Business Finance Cw

7/28/2019 Business Finance Cw

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BUSINESS FINANCE 1.

a) Explain how efficient management of cash, debtors and inventories

affect the liquidity of a business.

b) What factors influence the length of credit period granted for debtors.

c) Justify why business allow debtors in their transactions.

d)

e) 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.

f) 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.

g) 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.

h) 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.


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i) We will be subsequently discussing certain issues like the management of cash flows

and determination of optimal cash balance, etc. (in this unit).

j) Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competi-tive

pressures force most firms to offer credit. Today the use of credit in the purchase f goodsand 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. 11 Management of

Working Capital


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k) 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.

l) 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 result 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.

m) 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 organisation like other

components of current assets.

n) Inventory constitutes a very significant part of working capital or current assets in

manufacturing organisation. 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.

o) Inventory holding is desirable because it meets several objectives and needs but an

excessive inventory is undesirable because it costs a lot to firms.

p) 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.


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q) Marketable Securities: Cash and marketable securities are normally treated as one item

in any 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.

16.7 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 realised 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 organisation.

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.

Implementation of operating plans may become difficult and consequently the firm's

profit goals may not be achieved.


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Operating inefficiencies may creep in due to difficulties in meeting even day to day

commitments.

Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering

the rate of return on investments in the process.

Attractive credit opportunities may have to be lost due to paucity of working capital.

The firm loses its reputation when it is not in a position to honour its short-term

obligations. As a result, the firm is likely to face tight credit terms.

On the other hand, excessive working capital may pose the following dangers:

1 Excess of working capital may result in unnecessary accumulation of invento-ries, 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 eventu-ally to

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. 13 Management of Working Capital


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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.

Short term Investment decisions are concerned with the decisions about the

level of cash, inventory and debtors etc. (working capital)

Efficient cash management, Inventory management and receivable management

are essential ingredients of sound working capital management.

The working capital should be neither more or less than required. Both

the situations are harmful. If the amount of working capital is more than required,

it will no doubt increase the liquidity but decrease the profitability. Similarly if

there is a shortage of working capital, it will face the problem of meeting day to

day requirements.

Thus optimum amount of current assets and current liabilities should

be determined so that the profitability of the business remains intact and there is

no fall in the liquidity.

MEANING AND IMPORTANCE

Cash is the money, which the firm can disburse immediately without any restriction. Near- cash

items like marketable securities or bank time deposits are also included in cash.

Cash management is concerned with the managing of:

i. Cash flows into and out of the firm

ii. Cash flows within the firm and

iii. Cash balances held by a firm at a point of time.

Cash management is important because:

i. Cash is used for paying the firms obligation

ii. Cash is an unproductive asset, you need to invest it somewhere


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iii. It is difficult to predict cash flows accurately as there can not be perfect coincidence

between the inflows and outflows of cash

iv. Though cash constitutes the smallest portion of total current assets, managements

considerable time is devoted in managing it.

The obvious aim of the firm these days is to keep its cash balance minimum and to invest the

released cash funds in profitable opportunities.

In order to overcome the uncertainty about predictability of cash flow, the firms should evolve

strategies regarding the following four facets of cash management:

i. Cash planning: Cash surplus or deficit for each period should be planned; this can be

done by preparing the cash budget.

ii. Managing the cash flows: The firm should try to accelerate the inflows of cash flow

while trying to minimize the outflows.

iii. Optimum cash level: The cost of excess cash and the dangers of cash deficit should be

matched to determine the optimum level.

iv. Investing idle cash: The firm should about the division of such cash balances between

bank deposits and marketable securities.

In order to manage cash you need to manage the sources of additional working capital, which

includes the following:

Existing cash reserves

Profits (when you secure it as cash!)

Payables (credit from suppliers)

New equity or loans from shareholders

Bank overdrafts or lines of credit

Long-term loans

If you have insufficient working capital and try to increase sales, you

can easily over-stretch the financial resources of the business. This is

called overtrading.


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WHY DOES A FIRM NEED CASH?

i. Transaction motive: firm needs cash for transaction purpose.

ii. Precautionary motive: The magnitude and time of cash inflows and

outflows is always uncertain and hence the firms need to have some cash

balances as a buffer.

iii. Speculative motive: All firms want to make profits from fluctuations in

commodity prices, security prices, interest rates and foreign exchange

rates .A cash rich firm is in a better position to exploit such bargains. Hence,

the firm with such speculative leanings may carry additional liquidity.

The firm must decide the quantum of transactions and precautionary

balances to be held, which depends upon the following factors:

The expected cash inflows and outflows based on the cash budget

and forecasts, encompassing long/short range cash needs of the

firm.

The degree of deviation between the expected and actual net cash

flow.

The maturity structure of the firms liabilities.

The firms ability to borrow at a short notice, in case of emergency.

The philosophy of management regarding liquidity and risk of

insolvency

The efficient planning and control of cash.

CASH PLANNING

Cash planning is a technique to plan for and control the use of cash. The forecast may be based

on the present operations or the anticipated future operations.

Normally large, professionally managed firms do it on a daily or weekly basis, whereas,

medium size firms do it on a monthly basis. Small firms normally do not do formal cash

planning, incase they do it; its on a monthly basis.


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As the firm grows and its operation becomes complex, cash planning

becomes inevitable for them.

CASH FORECASTING AND BUDGETING:

A cash budget is a summary statement of the firms expected cash inflows and outflows over

a projected time period.

It helps the financial manager to determine the future cash needs, to arrange for it and to

maintain a control over the cash and liquidity of the firm. If the cash flows are stable, budgets

can be prepared monthly or quarterly, if they are unstable they can be prepared daily or weekly.

Cash budgets are helpful in:

Estimating cash requirements

Planning short term financing

Scheduling payments in connection with capital expenditure

Planning purchases of materials

Developing credit policies

Checking the accuracy of long- term forecasts.

Short Term Forecasting Methods

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

i. The receipt and payment method

ii. The adjusted net income method

The receipt and payment method is used for forecasting limited periods, like a week or a month,

where as, the adjusted net income method is used for longer durations. The cash flows can be

compared with budgeted income and expense items if the receipts and payment approach is

followed. On the other hand the adjusted net income method is appropriate in showing thecompanys working capital and future financing needs.

i. Receipts and Payment Method: It simply shows the timing and magnitude of expected

cash receipts and payments over the forecast receipts.


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The most difficult part is to anticipate the amounts as well as the time when the receipts will be

collected, the reason being that he projection of cash receipts relies heavily on sales forecasts and

the guesses regarding the time of payment by the customer.

Evaluation of the method: I

Its main advantages are:

Provides a complete picture of expected cash flows

Helps to keep a check over day-to-day transactions

ITEMS BASIS OF ESTIMATION

Cash salesEstimated sales and its division between cash/credit sales

Collection of a/cs

receivables

Estimated sales, its division between cash and credit sales,

and collection patternInterest and dividend

receipts

Firms portfolio of securities and return expected from the

portfolio

Increase in loans/deposits

and issue of securitiesFinancing plan

Sale of assetsProposed disposal of assets

Cash purchasesEstimated purchases, its division between cash/credit

purchases, and terms of credit purchases.

Payment for purchasesEstimated purchases and its division between cash/credit

purchases.

Wages and salariesManpower employed and wages and salaries structure

Manufacturing expenseProduction plan

General, administration

and selling expenses

Administration and sales personnel and proposed sales

promotion and distribution expenditure.

Capital equipment

purchases

Capital expenditure budget and payment pattern

associated with capital equipment purchases

Repayment of loans and

retirement of securitiesFinancing plan


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Its main drawbacks are:

Its reliability is impaired by delays in collection or sudden demand for large payments

and other similar factors.

It fails to provide a clear picture regarding the changes in the movement of working

capital, especially those related to the inventories and receivables.

ii. Adjusted net income method: It involves the tracing of working capital flows. It is also

called the sources and use approach. Its two objectives are:

To project companys need for cash at some future date.

To show if the company can generate this money internally, and if not, how

much will have to be either borrowed or raised in the capital market.

It generally has three sections; sources of cash, uses of cash and adjusted net balance .In

preparing the adjusted net income forecasts items like net income, depreciation, taxes dividends

etc can be easily determined from the companys annul operating budget. Normally it is difficult

to find WC changes, especially since the inventories and receivable pose a problem.

Its main advantages are:

Helps to keep a control on working capital

Helps anticipate financial requirements.

Its main disadvantages are:

It fails to trace the flow of cash.

Not useful in controlling day-to-day transaction

Long-Term Cash Forecasting

They are generally prepared for a period of two to five years and hence provide a broad picture

of firms financing needs and availability of investible surplus in future .Its major uses are:

Indicate future financial needs

Helps evaluate proposed capital projects

Improve corporate planning


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Long-Term Forecasting Methods

The adjusted net income method can be used here also. Long term forecasting not only reflects

more accurately the impact of any recent acquisitions but also foreshadows financial problems

that new additions may pose for the firm.

To enhance the efficiency of cash management, collection and payment must be properly

monitored. In this respect the following will be helpful.

Prompt Billing: It ensures early remittances. Also the firm has high control in this area

and hence there is a sizeable opportunity to free up the cash. To tap this opportunity the

treasurer should work with the controller and others in:

Accelerating invoice data

Mailing bills promptly

Identifying payment locations

Expeditious Collection Of Cheques: Two important methods for expediting

the collection process are:

1. Concentration banking: The important features of concentration banking are:

A major bank account of the company is set up with a concentration bank,

generally situated at the same place where the company is headquartered.

Customers are advised to mail their remittances to collection center closest

to them.

Payments received in different collection centers are deposited in local

banks, which in turn transfer them to the concentration bank.

Thus this helps saving mailing and processing time, reducing financial requirements. This system

leads to potential savings, which should be compared to the cost of maintaining the system.


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1. Lock box system: It functions as follows:

A number of post boxes are rented by the company in different locations.

Customers send their remittances to the lock box.

Banks are instructed and authorized to pick up the cheques from the local

boxes and deposit them in the companys account.

The main advantages of this system are, firstly, the bank handles the remittances prior to deposit

at a lower cost. Secondly the cheques are deposited immediately upon receipt of remittances and

their collection process starts sooner than if a firm would have processed them for internal

accounting purposes prior to their deposits.

Control of Payables: Payments arise due to trade credit, which is a

source of funds, and hence, the firm should try to slow them down as much as possible.

By proper control of payables a firm can conserve its cash resources. Following are some

of the ways of doing it:

Payments should be made only as and when they fall due.

Payments must be centralized. This helps in consolidating funds at the head

office, and investing surplus funds more effectively.

Arrangements may be made with the suppliers to set due dates of their bills to

match the firms period of peak receipts, thus helping the firm to get a better

mileage.

Playing the Float:The amount of cheques issued by the firm but not

paid for by the bank is referred to as payment float. At the same time the amount of

cheques deposited but not cleared is referred to as collection float.

The difference between the payment float and the collection float is referred to as the net

float. So if a firm enjoys a positive net float, it can still issue cheques, even if it means overdrawn


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bank accounts in its books. This action is referred to a s playing of float. Though risky the firm

may choose to play it safely and get a higher mileage from its cash resource.

OPTIMAL CASH BALANCE

Cash balance is maintained for transaction purposes and an additional amount may be

maintained as a buffer or safety stock. It involves a tradeoff between the costs and the risk.

If a firm maintains a small cash balance, it has to sell its marketable securities and

probably buy them later more often, than if it holds a large cash balance. More the number of

transactions more will be the trading cost and vice-versa; also, lesser the cash balance, less will

be the number of transaction and vice-versa. However the opportunity cost of maintaining the

cash rises, as the cash balance increases.

MEANING AND OBJECTIVES

Inventories are the stock of the products a company is manufacturing for sale

and the components that make up the product. They exist in three forms; raw

materials, work-in-process and finished goods. A fourth kind of inventory the

firms also maintain i.e. the inventories of supplies. It includes office and plant

cleaning material, oil, fuel, light bulbs, etc.

Inventories constitute the most significant part of current assets of a large

majority of companies in India. For e.g., on an average, 60 % of the current assets

in the public limited companies are, inventories.


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OBJECTIVES OF INVENTORY MANAGEMENT

The firms are required to maintain enough inventories for smooth production and selling process,

also at the same time they need to keep the investment in them minimum. The investment in the

inventories should be justified at the optimum level. The major dangers of over investment

include blockage of funds leading to reduced profits, excessive carrying cost and the risk of

liquidity. On the other hand major dangers of inadequate inventories include production hold

ups, failure to meet delivery commitments further leading to loss of firms image, losing

customers to competitors etc. Hence an effective inventory management should:

Ensure continuous supply of materials.

Maintain sufficient stock of RM in periods of short supply and anticipate price

changes.

Maintain sufficient FG inventory for smooth sales operation and efficient

customer service

Minimize the carrying cost and time.

Control investment in inventory, and keep it at an optimum level.

Average stock-holding periods will be influenced by the nature of the business. For

example, a fresh vegetable shop might turn over its entire stock every few days while a motor

factor would be much slower as it may carry a wide range of rarely-used spare parts in case

somebody needs them.

The key issue for a business is to identify the fast and slow stock movers with the objectives of

establishing optimum stock levels for each category and, thereby, minimize the cash tied up in

stocks. Factors to be considered when determining optimum stock levels include:

What are the projected sales of each product?

How widely available are raw materials, components etc.?


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How long does it take for delivery by suppliers?

Can you remove slow movers from your product range without compromising

best sellers?

For better stock control, the following steps can be undertaken:

Review the effectiveness of existing purchasing and inventory systems.

Know the stock turn for all major items of inventory.

Apply tight controls to the significant few items and simplify controls for the

trivial many.

Sell off outdated or slow moving merchandise - it gets more difficult to sell the

longer you keep it.

Consider having part of your product outsourced to another manufacturer rather

than make it yourself.

MANAGEMENT OF DEBTORS

Cash flow can be significantly enhanced if the amounts owing to a business are collected

faster. Slow payment has a crippling effect on business, in particular on small businesses that can

least afford it. If you don't manage debtors, they will begin to manage your business as you

will gradually lose control due to reduced cash flow and, of course, you could experience anincreased incidence of bad debt.

The following measures will help manage your debtors:

Make sure that the control of credit gets the priority it deserves.

Establish clear credit practices as a matter of company policy.


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Make sure that these practices are clearly understood by staff, suppliers

and customers.

Be professional when accepting new accounts, and especially larger ones.

Check out each customer thoroughly before you offer credit. Use credit

agencies, bank references, industry sources etc.

Establish credit limits for each customer... and stick to them.

Continuously review these limits when you suspect tough times are coming

or if operating in a volatile sector.

Keep very close to your larger customers.

Invoice promptly and clearly.

Consider charging penalties on overdue accounts.

Consider accepting credit /debit cards as a payment option.

Monitor your debtor balances and ageing schedules, and don't let any debts

get too large or too old.

Debtors due over 90 days unless within agreed credit terms should generally

demand immediate attention.

A customer who does not pay is not a customer . Here are a few ideas that may help you in

collecting money from debtors:

Develop appropriate procedures for handling late payments.

Track and pursue late payers.

Get external help if your own efforts fail. .

In difficult circumstances, take what you can now and agree terms for the

remainder. It lessens the problem.


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When asking for your money, be hard on the issue - but soft on the

person. Don't give the debtor any excuses for not paying.

Goal Of Credit Management

To manage the credit in such a way that sales are expanded to an extent to which the risk

remains within an acceptable limit. Hence for maximizing the value, the firm should manage its

credit to:

Obtain optimum not maximum value of sales.

Control the cost of credit and keep it at minimum.

Maintain investment in debtors at optimum level.

OPTIMUM CREDIT POLICY

The term credit policy refers to those decision variables that influence the amount of

trade credit; i.e. the investment in receivables. Main factors that affect the credit policy are

general economic conditions, industry norms, pace of technological change, competition, etc.

Lenient or stringent credit policy: Firms following lenient credit policy tend to sell on credit

very liberally, even to those customers whose creditworthiness is doubtful, where as, the firm

following stringent credit policy; will give credit only to those customers who have proven their

creditworthiness.

Firms having liberal credit policy, attract more sales, and also enjoy more profits. However at the

same time, they suffer from high bad debt losses and from problem ofliquidity.

The concept of probability can be used to

make the sales forecast. Different economic

conditions; good bad and average, can be

anticipated and accordingly sales forecast

under different credit policies can be made.


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You also need to consider the cost of credit extension, which mainly involves increased bad

debts, production cost, selling cost, administration cost, cash discount and opportunity cost.

Credit policy should be relaxed if the increase in profits from additional sales is greater than the

corresponding cost. The optimum credit policy should occur at a point where there is a trade off

between liquidity and profitability.

The important variables you need to consider before deciding the credit policy are:

Credit terms: Two important components of credit terms are credit period and cash

discounts. Credit period is generally stated in terms of net period, for e.g., net 30.it

means that the payment has to be made within 30 days from day of credit sale.

Cash discount is normally given to get faster payments from the debtors. The complete credit

terms indicate the rate of cash discount, the period of credit and the discount period. For ex:

3/10, net 30 this implies that 3 % discount will be granted if the payment is made by the tenth

day, if the offer is not availed the payment has to be made by the thirtieth day.

The firm also needs to consider the competitors action, if the competitors also relax their policy,

when you relax your policy, the sales may not go up as expected.

Credit standards: Liberal credit standard tend to put up sales and vice-versa. The firms

credit standards are influenced by the five Cs:

i. Character- the willingness of the customer to pay

ii. Capacity- the ability of the customer to pay

iii. Conditions- the prevailing economic conditions

iv. Capital- the financial reserves of a customer. If the customer has difficulty in

paying from operating cash flow, the focus shifts to its capital.

v. Collateral- The security offered by the customers.


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Collection policy: A collection policy is needed s as to induce the customer to pay his

bills on time and to remind him of payment if the credit period is over and he has still not

paid the bill.

i. Credit investigation: The factors that affect the extent and nature of credit investigation

are:

The type of customer, whether new or old.

The customers business line, background and related trade risks.

The nature of the product-durable or perishable.

Size of order and expected future volumes of business with him.

Companys credit policies and practices.

A performance report of each trade customer should be maintained and up dated

regularly. Whenever the firm experiences a change in the customers paying habit,

his file can be thoroughly checked. The intensity or the depth of credit review will

depend on the quality of customer account and the credit involved. Though creditinvestigation involves cost, credit decision without adequate investigation can be

more expensive in terms of collection cost or loss due to bad debt.

ii. Credit analysis: The credit information supplied should be properly analyzed. The ratios

should be calculated to find out the liquidity position and should be compared with the

industry average. This will tell us whether the downfall if any is because of general

industrial environment or due to internal inefficiencies of the firm.

For judging the customer the credit analyst may use quantitative measure like the

financial ratios and qualitative assessments like trustworthiness etc.

Credit analyst may use the following numerical credit scoring system:


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Identify factors relevant for credit evaluation.

Assign weights to these factors that reflect their relative importance.

Rate the customers on various factors, using the suitable rating scale.

For each factor multiply the factor rating with the factor weight to get the factor

score.

Add all the factor score to get the over all customer rating index

Based on the rating index, classify the customer.

On basis of this the credit granting decision is taken. If p is the probability that the

customer will pay, (1-p) the probability that he defaults, REV the revenue from

sales, (COST) the cost of goods sold, the expected profit for the action offer credit

is:

p (REV-COST) - (1-p) COST

The expected profit for the action refuse credit is 0, if the expected profit of the

course of action offer credit is positive; it is desirable to extend credit, otherwisenot.

For ex: if the probability that a customer would pay is 0.7 and the probability that a

customer would default is 0.3,the revenue from sales is Rs 1400 and the cost of

sales is Rs 600;the expected profit of offering credit is

0.7(1400-600) 0.3(600) = Rs. 380

iii. Credit limits: The next logical step is to determine the amount and duration of credit. It

depends upon the customers creditability and the financial position of the firm. A line

credit is the maximum amount of credit, which the firm will extend at a point of time. A

customer may sometimes demand a credit higher then his credit line, which may be

granted to him if the product has a high margin or the additional sales help to use the


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unutilized capacity of the firm. The normal collection period should be determined

keeping in mind the industry norm.

iv. Collection procedure: The firm should clearly lay down the collection procedures for

the individual accounts, and the actions it will resort to if the payments are not made on

time. Permanent customers need too be handled carefully; else the firm may lose them to

the competitors. In order to study correctly the changes in the payment behavior of

customers, it is necessary to look at the pattern of collections associated with credit sales.

Credit Policy

The credit policy of a company can be regarded as a king of trade-off between

increased credit sales leading to increase in profit and the cost of having larger

amount of cash locked up in the form of receivables and the loss due to the

incidence of bad debts.

A Firms investment in accounts receivable depends on:

a) The volume of credit sales

b) The collection period

Firms average investment = Daily credit sales X Average collection period

Credit policy is evaluated in terms of return and costs of additional sales.

Credit policy refers to


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a) Credit standards: Criteria to decide the types of customers to whom goods

could be sold on credit. Slow paying customers will increase investment in

receivable and is exposed to high default risk

b) Credit terms: The duration of credit and terms of payment by customers.

Extended time period for making payments will increase investment in

receivables.

c) Collection efforts: Determine the actual collection period. The lower the

collection period, the lower the investment in accounts receivables and vice

versa.

GOALS OF CREDIT POLICY

a) A firm following a lenient credit policy will grant credit in liberal terms and

standards and grant credit to longer period and also to customers whose

creditworthiness is not fully known.

b) A firm following a stringent credit policy sells on credit on a highly selective

basis only to customers with proven creditworthiness.

CREDIT POLICY AS MARKETING TOOL

Firms use credit policy as a marketing tool during expansion sales.

In a declining market, it is used to maintain market share.It helps to retain

old customers and to create new customers.

In a growing market, it is used to increase firms market share.

Under a highly competitive situation or recessionary economic conditions,

firm loosen its credit policy to maintain sales or to minimize erosion of sales.

Necessity of Granting Credit

Companies in India grant credit for:

1. Competition: Higher the degree of competition, the more the credit grant

2. Bargaining power: Higher bargaining power leads to less credit or no credit


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3. Buyers status and requirement: Large buyers demand easy credit terms.

4. Dealer relationship

5. Marketing tool

6. Industry practice & past practice

7. Transit delays: Forced reason for granting credit.

OPTIMUM CREDIT POLICY

Optimum credit policy is one which maximizes the firms value. Value of firm is

maximized when the incremental or marginal rate of return of an investment is

equal to the incremental or marginal cost of funds used to finance the investment.

MARGINAL COST- BENEFIT ANALYSIS

To achieve the goal of maximization of firms value, the evaluation of investment in

accounts receivable should involve:

Estimation of incremental operating profit (change in contribution

additional costs)

Estimation of incremental investment in accounts receivable

(Investment in accounts receivable = credit sales per day X

Average

Collection Period)

Estimation of the incremental rate of return of investment

(Operating profit after tax / Investment in accounts receivable)

Comparison of the incremental rate of return with the required rate of return.

Credit Policy Variables

In establishing an optimum credit policy, the financial manager must consider theimportant decision variables which influence the level of variables. The major

controllable decision variables include the following:

Credit standards and analysis

Credit terms

Collection policy and procedures.


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CREDIT STANDARDS

The two aspects of quality of customers are

Time taken by customers to repay credit obligation.

The average collection period (ACP) determines the speed of payment by

customers.

The default rate: It can be measured in terms of bad debt losses ratio.

The customers are categorized as good, bad and marginal accounts.

DEFAULT RISK

To estimate the probability of default the following three Cs are considered.

1. Character : It refers to the customers willingness to pay. The manager should

judge whether the customers will make honest efforts to honour their credit

obligations.

2. Capacity : It refers to the customers ability to pay. It is judged by assessing

the customers capital and assets offered as security. This is done by

analysis of ratios and trends in firms cash and working capital.

3. Condition : It refers to the prevailing economic and other conditions that

affect the customers ability to pay.

CREDIT ANALYSIS

A firm can do credit analysis using

Numerical credit scoring models: It includes

1. Adhoc approach: The attributes identified by the firm may be assigned

weights depending on their importance and combined to create an overall

score or index.

2. Simple discriminant analysis: A firm use more objective methods of

differentiating between good and bad customers.(Eg:- ratio of EBDIT to

sales).


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3. Multiple discriminant analysis: It combines many factors according to the

importance (weight) given to each factor and determine a score to

differentiate customers as good and bad.

CREDIT GRANTING DECISION


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CREDIT TERMS

The stipulations under which the firm sells on credit to customers are called creditterms.

These include

1. Credit period : The length of time for which credit is extended to customers is

called the credit period.

2. Cash discount : It is a reduction in payment offered to customers to include

them to repay credit obligations within a specified period of time, which will

be less than the normal credit period. It is expressed as a percentage of

sales. It is a cost to the firm for faster recovery of cash.

COLLECTION POLICY

1. Collection policy is needed to accelerate collections from slow payers and

reduce bad debt losses.

2. It should ensure prompt and regular collection.

3. It should lay down clear cut collection procedures.

4. The responsibility for collection and follow up should be explicitly fixed.

( Accounts or sales)

5. The firm should decide on cash discounts to be allowed for prompt payment

6. It should be flexible

CREDIT EVALUATION

For effective management of credit, clear cut guidelines and procedures forgranting credit to individual customers and collecting individual accounts should be

laid down.

The credit evaluation procedure includes:

1. Credit information.

2. Credit investigation.


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3. Credit limits.

4. Collection procedures.

CREDIT INFORMATION

To ensure full and prompt collection of receivables, credit should be allowed only to

customers who have the ability to pay in time. For this the firm should have credit

information of customers.

Collecting credit information involves cost. The cost should be less than the

potential profitability.

Depending on cost and time, the following sources can be employed to

collect credit information.

SOURCES OF CREDIT INFORMATION

Financial statement: One of the easiest ways to obtain information on the

financial condition of the customer is to scrutinise his financial statements.

(Balance sheet & P&L a/c).

Bank references: Bank where the customer maintains his account is another

source of collecting credit information.

Trade references: Contacting the persons or firms with whom the customer

has current dealings is an useful source to obtain credit information at no

cost.

Other sources: Credit rating organisations such as CRISIL, CARE,ICRA, KPMG

etc.

CREDIT INVESTINGATION AND ANALYSIS

The factors that affect the nature and extent of credit investigation of an individual

customer are:

Type of customer, whether new or existing.

The customers business line, background and the related trade risks.

The nature of the product- perishable or seasonal.


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Size of the customers order and expected further volumes of business with

them.

Companys credit policies and practices.

Steps involved in credit analysis are:

1. Analysis of the credit file: A credit file updated regularly is maintained for

each customer, who gives information on his trade experiences, performance

report based on financial statements, credit amount etc.

2. Analysis of financial ratios: The evaluation of the customers financial

conditions should be done very carefully. Ratios should be calculated to

determine the customers liquidity position, ability to repay debts etc.,

3. Analysis of business and its management: The firm should also consider thequality of management and the nature of the customers business. For this a

management audit.

CREDIT LIMIT

A credit limit is a maximum amount of credit which the firm will extend at a

point of time.

It indicates the extent of risk taken by the firm by supplying goods on credit

to a customer.

The decision on the magnitude of credit, the time limit etc depends on the

amount of sales, industry norms and customers financial strength.

MONITORING RECEIVABLE

For the success of collection efforts, the firm needs to monitor and control its

receivables.

The methods used for evaluation are:

1. Average collection period.

2. Aging schedule.

3. Collection Experience Matrix.


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