividends as expected by shareholders (very difficult to estimate). iii. The relationship between market price with earnings is known. Dividends also affect the market value (which one is to be considered). The following are the approaches to computation of cost of equity capital: 1. E / P Ratio Method: Cost of equity capital is measured by earning price ratio. 109 CU IDOL SELF LEARNING MATERIAL (SLM)
Symbolically Eo (current earnings per share) * 100 Po (current market price per share) the limitations of this method are: • Earnings do not represent real expectations of shareholders. • Earnings per share is not constant. • Which earnings-current earnings or average earnings (It is not clear). The method is useful in the following circumstances: • The firm does not have debt capital. • All the earnings are paid to the shareholders. • There is no growth in earnings. 2. E / P Ratio + Growth Rate Method: This method considers growth in earnings. A period of 3 years is usually being taken into account for growth. The formula will be as follows: Where (1 + b) 3 = Growth factor where b is the growth rate as a percentage and estimated for a period of three years. 3. D / P Ratio Method: Cost of equity capital is measured by dividends price ratio. Symbolically The following are the assumptions: 110 i) The risk remains unchanged. ii) The investors give importance to dividend. CU IDOL SELF LEARNING MATERIAL (SLM)
iii) The investors purchase the shares at par value. Under this method, the future dividend stream of a firm as expected by the investors are estimated. The current price of the share is used to determine shareholders’ expected rate of return. Thus, if Ke is the risk-adjusted rate of return expected by investors, the Present value of future dividends, discounted by Ke would be equal to the price of the share. Thus, Given the current price p and values for future dividends `Dt’, one can calculate Ke by using IRR procedure. If the firm has maintained some regular r pattern of dividends in the past, it is not unreasonable to expect that the same pattern will prevail. If a firm is playing a dividend of 20% on a share with a par value of Rs. 10 as a level perpetual dividend, and its market price is Rs. 20, then 4. D / P + Growth Rate Method: The method is comparatively more realistic as i) it considers future growth in dividends, ii) it considers the capital appreciation. Thus 111 CU IDOL SELF LEARNING MATERIAL (SLM)
5.Realized Yield Method: One of the difficulties in using D / P Ratios and E / P Ratios for finding out Ke is to estimate the rate of expected return. Hence, this method depends on the rate of return actually earned by the shareholders. The most recent five to ten years are taken and the rate of return is calculated for the investor who purchased the shares at the beginning of the study period, held it to the present and sold it at the current prices. This is also the realized yield by the investor. This yield is supposed to indicate the cost of equity share on the assumption that the investor earns what he expects to earn. The limiting factors to the usefulness of this method are the additional conditions that the investors expectation do not undergo change during the study period, no significant change in the level of dividend rates occurs, and the attitude of the investors towards the risk remain the same. As these conditions are rarely fulfilled, the yield method has severe limitations. In addition, the yield often differs depending on the time period chosen. 6.Security’s Beta Method: An investor is concerned with the risk of his entire portfolio, and that the relevant risk of a particular security is the effect that the security has on the entire portfolio. By “diversified portfolio” we mean that each investor’s portfolio is representative if the market as a whole and that the portfolio Beta is 1.0. A security’s Beta indicate how closely the security’s returns move with from a diversified portfolio. A beta of 1.0 for a given security means that, if the total value of securities in the market moves up by 10 percent, the stock’s price will also move up, on the average by 10 percent. If security has a beta of 2.0, its price will, on the whole, rises or falls by 20 percent when the market rises or falls by 10 percent. A share with –0.5 percent beta will rise by 10 percent, when the market falls by 20 percent. A beta of any portfolio of securities is the weighted average of the betas of the securities, where the weights are the proportions of investments in each security. Adding a high beta (beta greater than 1.0) security to a diversified portfolio increase the portfolio’s risk, and adding a low beta (beta less than zero) security to a diversified security reduces the portfolio’s risk. 112 CU IDOL SELF LEARNING MATERIAL (SLM)
How is beta determined? The beta co-efficient for a security (or asset) can be found by examining security’s historical returns relative to the return of the market. As it is, not feasible to take all securities, a sample of securities is used. The Capital Asset Pricing Model (CAPM) uses these betas co-efficient to estimate the required rate of return on the securities. The CAPM, specifies that the required rate on the share depends upon its beta. The relationship is: Ke = riskless rate + risk premium x beta where, Ke = expected rate of return. The current rate on government securities can be used as a riskless rate. The difference between the long-run average rate of returns between shares and government securities may represent the risk premium. During 1926-1981, this was estimated in USA to be 6 percent. Beta co-efficient are provided by the published date or can be independently estimated. The beta for Pan Am’s stock was estimated by Value Line to be 0.95 in 1984. Long-term government bond rates were about 12 percent in November 1984. Thus the required rate of return on Pan Am’s stock in November 1984 was – Required Rate = 12% + 6% * 0.95 = 17.7 % The use of beta to measure the cost of equity capital is definitely a better approach. The major reason is that the method incorporates risk analysis, which other methods do not. However, its application remains limited perhaps because it is tedious to calculate Beta value. Cost of Retained Earnings Some authors do not consider it necessary to calculate separately cost of retained earnings. They say that the cost of retained earnings is included in the cost of equity share capital. They say that the existing share price is used to determine cost of equity capital and this price includes the impact of dividends and retained earnings. There are authorities who also suggest that cost of retained earnings is to be determined separately. Two alternative approaches are there: i) One is to regard cost of equity capital as the cost of retained earnings. ii) The concept of external yields as suggested by Ezra Soloman. It assures investment of retained earnings in another firm. Symbolically Cost of Retained Earnings = 113 CU IDOL SELF LEARNING MATERIAL (SLM)
D1 (--------- + G ) ( 1 – TR ) (1-B) Po = Ke ( 1 – TR) ( 1 – B ) where Ke = Cost of equity capital based on dividends growth method TR = Shareholder’s Tax Rate B= Percentage Brokerage Cost WEIGHTED COST OF CAPITAL Weighted cost of capital is also called as composite cost of capital, overall cost of capital, weighted marginal cost of capital, combined cost of debt and equity etc. It comprises the costs of various components of financing. These components are weighted according to their relative proportions in the total capital. Choice of Weights The weights to be employed can be book value, market values, historic or target. Book value weights are based on the accounting values to assess the proportion of each type of capital in the firm’s structure. Market value weights measure the proportion of each type of financing at its market value. Market value weights are preferred because they approximate the current value of various instruments of finance employed by the company. Historic weights can be book or market weights based on actual data. Such weights however would represent actual rather than desired proportions of various types of capital in the capital structure. Target weights, which can also be based on book or market values, reflect 114 CU IDOL SELF LEARNING MATERIAL (SLM)
the desired capital structure proportions. If the firm’s historic capital structure is not much different from `optimal’ or desired capital structure, the cost of capital in both the cases is mostly similar. However, from a strictly theoretical point of view, the target market value weighting scheme should be preferred. Marginal weights are determined on the basis of financing mix in additional new capital to be raised for r investments. The new capital to be raised is marginal capital. The propositions of new capital raised will be the marginal weights. SOME MISCONCEPTIONS ABOUT COST OF CAPITAL The cost of capital is a central concept in financial management linking the investment and financing decisions. A few misconceptions in this regard are as follows: i. The concept of cost of capital is academic and impractical. ii. It is equal to the dividend rate. iii. Retained earnings are either cost free or cost significantly less than external equity. iv. Depreciation has no cost. v. The cost of capital can be defined in terms of an accounting based manner. vi. If a project is heavily financed by debt, its weighted average cost of capital is low. SUMMARY For any economy/company there are many avenues of investments, but one can’t go and invest in all of these avenues. This gives rise to problem of selection of a particular project out of the many available. Here capital budgeting techniques play an important role in deciding which project to select & which to reject. Capital budgeting technique involves matching of expected net cash inflows from the project with anticipated cost of the project. Capital budgeting techniques are broadly classified in two categories. Discounted and non- discounted the major difference between these two is that informer the future cash flows are discounted at appropriate discount rate (usually cost of capital) to get net present value of future cash flows. The cost of capital is the minimum acceptable rate of return on new investments. The basic factors underlying the cost of capital for a firm are the degree of risk associated with the firm, the taxes it must pay, and the supply of and demand of various types of financing. The term cost of capital refers to the minimum rate of return a firm must earn on its investments so that the market value of the company's equity shares does not fall. In estimating the cost of capital, it is assumed that, (1) the firms are acquiring assets which do not change their business risk, and (2) these acquisions are financed in such a way as to leave 115 CU IDOL SELF LEARNING MATERIAL (SLM)
the financial risk unchanged. In order to estimate the cost of capital, we must estimate rates of return required by investors in the firm's securities, including borrowings, and average those rates according to the market values of the various securities currently outstanding. While the cost of debt and preference capital is the contractual interest / dividend rate (adjusted for taxes), the cost of equity capital is difficult to estimate. Broadly, there are six approaches to estimate the cost of equity, namely, the E / P method, E / P + Growth method, D / P method, D / P + Growth method, realized yield method and using the Beta co-efficient of the share. Weighted cost of capital is computed by assigning book weights or market weights. The cost of capital is the minimum acceptable rate of return on new investments. The basic factors underlying the cost of capital for a firm are the degree of risk associated with the firm, the taxes it must pay, and the supply of and demand of various types of financing. The term cost of capital refers to the minimum rate of return a firm must earn on its investments so that the market value of the company's equity shares does not fall. In estimating the cost of capital, it is assumed that, (1) the firms are acquiring assets which do not change their business risk, and (2) these acquisions are financed in such a way as to leave the financial risk unchanged. In order to estimate the cost of capital, we must estimate rates of return required by investors in the firm's securities, including borrowings, and average those rates according to the market values of the various securities currently outstanding. While the cost of debt and preference capital is the contractual interest / dividend rate (adjusted for taxes), the cost of equity capital is difficult to estimate. Broadly, there are six approaches to estimate the cost of equity, namely, the E / P method, E / P + Growth method, D / P method, D / P + Growth method, realized yield method and using the Beta co-efficient of the share. Weighted cost of capital is computed by assigning book weights or market weights. KEYWORDS • Capital Budget – a company’s plan for capital expenditures (acquisition of fixed assets). • Capital Expenditures – money used to acquire or improve fixed assets. • Cost of Capital is the minimum rate of return that will maintain the value of the firm's equity shares. • Marginal Weights are determined on the basis of financing mix of additionalcapital. • Cost of Equity Capital is the discount rate which equates present value of all expected dividends in future with net proceeds per share / current market price. 116 CU IDOL SELF LEARNING MATERIAL (SLM)
• Business Risk is a possibility when the firm will not be able to operate successfully in the market. • Financial Risk is the possibility when the firm will not earn sufficient profits to make payment of interest on loans and / or to pay dividends. LEARNING ACTIVITY 1. The current dividend paid by the company is Rs. 5 per share, the market price of the equity share is Rs. 100 and the growth rate of dividend is expected to remain constant at 10%. Find out the cost of capital. 2. Contact Finance Managers of five PSUs and five Indian Companies to find out the existing capital budgeting evaluation methods used by them. UNIT END QUESTIONS A. Descriptive Question 1. Explain, what are the most critical problems that arise in calculating a rate of return for a prospective investment? 2. Discuss, why is the cost of capital the minimum acceptable rate of return on an investment? 3. Discuss, how is the Cost of Debt Capital ascertained? Give examples. 4. Discuss, how will you calculate the Cost of Preferences Share Capital? Long Questions 1. Are there conditions under which a firm might be better off if it chose a machine with a rapid payback rather than one with the largest rate of return? 2. Company X uses the payback method in evaluating investment proposals and is considering new equipment whose additional net after-tax earnings will be Rs.150 a year. The equipment costs Rs.500, and its expected life is ten years (straight-line depreciation). The company uses a three-year payback as its criterion. Should the equipment be purchased under the above assumptions? 117 CU IDOL SELF LEARNING MATERIAL (SLM)
B. Multiple Choice Questions (MCQs) 118 1. Capital Budgeting is a part of: a. Working Capital Management b. Marketing Management c. Capital Structure d. Investment Decision 2. Capital Budgeting deals with: a. Long-term Decisions b. Short-term Decisions c. Both (a) and (b) d. Neither (a) nor (b) 3. Which of the following is not used in Capital Budgeting? a. Time Value of Money b. Sensitivity Analysis c. Net Assets Method d. Cash Flows 4. Capital Budgeting Decisions are: a. Irreversible b. Unimportant c. Reversible d. All of these 5. Which of the following is not incorporated in Capital Budgeting? a. Tax-Effect b. Time Value of Money c. Required Rate of Return CU IDOL SELF LEARNING MATERIAL (SLM)
d. Rate of Cash Discount 6. The key sources of value (earning an excess return) for a company can be attributed primarily to . a. competitive advantage and access to capital b. quality management and industry attractiveness c. access to capital and quality management d. industry attractiveness and competitive advantage 7. The overall (weighted average) cost of capital is composed of a weighted average of . a. the cost of common equity and the cost of debt b. the cost of common equity and the cost of preferred stock c. the cost of preferred stock and the cost of debt d. the cost of common equity, the cost of preferred stock, and the cost of debt 8. What is the overall (weighted average) cost of capital in the following situation? The firm has $10 million in long-term debt, $2 million in preferred stock, and $8 million in common equity -- all at market values. The before-tax cost for debt, preferred stock, and common equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40% tax rate. a. 6.40% b. 6.54% c. 9.30% d. 10.90% 9. For which of the following costs is it generally necessary to apply a tax adjustment to a yield measure? a. Cost of debt. b. Cost of preferred stock. c. Cost of common equity. d. Cost of retained earnings. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
10. Which of the following is not a recognized approach for determining the cost of equity? a. Dividend discount model approach. b. Before-tax cost of preferred stock plus risk premium approach. c. Capital-asset pricing model approach. d. Before-tax cost of debt plus risk premium approach. Answers 1. d 2. a 3. c 4. c 5. D 6.d 7.d 8.c 9.a 10.d REFERENCES • Upadhyay, K.M. “Financial Management, Kalyani Publishers, New Delhi. • Schall, Lawrence D and Haley Charles W., Introduction to Financial Management, McGraw Hill Book Company, New York, London, New Delhi, Fourth (International Students') Edition. • Van Horne James W., Financial Management and Policy, Prentice Hall Inc. Englewood Cliffs, New Jersey. • Khan, M.Y. and Jain P.K. “Financial Management - Text and Problems”, Tata McGraw Hills, New Delhi. • Chandra, P., Fundamentals of Financial Management, Tata McGraw Hill, New Delhi. Maheshwari, S.N., Financial Management - Principles and Practices, Sultan Chand & Sons, New Delhi. • Singh, J.K. “Financial Management - Text and Problems” Dhanpat Rai & Co. Delhi. Srivastava, R.M., “Financial Management”, Pragati Prakashan, Meerut. • Kulkarni, P.V. & Satya Prasad, B.G., “Financial Management – A conceptual approach”, Himalaya Publishing House, Mumbai. • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 120 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 5 CURRENT ASSETS MANAGEMENT 121 Structure Learning Objectives Introduction Significance of Working Capital Operating Cycle Concepts of Working Capital Gross Working Capital Net Working Capital Fluctuating Working Capital Components of Working Capital Importance of Working Capital Management Determinants of Working Capital Needs Approaches to Managing Working Capital The Conventional Approach The Operating Cycle Approach Measuring Working Capital Working Capital Management under Inflation Determining Optimal Cash Balance Management of Cash Flows Speeding up Collections Recovering Dues Controlling Disbursements Investment Criteria Inventory Management Benefits and Costs of Holding Inventories: Costs of Holding Inventories: Objectives of Inventory Management: Receivable Management CU IDOL SELF LEARNING MATERIAL (SLM)
Working Capital Financing Summary Keywords Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • concepts and components of working capital • significance of and need for working capital • determinants of the size of working capital • criteria for efficiency in managing working capital • concepts and factors of inventory management • Explain about receivable management INTRODUCTION The ageing analysis of your current assets including stock, debtors etc. is of large importance, since it is directly linked to the liquidity position of the company. You have more space to business and more chances of profitability, when you are successful in reducing your money in hands of your associates. We have a strong analytical team which is trained in credit management. The debtor- creditor position will be analyzed periodically and insights on the ideal Current ratio position will be given to the management. We will intimate your team, when the optimum credit ratio is crossed or when the stock in hand position goes below the margin. Current asset management includes management of cash, cash equivalents, accounts receivable and prepaid expenses. Direct us can help you to maintain a good current asset position by effective debtors and creditors’ management. Direct us current assets management program focuses mainly on accelerating of the payments due to the company through continuous follow ups and thereby reduces the time of debt realization considerably. Effective financial management is the outcome, among other things, of proper management of investment of funds in business. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets, diversification and expansion of business, renovation or modernization of plants & machinery, and research & development. 122 CU IDOL SELF LEARNING MATERIAL (SLM)
Funds are also needed for short-term purposes, that is, for current operations of the business. For example, if you are managing a manufacturing unit you will have to arrange for procurement of raw material, payment of wages to your workmen and for meeting routine expenses. All the goods, which are manufactured in a given time period may not be sold in that period. Hence, some goods remain in stock, e.g., raw material, semi-finished (manufacturing -in-process) goods and finished marketable goods. Funds are thus blocked in different types of inventory. Again, the whole of the stock of finished goods may not be sold against ready cash; some of it may be sold on credit. The credit sales also involve blocking of funds with debtors till cash is received or the bills are cleared. Working Capital refers to firm's investment in short-term assets, viz. cash, short-term securities, accounts receivable (debtors) and inventories of raw materials, work-in- process and finished goods. It can also be regarded as that portion of the firm's total capital, which is employed in short-term operations. It refers to all aspects of current assets and current liabilities. In simple words, we can say that working capital is the investment needed for carrying out day-to-day operations of the business smoothly. The management of working capital is no less important than the management of long-term financial investment. SIGNIFICANCE OF WORKING CAPITAL You will hardly find a running business firm, which does not require some amount of working capital. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c) the capacity to wait for the market for its finished products, and (d) the ability to grant credit to its customers. Similarly, a commercial enterprise is virtually good for nothing without merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of fact, any organization, whether profit-oriented or otherwise, will not be able to carry on day-to-day activities without adequate working capital. OPERATING CYCLE The time between purchase of inventory items (raw material or merchandise) and their conversion into cash is known as operating cycle or working capital cycle. The successive events which are typically involved in an operating cycle are depicted in Figure 16.1. A perusal of the operating cycle would reveal that the funds invested in operations are re-cycled back into cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a financial year. Obviously, the shorter the operating cycle, the larger will be the turnover of funds invested for various purposes. The channels of the investment are called current assets. Sometimes the available funds may be in excess of the needs for investment in these assets, e.g., inventory, receivables and minimum 123 CU IDOL SELF LEARNING MATERIAL (SLM)
essential cash balance. Any surplus may be invested in government securities rather than being retained as idle cash balance. Figure 5.1 CONCEPTS OF WORKING CAPITAL There are two concepts of working capital, namely Gross concept and Net concept. Gross Working Capital According to this concept; working capital refers to the firm’s investment in current assets. The amount of current liabilities is not deducted from the total of current assets. This concept views Working Capital and aggregate of Current Assets as two inter-changeable terms. This concept is also referred to as `Current Capital' or ‘Circulating Capital'. The proponents of the gross working capital concept advocate this for the following reasons: a. Profits are earned with the help of assets, which are partly fixed and partly current. To a certain degree, similarity can be observed in fixed and current assets so far as both are partly financed by borrowed funds, and are expected to yield earnings over and above the interest costs. Logic then demands that the aggregate of current assets should be taken to mean the working capital. b. Management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come. 124 CU IDOL SELF LEARNING MATERIAL (SLM)
c. An increase in the overall investment in the enterprise also brings about an increase in the working capital. Net Working Capital The net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year and include creditor’s dues, bills payable, bank overdraft and outstanding expenses. Net working capital can be positive or negative. A negative net working capital occurs when current liabilities are in excess of current assets. \"Whenever working capital is mentioned it brings to mind current assets and current liabilities with a general understanding that working capital is the difference between the two\". ‘Net working capital’ is a qualitative concept, which indicates the liquidity position of the firm and the extent to which working capital needs may be financed by permanent sources of funds. This needs some explanation. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operating cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm. The net working capital concept also covers the question of a judicious mix of long- term and short-term funds for financing current assets. Every firm has a minimum amount of net working capital, which is permanent. Therefore, this portion of the working capital should be financed with permanent sources of funds such as owners' capital, debentures, long-term debt, preference capital and retained earnings: Management must decide the extent to which current assets should be financed with equity capital and/or borrowed capital. Several economists uphold the net working capital concept. In support of their stand, they state that: 1. In the long run what matters is the surplus of current assets over current liabilities. 2. It is this concept which helps creditors and investors to judge the financial soundness of the enterprise. 3. It is the excess of current assets over current liabilities, which can be relied upon to meet contingencies since this amount is not liable to be returned. 4. It helps to ascertain the correct comparative financial position of companies having the same amount of current assets. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
It may be stated that gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management and therefore neither can be ignored. While the net concept of working capital emphasizes the qualitative aspect, the gross concept underscores the quantitative aspect. KINDS OF WORKING CAPITAL Ordinarily, working capital is classified into two categories: • Fixed, Regular or Permanent Working Capital; and • Variable, Fluctuating, Seasonal, Temporary or Special Working Capital Fixed Working Capital The need for current assets is associated with the operating cycle, which, as you know, is a continuous process. As such, the need for current assets is felt constantly. The magnitude of investment in current assets however may not always be the same. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Nevertheless, there is always a certain minimum level of current assets, which is essential for the firm to carry on its business irrespective of the level of operations. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. This minimum level of investment in current assets is permanently locked up in business and is therefore referred to as permanent or fixed or regular working capital. It is permanent in the same way as investment in the firm's fixed assets is. Fluctuating Working Capital Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate. The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in the price level may lead to an increase in the amount of funds invested in stock of raw materials as well as finished goods. Additional doses of working capital may be required to face cutthroat competition in the market or other contingencies like strikes and lockouts. Any special advertising campaigns organized for increasing sales or other promotional activities may have to be financed by additional working capital. The extra working capital needed to support the changing business activities is called the fluctuating (variable, seasonal, temporary or special) working capital. 126 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.2 As seen in Figure, that fixed working capital is stable over time, whereas variable working capital is fluctuating-sometimes increasing and sometimes decreasing. The permanent working capital line, however, may not always be horizontal. For a growing firm, permanent working capital may also keep on increasing over time as has been shown in figure above. Both these kinds of working capital - permanent and temporary-are required to facilitate production and sales through the operating cycle, but temporary working capital is arranged by the firm to meet liquidity requirements that are expected to be temporary. COMPONENTS OF WORKING CAPITAL You have already noted that working capital has two components: Current assets and Current liabilities. Current assets comprise several items. The typical items are: i) Cash to meet expenses as and when they occur. ii) Accounts Receivables or sundry trade debtors iii) Inventory of: a) Raw materials, stores, supplies and spares, b) Work-in-process, and c) Finished goods Advance payments towards expenses or purchases, and another short-term advances which are recoverable. Temporary investment of surplus funds which could be converted into cash whenever 127 CU IDOL SELF LEARNING MATERIAL (SLM)
needed. A part of the need for funds to finance the current assets may be met from supply of. goods on credit, and deferment, on account of custom, usage or arrangement, of payment for expenses. The remaining part of the need for working capital may be met from short-term borrowing from financiers like banks. These items are collectively called current liabilities. Typical items of current liabilities are: 1. Goods purchased on credit 2. Expenses incurred in the course of the business of the organization (e.g., wages or salaries, rent, electricity bills, interest etc.) which are not yet paid for. 3. Temporary or short term borrowings from banks, financial institutions or other parties 4. Advances received from parties against goods to be sold or delivered, or as short term deposits. 5. Other current liabilities such as tax and dividends payable. Some of the major components of current assets are explained here in brief: Cash: All of us know that the basic input to start any business is cash. Cash is initially required for acquiring fixed assets like plants and machinery which enables a firm to produce products and generate cash by selling them. Cash is also required and invested in working capital. Investments in working capital is required, as firms have to store certain quantity of raw materials and finished goods and also for providing credit terms to the customers. A minimum level of cash helps in the conduct of everyday ordinary business such as making of purchases and sales as well as for meeting the unexpected payments, developments and other contingencies. As discussed earlier cash invested at the beginning of-the operating cycle gets released at the end of the cycle to fund fresh investments. However, additional cash is required by the firm when it needs to buy more fixed assets, increase the level of operations or for bringing out change in working capital cycle such as extending credit period to the customers. The demand for cash is affected by several factors, some of them are within the control of the managers and some are outside their control. It is not possible to operate the business without holding cash but at the same time holding it without a purpose also costs a firm either directly in the form of interest or loss of income that could be earned out of the cash. In the context of working capital management, cash management refers to optimizing the benefit and cost associated with holding cash. The objective of cash management is best achieved by speeding up the working capital cycle, particularly the collection process and investing surplus cash in short term assets in most profitable avenues. We will be subsequently discussing certain issues like the management of cash flows and 128 CU IDOL SELF LEARNING MATERIAL (SLM)
determination of optimal cash balance, etc. (in this unit). Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competitive pressures force most firms to offer credit. Today the use of credit in the purchase of goods and services is so common that it is taken for granted. Selling goods or providing services on credit basis leads to accounts receivable. When consumers expect credit, business units in turn expect credit from their suppliers to match their investment in credit extended to consumers. The granting of credit from one business firm to another for purchase of goods and services is popularly known as trade credit. Though commercial banks provide a significant part of requirements for working capital, trade credit continues to be a major source of funds for firms and accounts receivable that result from granting trade credit are major investment for the firm. Both direct and indirect costs are associated with carrying receivables, but it has an important benefit for increasing sales. Excessive levels of accounts receivables result in decline of cash flows and many results in bad debts which in turn may reduce the profit of the firm. Therefore, it is very important to monitor and manage receivables carefully and regularly. We would be dealing with this topic in MS-41: Working Capital Management. Inventory: Three things will come to your mind when you think of a manufacturing unit - machines, men and materials. Men using machines and tools convert the materials into finished goods. The success of any business unit depends on the extent to which these are efficiently managed. Inventory is an asset to the organization like other components of current assets. Inventory constitutes a very significant part of working capital or current assets in manufacturing organization. It is essential to control inventories (physical/quantity control and value control) as these are significant elements in the costing process constituting sometimes more than 60% of the current assets. Inventory holding is desirable because it meets several objectives and needs but an excessive inventory is undesirable because it costs a lot to firms. Inventory which consists of raw material components and other consumables, work in process and finished goods, is an important component of `current assets'. There are several factors like nature of industry, availability of material, technology, business practices, price fluctuation, etc. that determines the amount of inventory holding. Holding inventory ensures smooth production process, price stability and immediate delivery to customers. Since inventory is like any other form of assets, holding inventory has a cost. The cost includes opportunity cost of funds blocked in inventory, storage cost, stock out cost, etc. The benefits that come from holding inventory should exceed the cost to justify a particular level of inventory. Marketable Securities: Cash and marketable securities are normally treated as one item in any 129 CU IDOL SELF LEARNING MATERIAL (SLM)
analysis of current assets although these are not the same as cash they can be converted to cash at a very short notice. Holding cash in excess of immediate requirement means the firm is missing out an opportunity income. Excess cash is normally invested in marketable securities, which serves two purposes namely, provide liquidity and, also earn a return. IMPORTANCE OF WORKING CAPITAL MANAGEMENT Because of its close relationship with day-to-day operations of a business, a study of working capital and its management is of major importance to internal, as well as external analysts. It is being increasingly realized that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not lose sight of the fact that management of working capital is an integral part of the overall financial management and, ultimately, of the overall corporate management. Working capital management thus throws a challenge and should be a welcome opportunity for a financial manager who is ready to play a pivotal role in his organization. Neglect of management of working capital may result in technical insolvency and even liquidation of a business unit. With receivables and inventories tending to grow and with increasing demand for bank credit in the wake of strict regulation of credit in India by the Central Bank, managers need to develop a long-term perspective for managing working capital. Inefficient working capital management may cause either inadequate or excessive working capital, which is dangerous. A firm may have to face the following adverse consequences from inadequate working capital: Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds. 1. Implementation of operating plans may become difficult and consequently the firm's profit goals may not be achieved. 2. Operating inefficiencies may creep in due to difficulties in meeting even day to day commitments. 3. Fixed assets may not be efficiently utilized due to lack of working funds, thus lowering the rate of return on investments in the process. 4. Attractive credit opportunities may have to be lost due to paucity of working capital. 5. The firm loses its reputation when it is not in a position to honor its short-term obligations. As a result, the firm is likely to face tight credit terms. 130 CU IDOL SELF LEARNING MATERIAL (SLM)
On the other hand, excessive working capital may pose the following dangers: 1 Excess of working capital may result in unnecessary accumulation of inventories, increasing the chances of inventory mishandling, waste, and theft. 2 It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables, causing a higher incidence of bad debts. This has an adverse effect on profits. 3 Excessive working capital may make management complacent, leading eventuallyto managerial inefficiency. 4 It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal dividend policy, which becomes difficult to maintain when the firm is unable to make speculative profits. An enlightened management, therefore, should maintain the right amount of working capital on a continuous basis. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed at different points of time. DETERMINANTS OF WORKING CAPITAL NEEDS There are no set rules or formulas to determine the working capital requirements of a firm. The corporate management has to consider a number of factors to determine the level of working capital. The amount of working capital that a firm would need is affected not only by the factors associated with the firm itself but is also affected by economic, monetary and general business environment. Among the various factors the following are important ones. Nature and Size of Business The working capital needs of a firm are basically influenced by the nature of its business. Trading and financial firms generally have a low investment in fixed assets, but require a large investment in working capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. Some manufacturing businesses' like tobacco, and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities. The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. The hazards and contingencies inherent in a 131 CU IDOL SELF LEARNING MATERIAL (SLM)
particular type of business also have an influence in deciding the magnitude of working capital in terms of keeping liquid resources. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories. Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. You may have observed that firms making heavy machinery or other such products, involving long manufacturing cycle, attempt to minimize their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers. Business Fluctuations Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially the temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firm's investment in inventory and receivables or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall in the levels of stocks and book debts. Seasonal fluctuations may also create production problems. Increase in production level may be expensive during peak periods. A firm may follow a policy of steady production in all seasons to utilize its resources to the fullest extent. This will mean accumulation of inventories in off-season and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital requirement should be made in advance. The financial plan should be flexible enough to take care of any seasonal fluctuations. Production Policy If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs and risks. If the costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. Firms whose physical facilities can be utilized for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season and other products during off-season. Thus, production policies may differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will also vary. Turnover of Circulating Capital The speed with which the operating cycle completes its round (i.e., cash → raw materials → 132 CU IDOL SELF LEARNING MATERIAL (SLM)
finished product → accounts receivables → cash) plays a decisive role in influencing the working capital needs. (Refer to Figure 1(.1 on operating cycle). Credit Terms The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though the credit terms granted to customers to a great extent depend upon the norms and practices of the industry or trade to which the firm belongs; yet it may endeavor to shape its credit policy within such constraints. A long collection period will generally mean tying of larger funds in book debts. Slack collection procedures may even increase the chances of bad debts. The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm enjoying liberal credit terms will need less working capital. Growth and Expansion Activities As a company grows, logically, larger amount of working capital will be needed, though it is difficult to state any firm rules regarding the relationship between growth in the volume of a firm's business and its working capital needs. The fact to recognize is that the need for increased working capital funds may precede the growth in business activities, rather than following it. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate practices. Growing industries require more working capital than those that are static. Operating Efficiency Operating efficiency means optimum utilization of resources. The firm can minimize its need for working capital by efficiently controlling its operating costs. With in- creased operating efficiency the use of working capital is improved and pace of cash cycle is accelerated. Better utilization of resources improves profitability and helps in relieving the pressure on working capital. Price Level Changes Generally, rising price level requires a higher investment in working capital. With increasing prices the same levels of current assets need enhanced investment. However, firms which can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising levels. The effects of increasing price level may, however, be felt differently by different firms due to variations in individual prices. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit by it. Other Factors There are some other factors, which affect the determination of the need for working capital. A high net profit margin contributes towards the working capital pool. The net profit is a 133 CU IDOL SELF LEARNING MATERIAL (SLM)
source of working capital to the extent it has been earned in cash. The cash inflow can be calculated by adjusting non-cash items such as depreciation, out- standing expenses, losses written off, etc., from the net profit, (as discussed in Unit 6). The firm's appropriation policy, that is, the policy to retain or distribute profits also has a bearing on working capital. Payment of dividend consumes cash resources and thus reduces the firms working capital to that extent. If the profits are retained in the business, the firm's working capital position will be strengthened. In general, working capital needs also depend upon the means of transport and communication. If they are not well developed, the industries will have to keep huge stocks of raw materials, spares, finished goods, etc. at places of production, as well as at distribution outlets. APPROACHES TO MANAGING WORKINGCAPITAL Two approaches are generally followed for the management of working capital: (i) the conventional approach, and (ii) the operating cycle approach. The Conventional Approach This approach implies managing the individual components of working capital (i.e. inventory, receivables, payables, etc.) efficiently and economically so that there are neither idle funds nor paucity of funds. Techniques have been evolved for the management of each of these components. In India, more emphasis is given to the man- agreement of debtors because they generally constitute the largest share of the investment in working capital. On the other hand, inventory control has not yet been practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever rising prices. The Operating Cycle Approach This approach views working capital as a function of the volume of operating expenses. Under this approach the working capital is determined by the duration of the operating cycle and the operating expenses needed for completing the cycle. The duration of the operating cycle is the number of days involved in the various stages, commencing with acquisition of raw materials to the realization of proceeds from debtors. The credit period allowed by creditors will have to be set off in the process. The optimum level of working capital will be the requirement of operating expenses for an operating cycle, calculated on the basis of operating expenses required for a year. In India, most of the organizations use to follow the conventional approach earlier, but now the practice is shifting in favor of the operating cycle approach. The banks usually apply this approach while granting credit facilities to their clients. 134 CU IDOL SELF LEARNING MATERIAL (SLM)
MEASURING WORKING CAPITAL The factors discussed in the preceding section influence the quantum of working capital in a business enterprise. How to determine or measure the amount of working capital that an enterprise would need was discussed to some extent in Unit 6 dealing with funds flow analysis. Let us attempt to determine the amount of working capital needed by taking up an illustration. WORKING CAPITAL MANAGEMENT UNDERINFLATION It is desirable to check the increasing demand for capital, for maintaining the existing level of activity. Such a control acquires even more significance in times of inflation. In order to control working capital needs in periods of inflation, the following measures may be applied. Greater disciplines on all segments of the production front may be attempted as under: a) The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be under- taken, with financial assistance provided by the Government and the corporate sector, if any. b) Attempts must be made to increase the productivity of the work force by proper motivational strategies. Before going in for any incentive scheme, the cost involved must be weighed against the benefit to be derived. Though wages in accounting are considered a variable cost, they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments in recent times. Increased productivity results in an increase in value added, and this has the effect of reducing labor' cost per unit. The managed costs should be properly scrutinized in terms of their costs and benefits. Such costs include office decorating expenses, advertising, managerial salaries and payments, etc. Managed costs are more, or less fixed costs and once committed they are difficult to retreat. In order to minimize the cost impact of such items, the maximum possible use of facilities already created must be ensured. Further the management should be vigilant in sanctioning any new expenditure belonging to this cost The increasing pressure to augment working capital will, to some extent, be neutralized if the span of the operating cycle can be reduced. Greater turnover with shorter intervals and quicker realization of debtors will go a long way in easing the situation. Only when there is a pressure on working capital does the management become conscious of the existence of slow-moving and obsolete stock. The management tends to adopt ad hoc measures, which are grossly inadequate. Therefore, a clear-cut policy regarding the disposal of slow-moving and obsolete stocks must be formulated and adhered to. In addition to this, there should be an efficient management information system reflecting the stock position 135 CU IDOL SELF LEARNING MATERIAL (SLM)
from various standpoints. The payment to creditors in time leads to building up of good reputation and consequently it increases the bargaining power of the firm regarding period of credit for payment and other conditions. Projections of cash flows should be made to see that cash inflows and outflows match with each other. If they do not, either some payments have to be postponed or purchase of some avoidable items has to be deferred. DETERMINING OPTIMAL CASH BALANCE Holding of excessive cash is a non-profitable proposition, as idle cash does not earn any income. Similarly shortage of cash may deprive the business unit of availing the benefits of cash discounts, and of taking advantage of other favorable opportunities. It may even lead to loss of credit-worthiness on account of default in paying liabilities when the same become due. Hence, every organization, irrespective of its size and nature, has to determine the appropriate or optimum cash balance that it would need. Nature has to determine the appropriate or optimum cash balance that it would need. A firm's cash balance, generally, may not be constant over time. It would therefore be worthwhile to investigate the maximum, minimum and average cash needs over a designated time period. You are aware that cash is needed for various transactions in the organization. Maintenance of a cash balance however has an opportunity cost in the following ways: A) Cash can be invested in acquiring assets such as Inventory, or for purchasing securities. Opportunities for such investments may have to be lost if a certain minimum cash balance is not held. b) Holding of cash means that it cannot be used to offset financial risks from the short-term debts. c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term financial market. Now the financial manager should understand the benefits and the opportunity costs for holding cash. Thereafter, he must proceed to work out a model for determining the optimal amount of cash. First of all a critical minimum cash balance should be conceived below which the firm will incur definite and measurable costs. Apart from risk aversion the existence of the minimum balance is justified by institutional requirements such as credit ratings, checking accounts, lines of credit. The violation of maintaining a minimum cash balance will create shortage costs which will be determined by the actions of creditors on account of postponing their payments or non- availing of cash discounts. 136 CU IDOL SELF LEARNING MATERIAL (SLM)
At any point of time a firm's (ending) cash balance can be represented as follows: Ending balance = Beginning Balance + Receipts –Disbursements If receipts and disbursements are equal for any unit of time, no problem is involved. Ordinarily, however, receipts may be more than disbursements or vice versa. Hence, the ending balance will keep on fluctuating. In actual practice receipts and disbursements do vary, particularly in case of firms having seasonal activities. Suppose, the receipts and disbursements are not synchronized but the variation is predictable, then the main problem will be that of minimizing total costs. In case you set the balance too low you will incur high transaction costs. If you set the balance too high you will lose interest, which you can earn by investing cash in marketable securities. The determination of optimal cash balance under these conditions of known certainty is similar to the inventory problem: The costs of too little cash (transaction costs) can be balanced against the costs of too much cash (opportunity costs). Figure clarifies this position. It is seldom that receipts and disbursements are completely predictable. For a moment let, us take one extreme case where receipts and disbursements are completely random: A model can be developed using the Control Theory and fix maximum and minimum optimal balances as illustrated in Figure 16.5 137 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 5.3 You can observe from Figure 16.5 that the fluctuating cash balance is on account of random receipts and disbursements. At time to the balance touches the upper control point. At this point the excess of cash is invested in marketable securities. The balance falls to zero point at time t2 and at this stage marketable securities have to be sold to create cash balances. These two control points lay only the maximum and minimum balance. We can conclude that where cash flows (receipts and disbursements) are uncertain the principle will be: the greater the variability the higher the minimum cash balance. MANAGEMENT OF CASH FLOWS The cash flows could be properly and effectively managed by: Speeding up Collections In order to minimize the size of cash holding, the time gap between sale of goods and their cash collection should be reduced and the flow be controlled. Normally, certain factors creating time lags are beyond the control of management. Yet, in order to improve the efficiency, attention should be paid to the following. All cash collected should be directly deposited in one account. If there are more than one collection centres, all cash receipts should be remitted to the main account with. Top speed. Compared to a single collection centre, the aggregate requirement for cash will be more when there are several centres. Concentration of collections at one place will thus permit the firm to store its cash more efficiently. The time lag between the dispatch of cheque by the customer and its credit to our account with the bank should be reduced. Some firms with large collection transactions introduce lock box system. In this system the post boxes are hired at different centres where cash/cheques can be dropped in. The local banker can daily collect the same from the lockers. The collecting bank is paid service charges. In order to minimize time, banks may be asked to devise methods for speeding up the collection of cash. 138 CU IDOL SELF LEARNING MATERIAL (SLM)
Recovering Dues After sale of goods on credit, either on account of convention or for promoting sales, receivables are created. It may however be useful to reduce the amount blocked in receivables by seeing to it that they do not become overdue accounts. Incentive in the form of discounts for early payment may be given. More important than anything else is a constant follow-up action for the recovery of dues. This will improve position of cash balance. Controlling Disbursements Needless to assert that speeding up of collections helps conversion of receivables into cash and thus reduces the financing requirements of the firm. Similar kind of benefit can be derived by delaying disbursements. Trade credit is a costless source of funds for it allows us to pay the creditors only after the period of credit agreed upon. The dues can be withheld till the last date. This will reduce the requirement for holding large cash balance. Some firms may like to take advantage of cheque book float which is the time gap between the date of issue of a cheque and the actual when it is presented for payment directly or through the bank. Investment of Idle Cash Balances Two other important aspects in cash management are how to determine appropriate cash balance and how to invest temporarily idle cash in interest earning assets or securities. The first part relating to the theory of determining appropriate cash balance has already been discussed earlier. Now we shall discuss the investment of idle cash balance on temporary basis. Cash by itself yields no income. If we know that some cash will be in excess of our need for a short period of time, we must invest it for earning income without depriving ourselves of the benefit of liquidity of funds. While doing this, we must weigh the advantages of carrying extra cash (i.e. more than the normal requirement) and the disadvantages of not carrying it. The carrying of extra cash may be necessitated due to its requirement in future, whether predictable or unpredictable. The experience indicates that cash flows cannot be predicted with complete accuracy. Competition, technological changes, unexpected failure of products, strikes and variations in economic conditions make it difficult to predict cash needs accurately. Investment Criteria When it is realized that the excess cash will remain idle, it should be invested in such a way that it would generate income and at the same time ensure quick re-conversion of investment in cash. While choosing the channels for investment of any idle cash balance for a short period, it should be seen that (i) the investment is free from default risk, that is, the risk involved due to the possibility of default in timely payment of interest and repayment of principal amount; (ii) the investment shall mature in short span of time; and (iii) the 139 CU IDOL SELF LEARNING MATERIAL (SLM)
investment has adequate marketability. Marketability refers to the ease with which an asset can be converted back into cash. Marketability has two dimensions -price and time-which are inter-related. If an asset can be sold quickly in large amounts at a price determinable in advance the asset will be regarded as highly marketable and highly liquid. The assets which largely satisfy the aforesaid criteria are: Government Securities, Bankers' Acceptances and Commercial Paper. INVENTORY MANAGEMENT What is inventory? Inventory refers to those goods which are held for eventual sale by the business enterprise. In other words, inventories are stocks of the product a firm is manufacturing for sale and components that make up the product. Thus, inventories form a link between the production and sale of the product. The forms of inventories existing in a manufacturing enterprise can be classified into three categories: (i) Raw Materials: These are those goods which have been purchased and stored for future productions. These are the goods which have not yet been committed to production at all. (ii) Work-in-Progress: These are the goods which have been committed to production but the finished goods have not yet been produced. In other words, work-in-progress inventories refer to ‘semi- manufactured products.’ (iii) Finished Goods: These are the goods after production process is complete. Say, these are final products of the production process ready for sale. In case of a wholesaler or retailer, inventories are generally referred to as ‘merchandise inventory’. Some firms also maintain a fourth kind of inventory, namely, supplies. Examples of supplies are office and plant cleaning materials, oil, fuel, light bulbs and the like. These items are necessary for production process. In practice, these supplies form a small part of total inventory involving small investment. Therefore, a highly sophisticated technique of inventory management is not needed for these. The size of above mentioned three types of inventories to be maintained will vary from one business firm to another depending upon the varying nature of their businesses. For example, while a manufacturing firm will have all three types of inventories, a retailer or a wholesaler 140 CU IDOL SELF LEARNING MATERIAL (SLM)
business, due to its distinct nature of business, will have only finished goods as its inventories. In case of them, there will be, therefore, no inventories of raw materials as well as work-in- progress. Benefits and Costs of Holding Inventories: Holding inventories bears certain advantages for the enterprise. The important advantages but not confined to the following only are as follows: 1. Avoiding Losses of Sales: By holding inventories, a firm can avoid sales losses on account of non-supply of goodsat times demanded by its customers. 2. Reducing Ordering Costs: Ordering costs, i.e., the costs associated with individual orders such as typing, approving, mailing, etc. can be reduced, to a great extent, if the firm places large orders rather than several small orders. 3. Achieving Efficient Production Run: Holding sufficient inventories also ensures efficient production run. In other words, supply of sufficient inventories protects against shortage of raw materials that may at times interrupt production operation. Costs of Holding Inventories: However, holding inventories is not an unmixed blessing. In other words, it is not that everything is good with holding inventories. It is said that every noble acquisition is attended with risks; he who fears to encounter the one must not expect to obtain the other. This is true of inventories also. There are certain costs also associated with holding inventories. Hence, it is necessary for a firm to take these costs into consideration while planning for inventories. These are broadly classified into three categories: 1. Material Costs: These include costs which are associated with placing of orders to purchase raw materials and components. Clerical and administrative salaries, rent for the space occupied, postage, telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the 141 CU IDOL SELF LEARNING MATERIAL (SLM)
more will be the ordering costs and vice versa. 2. Carrying Costs: These include costs involved in holding or carrying inventories like insurance charges for covering risks, rent for the floor space occupied, wages to laborers, wastages, obsolescence or deterioration, thefts, pilferages, etc. These also include opportunity costs. This means had the money blocked in inventories been invested elsewhere in the business, it would have earned a certain return. Hence, the loss of such return may be considered as an ‘opportunity cost’. The above facts underline the need for inventory management, i.e., to decide the optimum volume of inventories in the firm/enterprise during the period. Objectives of Inventory Management: There are two main objectives of inventory management: 1. Making Adequate Availability of Inventories: The main objective of inventory management is to ensure the availability of inventories as per requirements all the times. This is because both shortage and surplus of inventories prove costly to the organization. In case of shortage of availabilityin inventories, the manufacturing wheel comes to a grinding halt. The consequence is either less production or no production. The either case results in less sale to less revenue to less profit or more loss. On the other hand, surplus in inventories means lying inventories idle for some time implying cash blocked in inventories. Speaking alternatively, this also means that had the organization invested money blocked in inventories invested elsewhere in the business, it would have earned a certain return to the organization. Not only that, it would have also reduced the carrying cost of inventories and, in turn, increased profits to that extent. 2. Minimizing Costs and Investments in Inventories: Closely related to the above objective is to minimize both costs as well as volume of investment in inventories in the organization. This is achieved mainly by ensuring required volume of inventories in the organization all the times. This benefits organization mainly in two ways. One, cash is not blocked in idle inventories which can be invested elsewhere to earn some return. Second, it will reduce the carrying costs which, in turn, will increase profits. In lump sum, inventory management, if done properly, can bring down costs and increase the revenue of a firm. RECEIVABLE MANAGEMENT Trade Credit is a prominent and all pervasive force in the present day competitive 142 CU IDOL SELF LEARNING MATERIAL (SLM)
industrialenvironment. This is because, it is highly difficult to a manufacturer to pay cash across the counter, whatever be his liquidity in meeting the debts. In the words of Pandey1, “A firm is said to have granted trade credit when it sells its products or services and does not receive cash immediately”. Trade credit is an essential marketing tool which acts as a bridge for the movement of goods from the stage of production to distribution. It acts as a device to protect firm’s sales from its competitors and also attracts potential customer, who otherwise finds it difficult to make cash purchases. Trade credit creates receivables, which the firm is expected to collect in the near future. Thus, the book debt or receivables, arising out of credit has three dimensions2. First, it embraces an element of risk which needs to be assessed, since cash sales are totally riskless. Second, it is based on economic values. To the buyer, the economic value in goods or services is passed on immediately at the time of sale while the seller expects an equivalent value to be received at a later date. Third, it implies futurity. The payment for value received, arises at a future date. But, creation of receivables block the firm’s funds for the period between the date of sale and the date of receipt of payment which is to be financed out of working capital funds. This necessitates the firm to arrange funds from banks and other sources. Thus, receivables represent investment, which constitutes a substantial portion of current assets of manufacturing firm. Thus, it needs careful analysis and proper management. Receivables, in the strict accounting sense, include (i) book debts or accounts, (ii) notes and bills and (iii) accrued receivables only. However, in broader sense, the term receivables is used to include further (iv) any pre-payment made against purchase and expenses contract and (v) advance to subsidiaries, employees and officers3 . The quantum of book debts depends upon the volume of credit sales and collection policy. The greater the volume of credit sales and larger the credit period allowed, the more is the investment in trade debtors. Sometimes, the customers, at the time of credit sales, may be asked to sign notes or bills promising therein to pay a specified date the amount extended to them as credit. Again, sale of durable goods on hire purchase basis gives rise to accrued receivables for those installments that become due for payment. Pre-payment arise when payment is made in advance of receipt of goods and services. As pre-payments represent items to be consumed during the course of business, it is different from typical receivables. Insurance premium, rent, etc., are pre-payments of this nature. Pre- paid tax is also considered an asset as it chargeable to a later period. Advances and loans to employees and officers of the company are also current assets. They are, however, good assets only to the extent that the responsibility of the employees or the officers can be relied upon. In the present chapter, the term ‘receivables’ has been used in its broader sense, that is, to include trade debtors and loans and advances in its purview. In order to evaluate the performance of receivables management in select cement companies, an attempt has been made to analyze the size, composition and efficiency of receivables during the study period. 143 CU IDOL SELF LEARNING MATERIAL (SLM)
Composition of Receivables A vital tool for evaluating the management of receivables is study of their composition. It helps to reveal the point where receivables concentrated most. Receivables in any organization comprise the total of sundry debtors and loans and advances. It is desirable to keep minimum investment in loans and advances because to that extent firm’s funds are blocked up which would have been otherwise used profitably. In other words, investment in loans and advances has high opportunity cost. Investment in debtors, on the other hand, is inevitable in the competitive environment. Further, increasing investment in debtors may increase the sales which in turn may increase profit. The table 7.6 shows the composition of receivables in select cement companies which reveals that first two years of the study period i.e., 2003-04 and 2004-05, the proportion of sundry debtors dominated the total receivables and later on loans and advances predominated the structure of receivables in the industry. On an average, the proportion of debtors was 42.76 per cent and loans and advances was 57.24 per cent in the industry. CREDIT POLICY Designing credit policy is the first step in receivables management. In designing credit policy, the management can follow two broad approaches. Firstly, the policy can be designed under the assumption of unlimited production/sales and funds available for investment in receivables. If credit policy is designed under this assumption and subsequently some constraints are experienced on sales or funds available for receivables, then managers have to restrict the credit at the time of implementing the credit policy. But this may cause certain difficulties to customers because of deviation from the announced credit policy. For example, if a company announces that credit will be unlimited to certain categories of customers based on unlimited funds assumption and subsequently refuse to grant credit due to limited funds available for investment in receivables, it will create hardship to the customer. Under the second approach, the credit policy could be designed keeping in mind the limitations on production/sales volume and funds available for investment in receivables. This is aimed to achieve optimum utilization of production capacity and funds available for receivables. It also ensures consistency of credit policy. The credit policy consists of the following components: 144 • Credit Period • Discount • Credit Eligibility • Credit Limit CU IDOL SELF LEARNING MATERIAL (SLM)
Credit Period Decision on credit period is determined by several factors. It is important to check the credit period given by other firms in the industry. It would be difficult to sustain by adopting a completely different credit policy as compared to that of industry. For example, if the industry practice is 30 days of credit period, a firm which offers 120 days credit would certainly attract more business but the cost associated with managing longer credit period also increases simultaneously. On the other hand, if the firm reduces the credit period to 10 days, it would certainly reduce the cost of carrying receivables but volume would also decline because many customers would prefer other firms, which offer 30 days credit. In other words, granting trade credit is an aspect of price. The time that the buyer gets before payment is due, is one of the dimensions of the product (like quality, service, etc.) which determine the attractiveness of the product. Like other aspects of price, the firm’s terms of credit affect its volume. All other things being equal, longer credit period and more liberal credit-granting policies increase sales, while shorter credit period and more stringent credit- granting policies decrease sales. These policies also affect the level and timing of certain costs. Evaluation of credit policy changes must compare with the changes in sales and additional revenues generated by the sales as a result of this policy change and costs effects. While additional volume and revenue associated with such additional volume are clear and measurable, the cost effects require further analysis. Cost of Extending Credit Period Lengthening credit period delays the cash inflows. For example, suppose a firm increases the credit period from 30 days to 90 days. Customers, old as well as new, will now pay at the end of 90 days and the cash inflows from these sales would occur further into the future. That means, the firm has to delay in settling its dues to others or resort to short-term borrowing if the payments cannot be delayed. The interest cost of short-term borrowing arises mainly on account of extending the credit period. Discount When a firm pursues aggressive credit policy, it affects cash flows in the form of delayed collection and bad debts. Discounts are offered to the customers, who purchased the goods on credit, as an incentive to give up the credit period and pay much earlier. For example, suppose the terms of credit is “3/10 net 60”. It means if the customer, who gets 60 days credit period can pay within 10 days from the date of purchase and get a discount of 3% on the value of order. 145 CU IDOL SELF LEARNING MATERIAL (SLM)
Since the customer uses the opportunity cost of funds and availability of cash in taking decision, the cash discount should be set attractive. The discount quantum should be greater than interest rate of short-term borrowings. Credit Eligibility Having designed credit period and discount rate, the next logical step is to define the customers, who are eligible for the credit terms. The credit-granting decision is critical for the seller since credit-granting has economic value to buyers and buyers decision on purchase is directly affected by this policy. For instance, if the credit eligibility terms reject a particular customer and requires the customer to make cash purchase, the customer may not buy the product from the company and may look forward to someone who is agreeable to grant credit. Nevertheless, it may not be desirable to grant credit to all customers. It may instead analyze each potential buyer before deciding whether to grant credit or not based on the attributes of that particular buyer. While the earlier two terms of credit policy viz. credit period and discount rate are not changed frequently in order to maintain consistency in the policy, credit eligibility is periodically reviewed. For instance, an entry of new customer would warrant a review of credit eligibility of existing customers. The decision whether a particular customer is eligible for credit terms generally involves a detailed analysis of some of the attributes of the customer. Credit analysts normally group the attributes in order to assess the credit worthiness of customers. One traditional way of organizing the information is by characterizing the applicant along five dimensions namely, Capital, Character, Collateral, Capacity and Conditions. These five dimensions are also popularly called Five Cs of credit analysis. Capital: The term capital here refers to financial position of the applicant firm. It requires an analysis of financial strength and weakness of the firm in relation to other firms in the industry to assess the credit worthiness of the firm. Financial information is normally derived from the financial statements of the firm and analyzed through ratio analysis. The liquidity ratios like current ratio, debt- service coverage ratio, etc. are often used to get a preliminary idea on the financial strength of the firm. Further analysis includes trend analysis and comparison with the other industry norm or other firms in the industry. Character: A prospective customer may have high liquidity but delay payment to their suppliers. The character thus relates to willingness to pay the debts. 146 CU IDOL SELF LEARNING MATERIAL (SLM)
Some relevant questions relating to character are: • What is the applicant’s history of payments to the trade? • Has the firm defaulted to other trade suppliers? • Does the applicant’s management make a good-faith effort to honor debts as they become due? Information on these areas are useful to assess the applicant’s character. Collateral: If a debt is supported by collateral, then the debt enjoys lower risk because in the event of default, the debt holder can liquidate the collateral to recover the dues. The collateral causes hardship to other debt holders. Thus, the analysts should look into both the availability of collateral for the debt and the amount of collateral the firm has given to others. In computing the liquidity of the firm, the analysts should remove the assets used for collateral and take into account only the free assets. The credit worthiness improves if the customer is willing to offer collateral assets or the value of collateral asset backed loan is low. Capacity: The capacity has two dimension - management’s capacity to run the business and applicant firm’s plant capacity. The future of the firm depends on the management’s ability to meet the challenges. Similarly, the facility should exist to exploit the opportunity. Since the assessment of capacity is a judgement on the part of analysts, a lot of care should be taken in assessing this feature. Conditions: These are the economic conditions in the applicant’s industry and in the economy in general. Scope for failure and default is high when the industry and economy are in contraction phase. Credit policy is required to be modified when the conditions are not favorable. The policy changes include liberal discount for payment within a stipulated period and imposing lower credit limit The information collected under five Cs can be analyzed in general to decide whether the customer is eligible for credit or fit into a statistical model to get an unbiased credit rating of the customer. Discussion on credit evaluation model is presented in the next section. Credit Limit If a customer falls within the desired limit of credit worthiness, the next issue is fixing the credit amount. This is something similar to banks fixing overdraft limit for the account holders. If a customer is new, normally the credit limit is fixed at the lowest level initially and expanded over the period based on the performance of the customer in meeting the liability. Credit limit may undergo a change depending on the changes in the credit 147 CU IDOL SELF LEARNING MATERIAL (SLM)
worthiness of the customer and changes in the performance of customer’s industry. MONITORING RECEIVABLES Managing receivables does not end with granting of credit as dictated by the credit policy. It is necessary to ensure that customers make payment as per the credit term and in the event of any deviation, corrective actions are required. Thus, monitoring the payment behavior of the customers assumes importance. There are several possible reasons for customers to deviate from the payment terms. Three ofthese possible reasons and their implications in credit management are discussed below: Changing Customer Business Characteristics: The customers, who have earlier agreed to make payment within a certain period of time, may deviate from their acceptance and delay the payment. For example, economic slowdown or slowdown in the industry of the customers’ business may force the customers to delay the payment. In fact, the bills payable become discretionary cash outflow item in economic recession. Thus, a close watch on the performance of customer’s industry is required. Inaccurate Policy Forecasts: A wide deviation from the credit terms and actual flow of cash flows show inaccurate forecast and defective credit policy. It is quite possible that a firm uses defective credit rating model or wrongly assesses the credit variable. For example, it is quite possible to overestimate the collateral value and then lend more credit. If this is the reason for wide deviation, it requires updating the model or training the employees. Improper Policy Implementation: Often wide deviation is noticed in practice while implementing credit policy. This may not be intentional but frequently in the form of accommodating special requests of the customers. For example, a customer may not be eligible for credit or higher credit as per the model in force. The customer may personally see the concerned manager and request her/him to relax the credit restriction. If there is no policy in place to deal with these types of request and ad hoc decisions are made, then wide deviation is possible. Often these deviations become costly for the firm. Intervention of top officials and ad hoc decisions are cited as major reasons for widespread defaults in many public financial institutions. Thus, it is necessary to ensure that policies are implemented in letter and spirit. Monitoring provides signals of deviation from expectations. There are several monitoring 148 CU IDOL SELF LEARNING MATERIAL (SLM)
techniques available to the credit managers. The monitoring system begins with aggregate analysis and then move down to account-specific analysis. Investments in Receivables: The decision to supply on credit basis leads to investments in receivables. Credit policy is designed in such a way that investment needs of receivables are optimized i.e. return is greater than cost associated with investments. Credit monitoring starts with an assessment of investment in receivables as a percentage of total assets. The investments in receivables are then compared with the budget. Any deviation from budgeted value shows delay in collection or managers deviating from the credit policy. For example, if a firm based on credit policy worked out that investments in receivables is 12%, the actual value for the last three months is around 18%, there are two possible reasons. Firstly, some of the customers are not paying and thus, the receivables value has gone up. Secondly, the managers would be giving more credit than the prescribed limit or extend the credit period. In either case, it requires an investigation and explanation from managers for the increased investment in receivables. Collection Period: Receivables can be related to sales in different ways. The simplest form of analysis is comparing sales and receivables for different periods to know the trend. While this analysis gives a reasonable understanding on how the receivables have moved over the period, it fails to give an implication of the changes in the trend. For example, if sales and receivables of two periods are Rs. 90 lakhs, 120 lakhs and Rs.120 lakhs, Rs.140 lakhs respectively, the figures show (i) the sales value has gone up during the period, and (ii) receivables have also gone up along with sales. A shaper focus on changes in the trend can be obtained by computing the collection period of the two periods. The collection period is computed as follows: Credit sales per day is computed by dividing the total credit sale of the period by the number of days of the period. If the sales value given above are related to quarterly sales value, then sales per day for the two quarters are Rs. 1 lakh (Rs.90 lakhs/90 days) and Rs. 1.33 lakh (Rs.120 lakhs/90 days) respectively. The collection period for the two quarters are Period 1: 120/1 = 120 days Period 2: 140/1.33 =105 days The collection period shows a decline and thus improved performance, which was not visible earlier in simple comparison. If the sales value for the second period is Rs. 100 lakhs instead of 120 lakhs, then average credit sales per day is Rs.1.11 lakh and collection period is 126 days. The collection performance in this case has marginally come down. The 149 CU IDOL SELF LEARNING MATERIAL (SLM)
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