Financial Management II

Chapter One
Dividend policy and theory
 Types of Dividends
Dividend may be distributed among the
shareholders in the form of cash or stock. Hence,
dividends are classified into:
1.Cash dividend
2.Stock dividend
3.Bond dividend
4. Property dividend
1.Cash dividend
• If the dividend is paid in the form of cash to the shareholders, it is
called cash dividend. It is paid periodically out the business enterprises
EAIT (Earnings after interest and tax).
• Cash dividends are common and popular types followed by majority
of the business enterprises. Cash dividends return profits to the owners
of a corporation.
• When cash dividend is distributed, both total assets and net worth of
the company decrease. Total assets decrease as cash decreases and net
worth decreases as retained earnings decrease. The market price per
share also decreases in most cases by the amount of cash dividend
distributed.
• Market price per share after cash dividend = Marker price per share
before cash dividend - dividend per share
The basic types of cash dividends are as
follows:
A. Regular cash dividend
B. Extra cash dividend
C. Special dividend
D. Liquidating dividend
Con’t…
• Regular Cash Dividend It is the dividend that is normally expected to be paid by
the firm. The most common type of cash dividend is a regular cash dividend, which
is a cash payment made by a firm to its stockholders in the normal course of
business. Most dividend paying companies issue a regular cash dividend four times
a year.
• Extra Cash Dividend A nonrecurring dividend paid to shareholders in addition to
the regular dividend. It may or may not be repeated in the future.
• Special Dividends A special dividend, like an extra dividend, is a one-time payment
to stockholders. It is tend to be considerably larger than extra dividend and to occur
less frequently. They are used to distribute unusually large amounts of cash.
• Liquidating Dividend Another form of dividend is a liquidating dividend, which is
any dividend not based on earnings. It is a dividend that is paid to stockholders
when a firm is liquidated. It implies a return of the stockholders’ investment rather
than of profits. For example, liquidating dividends may result from selling off all or
part of the business and distributing the funds to shareholders.
 2. Stock Dividend
Stock dividend – is a payment of additional shares of stock to
shareholders. It is often used in place of or in addition to a cash dividend.
• It is one type of “dividend” that does not involve the distribution of
value. When a company pays a stock dividend, it distributes new shares
of stock on a pro-rata basis to existing stockholders. The only thing that
happens when the stock dividend is paid is that the number of shares
each stockholder owns increases and their value goes down
proportionately. The stockholder is left with exactly the same value as
before.
• Due to stock dividend, retained earnings decrease, common stock and
paid in capital increase. The stock dividend does not affect the equity
position of stockholders. Market price per share and earnings per share
after stock dividend will decrease.
• Marker price per share after stock dividend = Market price per share
before stock dividend /1 + stock dividend in fraction
Con’t…
Advantages
A. It preserves the company's liquidity as no cash leaves the company. The
shareholders receive a dividend which can be converted into cash whenever
he wishes through selling the additional shares.
B. It broadens the capital base and improves image of the company.
C. It reduces the marker price of the shares, rendering the shares more
marketable.
D. It is an indication to the prospective investors about the financial
soundness of the company.
E. The shareholders can take the advantage of tax saving from stock dividend.
Disadvantage
.The future rate of dividend will decline.
.The future market price of share falls sharply after bonus issue.
.Issue of bonus shares involves lengthy legal procedures and approvals.
3. Bond dividend
• Bond dividend is also known as script dividend. If the company does
not have sufficient funds to pay cash dividend, the company promises
to pay the shareholder at a future specific date with the help of issue of
bond or notes
4. Property Dividend
Property dividends are paid in the form of some assets other than cash.
It will distribute under the exceptional circumstance.
Benefits and Costs of Dividends
• Dividends may attract investors who prefer to receive income directly
from their investments. However, the tax costs of dividends may drive
away other investors.
• Dividends can function as a signal to investors that the company is
performing well and has higher than expected cash flows.
• Dividends can help align manager and stockholder incentives. By
issuing dividends and raising capital through equity issues (rather than
internal funds), managers are subject to more scrutiny. This increases
the incentives for managers to perform well.
• Dividends reduce equity claims on the company; this can help
managers achieve the target capital structure suggested by the trade-off
theory.
Some costs associated with dividends include
• Taxes: Dividends have historically taxed at a higher rate than other
forms of income.
• Reinvestment costs: Investors who don’t intend to spend the cash must
pay the transactions costs associated with reinvesting (brokerage fees,
etc.).
• Increased cost of debt: By reducing the amount of equity through a
dividend issue, the firm becomes more leveraged. If the increase is
significant, this could increase the risk associated with the company
and increase the cost of debt should the company desire to borrow.
Dividend Payment Procedure
The four important dates associated with a dividend payment are as follows.
• Declaration date. The declaration date is the date when the board of directors announces the
dividend payment.
• Ex-dividend date. The ex-dividend date is the cut-off date for receiving the dividend. That is, the
ex-dividend date is the first date on which the right to the most recently declared dividend no
longer goes along with the sale of the stock. Companies and exchanges report the ex-dividend date
to remove any ambiguity about who will receive a dividend after the sale of a stock. Investors who
buy the stock before the ex-dividend date are entitled to the dividend, while those who buy shares
on or after the ex-dividend date are not.
• Record date. The record date is the date on which an investor must be a shareholder of record to be
entitled to the upcoming dividend. The brokerage industry has a convention that new shareholders
are entitled to dividends only if they buy the stock at least two business days before the record
date. This rule allows time for the transfer of the shares and gives the company sufficient notice of
the transfer to ensure that new stockholders receive the dividend. Therefore, a stock sells ex-
dividend two business days, not calendar days, before the record date. The board of directors sets
the record date, which is typically several weeks after the declaration date.
• Payment date. The payment date is the date when the firm mails the dividend checks to the
shareholders of record. This date is usually several weeks after the record date.
Con’t…
• On June 30, 2009, XYZ Company declared a dividend of Br. 5 per share, payable
on September 1 to the holders of record on August 1. Show the XYZ’s dividend
payment procedure.
Solution Declaration date: June 30, 2009 on which XYZ Company's board of
directors declared a dividend of Br. 5 per share.
Ex-dividend date: July 30, 2009 after which dividends are entitled with the seller of
the stock.
The record date: August 1, 2009 on which company makes a list of shareholders
who are entitled to receive dividend.
Payment date: September 1, 2009 on which XYZ Company mails the cheque of
dividends to the shareholder.
FACTORS INFLUENCING DIVIDEND POLICY
A. Profitable Position of the Firm
B. Sources of Finance
C. Stability of Earnings
D. Legal Constrains
E. Liquidity Position
F. Growth Rate of the Firm
G. Tax Policy
H. Access to the Capital Market
I. Desire of Shareholders
J. Cost of External Financing
K. Degree of Control
 Legal Constrains
• There are certain legal rules that may limit the amount of dividends a
firm may pay. Following are the rules relating to dividend payment:
• Net profit rule: According to this rule, dividends can be paid out of
present or past earnings. Amount of dividends cannot exceed the
accumulated profits. If there is accumulated loss, it must be set off out
of the current earnings before paying out any dividends.
• Insolvency rule: According to this rule, a firm cannot pay the
dividends when its liabilities exceed assets. When the firm's liabilities
exceed its assets, the firm is considered to be financially insolvent.
The firm, financially insolvent, is prohibited by law to pay dividends.
• Capital impairment rule: - According to this rule, a firm cannot pay
dividend out of its paid up capital. The dividend payout that impairs
capital is considered illegal.
Tax Position of Shareholders
• The tax position of shareholders also influences dividend
policy. The company owned by wealthy shareholders having
high income tax bracket tend toward lower dividend payout
where as the company owned by small investors tend toward
higher dividend payout.
Con’t…
How would each of the following changes tend to affect dividend
payout ratio, other things held constant?
• An increase in personal income tax rate.
• A decline in investment opportunities.
• An increase in corporate profit.
• A rise in interest rate.
 ESTABLISHING DIVIDEND POLICY
• Dividends are at the heart of the difficult choice that management
must make in allocating their capital resources: reinvesting the money
within the company or distributing it to shareholders.
• Although paying dividends directly benefits stockholders, it also
affects the firm’s ability to retain earnings to exploit growth
opportunities.
• Dividend policy provides guidelines for balancing the conflicting
forces surrounding the dividend payment versus retention decision.
Dividend policy refers to the payout policy that management follows
in determining the size and pattern of distributions to shareholders
over time.
• The dividend policy question centers on the percentage of earnings
that a firm should pay out
Con’t…
• A finance manager’s objective for the company’s dividend policy is to
maximize owner wealth while providing adequate financing for the
company.
• When a company’s earnings increase, management does not
automatically raise the dividend.
• Generally, there is a time lag between increased earnings and the
payment of a higher dividend. Only when management is confident
that the increased earnings will be sustained will they increase the
dividend.
• Once dividends are increased, they should continue to be paid at the
higher rate
TYPES OF DIVIDEND POLICY
Dividend policy depends upon the nature of the firm,
type of shareholder and profitable position. On the basis
of the dividend declaration by the firm, the dividend
policy may be classified under the following types:
• Residual Dividend approach
• Dividend stability
• A Compromise
Residual-dividend policy
• Residual dividend policy is based on the assumption that investors
prefer to have a firm retain and reinvest earnings rather than pay out
them in dividends.
• Under residual dividend policy, a firm pays dividend only after
meeting its investment need.
• Under residual dividend policy, if the net income exceeds the portion
of equity financing, then the excess of net income over equity need is
paid as dividend.
• The company does not pay any dividend when net income is less than
or equal to equity need for financing the investment proposals. In case,
net income is not sufficient to meet equity need, the company should
raise deficit amount by external equity.
 Stable dividend-per-share policy
Stable dividend policy means payment of certain minimum
amount of dividend regularly. Many companies use a stable
dividend-per-share policy since it is looked upon favorably by
investors.
Dividend stability implies in a low-risk company. Even in a
year that the company shows a loss rather than profit the
dividend should be maintained to avoid negative connotations
to current and prospective investors
Some stockholders rely on the receipt of stable dividends for
income.
A stable dividend policy is also necessary for a company to be
placed on a list of securities in which financial institutions
(pension funds, insurance companies) invest.
 A compromise policy
• A compromise between the policies of a stable dollar amount
and a percentage amount of dividends is for a company to
pay a low dollar amount per share plus a percentage
increment in good years.
• While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of
dividends they are likely to receive. Stockholders generally
do not like such uncertainty.
• However, the policy may be appropriate when earnings vary
considerably over the years.
• The percentage, or extra, portion of the dividend should not
be paid regularly; otherwise it becomes meaningless
 REPURCHASE OF STOCK
• Stock repurchase is method in which a firm buy back shares of its own
stock, thereby decreasing shares outstanding, increasing earnings per
share, and, often increasing the stock price.
• It is an alternative to cash dividends. In a stock repurchase, the company
pays cash to repurchase shares from its shareholders. These shares are
usually kept in the company's treasury and then resold when the
company needs money.
• If a firm has excess cash, it may purchase its own stock leaving fewer
shares outstanding, increasing the earning per share and increasing the
stock price. It may be an alternative to paying cash dividends. The
benefits to the shareholders are the same under cash dividend and stock
repurchase. In the absence of personal income taxes and transaction
costs, both cash dividend and stock repurchase have no any difference to
shareholders.
• Capital gain arising from repurchase should equal the dividend
otherwise would have been paid.
Con’t…
Share can be repurchased in different ways.
• A company can repurchase its shares through authorized
brokers on the open market.
• Shares can be also repurchased by making a tender offer
which will specify the purchases price, the total amount and
the period within which shares will be bought back.
• Similarly, a company can purchase a block of shares from
one large holder on a negotiated basis
 Advantages of repurchase of stock
• A firm can use idle cash to repurchase stock
• Dividend and earnings per share will be increased through
stock repurchase
• Stock repurchase will result in increase in the share value
• The buying shareholders will benefit
• The promoters of the company benefit by consolidating their
ownership and control over companies through stock
repurchase
• Repurchase of stock can remove a large block of stock that is
overhanging the market and keeping the price per share down
 Disadvantages of stock repurchase
• Shareholders may not be indifferent between dividends and
capital gains, and the price of stock might benefit more from
cash dividends than from repurchase.
• The remaining shareholder may lose if the company pays
excessive price for the shares under the stock repurchase
scheme
• Stock repurchase may signal to investors that the company
does not have long - term growth opportunities to utilize the
cash.
• The buyback of shares may be useful as a defense against
hostile takeover only in case of cash rich companies
 STOCK SPLIT
• A stock split is a method to reduce the market price per share by
giving certain number of share for one old share.
• Due to stock split, number of outstanding shares increase and par
value and marker price of the stock decrease.
• A stock split affects only the par value, market value and the number
of outstanding shares.
• The earnings per share will be diluted and market price per share fall
proportionately with a stock split.
Con’t…
Following are the reasons for splitting a firm's ordinary shares:
Stock split results in reduction in market price of the share.
It helps in increasing the marketability and liquidity of a
company's shares.
Stock splits are used by the company management to
communicate to investors that the company is expected to
earn higher profits in future.
Stock split is used to give higher dividends to shareholders.
 Chapter Two

Principles of Working capital Management

Introduction
• Decisions relating to working capital and short term
financing are referred to as working capital
management.
• These involve managing the relationship between a
firm's short-term assets and its short-term liabilities.
• The goal of working capital management is to ensure
that the firm is able to continue its operations and that
it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses
Con’t…
• Working capital is the capital required for day-to-day working of the
concerned organization
Fixed capital
capital working capital
Fixed capital means that capital, which is used for long-term investment
of the business concern. For example, purchase of permanent assets.
Normally it consists of non-recurring in nature.
Working Capital is another part of the capital which is needed for
meeting day to day requirement of the business concern. For example,
payment to creditors, salary paid to workers, purchase of raw materials
etc., normally it consists of recurring in nature.
It can be easily converted into cash. Hence, it is also known as short-
term capital.
Definition

• Mead, Baker and Malott, “Working Capital means Current Assets”

• J.S.Mill, “The sum of the current asset is the working capital of a
business”
• Weston and Brigham, “Working Capital refers to a firm’s investment in
short-term assets, cash, short-term securities, accounts receivables and
inventories”
• Bonneville, “Any acquisition of funds which increases the current
assets, increase working capital also for they are one and the same”
• Shubin, “Working Capital is the amount of funds necessary to cover the
cost of operating the enterprises”
• Genestenberg, “Circulating capital means current assets of a company
that are changed in the ordinary course of business from one form to
another, for example, from cash to inventories, inventories to
receivables, receivables to cash”.
Con’t…
The term working capital has several meanings in business and economic
development finance.
• In accounting and financial statement analysis, working capital is defined
as the firm’s shortterm or current assets and current liabilities. Just as
working capital has several meanings, firms use it in many ways.
• Most fundamentally, working capital investment is the lifeblood of a
company. Without it, a firm cannot stay in business.
• Working capital is an operational necessity. A firm needs to invest in short-
term current assets such as stocks (raw materials, work-in-progress and
finished product) and also needs debtors to allow it to perform its day-to-
day operations.
• This investment in current assets is for the short term, as raw materials will
be bought, converted into finished product, and sold to customers who
ultimately will pay
Con’t…
• Working capital, also known as circulating capital, is the amount of
money which a business needs to survive on a day-to-day basis. It
should be sufficient to cover
• paying creditors (without difficulty);
• allowing trade credit to debtors;
• Carrying adequate stocks
Sufficient working capital is needed, not only to be able to pay bills on
time (e.g. wages and suppliers), but also to be able to carry sufficient
stocks and also to allow debtors a period of credit to pay what they owe
 CONCEPTS OF WORKING CAPITAL

GWC refers to the firm’s total investment in current assets. Current assets are
the assets which can be converted into cash within an accounting year (or
operating cycle) and include cash, short–term securities, accounts receivable,
and stock (inventory).
GWC focuses on
(i) Optimization of investment in current
(ii) Financing of current assets. GWC also referred as “Economics Concept”
since assets are employed to derive rate of return .
Net Working Capital (NWC)
• NWC refers to the difference between current assets and current
liabilities. Current liabilities (CL) are those claims of outsiders which
are expected to mature for payment within an accounting year and
include accounts payable, bills payable and outstanding expenses.
NWC focuses on
(i) Liquidity position of the firm
(ii) Judicious mix of short–term and long–term financing.
NWC can be positive or negative.
Positive NWC = C > CL
Negative NWC = C < CL
Component of Working Capital
working capital

Current asset Current liability

Bill payable
Cash in hand Outstanding expense
Cash at bank Short term loan advances
Dividend payable
Bill receivables
Account receivables
Bank Over draft
Provision for taxation

Inventories
Prepaid expense
Accrued incomes
Short term investments
OPERATING AND CASH CONVERSION CYCLE
The Two tools to measure the working capital management efficiency
are the operating cycle and the cash conversion cycle.
The operating cycle begins when the firm receives the raw materials it
purchased and ends when the firm collects cash payments on its credit
sales.
Two measures A/R period and inventory period—help determine the
operating cycle.
Inventory period shows how long the firm keeps its inventory before
selling it. It is the ratio of the inventory balance to the daily cost of
goods sold.
The quicker a firm can move out its raw materials as finished goods,
the shorter the duration when the firm holds it inventory, and the more
efficient it is in managing its inventory.
Con’t…
• Accounts receivable period estimates how long it takes on
average for the firm to collect its outstanding accounts
receivable balance. This ratio is also called the average
collection period (ACP).
• An efficient firm with good working capital management
should have a low average collection period compared to its
industry.
• The operating cycle is calculated by summing the Inventory
period and the Accounts receivable period.
• (Operating cycle = inventory period + accounts receivable
period)
 Cash Conversion Cycle
• The cash conversion cycle is related to the operating cycle,
but it does not start until the firm actually pays for its
inventory.
• The cash conversion cycle is the length of time between the
cash outflow for materials and the cash inflow from sales.
• To measure the cash conversion cycle, we need another
measure called the payables period.
• Payable period shows how long a firm takes to pay off its
suppliers for the cost of inventory.
• The cash conversion cycle is then calculated by summing the
accounts receivable period and the inventory period and
subtracting the payables period
The Operating Cycle
The cash conversion cycle model
• The cash conversion cycle model, which focuses on the
length of time between when the company makes payments
and when it receives cash inflows, formalizes the steps
outlined above.
The following terms are used in the model:
1. Inventory conversion period, which is the average time
required to convert materials into finished goods and then to
sell those goods. Note that the inventory conversion period is
calculated by dividing inventory by sales per day. For
example, if average inventories are $2 million and sales are
$10 million, then the inventory conversion period is 73 days
Con’t…

Thus, it takes an average of 73 days to convert materials into finished

goods and then to sell those goods.
Con’t….
2. Receivables collection period, which is the average length of time
required to convert the firm’s receivables into cash, that is, to collect
cash following a sale.
The receivables collection period is also called the days sales
outstanding (DSO), and it is calculated by dividing accounts receivable
by the average credit sales per day. If receivables are $657,534 and sales
are $10 million, the receivables collection period is
Con’t….
3. Payables deferral period, which is the average length of time
between the purchase of materials and labor and the payment of cash for
them. For example, if the firm on average has 30 days to pay for labor
and materials, if its cost of goods sold are $8 million per year, and if its
accounts payable average $657,534, then its payables deferral period
can be calculated as follows:
Con’t…
4. Cash conversion cycle, which nets out the three periods just defined and
which therefore equals the length of time between the firm’s actual cash
expenditures to pay for productive resources (materials and labor) and its own cash
receipts from the sale of products (that is, the length of time between paying for
labor and materials and collecting on receivables). The cash conversion cycle thus
equals the average length of time a dollar is tied up in current assets. Each
component is given a number, and the cash conversion cycle can be expressed by
this equation
PERMANENT AND VARIABLE WORKING CAPITAL
Permanent or fixed working capital A minimum level of current
assets, which is continuously required by a firm to carry on its business
operations, is referred to as permanent or fixed working capital.
It is part of total current assets which is not changed due to variation in
sales. It is considered permanent because the level is constant, not
because the assets are not sold.
Fluctuating or variable working capital The extra working capital
needed to support the changing production and sales activities of the
firm is referred to as fluctuating or variable working capital.
It is the additional asset required to meet the variations in sales above
the permanent level. Additional current assets are needed during the
peak time. It increases with growth of business.
DETERMINANTS OF WORKING CAPITAL MANAGEMENT
1.Nature of Business
2. Seasonality of Operations
3. Production Cycle
4. Production Policy
5. Credit Policy
6. Market Conditions
7. Conditions of Supply
Computation or estimation of working capital
• Some of the common methods used to estimate working capital are
Con’t…
C. Operating cycle ;-this cycle begins with the acquisitions of material
and ends with the collection of receivables
Con’t…
Exercise
From the following information extracted from the books of
manufacturing company, compute the operating cycle in days and the
amount of working capital required
Source of working capital
FINANCING CURRENT ASSETS
A firm may adopt different financing policies for its current
assets. There are three types of financing:
1. Long-term financing: - Sources of long term financing
include ordinary share capital, preference share capital,
debentures (bonds), long-term borrowing from financial
institutions and reserves, and surplus (retained earnings).
2. Short-term financing: - Obtained for a period less than one
year. It is arranged in advance from banks, and other
suppliers of short-term finance in the money market. It
includes working capital funds from banks, public deposits,
commercial paper, factoring receivables, etc
Con’t…

3. Spontaneous financing: - Refers to the automatic sources of short-

term funds arising in the normal course of a business. Trade credit and
outstanding expenses are examples of spontaneous financing. There is
no explicit cost of spontaneous financing. A firm is expected to utilize
these sources of finance to the fullest extent.
Depending on the mix of short and long-term financing, the approach
followed by a company may be referred to as
Matching (hedging) approach: Match the maturity of the assets with
the maturity of the financing.
Conservative approach: Use permanent capital for permanent assets
and temporary assets.
Aggressive approach: Use short–term financing to finance permanent
assets
Alternative Current Asset Financing Policies
Con’t…
Con’t…
The characteristics of each approach in detail
Matching (hedging) approach: This approach tries to balance risk and
return concerns. Temporary current assets that are only going to be on
the balance sheet for short time should be financed with short–term
debt, current liabilities.
Modular permanent current assets and long– term fixed assets that are
going to be on the balance sheet for long time should be financed from
long–term debt and equity sources.
The firm has moderate amount of net working capital. It is relatively
amount of risk balanced by relatively moderate amount of expected
return. In the real world, each firm must decide on its balance of
financing sources and its approach to working capital management
based on its particular industry and the firm's risk and return strategy.
 Con’t…
Conservative approach: As the name itself suggests, under the approach the
finance manager does not undertake risk. As result, all the working capital
needs are primarily financed by long term sources and the use of short term
sources may be restricted to unexpected and emergency situation only.
The working capital policy of firm is called conservative policy when all or
most of the working capital needs are met by the long term sources and thus the
firm avoids the risk of insolvency. So, under the conservative approach, the
working capital is primarily financed by long term sources.
The larger the portion of long term sources used for financing the working
capital, the more conservative is said to be the working capital policy of the
firm. In case, the firm has no temporary working capital need then the idle long
term funds can be invested in marketable securities. This will help the firm to
earn some income. The firm uses small amount of short term sources to meet its
peak level working capital needs. Long–term financing is generally more
expensive than short–term financing.
Con’t…
Aggressive approach: Low level of investment more short–term
financing is used to finance current assets.
Support low level of production & sales Borrowing short–term is
considered more risky than borrowing long–term.
Firm risk increases, due to the risk of fluctuating interest rates, but the
potential for higher returns increases because of the generally low–cost
financing.
This approach involves the use of short–term debt to finance at least the
firm's temporary assets, some or all of its permanent current assets, and
possibly some of its long–term fixed assets.
(Heavy reliance on short term debt) The firm has very little net working
capital. It is more risky. May be negative net working capital. It is very
risky
Con’t…
 Chapter Three

CASH AND LIQUIDITY MANAGEMENT

 Introduction
• Cash management is one of the key areas of working capital
management.
• Cash is the liquid current asset. The main duty of the finance
manager is to provide adequate cash to all segments of the
organization.
• The term “cash” with reference to cash management used in
two senses.
1.In a narrower sense it includes coins, currency notes,
cheques, bank drafts held by a firm. In a broader sense it also
includes “near-cash assets” such as marketable securities and
time deposits with banks.
Con’t….
• Cash is often called a “non-earning asset.” It is needed to pay
for labour and raw materials, to buy fixed assets, to pay
taxes, to service debt, to pay dividends, and so on.
• However, cash itself earns no interest. Thus, the goal of the
cash manager is to minimize the amount of cash the firm
must hold for use in conducting its normal business activities,
yet, at the same time,
To have sufficient cash
(1)Taking trade discounts,
(2) Maintaining its credit rating, and
(3) Meeting unexpected cash needs.
 Motives of Holding Cash
• John Maynard identifies three motives for holding cash: Transaction
motive, precautionary motive and speculative motive.
1. Transactions motive
• The motive of holding cash reserves to pay for day to day business
transactions is called the transaction motive. Companies need a cash
reserve in order to balance short-term cash inflows and out flows since
these are not perfectly matched.
Transaction motive is used for holding cash, and the approximate size of
the cash reserve can be estimated by forecasting cash inflows and out
flows and by preparing cash budgets.
In addition to the cash reserve held for day-to-day operational needs, cash
may be built up to meet significant anticipated cash out flows, for example
those arising from investment in a new project or the redemption of debt
Con’t….
2. Precautionary motive
• Forecasts of future cash flows are subject to uncertainty and it is
possible that a company will experience unexpected demands for cash.
This gives rise to the precautionary motive for holding cash. Reserves
held for precautionary reasons could be in the form of easily-realized
short-term investments.
3. Speculative motive
• Companies may build up cash reserves in order to take advantage of
any attractive investment opportunities that may arise, for example in
the takeover market. Such reserves are held for speculative reasons. If
a company has significant speculative cash reserves for which it
cannot see an advantageous use, it may choose to enhance shareholder
value by returning them to shareholders, for example by means of a
share repurchase scheme or a special cash dividend
Cost of Holding Cash
• There are two major cost categories associated with holding cash reserves,
1.opportunity cost and 2.trading cost.
When a firm holds cash in excess of some necessary minimum, it incurs an
opportunity cost.
The opportunity cost of excess cash (held in currency of bank deposit) is the
interest income that could be earned in the next best use, such as investment in
marketable securities.
• Given the opportunity cost of holding cash, why would a firm hold cash in excess
of its compensating balance requirements? The answer is that a cash balance must
be maintained to provide the liquidity necessary for transaction needs- paying bills.
• If the firm maintains too small cash balance, it may run out of cash. If this
happens, the firm may have to raise cash on short term basis. This could involve,
for example selling marketable securities or borrowing.
• Activities such as selling marketable securities and borrowing involve various
costs. These costs are commonly referred to as trading or administrative cost.
 How to calculate the opportunity cost and trading cost?

a) Opportunity Cost
The opportunity cost is a function of average cash balance firms hold and a return (r) expected to
be earned by investing the cash in to alternative investments. i.e.:

Where C/2 is the average cash balance and r is the return obtainable by non cash investments.

b) Trading or Administrative Cost

A firm faces trading or administrative costs, F, every time it replenishes its cash balance (either by
selling other assets or by borrowing money from a bank). To measure total trading or
administrative costs, we need to determine first the number of times the firm actually needs to
replenish its cash balances over the year. To estimate this number, we simply divide the total
amount of cash the firm will be using over the year, T, by the amount of cash that is picked up
each time, C. Trading costs can then be estimated as:

Where T is the total amount needed during the reference period, C is the average cash balance, and
F is the trading or administrative cost the firm faces each time it replenishes the cash account.
 Con’t…
Putting everything together, the total cost of holding cash can be calculated as:

Example-Calculate the total cost of cash for the following two alternatives assuming a 9 percent
interest rate and Br.75 trading cost per transaction for both of them.

Alternatives Total amount of cash require Available Total cost

during relevant period Cash balance
A Br.32,100 Br.2,500 ?
B 31,200 2,750 ?
 Con’t…
Answer:
Alternatives Opportunity cost (C/2 x 0.09) Trading cost Total cost
(T/C x75)
A Br.112.5 Br.963 Br.1,075.5
B 123.75 850.9 974.66

Basic problems in Cash Management:

Cash management involves the following four basic problems.
 Controlling level of cash
 Controlling inflows of cash
 Controlling outflows of cash and
 Optimum investment of surplus cash.
 The Cash Budget
• Cash budgets are central to the management of cash. They show expected cash inflows and
outflows over a budget period and highlight anticipated cash surpluses and deficits. Their
preparation assists managers in the planning of borrowing and investment, and facilitates
the control of expenditure.
A cash budget can be prepared in the following ways:
Method 1- Receipt and payment method- in this method all expected receipts and payments
for budget period are considered. All the cash inflow and outflows of all functional budgets
including capital expenditure are considered. Anticipated cash inflow is added to the opening
balance of cash and all cash payments are deducted from this to arrive at the closing balance
of cash. This method is commonly used in most business organizations.
The preparation of cash budget in this method is divided into four steps:
• Forecasting sales.
• Estimating cash inflows.
• Estimating cash outflows.
• Estimating end of month cash and loan balances
Con’t…
• Sales forecast: Estimates of cash inflows and outflows are based primarily on
sales forecasts. This sales forecast could be made using either internally or
externally obtained information.
• Estimating cash inflows: The cash inflow section of the cash budget includes
two types of cash inflows:
1.Receipt on cash and credit sales; and
2.Other cash inflows not tied directly to sales.
• Each type of cash inflow is computed separately. Cash sales occur when payment
by check or currency is made at the time of purchase. These sales are recorded as
cash inflow in the month when the sales are made. The accounts receivable
generated from credit sales are recorded as cash inflows in the months when the
receivables are collected.
• In addition to cash inflows generated from sales, other cash inflows can occur
during the planning period. Examples of cash inflows not directly related to sales
include tax refunds; proceed from sale of marketable securities, and proceeds
from the sale of other assets
 Con’t…
• Estimating cash outflows: The cash outflow portion of the cash budget includes five types
of payments:
1. Payments for purchases 4. tax payment
2. Payments for salaries and wages 5. Other payments
3. Payments for other operating costs
Each type of payment is estimated separately.
• Payments for purchases:- Purchases are often made on credit basis, thus creating accounts payable. Purchase
payments are recorded as cash outflows in the months when payments are made by cash or check. When
estimating purchase payments on the basis of sales forecast, it is necessary to estimate the percentage that
purchases are contained in each birr of sale.
• Payments for salaries and wages:- These are recognized as cash out flows in the month they are paid to
employees. A firm typically incurs a minimum amount of payroll expense that is independent of sales volume.
Once the sales volume exceeds a minimum amount, wages and salaries tend to increase proportionally with
sales.
• Other payments:- There are several types of cash outflows that are not directly related to sales. These include
dividend payments, payments for the purchase of real estate, property, plant and equipment, and the payments
of principal and interest on long term debt.
Con’t…
Method 2-Adjusted income method- In this method the annual cash
flows are calculated by adjusting the sales revenue and cost figures for
delays in receipts and payments (change in debtors are creditors) and
eliminating non-cash items such as depreciation. This method is
commonly used in the preparation of annual cash budget.
Method 3-Adjusted balance sheet method- In this method, the budget
balance sheet is predicted by expressing each type of asset and short-
term liabilities as percentage of the expected sales.
The profit is also calculated as a percentage of sales, so that the increase
in owner’s equity can be forecasted. Known adjustment, may be made
to long term liabilities and the balance sheet will then show if additional
finance is needed.
 Cash Flow Management Techniques
• One of the major objectives of cash management is determination of optimal cash balance.
After the optimal amount is determined, firms must establish procedures so that cash is
collected and disbursed as efficiently as possible.
The following describes the different techniques used by many firms to improve the efficiency
of their cash management
A. Cash Flow Synchronization
• If you as an individual were to receive income once a year, you would probably put it in the
bank, draw down your account periodically, and have an average balance for the year equal to
about half your annual income. If instead you could arrange to receive income weekly and to
pay rent, tuition, and other charges on a weekly basis, and if you were confident of your
forecasted inflows and outflows, then you could hold a tiny average cash balance.
• Exactly the same situation holds for businesses—by improving their forecasts and by timing
cash receipts to coincide with cash requirements, firms can hold their transactions balances to a
minimum.
• Recognizing this, utility companies, oil companies, credit card companies, and so on, arrange to
bill customers, and to pay their own bills, on regular “billing cycles” throughout the month.
This synchronization of cash flows provides cash when it is needed and thus enables firms to
reduce the cash balances needed to support operation
 Con’t…
B. Using Float
• A firm’s cash balance as reported in its financial statements (book cash or ledger cash) is
not the same thing as the balance shown in its bank account (bank cash or collected bank
cash). The difference between bank cash and book cash is called float and represents the net
effect of checks in the process of collection.
• Checks written by the firm generate disbursement float, causing an immediate decrease in
book cash but no immediate change in bank cash. Whereas, Checks received by the firm
represent collection float, which increases book cash immediately but does not immediately
change bank cash. The sum of disbursement float and collection float is net float.
• Suppose a firm writes, on average, checks in the amount of Br. 6,000 each day, and it takes
five days for these checks to clear and be deducted from the firm’s bank account. This will
cause the firm’s own check book to show a balance Br. 30,000 smaller than the balance on
the bank’s records; this difference is called disbursement float. Now suppose the firm also
receives checks in the amount of Br. 4,000 daily, but it loses five days while they are being
deposited and cleared. This will result in Br. 20,000 of collections float. In total, the firm’s
net float— the difference between the Br.30,000 positive disbursement float and the
Br.20,000 negative collections float—will be Br.10,000.
 Con’t…
• Delays that cause float arise because it takes time for checks
(1) To travel through the mail (mail float),
(2) To be processed by the receiving firm (processing float),
(3) To clear through the banking system (clearing, or availability, float).
• Float management involves controlling the collection and disbursement of
cash.
• The objective in cash collection is to reduce the lag between the time
customers pay their bills and the time the checks are collected.
• The objective in cash disbursement is to slow down payments, thereby
increasing the time between when checks are written and when checks are
presented. In other words, collect early and pay late.
 Con’t….
Example:
• Each business day, on average, a company writes checks totaling
Br.12,500 to pay its suppliers. The usual clearing time for these checks is
four days.
• Each day, the company receives payments from its customers in the form
of checks totaling Br.15,500. The cash from the payments is available to
the firm after four days.
• Calculate the company’s disbursement float, collection float, and net float.
• How would these values change if the collected funds were available in
three days instead of four?
Con’t…
Disbursement float=12,500 x 4
= Br. 50,000.00

Collection float =15,500 x 4

= Br. 62,000.00
Net float = 50,000-62,000
= Br. -12,000.00

Assuming the three days of delays for the collected funds, the change will be:
o Collection float = 15,500 x 3
= Br.46,500.00

o Net float =50,000-46,500

= Br.3,500.00
 C. Speeding Up Receipts

• As indicated in the previous section, the total time in cash collection process is
made up of mailing time, check-processing time, and check clearing time.
• The amount of time cash spends in each part of the cash collection process
depends on where the firm’s customers and banks are located and how efficient
the firm is at collecting cash.
• The two major techniques are now used both to speed collections and to get
funds where they are needed: (1) lockbox plans and (2) payment by wire or
automatic debit.
• Lockboxes- A lockbox plan is one of the oldest cash management tools. In a
lockbox system, incoming checks are sent to post office boxes rather than to
corporate headquarters.
Con’t…
• The collection process is started by customers mailing their checks to a
post office box instead of sending them to the firm.
• The lockbox is maintained by a local bank and is typically located no more
than several hundred miles away. In the typical lockbox system, the local
bank collects the lockbox checks from the post office several times a day.
• The bank deposits the checks directly to the firm’s account. Details of the
operation are recorded and sent to the firm.
• A lockbox system reduces mailing time because checks are received at a
nearby post office instead of at corporate headquarters. Lockboxes also
reduce the firm’s processing time because they reduce the time required
for a corporation to physically handle receivables and to deposit checks for
collection.
• A bank lockbox should enable a firm to get its receipts processed,
deposited, and cleared faster than if it were to receive checks at its
headquarters and deliver them itself to the bank for deposit and clearing
Con’t…
• Example -A Corporation is considering a lockbox arrangement that will cost
Br.12, 000 per year. Average daily collections are Br. 37, 000. As a result of the
system, the float time will be reduced by 3 days. Assuming annual rate of return of
12 percent, determine whether the lockbox arrangement be instituted or not?
Cost...................................................................................Br.
(12,000.00)Benefit per year from reduction of float time (37,000
x3x0.12)...13,320.00
Advantage of the lock box system..................................................Br 1,320.00
Hence the lock box system should be used.
• Concentration Banking- In concentration banking the company establishes a
number of strategic collection centers in different regions instead of a single
collection center at the head office.
• This system reduces the period between the time a customer mails in his
remittances and the time when they become spendable funds with the company.
Payments received by the different collection centers are deposited with their
respective local banks which in turn transfer all surplus funds to the concentration
bank office.
Con’t…
Payment by Wire or Automatic Debit- Firms are increasingly
demanding payments of larger bills by wire, or even by automatic
electronic debits. Under an electronic debit system, funds are
automatically deducted from one account and added to another.
since the transfers take place electronically, from one computer to
another, it eliminates the mailing and check clearing times associated
with other cash-transfer methods.
This is, of course, the ultimate in a speeded-up collection process, and
computer technology is making such a process increasingly feasible
and efficient.
Con’t…
Delaying Disbursements
• Accelerating collections is one method of cash management; paying more slowly is
another. Techniques to slow down disbursement will attempt to increase mail time
and check-clearing time. There are various ways to delay cash disbursements,
including:
• Using drafts to pay bills since drafts are not due on demand. When a bank receives
a draft it must return the draft to the issuer for acceptance prior to payment. When
the company accepts the draft, it then deposits the required funds with the bank;
hence, a smaller average checking balance is maintained.
• Mailing checks from post offices having limited service or from locations where the
mail must go through several handling points, lengthening the payment period.
• Drawing checks on remote banks or establishing cash disbursement centers in
remote locations so that the payment period is lengthened.
• Using credit cards and charge accounts in order to lengthen the time between the
acquisition of goods and the date of payment for those goods.
 Class Work
1. Which of the following costs of holding cash is directly related
to the liquidity position of a firm?
A. Trading cost.
B. Opportunity cost.
C. Holding cost.
D. None of the above
2. Cash disbursement can be delayed by:
A. Mailing checks from locations where the mail must go through several
handling points.
B. Paying through bank drafts.
C. Establishing cash disbursement centers in remote locations.
D. All of the above are methods of delaying cash payments
 Con’t…
3. Which of the following statement is false about the cash budgeting techniques?
A. Forecasting sales is often the first stem in the preparation of cash budget using the receipt and
payment method.
B. Non-cash items are taken out from expected revenues and expenses to forecast the net cash
balance using adjusted income method.
C. In the receipt and payment method of cash budgeting, financing needs should be determined
prior to identifying the net cash balance.
D. All of the above statements are true.
4. Which of the following was not suggested by John Maynard as a motive for holding
cash?
A. Transaction motive.
B. Speculative motive.
C. Investment motive.
D. Precautionary motive.
Con’t…
5. Collection float is __________.
A. The total time between the mailing of the check by the customer and the
availability of cash to the receiving firm.
B. The time the check is in the mail.
C. The time consumed in clearing the check through the banking system.
D. The time during which the check received by the firm remains uncollected
Short answer questions
Instruction-Briefly define the following terms
1.Transaction, precautionary and speculative motives of cash.
2. Lock box system and concentration banking of cash management
techniques
3.Write the objectives of cash collection and cash disbursement
 Basic Ratios Used to Manage Cash
• The main goal of cash management is to maintain the
optimum cash balance that provides firms with
sufficient liquidity needed to meet its financial
obligation and to enhance its profitability without
exposing it to undue risk.
• To achieve this goal effectively, efficiently and
maintain the required amount of cash, financial
managers use different techniques.
• The financial ratios financial managers use to measure
their cash efficiency and solvency discussed below.
 A. Cash Turnover Ratio

This ratio is useful to find out efficiency of cash utilization. A high cash turnover is desirable
because it reduces a firm’s average cash balance and the cost of holding those funds. This ratio is
calculated as:

* Cash cycle is the time between cash disbursement and cash collection. It begins when cash is
paid for materials and ends when cash is collected from receivables. The cash cycle can be thought
of as the operating cycle less the accounts payable period. i.e.:

Cash cycle = Operating cycle - Accounts payable period

 Con’t….
Where:
 Operating cycle is the time period between the acquisition of inventory and the collection
of cash from receivable.
 The accounts payable period is the length of time the firm is able to delay payment on the
purchase of various resources, such as wages and raw materials
Example- A Company is trying to get a hand on its cash management. Reviewing the books they
have found that, over the past years, accounts receivables have averaged 45 days sales and
inventories have averaged 35 days. The company has paid its creditors, on average, 30 days after
receiving the bill. The company produces evenly over the years and is expected to spend Br.
54,750.00 during the year for material and supplies. Compute:
- The cash cycle.
- The cash turnover.

- Cash cycle = Operating cycle - Accounts payable period

= (45+35) - 30
= 50 days

= 7.3 times
 B. Current ratio
• Measures the ability of an entity to pay its near-term obligations.
Current usually is defined as within one year. This ratio establishes the
relationship between the cash and the current assets. It is calculated as
follows:
Current Ratio = Total Current Assets/ Total Current Liabilities
• In general, if your current ratio is above 1.0, you can pay your short-
term debts on time and if it below 1.0, you cannot.
• The latter is not a good position to be in. For example, if a company has
Br10 million in current assets and Br5 million in current liabilities, the
current ratio would be 2 (10/5 = 2).
• As of December 31, 2015, with amounts expressed in millions, Zimmer
Holdings' current assets amounted to Br1,575.60 (balance sheet); while
current liabilities amounted to Br606.90 (balance sheet. Calculate
current ratio and interperate it.
 C. Quick ratio (or "acid test"):
• Where "quick assets" consist of cash, marketable securities and
receivables - measures a more strict definition of the company's
ability to make payments on current obligations.
• This ratio establishes the relationship between the cash and current
liabilities. It is calculated as follows:
Quick Ratio = Current Assets - Inventory/Current Liabilities
Example: If a business firm has Br200 in current assets and Br50 in
inventory and Br100 in current liabilities, the calculation is Br200-
Br50/Br100 = 1.50X. The "X" (times) part at the end is important.
It means that the firm can pay its current liabilities from its current
assets (less inventory) one and a half times over
 Interpretation and Analysis

• This is obviously a good position for the firm to be in. It can meet its short-term
debt obligations with no stress.
• If the quick ratio was less than 1.00X, then the firm would have to sell
inventory to meet its obligations So, a quick ratio great than 1.00X is better than
a quick ratio of less than 1.00X with regard to maintaining liquidity and not
being forced into the position of having to sell inventory.
• Or for every Br of firm's current liabilities, the firm has Br1.50 of very liquid
assets to cover those immediate obligations.
• Cash to total assets: Cash/Total Assets - measures the portion of a company's
assets held in cash or marketable securities.
• Although a high ratio may indicate some degree of safety from a creditor's
viewpoint, excess amounts of cash may be viewed as inefficient.
Con’t…

Exercise 1:

To demonstrate, let's assume this information was pulled from the balance sheet of -- Company
XYZ:

XYZ Company
Balance sheet
Cash Br60,000 Accounts payable Br30,000
Marketable securities 10,000 Accrued expenses 20,000
Accounts receivables 40,000 Notes payable-current 5,000
Inventory 50,000 Current portion of long term debt 10,000

Calculate Company XYZ's current ratio and quick ratio

 Chapter Four

Receivable Management
Con’t…
• Receivable are asset accounts representing amounts
owed to the firm as a result of sale of goods or services
in the ordinary course of business.
• Receivables constitute a significant portion of the total
assets of the business.
• When a firm sells goods or services on credit, the
payments are postponed to future dates and receivables
are created.
• If they sell for cash no receivables created.
 Factors Affecting the Size of Receivables
• Level of Sales
• Credit Policies
• Terms of Trade
• Credit period;-The term credit period refers to the time duration for
which credit is extended to the customers. It is generally expressed in
terms of “net days”. Firms must consider four factors in setting a
credit period
1.The Probability That the Customer Will Not Pay
2. The Size of the Account
3. The Extent to Which the Goods Are Perishable
4. Competition
 Con’t…
• Cash discount: Most firms offer cash discount to their customers to encourage
them to pay their dues before the expiry of the credit period.
• The terms of the cash discounts indicate the rate of discount as well as the period
for which the discount has been offered.
• For example, suppose a customer is granted credit with terms of 2/10, net 30. This
means that the customer has 30 days from the invoice date within which to pay.
• Example-The finance officer of a company is considering the request of the
company’s largest customer, who wants to take a 2 % discount for payment within
15 days on a Br, 125,000 purchases. Normally, the customer pays in 30 days with
no discount (Net 30 days).
• How much cash is expected to be collected after 15 days, if the customer’s request
is accepted?
• Cash discount 125,000 X (1-0.02)= Br. 122,500
 Con’t…
Other Factors: In addition to the above determinants, the
level of receivable is also affected by the following general
factors:
• Type and nature of business
• Size of the business
• Price level variations
• Availability of funds
• Attitude of executives
 Cost of Maintaining Receivables

1.Capital Cost
Increase in the level of accounts receivables implies an investment in current
assets. There is a time gap between the sale of goods on credit and payment by
the customers.
During this time gap, the firm’s funds are blocked in the form of receivables
and so it will have to arrange for additional finance for meeting its own
obligations.
The cost involved in financing the additional capital can be in the form of
interest payments in case of external finance or opportunity cost of capital in
case of internal sources that could have been put to some other use.
The cost associated with the use of additional capital to support credit sales,
which could have been profitably employed in other alternatives, is a part of
the cost of extending trade credit.
 Con’t…
2. Administrative Costs
• These are costs related to obtaining information about the creditworthiness of
the customer and the maintenance of records.
• As a result the firm is required to analysis and supervises a large volume of
accounts at the cost of expenses related with acquiring credit information either
through outside specialist agencies or forms its own staff.
3. Collection Costs
• These are the costs that are incurred while collecting the receivables from the
debtors.
• It includes additional expenses of credit department incurred on the creation
and maintenance of staff, accounting records, stationary, postage and other
related items
 Con’t…
4. Default Costs
• This type of cost arises when customers fail to make payments of the
receivables as and when they fall due after the expiry of the credit
period. Such debts are treated as doubtful debts and involve:
Blocking of firm's funds for an extended period of time.
• Additional collection costs (legal expenses and cost of initiating
other collecting efforts).
• If the customer does not pay after all the collection efforts, the
receivables are treated as bad-debts and have to be written-off as
they cannot be realized
 Receivables Management and Ratio Analysis

• The basic target of receivables management is to enhance the overall

return on the optimum level of investment made by the firm in
receivables. The optimum investment is determined by comparing the
benefits to be derived from a particular level of investment with the
cost of maintaining that level.
• Receivables management begins with the credit policy, but a
monitoring system is also important
Credit Policy
• The credit policy of a firm provides the framework to determine
whether or not to extend the credit to a customer and also on the
amount of credit that should be extended. Credit policy consists of the
following five variables
 Con’t…
1.Credit Standards: Credit standards are the criteria that a firm follows while
choosing customers to whom credit could be extended.
• Stringent credit standards will have less credit sales granted to customers with a
high credit rating and consequently it will have lower bad debts and
administrative costs and lower investment in receivables.
• Lenient credit standards will have increased sales but with a high probability of
bad debt losses, administrative costs and the amount of funds locked up in
receivables.
2.Credit Period:
• The time given to the customers to pay the book debts is referred to as credit
period. Increasing the credit period will help in pushing up the sales but it will
also lead to increase in investment in receivables and increase in proportion of
bad-debts.
• The short credit period leads to the decrease in the incidence of bad debts and
reduction in the funds locked up in receivables but at the same time it will result
in reduced sales
Con’t
1. Cash Discount: A cash discount is reduction in the amount payable, offered to the customers in
order to induce them to repay the trade credit within the specified period of time which is less
than the normal credit period
 A firm that introduces a cash discount policy will have benefits in the form of additional
sales and reduction in the amount locked up in receivables but the cost involved would
also increase due to the cash discounts offered.
Example-A Corporation provides the following data:
Current annual credit sales Br. 13,450,000.00
Collection period 3 months
Term of sale net 30
Rate of return 0.12
 Con’t
The corporation proposes to offer a 2/10, net 30 discounts. The corporation anticipates 45 percent
of its customers will take advantage of the discount.As a result of the discount policy, the collection
period will be reduced to 2months. Should the corporation offer the new terms?
Yes, because the new proposal gives the corporation additional benefit of Br. 13,450.00
Given:
Current Proposed
Annual credit sales Br. 13,450,000.00 Br. 13,450,000.00
Collection period 3 months 2 months
Term of sale net 30 2/10, net 30
Rate of return 12% 12%

The additional Br. 13,450 benefit of the new proposal is determined as follows:
Con’t
Benefit due to reduction of collection period:
Current Average Accounts Receivable
(13,450,000 x 3/12) Br. 3,362,500.00
Average Accounts receivable-Proposed policy
(13,450,000 x 2/12) 2,241,666.67
Reduction in Accounts receivable 1,120,833.33
Rate of return 0.12
Benefit due to reduction of collection period
(1,120,833.33 x 0.12) (a) 134,500.00
Cost of Discount:
Current policy No discount
Proposed policy (13,450,000 x 0.02 x 0.45) 121,050.00
Cost of Discount (b) 121,050.00
Advantage of the proposed policy (a-b) 13,450.00
 Con’t
4.Collection Policy: A proper collection policy is needed for ensuring
timely collection of receivables so that funds are not locked up in
receivables for a longer period and for reducing the incidence of bad
debt losses. Some of the activities that form a part of the collection
policy include:
• Monitoring the state of receivables– postal, telegraphic or telephonic
reminders to customers for whom the due date is nearing,
• Threat of legal action to overdue accounts etc
 Con’t
5.Credit Instruments:
• Most credit is offered on open account.
• The firm may require that the customer sign a promissory note, This is used when
the order is large and when the firm anticipates a problem in collections.
• One way to obtain a credit commitment from a customer before the goods are
delivered is through the use of a commercial draft. The selling firm typically writes
a commercial draft calling for the customer to pay a specific amount by a specified
date.
• When the banker agrees to do so in writing, the document is called a banker’s
acceptance. That is, the banker accepts responsibility for payment. Because banks
generally are well-known and well-respected institutions, the banker’s acceptance
becomes a liquid instrument. In other words, the seller can then sell (discount) the
banker’s acceptance in the secondary market.
• A firm can also use a conditional sales contract as a credit instrument. This is an
arrangement where the firm retains legal ownership of the goods until the customer
has completed payment.
 Credit Evaluation
Credit evaluation is done to analyze the ability and willingness of the
customer to Honor his financial obligations. The analysis is done
based on five factors:
• Character: It is a moral attribute reflecting the integrity of the
person and his willingness to repay the credit obligation.
• Capacity: It indicates the customer’s ability to meet credit
obligations out of operating cash flows.
• Capital: It shows the customer’s financial reserves.
• Condition: It refers the prevailing economic conditions that might
affect a firm’s ability to pay.
• Collateral: It refers to the assets that are offered by the customer as
a security
 Con’t
There are various sources and techniques that help in evaluating the credibility
of a customer. Some of them are:
F/s and ratios: Information in the form of balance sheet. profit and loss account
help the firm in analyzing the financial credibility of the customer. Certain ratios
like the current ratio, quick ratio, average payment period, debt-equity ratio etc.,
indicate the ability of the client to pay the receivables on time.
Bank references: A customer’s bank can serve as a major source in obtaining
information that is required to assess the financial strength of the firm.
Firm’s experience: A firm’s previous dealings with a client help the firm in
making a more valid judgment about the integrity of the customer.
Numerical credit scoring: Numerical credit scoring is a technique that is used
to pre-screen the credit applications. In this technique, the firm may identify,
based on its past experience or empirical study, both financial and non-financial
attributes that measure the creditworthiness of a customer.
 Credit Granting Decision

After assessing the creditworthiness of the customer, the firm has to

decide whether it should extend credit to the customer or not.
The decision to grant credit depends on four factors:
1.The delayed revenues from granting credit.
2.The immediate costs of granting credit.
3.The probability of payment.
4.The appropriate required rate of return for delayed cash flows.
Con’t
Example-Suppose a company has determined that, if it offers no credit
to its customers, it can sell its existing computer software for Br.30 per
program. It estimates that the costs to produce a typical computer
program are equal to Br.15 per program. The alternative is to offer
credit. In this case, they will pay one period later. With some
probability, the company has determined that if it offers credit, its level
of sales will increase due to higher sales volume.
 Con’t
The net cash flow at period 1 is zero, and the net present value of refusing credit will simply be the
period 0 net cash flow:
NPV = NCF
For example, if credit is not granted and Q0 = 150, the NPV can be calculated as:
(30 - 15) x 150 = Br.2,250
Strategy 2: Offer Credit alternatively - let’s assume that the company grants credit to all customers
for one period. The factors that influence the decision are listed below:
Strategy 1 Strategy 2
Refuse Offer
credit credit
Price per unit Br30 Br.30
Quantity sold 150 280
Cost per unit Br15 Br.17
Probability of payment (h) h=1 h=0.90
Credit period 0 1 Period
Discount rate 0 rB=0.02
 Con’t
The prime (′) denotes the variables under the second strategy. If the firm offers credit and the new
customers pay, the firm will receive revenues of one period (P'o Q'o). But its costs are incurred in
period 0. If the new customers do not pay, the firm in curs costs and receives no revenues. The
probability that customers will pay, h, is 0.90 in the example.
Quantity sold is higher with credit, because new customers are attracted. The cost per unit is also
higher with credit because of the costs of operating a credit policy.The expected cash flows for each
policy are set out as follows:

Expected cash flow

Time 0 Time 1
Refuse credit Po Qo - Co Qo 0
Offer credit - C'o Q'o h x P'o Q'o
Con’t
 Monitoring Receivables
• The payment of receivables should be constantly monitored by the
credit manager for the purpose of internal control. For better control,
monitoring should be done through different techniques and on a more
frequent basis.
• Given below are some methods that are used for monitoring the
accounts receivable.
1.Financial Ratios (Traditional Methods)
• Companies often use financial ratios to measure the status of
receivables from different aspects. Such ratios are ways of comparing
and investigating performances receivables using relationships
between different pieces of financial information. Some of these
ratios are discussed below:
Con’t
i. Days’ Sales Outstanding: It indicates the average length of time that a firm must wait
before receiving cash from the sales that are made on credit. It is also called average
collection period. Days’ sales outstanding is computed as:

Average daily sales can be determined by dividing the total sal es by number of days
in a year.

If the days’ sale outstanding is within the period specified in the credit policy, then the
position of the receivables is said to be under control. Otherwise, the collection policy
has to be strengthened further.
 Con’t
Example-A company sells 146,000 units of product a year at Br.250 each. All sales are for credit
with terms of 2/20, net 60. Suppose that 80 % of the customers take the discounts and pay on
day 20; the rest pay on day 60. How much will be days’ sales outstanding if the receivable today
is Br.3,000,000.

=100,000
 Con’t
i. Receivable Turnover Ratio: The receivables turnover ratios assess how much the
firm is collecting credit sales. In general, the higher the receivables turnover ratio the
better since this implies that the firm is collecting on its accounts receivables sooner.
However, if the ratio is too high then the firm may be offering too large of a discount
for early payment or may have too restrictive credit terms.
The Receivables Turnover ratio is calculated by dividing sales by accounts Receivables. (Note:
since accounts receivables arise from credit sales it is more meaningful to use credit sales in the
numerator if the data is available.)

Or it can be calculated as

Example: With the following information given, calculate the receivable turnover:
 Annual credit sales ……………………….. Br. 180,000
 Beginning balance of accounts receivable ……. 35,000
 Yearend balance of account receivable…..……. 25,000

Or

= 60.8 days

- This indicates that receivables were converted over into cash 6 times during the year.
 Con’t
i. Average Investment in Accounts Receivable: It measures investment in account
receivables using cost of credit sales- either variable cost or total cost. Considering
variable cost, the average investment in account receivable can be calculated as
follows:

Example: If a company's annual credit sales are Br.125, 000, the collection period is 60 days, and
the variable cost is 60 % of sales price, what the average investment in accounts receivable?

First let us calculate the account receivable turnover:

 Con’t
Average investment in Accounts receivable

Or it can also be calculated as:

Average Investment in Account receivable= Average account receivable balance x Variable cost
rate.
To determine the average investment in account receivable using this formula, let us first calculate
the average account receivable balance:

Hence, Average Investment in Account receivable =20,547.94 x 0.6 =Br.12,328.8

Example 2: A company has average accounts receivable balance of Br. 600,000. The average
manufacturing cost is 45 % of the sales price. The carrying cost of inventory is 4 % of selling price.
The sales commission is 9 % of sales. The investment in accounts receivable is:
Average Investment in Account receivable= 600000 x (.45 + 0.04 +0.09)
=Br. 348,000
 Ageing Schedule
The ageing schedule gives the age-wise distribution of the receivables at a given time. The
average collection period does not give any specific information about the age (from the time
the receivables have been outstanding). The ageing schedule removes this limitation of average
collection period by Breaking down the receivables according to the length of time for which
they have been outstanding (i.e. age of the receivables).

Example: Following is the ageing schedule for a company which has Br. 100,000 in
receivables:
Ageing Schedule
Age of account Amount in Br. Percent of total value of
outstanding accounts receivables
0-10 days 50,000 50%
11-60 days 25,000 25%
61-80 days 20,000 20%
Over 80 days 5,000 5%
Total: 100,000
If the company has a credit period of 60 days, then as per the above ageing schedule, 25% of the
firm’s accounts are yet to be collected.
 Collection Matrix
This method relates the receivables to sales of the same period. Under this method, a matrix is
formed with the sales over a period of time shown horizontally and associated receivables
shown vertically. With the help of the matrix one can judge whether the collections are
improving, or are stable or deteriorating.
For example, following is the collection matrix for ABC Ltd.
Percentage of receivables collected during January February
The month of sales 30% 40%
First Month after the sales 48% 35%
Second month after the sales 22% 25%
In case of ABC Ltd., in the month of January, 30% of the sales were collec
ted in the same month;
48% were collected in the next month i.e. February; 22% were collected in March (i.e. the second
month after the sales). Similarly, 40% of February ’s sales were collected in that month itself,
35% were collected in March and 25% were collected in the month of April.
Handling receivables/ debtors

issues that a firm has to carry out in process of collecting the receivable:
• Firm needs an open cash flow to be surviving and flourish. Therefore collecting the
outstanding receivables on time.
• Make invoicing a priority: invoice and notify prior to the due date.
• Follow-up on invoices: as soon as an invoice is past due, make a follow- up phone call
to the client.
• A firm usually goes through the following sequence of procedures for customers whose
payments are overdue:
• Sends out a delinquency letter informing the customer of the past-due status of the
account.
• Makes a telephone call to the customer.
• Employs collecting agents.
• Takes legal action.
Outsourcing Credit and Collections: The entire credit/collection function can be
outsourced.
 CHAPTER FIVE

INVENTORY MANAGEMENT