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.

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 goods and services is so common that it is taken for granted. Selling goods or providing services on credit basis leads to accounts receivable. When consumers expect credit, business units in turn expect credit from their suppliers to match their investment in credit extended to consumers. The granting of credit from one business firm to another for purchase of goods and services is popularly known as trade credit. 11 Management of Working Capital

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.

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.

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

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. ii. iii. i. ii. Cash flows into and out of the firm Cash flows within the firm and Cash balances held by a firm at a point of time. Cash is used for paying the firms obligation Cash is an unproductive asset, you need to invest it somewhere

Cash management is important because:

iii. iv.

It is difficult to predict cash flows accurately as there can not be perfect coincidence between the inflows and outflows of cash 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. ii. iii. iv. Cash planning: Cash surplus or deficit for each period should be planned; this can be done by preparing the cash budget. Managing the cash flows: The firm should try to accelerate the inflows of cash flow while trying to minimize the outflows. Optimum cash level: The cost of excess cash and the dangers of cash deficit should be matched to determine the optimum level. 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.

WHY DOES A FIRM NEED CASH?

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

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 the companys 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.

ITEMS Cash sales Collection of a/cs receivables Interest and dividend receipts Increase in loans/deposits and issue of securities Sale of assets

BASIS OF ESTIMATION Estimated sales and its division between cash/credit sales Estimated sales, its division between cash and credit sales, and collection pattern Firms portfolio of securities and return expected from the portfolio Financing plan Proposed disposal of assets Estimated purchases, its division between cash/credit purchases, and terms of credit purchases. Estimated purchases and its division between cash/credit purchases. Manpower employed and wages and salaries structure Production plan Administration and sales personnel and proposed sales promotion and distribution expenditure. Capital expenditure budget and payment pattern associated with capital equipment purchases Financing plan

Cash purchases Payment for purchases Wages and salaries Manufacturing expense General, administration and selling expenses Capital equipment purchases Repayment of loans and retirement of securities

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

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

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.

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

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.

% OF INVENTORY
INDUSTRY

TO ASSETS

CURRENT

Tea plantation, edible vegetables, hydrogenated oils, sugar, cotton, jute and woolen textiles, nonferrous metals, transport equipments, engineering workshops etc Printing and publishing, electricity generation and supply, trading and shipping industries. Tobacco 30 % 76 % 60 %

Need to hold inventory: Though maintaining inventories holds up companies cost, yet holding inventories is unavoidable.

Process or movement inventories are required because it takes time to complete a process/operation and to move products from one stage to another. The average qty of such inventory would be equal to:

Avg. o/p of the process (avg. usage at the end of the movement) * time require for the (Or time required in movement.)

process.

For Ex1: if the avg. output of the process is 300 units per day and the process time is 5 days, the avg. process inventory would be 1500 units. Organization inventories are maintained to widen their latitude in planning and scheduling successive operations. Raw material inventories help to maintain flexibility in purchasing; you need to have raw material stock so that it can be used for production as and when required. WIP inventories help to maintain production flexibility. Where as finished goods inventory help to maintain marketing and selling flexibility. It helps them to meet the customer demand as and when it comes, since it is not possible to instantaneously produce the goods on demand.

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.?

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 an increased 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.

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.

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 of liquidity. 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.

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. ii. iii. iv. Character- the willingness of the customer to pay Capacity- the ability of the customer to pay Conditions- the prevailing economic conditions Capital- the financial reserves of a customer. If the customer has paying from operating cash flow, the focus shifts to its capital. v. Collateral- The security offered by the customers. difficulty in

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 credit investigation 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:

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, otherwise not. 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

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

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

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 the important 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.

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).

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

CREDIT TERMS The stipulations under which the firm sells on credit to customers are called credit terms. 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 for granting credit to individual customers and collecting individual accounts should be laid down. The credit evaluation procedure includes: 1. Credit information. 2. Credit investigation.

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.

 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 the quality 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.