BLOCK 4 MANAGEMENT OF CASH, RECEIVABLES AND INVENTORY

Transcription

1 BLOCK 4 MANAGEMENT OF CASH, RECEIVABLES AND INVENTORY CONTENTS Objectives... Time to study Study skills 4.1 Introduction 4.2 Motives of holding cash 4.3 Objectives of cash management 4.4 Factors determining cash needs 4.5 Problems of cash management Let us sum up for cash management. 4.7 Characteristics of receivables Objectives of receivables management 4.9 Costs of accounts receivables management Benefits of accounts receivable management Factors influencing the size of investment in receivables Modes of payment Credit policy Areas covered by receivables management or Components of receivables management Let us sum up for receivables management.. 1

2 4.16 Components of inventory 4.17 Motives of Inventory management Objectives of inventory management Benefits or advantages of holding inventory Disadvantages or risks of holding inventory Need for balanced investment in inventory 4.22 Tools and techniques of inventory management Let us sum up for inventory management Glossary Further readings Unit end activities 2

3 OBJECTIVES: After reading this unit, you will be able to Know the relevance of the term cash, receivables and inventory management. Understand the different reasons for holding cash in the organization. Comprehend the difficulties that organization s face while managing cash. Identify the various factors that the organizations consider for managing cash, receivables and inventory. Know different modes of payment through which the accounts receivables are paid. Comprehend the components of receivables management. Describe the various costs associated with accounts receivables management Discuss the kinds of credit policies Know different components of inventory. Discuss the objectives of inventory management. Comprehend the motives of receivables management. Identify the benefits and risks associated in holding inventory Describe the various tools and techniques used for inventory management. TIME TO STUDY: This unit will approximately take 15 hours of study. STUDY SKILLS The skills you require for completing this unit are: 1. Proper understanding of the concepts. 2. Comprehensive reading abilities. 3. Supportive reference of other related study materials. 4. Knowledge representation skills. 5. Better understanding of the concepts. 6. Analytical understanding of the methods explained 7. Logical understanding of the concepts. 8. Timely practice of the given exercise. 3

4 4.1 INTRODUCTION: Cash, receivables and inventory together form working capital of a firm. It is very important to a have a proper balance of each of the above for smooth running of the working capital cycle. Therefore, it is relevant to confer proper attention for their efficient management. Let us discuss it further.. Cash Management: Cash is one of the components of current assets. It is a medium of exchange for purpose of goods and services and for discharging liabilities. Management of cash is one of the most important areas of overall working capital management due to the fact that cash is the most liquid type of current assets and it is both beginning and the end of the working capital cycle to quote Gitman, liquid assets provide a pool of funds to cover unexpected outlays, thereby reducing the risk of a liquidity crisis. It is like blood stream in the human body, gives vitality and strength to the firm. Adequate availability of cash is essential to meet the business needs. Since, it is necessary in daily business operations and is productive, the cash owned by an enterprise at any time should be carefully regulated. As such it is the responsibility of the finance manager to see that the various functional areas of the business have sufficient cash whenever they require the same. At the same time, it has also to be ensured that the funds are not blocked in the form of idle cash, as the cash remaining idle also involves cost in the form of interest cost and opportunity cost. As such the management of cash has to find a mean between these two extremes of shortage of cash as well as idle cash. Therefore, effective management of cash involves an effort to minimize investment in cash without impairing to liquidity of the firm. It implies a proper balancing between the two conflicting objectives of the liquidity and profitability. Receivables Management: The term receivable is defined as, debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business. When the firm sells its products, services on credit, and it does not receive cash for it immediately, but would be collected in near future is called as receivables. However, no receivables are created when a firm conducts cash sales as payments are received immediately. A firm conducts credit sales to protect its sales from the competitors and to attract the potential customers to buy its products at favorable terms. Usually, the credit sales are made on open account which means that no formal acknowledgements of debt obligations are received from the buyers. This facilitates business transactions and reduces the paperwork required in connection with credit sales. Accounts Receivables Management means making decisions relating to the investment in the current assets as an integral part of operating process, the objective being maximization of return on investment in receivables. In other words, accounts receivables management involves maintenance of receivables of optimum level, the degree of credit sales to be made, and the debtors collection. 4

5 Receivables or accounts receivables constitute a substantial portion of the total current assets of several firms after inventories. They form about one-third of current assets in India since a very substantial amount is tied up in trade debtors, it requires a careful analysis and proper management. Inventory Mnagement: The term Inventory is originated from the French word Inventaire and the Latin Inventoriom which implies a list of things found. The term inventory has been defined by the American Institute of Accountants, as the aggregate of those items of tangible personal property which: a) are held for sale in the ordinary course of business; b) are in the process of production for such sales, or c) are to be currently consumed in the production of goods or services to be available for sale. The term inventory refers to the stockpile of the products a firm is offering for the sales and the components that make up the product. Inventories are the stocks of the product of a company manufacturing for sale and the components that make up the product. The various forms in which inventories exist in a manufacturing company are: i. Raw materials, ii. Work-in process, iii. Finished goods, and iv. Stores and spares. 4.2 MOTIVES OF HOLDING CASH: A company may hold the cash with the various motives. Let us discuss them in the following way. Transaction Speculative Precautionary Motives of Holding Cash Chart 4.1 Motives of Holding Cash 5

6 1. Transaction motive: The company may be required to make various regular payments like purchases, wages/salaries, various expenses, interest, taxes, dividends etc. for which the company may hold the cash similarly, the company may receive the cash basically from its sales operations. However, receipts of the cash and the payment by cash may not always match with each other. In such situations, the company will like to hold the cash to honor the commitments whenever they become due. The requirement of cash balances to meet routine needs is known as transaction motive. 2. Precautionary motive: In addition to the requirement of cash for routine transactions, the company may also require the cash for such purposes which cannot be estimated or foreseen. E.g.: there may be a sudden decline in the collection from the customers; there may be a sharp increase in the prices of the raw materials etc. The company may like to hold the cash balance to take care of such contingencies and unforeseen circumstances. This need of cash is known precautionary motive. 3. Speculative motive: The company may like to hold some reserve kind of cash balance to take the benefit of favorable market conditions of some specific nature. E.g purchases of raw material available at low prices on the immediate payment of cash, purchase of securities if interest rates are expected to increase etc. This need to hold the cash for such purposes is known as speculative motive. 4.3 OBJECTIVES OF CASH MANAGEMENT: One of the prime responsibilities of the financial manager is that managing cash to make balance between profitability and liquidity. In other words, there should not be excess cash or inadequate cash. From the above, we can trace the following as the objectives of cash management: 1. To meet cash payments: The prime objective of cash management is to meet various cash payments needed to pay in business operations. The payments are like payment to supplier of row materials, payment of wages and salaries, payment of electricity bills, telephone bills and so on.firm should maintain cash balances to meet the payments; otherwise it will not be able to run business. To quote Bollen, cash is an oil to lubricate the ever turning wheels of business: without it, the process grinds to a stop. Hence, one of the cash management objectives is to meet the payments with the maintenance of sufficient cash. 6

7 2. To maintain minimum cash balance: This is the second important objective of cash management. It means the firm should not maintain excess cash balances. Excess cash balance may ensure prompt payment, but it the excess balance will remain idle, as cash is a non-earning asset and firm will have to forego profit on the other hand, Maintenance of low level of cash balance, may not help to pay the obligations. Hence, the aim of the cash management is to maintain optimum cash balance. One of the tools available to the company to ensure the maintenance of optimum cash balance is to prepare the cash budget. By preparing the cash budget in a proper manner, the company can have an idea in advance of the timing and quantum of excess availability of cash or shortage of cash. Accordingly, the company can take the decision of investment of excess cash on short term basis (in case of excess cash available) or to meet the short fall (in case of shortage of cash). 4.4 FACTORS DETERMINING CASH NEEDS: A firm has to decide the cash balance based on their needs, which is determined after taking into consideration the following factors: 1. Synchronization of Cash Flows: Synchronization of cash flows arises only when there is no balance between the expected cash inflows and cash outflows. There is no need to manage cash balance, if there is perfect match between cash inflows and cash outflows. Otherwise, there is a need to manage cash balance for managing. 2. Short Costs: This is another factor to be considered while determining the cash needs. Short costs are those costs that arise with a short fall of cash for the firm s requirements. Shortage of cash can be found through preparation of cash budget. Cash shortage is not cost free; it involves cost whether it is expected or unexpected shortage. The expenses incurred as a result of shortfall are called short costs. They include the following: i. Cost of transaction: Whenever there is a shortage of cash it should be financed. Financing may be done through the borrowings from banks or sale marketable securities. If the firm is planning to finance the deficit cash by sale of marketable securities, then the firm is expected to spend some expenses from brokerage. 7

8 ii. Cost of borrowings: If the firm does not have marketable securities with it, then it prefers borrowing as a source of financing, shortage of cash. It involves costs like interest on loan, commitment charges and other expenses relating to the loan. iii. Cost of deterioration of the credit rating: Generally credit rating is given by credit rating agencies. Low credit rating firms may have to go for bank loans with high interest charges, since they cannot raise the required amount from the public. Low credit rating may also leads to stoppage of supplies, demands from cash payment, refusal to sell, loss of image and attendant decline in sales and profits. iv. Cost of loss of cash discount: Sufficient cash helps to get cash discount benefits, but shortage of cash cannot help to obtain cash discounts. v. Cost of penalty rates: Whenever there is shortage of cash firm may not be able to honor current returned obligations, which in turn demand penalty. 3. Surplus Cash Balance Costs: It is self-explanatory. It means that the cost associated with excess or surplus cash balance, cash is not an earning asset surplus cash funds are idle, an impact of idle cash is that the firm losses opportunities to invest those funds and thereby lose interest, which would otherwise have been earned. 4. Management Costs: Management Costs are those costs involved with setting up and operating cash Management staff. These casts are generally fixed over a period, and are mainly include staff salary, storage handling cost of security and so on. Activity 4.1 Describe the following factors that determine the cash needs of an organization: 1. Short costs 2. Management costs 3. Synchronization of cash flows 8

9 4.5 PROBLEMS OF CASH MANAGEMENT: The problem of cash management can be examined under four heads. They are: 1. Controlling level of cash: One of the fundamental objectives of cash management is the minimization of the level of cash balance with the firm. This goal can be accomplished in the following ways: i. Preparing cash budget: Cash budget is an important device to forecast the predictable discrepancies between cash inflows and cash outflows. It reveals the timing and size of net cash flows and the periods during which excess cash may be available for temporary investment. In large firms, the preparation of cash budget is almost a full-time exercise and it is a common practice to delegate this responsibility to the controller or the treasurer. But in the case of small firms its preparation is relatively a minor job as it does not involve much of complications. ii. Providing for unpredictable discrepancies: Although cash budget predicts discrepancies between cash inflows and outflows on the basis of normal business activities, it does not consider discrepancies between cash inflows and outflows through unforeseen situations such as strikes, short-term recession, floods, etc. These unforeseen events can either interrupt cash or cause sudden outflow. Thus a certain portions of cash balance is to be kept for meeting such contingencies and this amount is fixed on the basis of past experience and some intuition regarding the future. iii. Availability of other sources of funds: A firm may have external sources to obtain funds on short notice. If a firm has to pay a slightly higher rate of interest than that on a long-term debt, it can avoid holding unnecessary large balance of cash. iv. Consideration of short costs: The cost which incurs as a result of shortage of cash is called the short cost. Such costs may arise in any of the following forms: a. If a firm fails to meet its obligation in time, the creditors may file suit against it. In such a situation, the cost is incurred in terms of fall in the firm s reputation apart from financial costs to be incurred in defending the suit. b. Sometimes, a firm may resort to borrowings at high rates of interest. In such a situation, if the firm fails to meet its obligation to bank in time, it is required to pay penalties. 2. Controlling inflows of cash: In order to manage cash efficiently, the process of cash inflow can be accelerated by way of systematic planning and redefined techniques. Thus an important problem for the financial manager is to control cash inflows. He has to devise action not only to prevent 9

10 fraudulent diversion of cash receipts but also to speed up collection of cash. However, the proper installation of internal can minimize the possibility of misuse of cash. Moreover, collection of cash can be expedited through the adoption of various techniques such as: i. Concentration banking: It is a system of decentralizing collection of accounts receivables in the case of big firms having business spread over a large area. Under this system, the firm establishes a large number of collection centers in different areas selected on geographical basis and opens its bank accounts in local banks of different areas. These collection centers are required to collect and deposit remittances in local banks and from the local banks they are transferred to the firm s head office bank. However, fast movement of funds is effected by means of wire transfer or telex. The system of concentration has the following advantages: a. Reduction of mailing time: b. Reduction of time required to collect cheques c. Expediting collection of cash ii. Lock-box system: Lock-box is a post office maintained by a firm s bank that is used as a receiving point for customer remittance. Lock-box system is another step in expediting collection of cash. This system is developed to eliminate the time gap between the actual receipt of cheques by a collection center and its actual depositing in the local bank account under concentration banking. Under lock-box system, the firm hires a post office and instructs its customers to mail their remittances to the box. The firm s local bank is given the authority to pick up the remittances directly from the local box. The bank collects from the box several times a day. It deposits the cheques, clears them locally and credits the cash in the firm s account. Local banks are given standing instructions to transfer funds to the head office when they exceed a particular limit. The following are the advantages of lock-box system: a. It helps to eliminate time lag between the receipt of cheques by a firm and their deposit into the bank. b. This system helps to reduce the overhead expenses. c. It facilitates control by separating remittance from the accounts section. d. It also helps to reduce the credit losses by speeding up the time at which data are posted to the ledger. 3. Control over cash outflows: In order to conserve cash and reduce financial requirements, the firm should have strong control over its cash outflows or disbursements. It aims at slowing down disbursements as much as possible as against the maximum acceleration of collection in the 10

11 case of control over inflows. However, the combination of fast collections and slow disbursements will result in the maximum availability of funds. A firm can beneficially control outflows if the following points are considered: i. The firm should follow the centralized system for disbursements as against decentralized system for collections. Under centralized system, as all payments are made from a single control account, there will be delay in presentation of cheques for payment by parties who are away from the place of account control. ii. The financial manager should generally stress on the value of maintaining careful controls over the timing of payments so as to ensure that bills are paid only as they become due. When a firm makes payment on due dates, it should neither lose cash discount nor its prestige on account of delay in payments. Thus all payments should be made on the due dates, neither before nor after. iii. The firm should adopt the technique of playing float for maximizing the availability of funds. The term float refers to the amount tied up in cheques that have been drawn but have not been presented for payment. Usually, there is a time gap between the issue of cheque by the firm and its actual presentation for payment. Consequently, the firm s actual balance at bank is greater than the balance shown by its books. The longer the float period, the higher the benefit to the firm. 4. Investing surplus cash: Cash in excess of the firm s normal cash requirement is surplus cash. It may be temporary or it may exist more or less on permanent basis. Temporary cash surplus is composed of funds that are available for investment on a short-term basis as they are required to meet regular obligations such as dividend and tax liabilities. Cash surplus may also be maintained more or less permanently as a hedge against unforeseen heavy expenses. Cash may also be accumulated over several years as a measure of a long-term plan. Explain the following: 1. Concentration banking 2. Lock - box system Activity

12 4.6 LET US SUM UP FOR CASH MANAGEMENT: Cash is your business's lifeblood. Managed well, your company remains healthy and strong. Managed poorly, your company goes into cardiac arrest. If you haven't considered cash management an important issue, then you're probably undermining your business's short-term stability and its long-term survival. A control of the cash position is a vital aspect of the financial management of a concern. There should be a balance between cash and cash demanding activities operations, capital additions, etc. The objectives of cash management are to make the most effective use of funds, on the one hand, and accelerate the inflow and decelerate the outflow of cash on the other. 4.7 CHARACTERISTICS OF RECEIVABLES: 1. Risk involvement: Receivables involve risk; since payment takes place in future and future is uncertain, so they should be carefully analyzed. 2. Based on economic value: Accounts receivables are based on economic value. The economic value in goods or services passes to the buyer currently in return the seller expects an equivalent value from the buyer latter 3. Implies futurity: Buyer will make cash payment of the goods or services received by him or her in a future period i.e. generally after a credit period. Enumerate the characteristics of receivables. Activity OBJECTIVES OF RECEIVABLES MANAGEMENT: 1. Maximizing the value of the firm: The basic objective of debtors management is to maximize the value of the firm by achieving a trade-off between liquidity (risk) and return. The main purpose of receivables management is to minimize the risk of bad debts and maximization of order. 12

13 Efficient management of receivables expands sales by retaining old customers and attracting new customers. 2. Optimum investment in sundry debtors: Credit sales expand, but they involve block of funds, that have an opportunity cost, which can be reduced by optimum investment in receivables. Providing liberal credit increases sales consequently, profits will increase, but increasing investment in receivables result in increased costs. 3. Control and the cost of credit: When there are no credit sales, there will not be any trade credit. But credit sale increases profits. It is possible only when the firm is able to keep the costs at minimum. 4.9 COSTS OF ACCOUNTS RECEIVABLES MANAGEMENT: Management of Accounts Receivables is not free. The following are the main costs associated with accounts receivables management: Opportunity Cost Collection Cost Bad Debts Chart 4.2 Costs of Accounts Receivables Management 1. Opportunity Cost/ Capital Cost: Providing goods or services on credit involves block of firm s funds. In other words, the increased level of accounts receivables is an investment in current assets. These blocked funds or investment in receivables need to be financed, by shareholders funds or from short-term borrowings. They involve some cost. If they are financed by borrowed funds, it involves payments of interest, which is also a cost. 13

14 2. Collection Cost: Collection of receivables is one of the tasks of receivables management. Collection costs are those costs that are increased in collecting the debts from the customers to whom the credit sales have been granted. The collection costs may include staff, records, stationary, postage etc., they are related to maintenance and credit department, and expose the details involved in collecting information about prospective customers, from specialized agencies, for evaluation of prospective customer before going to grant credit. 3. Bad Debts: Sometimes customer may not be able to honor the dues to the firm because of the inability to pay. Such costs are referred as bad debts, and they have to be written off, because they cannot be collected. These costs can be reduced to some extent, if the firm properly evaluates customer before granting credit, but complete avoidance is not possible BENEFITS OF ACCOUNTS RECEIVABLE MANAGEMENT: Accounts Receivables Management involves not only costs but also benefits. The benefits are: 1. Increased Sales: Providing goods or services on credit expands sales, by retaining old customers and attraction prospective customers. 2. Increased Market Share: When the firm s able to retain old customers and attract new customers automatically market share will be increased to the extent new sales. 3. Increase in profits: Increase sales, leads to increase in profits, because it need to produce more products with a given fixed cost and sales of products with a given sales network in both cost per unit comes down and the profit will be increased FACTORS INFLUENCING THE SIZE OF INVESTMENT IN RECEIVABLES: The level of investment in rebels is affected by the following factors: a) Volume of credit sales: 14

15 Size of credit sales is the prime factor that affect the level of investment in receivables investment in receivables increase when the firm sells major portion of goods on credit base and vice versa. In other words an increase in credit sales, increase the level of receivables and vice-versa. b) Credit policy of the firm: There are two types of credit policies such as lenient and stringent credit policy. A firm that is following lenient credit policy tends to sell on credit to customers very liberally, which will increase the size of receivables on the other hand, a firm that following stringent credit policy will have low size of variables because the firm is very selective in providing of stringent credit. A firm that is providing stringent credit, may be able to collect debts promptly this will keep the level of receivables under control. c) Trade terms: It is the most important factor in determining the level of investment in receivables. The important credit terms are credit period and cash discount. If credit period is more when compared to other companies/industry, then the investment in receivables will be more. Cash discount reduces the investment in receivables because it encourages yearly payments. d) Seasonality of business: A firm doing seasonal business has to provide credit sales in the other seasons. When the firm provides credit automatically the level of investment in receivables will increase with the comparison of the level of receivables in the season; because in season firm will sell goods on cash basis only. For example, refrigerators, air cooling products will be sold on credit in the winter season and on cash in summer season. e) Collection policy: Collection policy is needed because all customers do not pay the firm s bill in time. A firm s liberal collection policy will not be able to reduce investment in receivables, but in future sales may be increased. On the other hand, a firm that follows stringent collection policy will definitely reduce receivables, but it may reduce future sales. Therefore, collection policy should aim at accelerating collections from slow payments and reducing bad debts base. f) Bill discounting and endorsement: Bill discounting and endorsing bill to the third party, which the firm has to pay will reduce the size of investment in receivables. If the bills are dishonored on the due date against the investment in receivables will increase because discounted bills or endorsed bills have to be paid by the firm. 15

16 Activity 4.4 Explain the various factors that are considered while deciding the size of investment in receivables management MODES OF PAYMENT: The economic value of goods on services sold on credit will be paid by adaptation of different modes: a) Cash Mode: Whenever a firm sells goods or services on cash terms, the value of goods or services will be received either cash in advance or on delivery. Receipt of advance is necessary whenever the goods are manufactured on a special order. It is for financial production and to avoid the non-acceptability goods ordered by the order or buyer. Immediate cash payment will take place only when the seller has high bargaining power due to monopoly power or the customer is a risky customer. b) Open Account: Majority of the sales takes place on an open account mode. Open account means after the sales and purchase agreement between seller and buyer, the seller first shifts goods and he sends the invoice(bill) which consists of credit terms, credit period allowed, cash discount for early payment and the period of cash discount offered, quality of goods with their total value and so on. The invoice is generally acknowledged by the buyer. (Cash discount: it is the discount allowed to buyer for an early payment). c) Bill of Exchange: A bill of exchange represents an unconditional order issued by the seller asking the bill to pay the amount maintained on it as per demand at a certain future date. This type of demand is made only when the seller does not strong evidence of the buyer s obligation. Hence, there is a need of secret arrangement in the form of bills of exchange. d) Letter of Credit: It is a formal document issued by a bank on behalf of customer, stating the conditions under which the bank will honor the commitments of its customer. Payment through the letter of credit arises whenever trade takes place at international level, but 16

17 now-a-days it has been used in domestic trade also. In other words, letter of credit is issued when a unknown people are involved in the contract. e) Consignment: In consignment business, consignor sends goods to consignee (agent of the seller). In this case, goods sent are just shipped but not sold to the consignee since the consignor retains the title of the goods till they sold by the consignee to a third party. In these consignments only sales proceeds are remitted to the consignor by the consignee. Activity 4.5 According to you, which one of the above modes of payments are best suitable and convenient for the organizations? 4.13 CREDIT POLICY: A firm s credit policy depicts details regarding its credit standards, credit period, cash discounts and collection procedures. The credit policy may be lenient or stringent. Types of Credit Policy Lenient Credit Policy Stringent Credit Policy Chart 4.3 Types of Credit Policy I. Lenient/Liberal Credit Policy: It is that policy where the seller sells goods on very liberal credit terms and standards. In other words, goods are sold to the customer whose credit worthiness is not upto the standards or whose financial position is doubtful. 17

18 Advantages of Lenient or Liberal credit policy: i. Increase in sales: This policy expands sales because of the liberal credit terms and favorable incentives granted to customers. ii. Higher profits: Increase in sales leads to increase in profits, because higher level of production and sales reduces permit cost. Disadvantages of Lenient or Liberal credit policy: i. Bad debts loss: A firm that follows lenient policy may suffer from bad debt loss that arises due to non-payment of credit sales. ii. Liquidity problem: Lenient credit policy not only increases bad debts losses but also creates liquidity problem, because when the firm is not able to receive the payment at a due date, it may become difficult to pay currently maturing obligations. II. Stringent Credit Policy: Here, seller sells goods on a highly selective basis only i.e. the customers who has proven credit worthiness and financially sound. Advantages of Stringent credit policy: i. Less debt losses: A firm that adopts stringent policy will have minimum bad debt losses, because it had granted credit only to the customers who are credit worthy. ii. Sound liquidity position: The firm that allows stringent policy will have sound liquidity position due to the receipt of all payments from customers on due date, the firm can easily pay the currently maturing obligations. Disadvantages of Stringent credit policy: i. Less sales: This policy restricts sales, because it is not extending credit to average creditworthiness customers. 18

19 ii. Less profits: Less sales automatically reduce profits, because firm may not be able to produce goods economically and it may not be able to use resources efficiently that leads to increase in production cost per unit. Activity 4.6 If you were a finance manager of a trading company, which one of the above mentioned types of credit policies you would adopt? Justify your answer with suitable reasons AREAS COVERED BY RECEIVABLES MANAGEMENT OR COMPONENTS OF RECEIVABLES MANAGEMENT: The Receivables Management may be concerned with the following aspects: A. Credit Analysis: Even though the intention of the company will be to increase the profit by increasing the sales, the company will not like to sale its products to any customer who comes its way. From this the company has to decide the customers to whom it should sell its products on credit. The credit should be extended only to those customers whose creditworthiness is established. From this, the company may consider various factors like, financial status of the customer, reputation, record of previous dealings, quality and character of management running the business of the customer etc. more information can be stored from following sources: i. Trade references: The company can ask the prospective customer to give trade references. The company may insist that the references should be given of those names who are currently dealing with the company. The company can obtain the information from these references, either by personal interviews or sending short questionnaires while doing this honesty, seriousness, integrity of the references should be examined. ii. Bank references: The company can ask the prospective customer to instruct its banker to give the relevant information to the company. In this case, there may be two problems. Firstly, the banker of the prospective customer may not give clear 19

20 answers to the enquiries made by the company. Secondly, even though the Bank of the prospective customer certifies the proper conduct of the account, it may not mean that he will settle his dues of the company in time. iii. iv. Credit bureau reports: Authentic information about customers can be taken from the bureau reports. In some cases, the associations for some specific industries maintain credit bureau which may give useful and authentic information about their members. Financial statements: This is one of the easiest ways to obtain the information about the credit worthiness of the prospective customer. The information from public and private limited companies can be obtained through financial statements like Profit and loss accounts, Balance sheet etc. v. Past experience: Past experiences with existing customers may help to get information relating to their credit worthiness. vi. Salesman s interviews and reports: Many a times, the company s may depend upon the reports given by the sales personnel for evaluating the credit worthiness of the customers. B. Credit terms: Credit terms indicate the terms on which the company should extend the credit to the customer. It includes: i. Credit period: Credit period is the time allowed by the company to the customer to pay their dues. The duration of this credit depends upon various factors: a) In case of the products having inelastic demand, the credit period may be small. b) Credit period may depend upon the nature of industry. In the buyers market, company may be required to offer more credit period. Whereas in the sellers market, the company may afford to offer smaller credit period. c) Decision regarding credit period may be affected by the management s attitudes. If it is aggressive, it may offer more credit period to increase sales and profits. However if management attitude is conservative, it will like to reduce the credit period. 20

21 d) Lastly, it will also depend upon the amount of funds available and also upon possible bad debts losses. ii. iii. Credit limit: Credit limit is the percentage of credit amount allowed by the company to the customers. For example, a company may decide a certain fixed percentage of credit to be given to its customers, say 50% credit and remaining amount in cash. This again depends upon many factors. Discount policy: Discounts are usually allowed to speed up the collection process and to induce the customers to pay the due early. The decisions regarding the rate of discount and period of discount depend upon the usual cost benefit consideration i.e. the cost of carrying the debts on one hand and on other hand, the benefits received from getting the amount released from the debtors immediately, which may be available for some different and beneficial use. C. Credit Collection: This indicates the steps taken by the company to collect the dues from the customer. For this purpose, the company may follow the standard practices of reminding the customer just before the due date. This can be done by sending the reminder letters, or making telephone calls or by paying the personal visits. The customers who are slow paying ones should be handled properly. If they are permanent customers, they may object too harsh collection procedure and the company may lose them ultimately. The company should understand their problem for certain defaulters company may ask help of factoring services. D. Financing the Receivables: Whichever sources are available to the company for financing the working capital requirement, are equally the sources available for financing the receivables. This is due to the fact that receivables are a part of working capital. However, following sources may be identified as the sources available for financing the financing the receivables particularly. i. Bill discounting. ii. Cash credit against hypothecation of book debts as the security. iii. In the recent times, factoring has become one of the sources available for financing the receivables. 21

22 Activity 4.7 Can you list any 3 important components or terms which according to you have been the most significant in making a credit sale successful? E. Monitoring the Receivables: It may be necessary to ensure that the outstanding receivables are within the framework of the credit policy decided by the company. For this, the company may be required to apply regular checks and have a regular statement to monitor the receivables properly. For this, the company may use the following techniques: i. Techniques available on macro basis: One of the most common methods to monitor the receivables on macro basis is to calculate the average collection period (ACP) which effectively indicate the period taken by the customers to make payment to the company or the average period of credit allowed by the company to the customer. ii. Techniques available on micro basis: Considering the limitations associated with ACP. It may not be a tool available to monitor the receivables on micro basis. For this, the calculation of age-wise analysis of receivables may be made. Age-wise analysis of the receivables involve the classification of outstanding receivables at the given point of time (say at the end of every month) into the different age groups (age i.e. number of days). Percentage of receivables falling under each age group may also be calculated. For example: Age Group (Number of days) Less than 30 days 31 to 60 days 60 to 90 days More than 90 days Amount in percentage Now, if the normal credit period offered by the company to the customer is 30 days, any amount which is outstanding for more than 30 days is definitely indicating the inefficiency on the part of collection department of the company in collecting receivables. Hence, it provides superior information. 22

23 Activity 4.8 Explain the concept of Average Collection Period (ACP) with a suitable example from an organization which is known to you LET US SUM UP FOR RECEIVABLES MANAGEMENT: Accounts receivable is a permanent investment in the business. As old accounts are collected, new accounts are created. Accounts receivable is a major component of the current assets. This account emerges because of the existence of credit sales. As this account constitutes a major share it has got a greater significance in working capital management. Credit sales no doubt increases turnover and profit of the business. But carrying permanently the accounts receivable in the firm involves greater risk. Hence there is a need for management to establish the level of accounts receivable. In short, receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. The purpose of maintaining or investing in receivables is to meet competition, and to increase the sales and profits COMPONENTS OF INVENTORY: Raw Materials Work-in- Process Components of Invnetory Stores and Spares Finished Goods Chart 4.4 Components of Inventory 23

24 1. Raw materials: Raw materials are those inputs that are converted into finished goods throughout manufacturing or conversion process. Those form a major input for manufacturing a product. In other words, they are very much needed for uninterrupted production. 2. Work-in-process: Work in- process is a stage of stocks between raw materials and finished goods. Work-in-process inventories are semi-finished products. They represent products that need to undergo some other process to become finished goods. 3. Finished products: Finished products are those products which are completely manufactured and ready for sale. The stock of finished goods provides a buffer between production and market. 4. Stores and spares: It includes office and plant cleaning materials like soap, brooms, oil, fuel, light, bulbs etc. and are purchased and stored for the purpose of maintenance of machinery MOTIVES OF INVENTORY MANAGEMENT: Managing inventories involves lack of funds and inventory holding costs. Maintenance of inventories is expensive, then why should firms hold inventories. There are three general motives: i. The transaction motive: The company may be required to hold the inventories in order to facilitate the smooth and uninterrupted production and sales operations. It may not be possible for the company to procure raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Hence it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence, it is needed to hold the finished goods inventory. The need to hold work-in-progress may arise due to production cycle. ii. The precautionary motive: 24

25 In addition to the requirement to hold the inventories for routine transactions, the company may like to hold them to guard against the risk of unpredictable changes in demand and supply forces. E.g. the supply of raw material may get delayed due to the factors like strike, transport disruption, short supply, lengthy processes involved in import of the raw materials etc. iii. The speculative motive: The company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purposes. This may be with intention to get the advantages in terms of quantity discounts connected with bulk purchasing or anticipated price rise. Activity 4.9 According to you, which one of the above metioned objectives is very significant for inventory management? 4.18 OBJECTIVES OF INVENTORY MANGEMENT: The objectives of inventory management may be viewed in two ways and they are operational and financial: A. The operational objective is to maintain sufficient inventory, to meet demand for product by efficiently organizing the firm s production and sales operations, and B. Financial view is to minimize inefficient inventory and reduce inventory-carrying costs. These two conflicting objectives of inventory management can also be expressed in terms of cost and benefit associated with inventory. The firm should maintain investments in inventory which implies that maintaining an inventory involves cost such that smaller the inventory the lower the carrying cost and vice-versa. But inventory facilitates the smooth functioning of the production. Effective inventory management should ensure: i. A continuous supply of raw materials and supplies to facilitate uninterrupted manufacturing. ii. Maintaining sufficient stock of raw materials in periods of short supply and anticipate price changes. 25

26 iii. Maintaining sufficient finished goods inventory for smooth sales operation, and efficient customer service. iv. Minimize the carrying cost and time, and v. Control investment in inventories and keep it at an optimum level. vi. Others: apart from the above, the following are also objectives of inventory management; control of cost, control of materials cost, elimination of duplication in ordering by decentralization of purchasers, supply of right quality of goods of reasonable price provide data for short term and long term for planning control of inventories. Therefore, management of inventory needs careful and accurate planning so as to avoid both excess and inadequate inventory in relation to the operational requirement of a firm. To achieve higher operational efficiency and profitability of a firm, it is very essential to reduce the amount of capital locked up in inventories. This will not only help in achieving higher return on investment by minimizing tied up working capital, but will also improve the quality position of the enterprise BENEFITS OR ADVANTAGES OF HOLDING INVENTORY: Optimum level of inventory is that level where the total cost of inventory is less. The major benefits of inventory are the basic functions of inventory. Proper management of inventory will result in the following benefits to a firm: i. Inventory management ensures an adequate supply of materials and stores minimize stock outs and shortages and avoid costly interruption in operations. ii. It keeps down investment in inventories; inventory carrying costs, and obsolescence losses to the minimum. iii. It facilitates purchasing economies throughout the measurement of requirements on the basis of recorded experience. iv. It eliminates duplication in ordering stock by centralizing the source from which purchase requisition emanate. v. It permits better utilization of available stock by facilitating inter-department transfers within a firm. vi. It provides a check against the loss of materials through carelessness or pilferage. vii. Perpetual inventory values provide a consistent and reliable basis for preparing financial statements a better utilization. 26

27 4.20 DISADVANTAGES OR RISKS OF HOLDING INVENTORY: Holding of inventories involves the different costs, they also exposes the firm to take some risks. Risk in inventory management refers to the chance that inventories cannot be turned over into cash through normal sales without loss. Risks associated with inventory management are as follows: i. Price decline: Price decline is the result of more supply and less demand. In other words, it may be the result due to introduction of competitive product. Generally, prices are not controllable in the short run by the individual firm. Controlling inventory is the only way that a firm can counter act with these risks. On the demand side, a decrease in the general market demand when supply remains the same may also cause price to increase. This is also a long run management problem, because decrease demand may be due to change in customer buying habits, tastes and incomes. ii. iii. Product deterioration: Holding of finished goods for a long period or shortage under improper conditions for light, heat, humidity and pressures lead to product deterioration. For example: Cadbury s chocolate. Recently, there were some live worms in chocolate; it was due to improper storage. Deterioration usually prevents selling the product through normal channels. Product obsolescence: Product may become obsolete due to improved products, changes in customer tastes, particularly in high style merchandise, changes in requirements etc. This risk may prove very costly for the firms whose resources are limited and tied up in slow moving inventories. Obsolescence cost risk is least controllable except by reduction in inventory management. Activity 4.10 Enlist the different benefits and risks of managing inventory NEED FOR BALANCED INVESTMENT IN INVENTORY: Management of optimum level of inventory investment is the prime objective of inventory management. Inadequate or excess investment in inventories is not healthy by for any firm. In other words a firm should avoid inadequate investments or excess investment in 27

28 inventory. The investment in inventories should be sufficient. The optimum level of investment in inventories lies between excess investment and inadequate investment. A. Dangers of Excessive Investment in Inventory: The following are the dangers of excessive investment in inventory: i. The excessive level of inventories consumes funds of the company, they cannot be used for any purpose since they have locked in inventory, and they involve an opportunity cost. ii. The excessive investment in inventory increases carrying costs that include cost of storage, capital cost (interest on capital in inventories, insurance, handling, recording, inspection, obsolescence cost, and taxes). These costs will reduce the firm s profits. iii. Carrying excessive inventory over a long period leads to the loss of liquidity. It may not be possible to sell the inventories in time without loss. iv. Another danger of carrying excessive inventory is the physical deterioration of inventories while in storage. In case of certain goods or raw materials, deterioration occurs with the passage of time or it may be due to mishandling and improper storage facilities. v. Excess purchases or storage leads to theft, waste and mishandling of inventories. B. Dangers of Inadequate investment in Inventory: Under investment in inventory is also not healthy one. It has more negative points, they are: i. Inadequate raw materials and work-in-progress inventories will disturb production. ii. When the firm is not able to produce goods without interruption that leads the inadequate storage of finished goods. If finished goods are not sufficient to meet customer demand, the customers may shift to the competitors, which will lead to loss of customers permanently. Activity 4.11 What will happen if an organisation maintains an excessive amount of inventory? Comment TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT: 28