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The Advantages & Disadvantages of Economic Order Quantity (EOQ)
The Advantages & Disadvantages of Economic Order Quantity (EOQ)
Storing inventory may be expensive for small business owners. The main advantage of the EOQ
model is the customized recommendations provided regarding the most economical number of
units per order
Maintaining sufficient inventory levels to match customer demand is a balancing act for many
small businesses. Another advantage of the EOQ model is that it provides specific numbers
particular to the business regarding how much inventory to hold, when to re-order it and how
many items to order
The EOQ model requires a good understanding of algebra, a disadvantage for small business
owners lacking math skills. Additionally, effective EOQ models require detailed data to calculate
several figures. For example, the key formula of the model calculates the square root of 2DS/H,
where D is the number of units purchased annually, S is the fixed ordering charge, and H is the
holding cost per unit.
Based on Assumptions
The EOQ model assumes steady demand of a business product and immediate availability of
items to be re-stocked. It does not account for seasonal or economic fluctuations. It assumes
fixed costs of inventory units, ordering charges and holding charges. This inventory model
requires continuous monitoring of inventory levels. The effectiveness of the basic EOQ model is
most limited by the assumption of a one-product business, and the formula does not allow for
combining several different products in the same order.
1. Credit policy
Credit policy effects debtor management because it guides management about how to control
debtors and how to make balance between liberal and strict credit. If company does not restrict to
sell the products on credit after a given limit of sale. This liberated credit policy will increase the
amount of sale and profitability. But risk will also increase with increasing of sale. If we sell the
good to those debtors whose capability to pay is not good, then it is possible that some amount
will become bad debts. Company can increase the time limit for paying by such debtors. On the
other hand, if company’s credit policy is strict, then it will increase liquidity and security, but
decrease the profitability. So, finance manager should make credit policy at optimum level
where profitability and liquidity will be equal. We can show it graphically.
Length of credit period is also an element that affects decisions of finance manager relating to
manage debtors. It is the time which allows to debtor to pay his debt for purchasing goods on
credit from vendor. Finance manager can increase the length of credit period according to
reputation of customers.
Cash discount is technique to get money fastly from debtors. It is cost of investment in credit
sale.
It means decision relating to analysis of credit policy. Evaluation and analysis of credit policy is
based on following factors.
For analysis the financial position of debtors, we have to collect the information relating to
debtors. This information can be obtained from customer’s financial statements of previous
years, bank reports, and information given by credit rating agencies. These information will be
useful for deciding where debtors will our debt or not. It will also be useful for knowing
capability to pay the debt.
b) Credit Decisions
After collection and analysis the debtor’s information, manager has to decide whether company
should facilitate to sell goods on credit or not. If company sells the goods on credit to particular
debtor, then at what level it will be sold after seeing his position. For this manager can fix the
standard for providing goods on credit. If a particular debtor is below than given standard, then
he should not accept his proposal of buying goods on credit.
For getting fund fastly from debtor, the following steps will be taken under formulation of
collection policy.
b) Take the help of debt collection agency for getting bad debt.
e) Finance manager should monitor collection position through average collection period from
past sundry
debtor and their turnover ratio.
Step 1
Examine the ratio of assets to liablities. Divide the value of assets by the value of liabilities. A
ratio of 2 or better indicates that the company is handling its liabilities well and has assets that
can produce enough income to cover debts and produce profits. If a company has an almost 1 to
1 ratio of assets to liabilities, it may be carrying to much debt and could default on an enterprise
with your company.
Step 2
Calculate days in receivables. This figure will tell you how long receivables go unpaid for the
company. Divide the accounts receivable balance by average monthly sales. Multiply that
number by 30 (the number of days in a month) to get the average number of days receivables go
unpaid. Example: $100,000 in accounts receivable divided by $30,000 in monthly sales equals
3.3. Multiply by 30 to find that the average account is going for 99 days unpaid. You want a
lower number here, so that you know the company has cash to pay debt service if you enter a
joint venture. Less than 45 days for the number of days in recievables tells you the company is
taking in cash regularly.
Step 3
Assign a score to the product base. A company is more likely to maintain profitability if it has
diversified products it sells to a wide variety of customers. If a company has only one main
product, assign it a score of 1. Continue up the scale to 5 for a company that has a broad product
offering. There is no exact formula for this; it is a judgment call.
Step 4
Figure the amount of debt the company may incur in a joint venture with you. Add that figure to
the company's current indebtedness. Calculate the assets-to-liabilities ratio using the new debt
figure. This ratio will show you how well the company could handle the new indebtedness if
your venture failed. You do not want this to be below 1 to 1. A score that low would indicate you
could get stuck paying off the loans if the joint venture does not work.
Invoice Discounting is a confidential finance facility. As a confidential facility, credit management and
reporting is generally managed in-house by the approved business, and customers do not experience
any change in payment procedures.
Invoice Factoring is a disclosed finance facility and often includes credit management and reporting
support. As a disclosed facility, customers are instructed to make invoice payments to the financier and
the financier will often provide debtor management support to assist in prompt collection.
Although there are key differences between factoring and invoice discounting, the benefits are
the same:
Credit management is essential to the ongoing creditworthiness and day-to-day financial functioning of
a business. It is possible for a business to successfully make sales but find itself unable to meet its day-
to-day financial obligations because it employs poor credit management practices.
Credit Checking
Most commercial enterprises are sales-driven, which is to say that a great emphasis is
placed on finding new customers and getting customers to place product orders. The
function of credit management in this process is to check the creditworthiness of
prospective new customers and continue to monitor the creditworthiness of existing
customers. It may be that some prospective customers have such a bad credit rating that it
is not worth doing business with them. Credit management is also responsible for
negotiating payment terms and conditions with new and existing customers with the
intention of minimizing the potential exposure to bad debt. For example, if a customer
orders products monthly but only has a payment due every three months, credit managers
might renegotiate the credit terms offered to this customer if they suspect that the
customer's credit rating has lowered. Monthly terms, or even cash on delivery terms
would minimize the amount of outstanding bad debt owed by the customer.
Credit management is responsible for ensuring that invoices, statements and bills are
issued to customers, reflecting accurately the current status of the customer's account and
the amounts and details of payments due. Invoices must be dispatched early enough for
the customer to have time to evaluate the details contained in them and make payment by
the due date. An important credit management function is the checking of the details of
invoices and statements for accuracy. Inaccuracies could lead to the customer disputing
the invoice, resulting in a subsequent delay in payment, which would then adversely
effect cash-flow.
Credit Collection
Credit management officers are responsible for identifying bad debts and for taking steps
to recover bad debts. This can involve the renegotiation of lines of credit (the cash-value
of goods and services that will be supplied to the customer on account), renegotiation of
terms of payment for subsequent purchases, and the negotiation of terms to repay
currently outstanding amounts. Where a customer is not willing or able to negotiate the
repayment of a debt, credit management officers may decide to pass the debt to
commercial credit rating and credit collection agencies. In extreme cases, civil actions are
instigated, allowing the courts to mandate the recovery of the debt.
Cost of Credit
Accounts payable, or trade credit, are what businesses owe to their suppliers of inventory,
products, and other types of goods that are necessary to operate the business. It is estimated by
most experts that small businesses usually have as much as 40 percent of their financing from
trade credit - what they owe their suppliers
The formula for computing the cost of credit if a cash discount is not taken is:
Credit Cost = [Percent Discount / (100 – Percent of Discount)] x [360 / (credit period – discount
period)
Here
Average Receivables Processing Period (in days) = Accounts Receivable/Average Daily Credit
Sales Average Stockholding Period (in days) = Closing Stock/Average Daily Purchases
Average Payable Processing Period (in days) = Accounts Payable/Average Daily Credit
Purchases
A short cash cycle reflects sound management of working capital. On the other hand, a long
cash cycle denotes that capital is occupied when the commercial entity is expecting its clients to
make payments.
Debtors are organisations or people that owe the business money. This means that debtor’s collection
period, is the average amount of days it takes, for the business to receive the money it is owed from its
customers. The sooner debtors pay the business the better, so a short debtor’s collection period is good.
If debtors pay quickly, it helps cashflow and reduces the risk of customers not paying the money they o
Debtor Collection Period indicates the average time taken to collect trade debts. In other words,
a reducing period of time is an indicator of increasing efficiency. It enables the enterprise to
compare the real collection period with the granted/theoretical credit period.
Debtor Collection Period = (Average Debtors / Credit Sales) x 365 ( = No. of days) (average
debtors = debtors at the beginning of the year + debtors at the end of the year, divided by 2 or
Debtors + Bills Receivables)
measure how quickly a business pays its debts to its suppliers and other short term creditors. Creditors
divided by credit purchases or cost of sales, times 365
An indicator measures the average time it takes a company to settle its debts with trade suppliers
(accounts payable). Thus, among other things, it gives information about payment habits and also
whether a business is taking full advantage of trade credit available. In other words if we do not
pay too soon.
In the enterprise it used by CFO in financial ratios.
The difference between a company that succeeds and one that fails is often cash management. Having
too little cash means a business may have to pass on profitable ventures or take out loans to overcome
liquidity issues. Too little cash may also mean a company may be unable to operate at normal levels or
be forced to shut down completely. To avoid these issues, companies rely on a cash budget to plan and
control cash receipts and payments.
Company Performance
A cash budget is used to illustrate a company’s financial position to internal and external
stakeholders – individuals with an interest in the company – including investors, suppliers and
company leadership
Corrective Actions
A cash budget is a way to determine if a company has the cash necessary to meet upcoming
obligations and to trigger corrective actions if a company’s actual figures don’t match the budget
estimates.
Financing Needs
By creating a cash budget, a company can anticipate when a cash deficit might exist and the
extent of that shortfall. In turn, the budget indicates when a difference between budgeted and
actual values might need to be made up by borrowing. Short-term financing might be required to
acquire inventory, promote products or pay monthly expenses
(1) Helpful in Planning. Cash budget helps planning for the most efficient use of cash. It
points out cash surplus, or deficiency at selected point of time and enables the
management to arrange for the deficiency before time or to plan for investing the
surplus money as profitable as possible without any threat to the liquidity.
(2) Forecasting the Future needs. Cash budget forecasts the future needs of funds, its
time and the amount well in advance. It, thus, helps planning for raising the funds
through the most profitable sources at reasonable terms and costs.
(3) Maintenance of Ample cash Balance. Cash is the basis of liquidity of the enterprise.
Cash budget helps in maintaining the liquidity. It suggests adequate cash balance for
expected requirements and a fair margin for the contingencies.
(4) Controlling Cash Expenditure. Cash budget acts as a controlling device. The
expenses of various departments in the firm can best be controlled so as not to exceed
the budgeted limit.
(5) Evaluation of Performance. Cash budget acts as a standard for evaluating the
financial performance.
(6) Testing the Influence of proposed Expansion Programme. Cash budget forecasts the
inflows from a proposed expansion or investment programme and testify its impact on
cash position.
(7) Sound Dividend Policy. Cash budget plans for cash dividend to shareholders,
consistent with the liquid position of the firm. It helps in following a sound consistent
dividend policy.
(8) Basis of Long-term Planning and Co-ordination. Cash budget helps in co-ordinating
the various finance functions, such as sales, credit, investment, working capital etc. it is
an important basis of long term financial planning and helpful in the study of long term
financing with respect to probable amount, timing, forms of security and methods of
repayment.
TREASURY MANAGEMENT
Most banks have whole departments devoted to treasury management and supporting their
clients' needs in this area. Until recently, large banks had the stronghold on the provision of
treasury management products and services. However, smaller banks are increasingly launching
and/or expanding their treasury management functions and offerings, because of the market
opportunity afforded by the recent economic environment (with banks of all sizes focusing on
the clients they serve best), availability of (recently displaced) highly seasoned treasury
management professionals, access to industry standard, third-party technology providers'
products and services tiered according to the needs of smaller clients, and investment in
education and other best practices. A number of independent treasury management systems
(TMS) are available, allowing enterprises to conduct treasury management internally.
For non-banking entities, the terms Treasury Management and Cash Management are sometimes
used interchangeably, while, in fact, the scope of treasury management is larger (and includes
funding and investment activities mentioned above). In general, a company's treasury operations
comes under the control of the CFO, Vice-President / Director of Finance or Treasurer, and is
handled on a day-to-day basis by the organization's treasury staff, controller, or comptroller.
Bank Treasuries may have the following departments:
A Fixed Income or Money Market desk that is devoted to buying and selling interest bearing
securities
A Foreign exchange or "FX" desk that buys and sells currencies
A Capital Markets or Equities desk that deals in shares listed on the stock market.
In addition the Treasury function may also have a Proprietary Trading desk that conducts trading
activities for the bank's own account and capital, an Asset liability management (ALM) desk that
manages the risk of interest rate mismatch and liquidity; and a Transfer pricing or Pooling
function that prices liquidity for business lines (the liability and asset sales teams) within the
bank.
Banks may or may not disclose the prices they charge for Treasury Management products,
however the Phoenix Hecht Blue Book of Pricing may be a useful source of regional pricing
information by product or service.
Regulation
Concerns about systemic risks in Over The Counter (OTC) derivatives markets, led to G20
leaders agreeing to new reforms being rolled out in 2015. This new regulation, states that largely
standardized OTC derivative contracts should be traded on electronic exchanges, and cleared
centrally by Central Counterparty/Clearing House trades. Trades and their daily valuation should
also be reported to authorized Trade Repositories and initial and variation margins should be
collected and maintained