CHAPTER 1 INTRODUCTION TO RECEIVABLES MANAGEMENT

1. INTRODUCTION TO WORKING CAPITAL

 Working Capital is the funds required for managing day-to-day operations of a business. Basically, the capital
which is required to finance current assets is called working capital. It represent short term business needs.

 Working Capital is the management of current assets and current liabilities. Working capital is also known as
Circulating Capital or Trading Capital or Short Term Capital.

 Current Assets are those assets, which are meant for conversion into cash within a short duration, i.e.
generally upto 1 year (12 months). Current assets mainly used for trading purposes. Examples of current
assets include inventories, debtors, cash and bank balances, prepaid expenses, loans and advances,
marketable investments etc.

 Current Liabilities are those liabilities which are payable within a short duration, i.e. generally upto 1 year.
Such liability is created for day-to-day trading purposes. Examples of current liabilities include creditors,
outstanding expenses, tax provision, proposed dividend, short term loans, bank overdraft, cash credit etc.

2. TYPES OF WORKING CAPITAL

a) Gross Working Capital – the aggregate of only current assets

b) Net Working Capital – the difference between current assets and current liabilities, i.e. NWC = CA - CL

c) Permanent Working Capital – it is the minimum level of investment required in the business at any point of
time and hence at all points of time, it is also called Fixed or Core Working Capital.

d) Temporary Working Capital - it represents working capital requirements over and above permanent
working capital and is dependent on factors like ‘peak season, trade cycle, boom etc. It is also called as
Fluctuating or Variable Working Capital.

e) Initial Working Capital – Funds required at the commencement of business, are called initial working
capital. These are the promotion expenses incurred at the earliest stage of formation of the enterprise which
include the incorporation fees. Attorney’s fees, office expenses and other preliminary expenses.

f) Reserve margin working capital: It represents an amount utilized at the time of contingencies. Such
unpleasant events may occur at any time in the running life of the business such as inflation, depression,
slump, flood, fire, earthquakes, strike, lay-off and unavoidable competition etc. In this case greater amount of
capital is required for maintenance of the business.

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g) Negative Working Capital – It implies a situation where the current liabilities exceed the current assets, i.e.
the company is unable to honour its short-term commitments. It is a sign that the company may be facing
bankruptcy or a serious financial trouble. As a result, late payments to creditors, delay in EMI payments etc.
reduces its credit rating. Companies with negative working capital may lack the funds necessary for growth.
However, successful companies may also have negative working capital and still earn profits as long as the
transactions are timed correctly. It may be taken as a sign of extreme efficiency. E.g. Amazon, Wal-Mart

3. IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Working Capital Management can be defined as the management of a firm’s sources and uses of working capital,
for maximization of shareholders’ wealth. Working capital management is a short term concept, and hence time
value of money not considered. Working capital management affects the short term liquidity. Excess working capital
implies blocking up funds that can be productively used elsewhere. Insufficient working capital affects profitability,
production interruptions, inefficiencies and results in loss of opportunity, e.g. stock-outs, delayed payments etc.

Effects of Excess Working Capital –

 Unnecessary accumulation of inventories, resulting in possibility of theft, wastage etc.
 Indication of defective credit policy, resulting in delays in collection of debtors, bad debts etc.
 Excess working capital makes management complacent, leading to inefficiencies
 Higher liquidity may result in incorrect decision making, unproductive use of resources
 Idle cash – loss of investment opportunity, risk of theft and misappropriation.

Effects of Inadequate Working Capital –

 Growth is stagnated, i.e. it becomes tough for the firm to undertake profitable projects due to non-availability
of working capital resources/ funds.
 Difficult to implement operating plans and achieve firm’s profit targets.
 Operating inefficiencies due to daily crunch situation.
 Fixed assets are not efficiently utilized, leading to decreased profitability
 Interruptions in production, stock-outs, delivery schedules not met, poor quality (i.e. loss of reputation)

4. INVESTMENT IN CURRENT ASSETS vis-à-vis FIXED ASSETS

Higher the funds invested in working capital, lesser is the return in term of profitability as well as less amount is
available for investing in long-term fixed assets. Hence, a company should minimise investment in working capital
and concentrate on investment in fixed assets. Generally, it is said that current assets should be financed by current
liabilities. But it depends upon economic conditions prevailing at particular time and opportunities available. Certain
level of current assets is maintained throughout the year and it represents permanent working capital. Additional
inventory is maintained to support peak selling period when receivables also increase and must be financed.
Current assets financing is done by raising short-term loans or cash credits limits but fixed assets financing is done
by raising long-term loans or equity.

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5. ADEQUACY OF WORKING CAPITAL [WHETHER BALANCE SHEET IS TRUE]

Basically, it is believed that higher the level of current assets, higher the liquidity. Thus, a firm with high current ratio
is favourable and can easily pay its current liabilities. However, this may not be true since current assets should be
proportional to the level of turnover. If current assets are disproportionate to the turnover, it is an adverse situation,
despite a high level of current assets. It may be due to old inventory, long overdue receivables etc. Hence, it may
result in high cost of maintaining inventory, interest cost on financing current assets, obsolescence, bad-debts etc.

The Balance Sheet may not show the true picture of current assets. A Balance Sheet is prepared to show the
position at the end of a financial year. To have a better idea of current assets, we should take an average (weekly,
monthly, or quarterly) for the year. Further, the level of current assets should also be compared to the seasonal
nature of industry. Also, the quality of current assets is vital in deciding the liquidity position. Obsolete stock, over
debtors etc. only inflate the current ratio, but do not reflect the real liquidity position.

6. SOURCES OF WORKING CAPITAL FINANCE

Temporary Working Capital Permanent Working Capital

1 Trade Creditors 1 Equity Share Capital
2 Bills Payable 2 Preference Share Capital
3 Accrued / outstanding expenses 3 Debentures
4 Bank Overdraft 4 Deposits
5 Cash-Credit Facility 5 Bonds
6 Bill Discounting 6 Working Capital Term Loan (WCTL)
7 Pledging of Current Assets 7 Debt Securitization
8 Commercial Paper
9 Advances from Customers
10 Inter-Corporate loans
11 Depreciation
12 Factoring Services

7. APPROACHES TO WORKING CAPITAL MGT. / FINANCE

Every company requires working capital finance to continue regular production and smooth flow of the business
operations. However, every management has their own approach/ strategy for such financing, as given below:

 Aggressive Approach
In this approach, a company uses short term financing as a major source of funds, for its short term as well
as long term requirements. In other words, short term funds are used to purchase fixed assets and
permanent working capital etc. It is an aggressive approach since the firm depends believes on maintaining

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less liquidity at all times. Hence, blockage of funds is reduced and profitability is higher. However, there
might be liquidity problems in cases of emergency situations/ contingencies, i.e. it is a high risk approach.

 Conservative Approach
In this approach, a company uses long term funds as a major source of finance, for meeting its short term as
well as long term requirements. Long term funds include equity capital, debentures and term loans. In other
words, long term funds are used to purchase fixed assets as well as maintaining working capital. It is a
conservative approach since the firm depends on high safety through long term financing and thus maintains
high liquidity at all times. Hence, blockage of funds is considerably high and return on assets is on the lower
side. There is no problem of liquidity i.e. it is a low risk approach. But, profitability is lower.

 Matching / Hedging Approach

In this approach, a company uses a balanced mechanism. Thus, long term funds are used for long term
requirement and short term funds are used for short term requirements. In other words, short term funds are
used to finance current assets whereas long term funds are used to purchase fixed assets. It is a matching
approach since there is a balance between liquidity and profitability.

8. IMPROVING WORKING CAPITAL POSITION

Working capital is an effective barometer of a company’s operational and financial efficiency and effectiveness.
Better the WC condition, the better company is positioned to focus on developing its core business. Following steps
can be taken for improving the working capital position of a company –

a) Create Awareness – A properly planned and executed improvement program will focus on optimizing each
WC component. Executives shall integrate WC management into their strategic and tactical thinking.

b) Proper Communication – Institute a system of communication to identify problems and brainstorm for the
probable solutions. Involvement of all levels of management shall make the process all-inclusive.

c) Collaborative Supplier–Customer Management – Plan working capital along with clear and honest
discussions with suppliers and customers. Identify their needs, know their operations and then plan working
capital. Such collaboration helps in aligning the procurement, production and distribution cycles.
Documentation of such process is vital for future references as well as to avoid any disputes.

d) Collection of Cash – Ensure that the cash is received and collected promptly. Confirm with customers
about receipt of invoices and dispatches of cheques or any other mode of money transfer.

e) Realistic Targets – Ensure that the staff are given realistic and practical targets to manage working capital.
The targets shall be hard enough to motivate the employees and good enough to achieve them.

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9. RECEIVABLES / DEBTORS MANAGEMENT

Receivables or Debtors are the amount represented by good or services sold on credit. Receivables are expected to
be realized/ collected in future. It forms a vital part of current assets of a firm. Debtors result in blockage of funds
and hence it represents investment by a firm. Hence, management of sundry debtors is an important issue and
requires proper policies and efficient execution of such policies.

Reasons for creation of Debtors:

 Marketing – credit is used as a marketing tool to attract new customers.

 Competition – higher the degree of competition, more credit granted to clients.
 Business Practice – no choice to new entrepreneurs
 Bargaining Power of Seller – stronger bargaining power implies less or no credit.
 Relationship – credit is granted due to good relations with dealers / clients
 Bargaining Power of Buyers – large buyers command easy credit due to bulk purchases
 Buyers’ Requirements – buyer is not able to pay immediately.

Costs involved in Receivables Management

1) Interest Cost – Funds are blocked in receivables. This involves cost in the form of opportunity cost on
owned funds or actual interest costs in case of loan funds.
2) Administrative Costs – Costs of record keeping, investigation of credit worthiness etc.
3) Delinquency Costs – Costs of reminders, phone calls, follow-up letters etc.
4) Collection Costs – Cost of contacting customers, collecting cheques in person, collection charges, etc.
5) Default Costs – Bad debts, legal charges in respect of suits pending against debtors etc.
6) Inflationary Costs – Under high inflation, investment in receivables should be minimized as far as
possible.

Steps in Receivables Management

Following are the steps involved in management of receivables –

1. Credit Policy – A credit policy determines the investment in sundry debtors, average collection period and bad
debt losses. Hence, credit policy of a firm should enable it to achieve the objectives of –
 Increasing sales and market share,
 Increasing profits due to higher sale and higher margins on credit sales, and
 Meeting competition

Example – if credit sales are Rs. 30,000 per day and credit period is of 60 days, firm’s average investment in
debtors (i.e. funds blocked) are Rs. 18,00,000 (Rs. 30,000 x 60 days).

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Credit policy involves decisions relating to length of the credit period, credit limits, discount policy, dealer
agreements, warranty terms, interest on delayed payments, business deposits, issuance of credit notes,
debtors’ account reconciliation and any other special items etc.

Credit Period denotes the period allowed for payment by customers, in the normal course of business. It is
generally stated in terms of net days. For example, if the credit terms are “net 45”, it means that customers will
repay credit obligations not later than 45 days. The credit period depends on a number of factors such as –

 Nature of product i.e. if demand is inelastic or if product is perishable, credit period may be small.
 Quantum of Sales - Credit may not be allowed if small quantities are purchased.
 Customs and Practices - normal trade practices and those followed by competitors
 Funds available with the company
 Credit Risk i.e. possibility of bad debts

Discount Policy involves decisions relating to percentage of cash discount to be offered as incentive for early
settlement of invoice and the period within which cash discount can be availed. Discounts are offered to speed
up the collection of debts. Hence, it improves the liquidity of the seller. It also ensures prompt collection and
reduces risk of bad debts. Normally, discount terms and credit terms are expressed as “2/10 net 60” means that
a cash discount of 2% will be granted if customer pays within 10 days; if he does not avail the offer he must pay
within 60 days, being the credit period.

A lenient credit policy may result in increased sales. However, additional costs incurred must also be
considered, viz. production and selling costs, administration costs, recovery costs and bad debts. Discount
policies of firms are based on cost-benefit analysis w.r.t credit period granted and classification of customers.

2. Credit Analysis – Credit Analysis is the measurement of risk borne by a seller. It evaluates the quality of
customers. Sufficient records of clients must be available and scrutinized by the seller, such as average
collection period, default rate, references, goodwill etc. and suitable rating given. Based on such scrutiny,
customers shall be categorized as per their creditworthiness and default risk. Finally, there shall be
synchronization of credit policy and credit analysis.

Factors to be analysed before Credit is granted to a Customer:

Credit should be granted on a case–to–case basis, on the following illustrative factors:

 Nature of Product: Generally perishable items are “cash and carry” basis, while durable / non-
perishable items may be sold on credit.
 Nature of customer: A valued customer, who has long and favourable past dealings with the firm may
be given credit immediately, than a new customer. However, credit may be offered for attracting new
customers
 Quantity purchased: Firms may decide to grant credit only beyond a certain lot size. For example sale
upto 5 kg per invoice is made on cash basis only, while orders beyond 5 kg may be supplied on credit.
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 Value of Sales: Sometimes, the invoice value (instead of quantity) may be the determinant in a credit
decision. For example, credit may be granted for amounts exceeding Rs. 15,000/-.
 Credit-worthiness of the customer: The credit-worthiness of the customer is the most crucial factor in
deciding whether credit should be granted or not. This is based on past experience (for existing
customers) and credit analysis (for existing and new customers).
 Risk of Bad Debts: The extent of risk of bad debts that a firm can bear should be determined. For
example, if there is a 1 % chance of bad debts, the firm may take the risk of credit supply, but when the
chance of bad debts is 55%, credit should not be granted.

Sources of Credit Rating Information

Credit rating of a customer is based on the ability and willingness of a customer. It is comparatively easy to
judge the financial ability than willingness of a buyer. Based on such credit rating, a seller has to decide how
much and how long can credit be extended. Credit can be granted only to a customer who is reliably sound. This
decision would involve analysis of the financial status of the party, his reputation and previous record of meeting
commitments.

Following are the important sources of credit information –

1) Trade references: The prospective customer may be required to give two/three trade references. Thus, the
customers may give a list of personal acquaintances or some other existing credit-worthy customers. The
credit manager can send a short questionnaire, seeking relevant information, to the referees.
2) Bank references: Sometimes, the customer is asked to request the banker to provide the require
information. In India, bankers do not generally give detailed and unqualified credit reference.
3) Credit bureau reports: Associations for specific industries may maintain a credit bureau, which provide
useful and authentic credit information for their members.
4) Past experience: The past experience of dealings with an existing customer is a valuable source of
essential data. The transactions should be carefully scrutinised and interpreted for finding out the credit risk
involved.
5) Published financial statements: Published financial statements of a customer, (in case of limited
companies) can be examined to determine the credit-worthiness.

3. Monitoring Receivables – Monitoring of receivables involves the following measures:

1) Average Age of Receivables: Debtors Turnover Ratio and Average Collection Period are worked out at
periodic intervals. These are compared with the industry norms or the standards set by firm. In case of high
collection period, intense collection efforts are initiated.
2) Ageing Schedule: The pattern of outstanding / receivables is determined by preparing the Ageing
Schedule. If receivables denote old outstanding due for longer periods, suitable action to be taken to collect
them immediately.

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3) Collection Programme: The procedures for collection e.g. reminder letters, direct follow-up etc. should be
initiated based on the company’s policies and procedures.
4) Debtors’ Reconciliation – Periodic and regular reconciliation with customers’ accounts helps to reduce any
differences, and also avoid frictions involved in collection process.

Ageing Schedule – In an ‘Ageing Schedule’, the receivables are classified according to their age, i.e. period for
which they have been outstanding, e.g. less than’ 30 days, 30-45 days, 45-60 days, above 60 days etc. Role:
Preparation of ageing schedule helps management in analysis of quality of customers, trend Analysis of debtors,
supplement to average collection period of receivables / sales analysis and recognition of recent increase and
slump in sales.

An illustrative Ageing Schedule is given below:

Period due No. of No. of Amount % of Remarks

parties bills due Total
Less than 15 days 65 70 34,180 3.42% Less than normal credit period
16 - 30 days 12 80 46,840 4.68% Less than normal credit period
31 - 45 days 86 241 3,83,690 38.37% Normal Credit Period debts
46 - 60 days 91 196 3,59,960 36.00% Regular reminders sent
61 - 90 days 43 52 97,100 9.71% Special reminders sent
91 - 180 days 12 22 41,350 4.13% Rs. 18,150 doubtful
181 - 365 days 6 9 3,000 0.80% Legal notice sent - reply due
> 1 year 3 3 17,860 1 .79% Suit filed - decision awaited
> 2 years 2 2 11,020 1.10% Suit filed - decision awaited
Total 320 675 10,00,000 100.00%

4. Collection Policy

Average collection period and bad debt losses are reduced by efficient and timely collection of debtors. Hence, a
proper collection policy should be laid down. The following aspects should be covered in Collection Policy and
procedures.
 Timing of the collection process - when to start reminding etc.
 Despatch of reminder letters to Customers.
 Personal follow-up by Company’s representatives and telephonic calls.
 Appointment of agents for collection or follow-up.
 Dealing with default accounts, legal action to be initiated, notice to defaulting customer etc.

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Cost Benefit Analysis: There are certain routine costs associated with collection from customers e.g. contacting
customers, collecting cheques in person, collection agency fees etc. If a firm spends more on collection of debts, it
is likely to have smaller bad debts. Hence the amount of collection costs to be incurred should be determined by
Cost-Benefit Analysis i.e. level of expenditure vis-à-vis decrease in bad debt losses and investment in debtors.

Collection Programme – The following are the illustrative steps in a collection programme.
a) Monitoring the state of receivables.
b) Intimation of due dates to customers.
c) Telegraphic and telephonic advice to customers on the due date.
d) Threat of legal action on overdue accounts.
e) Legal action on overdue accounts.

5. Innovations in Receivables Management

1. Centralization: Centralization of high nature transactions of accounts receivables and payable is one of the
practices for better efficiency. This focuses attention on specialized groups for speedy recovery.

2. Direct debit: i.e. authorization for the transfer of funds from the buyers’ bank account.

3. Collection by a third party: The payment can be collected by an authorized external firm. The payments
can be made by cash, cheque, credit card or Electronic fund transfer. Banks may also be acting as
collecting agents of their customers and directly depositing the collections in customers’ bank accounts.

4. Lock Box Processing: Under this system an outsourced partner captures cheques and invoice data and
transmits the file to the client firm for processing in that firm’s systems.

5. Internet Payment

6. E-commerce refers to the use of computer and electronic telecommunication technologies. It uses
technologies such as Electronic Data Inter-change (EDI), Electronic Funds Transfer (EFT) and Electronic
Clearance System (ECS) to allow buyer and seller to transact business by exchange of information between
computer systems.

7. Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the purchase of
trade bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in
the form of discounting the documents covering entire risk of non-payment in collection. All risks and
collection problems are fully the responsibility of the purchaser (forfaiter) who pays cash to seller.

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RECEIVABLES MANAGEMENT NUMERICAL:

1) A new customer with 10% risk of non-payment desires to establish business connections with you. He requires
1.50 month of credit period and is likely to increase your sales by 120,000 p.a., cost of sales amounted to 85%
of sales. The tax rate is 30%. Should you accept the offer if the required rate of return is 40% (after tax)?

2) Kiran Corporation is considering relaxing its present credit policy and is in the process of evaluating two
proposed policies. Currently, the firm has annual credit sales of Rs. 50 lakhs and accounts receivable turnover
ratio of 4 times a year. The current level of loss due to bad debts is Rs. 150,000. The firm is required to give a
return of 25 % on the investment in new accounts receivables. The company’s variable costs are 70 % of the
selling price. Select the best option from the following:

Particulars Present Policy Policy Option – I Policy Option –II

Annual Credit Sales Rs. 50,00,000 Rs. 60,00,000 Rs. 67,50,000
Accounts receivables turnover ratio 4 times 3 times 2.40 times
Bad debt losses Rs. 1,50,000 Rs. 3,00,000 Rs. 4,50,000

3) A firm’s product sells for Rs. 10 per unit out of which Rs. 7 is variable costs before taxes (including credit
departmental costs). Current annual sales are Rs. 12 lakhs, represented entirely by credit sales, and average
total cost per unit is Rs. 9 per unit before taxes. The firm is considering a more liberal extension of credit which
will result in slowing process of the average collection period from one to two months. This credit relaxation is
expected to increase sales by 25 %, i.e. sales would become Rs. 15 lakhs annually. Advice the management if
minimum expected rate of return is 20 %.

4) Gelcorp Ltd. provides ‘net 30 days’ credit to its customers of 600 lakhs and its average collection period is 45
days. To stimulate sales, the company may grant credit terms of ‘net 60 days’. The turnover is expected to rise
by 15% and the expected collection would be after 75 days. There would be no difference in payment habits of
old and new customers. Variable cost of 80 paise per rupee of sales. Gelcorp’s expected rate of return on
investments in receivables is 20%. Assuming 360 days in a year, advise whether credit terms be changed?

5) Shrinath Traders Ltd. currently sells on terms of ‘net 30 days’. All sales are on credit basis and average
collection period is 35 days. Currently, it sells 500,000 units at an average price of Rs. 50 per unit. The variable
cost to sales ratio is 75% and a bad debt to sales ratio is 3%. In order to expand sales, the management of the
company is considering changing the credit terms from net 30 to 2/10, net 30. Due to the change in policy,
sales are expected to go up by 10%, bad debt loss on additional sales will be 5%. Now, 40% of the customers
are expected to avail the discount and pay on the tenth day. The average collection period for the new policy is
expected to be 34 days. The company required a return of 20% on its investment in receivables. Whether policy
shall be changed? Advice.

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6) The manager of Suhana Ltd. is giving a proposal to Board of Directors of company that an increase in credit
period allowed to customers from the present one month to two months will bring a 25% increase in sales. The
following operational data of the company for the current year are taken from the records of the company:
 Selling price Rs. 21, Variable cost per unit 14, Total cost per unit Rs. 18, Sales value Rs. 18,90,000
 Board has requested you to give your expert advice on new credit policy, if required rate of return is 40%.
 Also compute the actual return earned on additional investment.

7) Pawan Ltd. has total sales Rs. 30 lakhs with average collection period of 2 months. To expedite collection, the
company is thinking of offering 2% discounts. As a result, 50% of existing customers are likely to avail the
discount. Also, average collection period shall reduce by 1 month. If Pawan Ltd. expects 25% return on
investments, whether the policy shall be changed? Show working notes to justify your suggestion.

8) Sadhana Ltd. currently maintains a centralized billing system at Head Office to handle the daily collections of
Rs. 450,000. The total time of mailing, processing and clearing has been estimated at 4 days. If the company’s
opportunity cost on short-term funds is 15%, what is the cost of this delay of 4 days to the company? If
management designed a lock-box system with local banks, the float would reduce by 1.50 days and Head
Office expenses would reduce by Rs. 52,000. If cost of lock-box system is Rs. 200,000 p.a., decide?

9) Universal Cables has a centralized billing system. On an average 5 days are required for customers’ mailed
payments to reach the central location. Additional 2 days are required for processing the payments and deposit
in the bank account. The daily average collection is Rs. 800,000. The company is thinking of a lock-box system
which will reduce mailing delays to 3 days. Also, processing time will reduce by one day. Determine the
reduction in cash balances that can be achieved through the use of lock box system. The opportunity cost is
7.50% on short term investments. If annual cost of lock box is Rs. 120,000, should be system be initiated?

10) A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average collection period of 30
days wants to pursue a more liberal policy to improve sales. A study made by a management consultant
reveals the following information:
Credit Policy Increase in Collection Increase in Sales (Rs.) Present Default
Period Anticipated
A 10 days 30,000 1.50%
B 20 days 48,000 2%
C 30 days 75,000 3%
D 45 days 90,000 4%
The selling price per unit is Rs. 3. Average cost per unit is Rs. 2.25 and variable costs per unit are Rs. 2. The
current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.
ANALYSE which of the above policies would you recommend for adoption?

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11) A company is presently having credit sales of ₹ 12 lakh. The existing credit terms are 1/10, net 45 days and
average collection period is 30 days. The current bad debts loss is 1.5%. In order to accelerate the collection
process further as also to increase sales, the company is contemplating liberalization of its existing credit terms
to 2/10, net 45 days. It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase
to 2% of sales and average collection period to decline to 20 days. The contribution to sales ratio of the
company is 22% and opportunity cost of investment in receivables is 15 percent (pre-tax). 50 per cent and 80
percent of customers in terms of sales revenue are expected to avail cash discount under existing and
liberalization scheme respectively. The tax rate is 30%. ADVISE, should the company change its credit terms?
(Assume 360 days in a year).

12) Mosaic Limited has current sales of Rs. 15 lakhs per year. Cost of sales is 75 per cent of sales and bad debts
are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent fixed costs, while
the company’s required rate of return is 12 per cent. Mosaic Limited currently allows customers 30 days’ credit,
but is considering increasing this to 60 days’ credit in order to increase sales. It has been estimated that this
change in policy will increase sales by 15 per cent, while bad debts will increase from one per cent to four per
cent. It is not expected that the policy change will result in an increase in fixed costs and creditors and stock will
be unchanged.
Should Mosaic Limited introduce the proposed policy? ANALYSE (Assume a 360 days year)

13) Ash Ltd follows a collection policy as detailed below:

1) 10% of sales is collected in same month.
2) 20% of sales is collected in second month.
3) 40% of sales is collected in third month.
4) 30% of sales is collected in fourth month.
Sales of the company for first three quarters of the year are as follows:
Month of the Quarter Quarter – I (in Rs) Quarter II (in Rs) Quarter III (in Rs)
1 15,000 7,500 22,500
2 15,000 15,000 15,000
3 15,000 22,500 7,500
Total 45,000 45,000 45,000
No of Working Days 90 90 90
You are required to work out average age of receivables.

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CHAPTER 2 FACTORING
1. PLEDGING

 This refers to the use of a firm’s receivable to secure a short-term loan. After cash, a firm’s receivables can be
termed as its most liquid assets and this serve as prime collateral for a secured loan.
 The lender scrutinizes the quality of the account receivables, selects acceptable accounts, creates a lien on the
collateral and fixes the percentage of financing receivables which ranges around 50 to 90%.
 The major advantage of pledging accounts receivables is the ease and flexibility it provides to the borrower.
 Moreover, financing is done regularly. This, however, suffers on account of high cost of financing. Also being a
loan, it leaves an impact on the debt equity ratio as well by increasing the amount of debt.

2. FACTORING

Basically, factoring is a kind of financial service in which a business organization sells its Account Receivables to
another person, called a factor, at a discount in order to raise money. Factoring is different from bill discounting. In
bill discounting invoice are discounted at a certain rate to get the funds, whereas the concept of factoring is broader.
In the factoring process, the Account Receivables are sold to an outside agency.

Example - The seller sold good on credit and raised the invoice. However, the seller needs immediate money to
meet its working capital requirements i.e. meeting day to day expenses of the business. For this purpose, he sold
the receivables to an outside agency i.e. a factor. The factor pays the required amount to the seller after deducting
some amount. So, the entire invoice amount is not paid by the factor. Rather, about 70-80% of the bill amount is
paid by the factor. The remaining amount is paid after the factor receives the entire bill amount from the customers
(debtors). The factor charges some commission for providing these services. Thus, essential features of factoring
can be summarized as under:

 Factoring is a relatively new concept in financing of accounts receivables.

 This refers to outright sale of accounts receivables to a factor or a financial agency.
 A factor is a firm that acquires the receivables of other firms.
 The factoring lays down the conditions of the sale in a factoring agreement.
 The factoring agency bears the risk of collection and services the accounts for a fee.

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Factoring agreement can be on either of the two basis:

 Recourse: In case factor is unable to collect the amount from receivables then, factor can turn back the same
to the organization for resolution (which generally is by replacing those receivables with new receivables). In
other words, factor does not the risk of bad debts.

 Non-Recourse: The factor bears the ultimate risk of loss in case of default and hence in such cases they
charge higher commission.

There are a number of financial institutions providing factoring services in India. Some commercial banks and other
financial agencies provide this service. The biggest advantages of factoring are the immediate conversion of
receivables into cash and predicted pattern of cash flows. Financing receivables with the help of factoring can help a
company having liquidity without creating a net liability on its financial condition and hence no impact on debt
equity ratio. Besides, factoring is a flexible financial tool providing timely funds, efficient record keepings and
effective management of the collection process. This is not considered as a loan. There is no debt repayment and
hence no compromise to balance sheet, no long-term agreements or delays associated with other methods of
raising capital. Factoring allows the firm to use cash for the growth needs of business.

3. FACTORING & FORFAITING DIFFERENCE

Forfaiting
Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the purchase of trade
bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in the form of
discounting the documents covering the entire risk of non-payment in collection. All risk and collection problems are
fully the responsibility of the purchaser (forfaiter) who pays cash to the seller after discounting the bills/notes.

Difference between Forfaiting and Export Factoring

(a) A forfaiter discounts the entire value of the note/bill. In a factoring arrangement, the extent of financing
available is 75-80%.
(b) The forfaiter’s decision to provide financing depends upon the financing standing of the availing bank. On
the other hand, in a factoring deal the export factor bases his credit decision on the credit standards of the
exporter.
(c) Forfaiting is a pure financial agreement while factoring includes ledger administration as well as collection.
(d) Factoring is a short-term financial deal. Forfaiting spreads over 3-5 years.

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Examples:

1. A firm has credit sales of Rs. 360 lakhs and its average collection period is 30 days. The financial controller
estimates, bad debt losses are around 2% of credit sales. The firm spends Rs. 1,40,000 annually on debtors’
administration. This cost comprises of telephonic and fax bills along with salaries of staff members. These are
the avoidable costs. A Factoring firm has offered to buy the firm’s receivables. The factor will charge 1%
commission and will pay an advance against receivables on an interest @15% p.a. after withholding 10% as
reserve. ANALYSE what should the firm do? Assume 360 days in a year.

2. A factoring firm has offered a company to buy its accounts receivables. The relevant information is given below:
(i) The current average collection period for the company's debt is 80 days and ½% of debtors default. The
factor has agreed to pay over money due to the company after 60 days and it will suffer all the losses of
bad debts also.
(ii) Factor will charge commission @2%.
(iii) The company spends Rs. 1,00,000 p.a. on administration of debtor. These are avoidable cost.
(iv) Annual credit sales are Rs. 90 lakhs. Total variable costs are 80% of sales. The company's cost of
borrowing is 15% per annum. Assume 365 days in a year. Whether company should enter into factoring
agreement.

3. Under a factoring arrangement Ranki Factors Services Limited has advanced a sum of 140 lakh against the
receivable purchased from Aangi Limited. The Factoring agreement provides for an advance payment of 80%
(maintaining factor Reserve of 20% to provide for disputes and deductions relating to the bills Assigned) of the
value of factored receivable and for guaranteed payment after three months from the date of purchasing the
receivables. The advance carries a rate of interest of 12% per annum compounded quarterly and the factoring
commission is 2.5% of the value of factored receivables. Both the interest and commission are collected
upfront. You are required to compute the amount of advance payable to Aangi Limited.

4. A company has credit sales of Rs. 800 lakhs, and its average collection period is 60 days. The company
estimates its bad debt losses to be 2.5% of credit sales. The annual cost of managing debtors, including
telephone and administrative expenses, amounts to Rs. 2,00,000, which are considered avoidable costs. A
Factoring firm has proposed to purchase the company's receivables. The factoring firm will charge a 1.5%
commission and will provide an advance against the receivables at an annual interest rate of 10% p.a.,
withholding 6% as a reserve. Assume there are 360 days in a year. Whether factoring proposal should be
accepted?

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5. A business engages in substantial credit sales amounting to Rs. 150 lakhs annually. Their average collection
period stretches to 100 days, and they maintain a conservative default rate of 0.3% among their debtors. An
intriguing proposition has arisen from a Factoring firm, expressing interest in acquiring the company's accounts
receivables. The Factoring firm commits to disbursing funds to the company within 75 days and assumes all
risks associated with bad debt. They apply a commission rate of 2%. The company allocates Rs. 2,00,000
annually for debtor management, costs that can be eliminated through factoring. Moreover, the company's total
variable costs represent 65% of their sales, and they grapple with a cost of borrowing at 14% per annum.
Considering a year comprising 365 days, should the company give serious thought to accepting the factoring
proposal?

6. A firm conducts credit sales worth Rs. 600 lakhs with an average collection period of 45 days. They anticipate
that bad debt losses will account for 3% of their credit sales. The annual cost associated with debtor
management, encompassing telephone and administrative expenses, is Rs. 1,50,000, and these costs are
considered avoidable. A Factoring firm extends an offer to purchase the firm's receivables. The Factoring firm
proposes a 2% commission and offers an advance against receivables at a yearly interest rate of 12%, holding
back 5% as a reserve. With 360 days in a year, should the firm consider accepting the factoring proposal?

7. A firm engages in credit sales worth Rs. 120 lakhs annually. They face a relatively long average collection
period of 90 days, and their default rate among debtors is negligible at 0.5%. An enticing offer from a Factoring
firm has emerged, proposing to acquire the company's accounts receivables. The Factoring firm commits to
delivering funds to the company within 60 days and undertakes all bad debt losses. The commission charged
by the Factoring firm is set at 2%. The company incurs annual administrative costs of Rs. 1,50,000, costs that
can be avoided through factoring. Furthermore, the company's total variable costs constitute 70% of their sales,
and they face a cost of borrowing at 10% per annum. With a year consisting of 365 days, should the company
seriously consider the factoring offer?

8. A company achieves credit sales of Rs. 1,200 lakhs, and their average collection period spans 90 days. They
estimate bad debt losses at 1.5% of credit sales. Managing debtors, including telephone and administrative
expenses, costs the company Rs. 3,50,000 annually. These costs are regarded as avoidable. The Factoring
firm approaches the company with a proposal to purchase their receivables. The offer entails a 2.5%
commission and an advance against receivables at an annual interest rate of 8%, while reserving 7% of the
amount. With 360 days in a year, should the company contemplate accepting the factoring offer?

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9. A business records credit sales amounting to Rs. 500 lakhs, and their average collection period is a swift 30
days. They anticipate that bad debt losses will be limited to 1% of credit sales. The annual cost related to
debtor management, which includes telephone and administrative expenses, totals Rs. 1,00,000. These
expenses are considered avoidable. An offer has been presented by a Factoring firm to acquire the company's
receivables. The proposal involves a 1.2% commission and provides an advance against the receivables at an
annual interest rate of 15%, holding back 8% as a reserve. With 360 days in a year, should the company
entertain the prospect of embracing the factoring proposal?

10. A company conducts credit sales totaling Rs. 75 lakhs annually. They experience an average collection period
of 70 days, with a 1% default rate among their debtors. A Factoring firm has extended an offer to purchase the
company's accounts receivables. The Factoring firm commits to providing the company with funds within 45
days while bearing the burden of bad debt losses. A commission of 2% is charged by the Factoring firm. The
company incurs avoidable administrative costs of Rs. 80,000 per annum related to debtor management.
Furthermore, the company's total variable costs amount to 75% of their sales, and their cost of borrowing
stands at 12% per annum. Interest @7% p.a. payable to the factor. Assuming a year with 365 days, should the
company consider accepting the factoring proposal?

11. A small business has credit sales of Rs. 50 lakhs per year. They typically experience a 90-day average
collection period and estimate bad debt losses at 2% of credit sales. The business incurs an annual cost of Rs.
20,000 for managing debtors, which is considered an avoidable cost. A Factoring firm offers to buy their
receivables, charging a 1.5% commission and providing an advance against receivables at a 10% annual
interest rate while withholding 5% as a reserve. Should the small business accept the factoring offer?

12. A medium-sized company has credit sales of Rs. 200 lakhs annually. Their average collection period is 60
days, and they anticipate bad debt losses of 1.5% of credit sales. The company spends Rs. 1,50,000 each year
on debtor administration costs, which they consider avoidable. A Factoring firm proposes to purchase their
receivables, charging a 2.5% commission, offering an advance against receivables at a 12% annual interest
rate, and withholding 7% as a reserve. Should the medium-sized company consider the factoring proposal?

13. A retail business has credit sales amounting to Rs. 30 lakhs per year. Their average collection period is 45
days, and they expect bad debt losses to be 3% of credit sales. The business incurs an annual cost of Rs.
10,000 for managing debtors, which they consider avoidable. A Factoring firm approaches them with an offer to
purchase their receivables. The factoring firm charges a 1% commission and provides an advance against
receivables at an 8% annual interest rate while withholding 4% as a reserve. Should the retail business explore
the option of accepting the factoring offer?

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CHAPTER 3 INVENTORY MANAGEMENT

INTRODUCTION  material cost comprises 60-70% of the total cost structure

 the term ‘material’ refers to raw materials used for production, sub-
assemblies and fabricated parts
 ‘Stores’ has a wider meaning and consists of many other items such
as finished goods, semi-finished goods (WIP), tools, equipment,
maintenance and repair items, factory supplies, components, jigs,
fixtures
 Materials are of two types, viz. direct materials and indirect
materials.
Direct materials  can be easily identified and attributable to the
individual units being manufactured.
 All costs which are incurred to obtain direct
material are known as direct material costs, e.g.
carriage inwards, customs duty, and octroi duty
etc.
Indirect  Indirect materials are those materials which
Materials cannot be identified with the cost units,
 e.g. spares, consumables, oil and fuel etc.
Inventory Control Meaning The systematic control, monitoring and regulations of
purchases, storage and usage of materials.
Objectives  To provide continuous flow of required
materials, for efficient and uninterrupted flow of
production,
 To minimize investment in inventories
 To provide for efficient storage of materials so
that inventories are protected from loss by fire
and theft
 Material should be purchased only when it is
needed and in most economic quantities
 Issues of materials are authorized properly
 To keep surplus and obsolete items to minimum
Techniques 1. Min-Max Plan 1. The min and max level of stock is decided for
each item
2. Minimum level means time to purchase (reorder
point)
3. Material will be purchased once it reaches min
level.
4. Purchase would be such that the items stock is at
maximum level. (min level + purchase qty. =
Max Level)
5. EOQ, high value/critical items are ignored

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2. ABC analysis The items of material are classified into ‘A’, ‘B’ or ‘C’
category
 ‘A’: 5-10% of the total items(Qty.) & about 80% of
the total value of the inventory. Maximum control is
ensured on ‘A’ items such as adequate security,
periodical physical verification

 ‘B’: 20-25% of the total items (Qty) & about 15% of

the total value. Control over ‘B’ items is lenient as
compared to ‘A’ class items. Physical verification
may be conducted annually.

 ‘C’: 65-75% of the total quantity & about 5% of the

total value of the inventory (negligible). Control is
based on cost-benefit analysis. Physical verification
may be conducted once in two years
3. Fixing 1. Material control is ordering discipline, i.e.
inventory levels Neither purchase more nor less
2. The timing of the procurement is also important
3. Fixing material levels is a technique which tries
to achieve correct procurements – quantity and
timing
3a. Reorder level  It is for deciding the time of placing an order
(ROL)  Once stock reaches this level, fresh order is
placed
ROL = max consumption per period * max lead time
3b. Maximum  Highest level beyond which the inventory of
level material is not allowed to rise.
 The purpose of maximum level is to avoid
overstocking
Max level= ROL + reorder qty.–[min. Consumption *
min. Lead time]
3c. Minimum  Objective of this level is to avoid shortage of
level material.
 If production is held up due to shortage of
material, there will be huge loss to the company
Min level = ROL – [avg. Consumption * avg. Lead time]
3d. Average Average level =
level

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3e. Danger level  Danger level of stock is maintained below the

minimum stock level.
 When the danger level is reached, the
procurement must be done under all
circumstances
Danger level = avg. Consumption * emergency lead
time
Safety level = ROL – (avg. Consumption * lead time), or
Safety level = (max consumption – avg rate of
consumption) * lead time.
4. Economic 1. Inventory management has two costs -
order quantity procurement (ordering) cost and carrying
(EOQ) (storage) cost
(re-order 2. Ordering cost and carrying cost are inversely
quantity) related to each other
3. Bulk purchase reduces ordering costs but
increases carrying costs and vice versa
4. EOQ is that order (purchase) size which
minimizes the total of ordering and carrying
costs
5. Procurement (ordering) costs include handling
and transportation costs, stationery costs,
postage, telegraph and telephone charges, costs
incurred for inviting quotations and tenders etc.
6. Carrying costs include interest on capital
blocked, rent of warehouse, salaries of store-
keepers, loss due to deterioration, insurance
charges etc.
E.O.Q. = √
A= annual requirement of rm in units
O= ordering cost per order
C= carrying cost per unit per annum
5. Perpetual 1. Perpetual inventory system means continuous
inventory stock-taking
system 2. A continuous record of receipt and issue of
materials is maintained by the stores department
3. Entries in the bin card and the stores ledger are
made after every receipt and issue and the
balance is reconciled on regular basis with the
physical stock
4. Avoids disruptions in the production caused by
shortages

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5. Helps in having a detailed and more reliable

check on the stocks
6. Eliminates delays and stoppage in production
7. Discrepancies and errors are promptly
discovered
8. This method has a moral effect on the staff
9. Management can exercise control over cost
10. The investment in stock can be reduced to the
minimum
6. Review of 1. These items represent money locked in the
slow moving business
and non- 2. If more money is locked, lesser is the amount
moving available for the working capital
3. These items increase cost of carrying inventory
4. Slow moving items must be reviewed carefully
before eliminating them
5. Non-moving items stands for dead stock or
dormant stock which will not be used further.
6. It is necessary to identify these items and if there
cannot be any alternative use for the same,
should be eliminated.

INVENTORY CONTROL TECHNIQUES NUMERICAL

Q1. Find out EOQ from the following particulars. Monthly usage – 500 units. Cost of material
per unit – Rs. 20 Cost of placing and receiving one order – Rs. 60. Annual carrying cost –
10%.

Q2. Annual consumption is 15,000 kg of raw material. Ordering cost per order amounts to Rs.
48 and cost of raw material is Rs. 2 per kg. Storage cost is 8% of average inventory.
Compute EOQ.

Q3. A company uses 50,000 units of an item each costing Rs. 1.20. Each order costs Rs. 45 and
carrying cost 15% of annual inventory value. Calculate EOQ.

Q4. The annual requirement of an item is 12,000 units, each costing Rs. 6, every order costs Rs.
200 to release and inventory carrying charges are 20% on average inventory per annum.
Compute EOQ.

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Q5. A manufacturing company manufactures a special product. The following are particulars
collected for the year 2013-14:
Monthly demand: 1,000 units. Cost of placing an order: Rs. 100. Annual carrying cost per
unit: Rs. 15. Usage per week: Normal – 50 units, Maximum – 75 units, Minimum – 25 units.
The Re-Order Period is 4 – 6 weeks. From the above information, compute the Average
Stock Level.

Q6. Normal consumption: 300 units per day. Maximum consumption: 420 units per day.
Minimum consumption: 240 units per day. Re-Order Quantity: 3,600 units. Minimum time
period for receiving the goods – 10 days. Maximum period – 15 days. Normal period for
receiving the goods – 12 days. Compute all material levels.

Q7. Two components A and B are used as follows:

Particulars A B
Normal Usage 50 units per week 50 units per week
Minimum Usage 25 units per week 25 units per week
Maximum Usage 75 units per week 75 units per week
Re-Order Quantity 300 units 500 units
Re-Order Period 4-6 weeks 2-4 weeks
1. Re-Order Level
2. Minimum Level
3. Maximum Level
4. Average Stock Level

Q8. In a company weekly minimum and maximum consumption of material A are 25 and 75
units respectively. The re-order quantity as fixed by the company is 300 units. The material
is received within 4 to 6 weeks from issues of supply order. Calculate minimum level and
maximum level of material A.

Q9. ASUS Ltd. produces picture tubes for televisions, LCD and LED monitors. Following are
details of operations –
 Ordering Cost per order Rs. 100
 Inventory carrying cost 1.00 % p.a.
 Cost of tubes Rs. 500 per tube
 Normal Usage 100 tubes per week
 Minimum Usage 50 tubes per week
 Maximum Usage 200 tubes per week
 Lead time to supply 6-8 weeks
Calculate EOQ, Maximum level of stock, Minimum level of stock and Re-order Level and
Average Level. If the supplier is willing to supply quarterly 1500 units at a discount of 5%,
should the proposal be accepted?

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Q10. A machine requires about 50 items every day. A fixed cost of Rs. 50 per order is incurred.
The inventory carrying cost per item amount to Re. 0.02 per day. The lead period is 32 days.
Compute:(i) Economic Order Quantity and (ii) Re-order level

Q11. From the following information calculate EOQ, and the number of orders to be placed in
one quarter of the year:
Quarterly consumption of materials 2,000 Kg
Cost of placing one order Rs. 50
Cost per unit Rs. 40
Storage and carrying cost 8% on average inventory

Q12. Cost of placing a purchase order is Rs. 20, number of units to be purchased during the year
is 5,000, purchase price per unit inclusive of transportation cost is Rs. 50, annual cost of
storage per unit is Rs. 5.
Details of lead time: Average 10 days, Maximum 15 days, Minimum 6 days, for emergency
purchases 4 days.
Rate of consumption: Average 15 units per day, Maximum 20 units.
Find – Re-ordering level, Maximum level, Minimum level, Danger level and Average level

Q13. Shriram Enterprises manufactures a special product 'ZED'. The following particulars were
collected for the year 2022:
Monthly demand of ZED 1,000 units, Cost of placing an order Rs. 100, Annual carrying cost
per unit Rs. 15, Normal usage 50 units per week, Minimum usage 25 units per week,
Maximum usage 75 units per week, Re-order period 4 to 6 weeks. Compute: Re-order
quantity (EOQ); Re-order level; Minimum level; Maximum level and Average stock level.

Q14. XYZ Ltd. buys in lots of 500 boxes which is a 3 month supply. The cost per box is Rs. 125
and the ordering cost is Rs. 150. The inventory carrying cost is estimated at 20% of unit
value. What is the total annual cost of the existing inventory policy? How much could be
saved by employing the economic order quantity?

Q15. The Purchase Department of an organisation has received an offer of quantity discounts on
its orders of materials as under:
Price per kg.
(Rs) Kgs
1,200 Less than 500
1,180 500 and less than 1,000
1,160 1,000 and less than 2,000
1,140 2,000 and less than 3,000
1,120 3000 and above
The annual requirement for the material is 5,000 kgs. The ordering cost per order is Rs.
1,200 and the carrying cost is estimated at 20% per annum. You are required to compute the
most economic order quantity.

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Q16. Ratan Enterprises requires 180,000 units of a certain item annually. The cost per unit and
the cost per purchase order are Rs. 6 and Rs. 600 respectively. The inventory carrying cost
is Rs. 6 per unit per year.
i. What is the economic order quantity?
ii. What should the firm do if the supplier offers discount as below:
Order Quantity Discount
9,000 – 11,999 2%
12,000 and above 3%

Q17. Blue Berry Ltd estimates its carrying cost at 12% and it’s ordering cost at Rs. 12 per order.
The estimated annual requirement is 40,000 units at a price of Rs 5 per unit. What is the
most economical number of units to order and how often will an order need to be placed?
Find the total cost of inventory. If the supplier is ready to give a discount of 5% for five
deliveries in a year, should the offer be accepted?

Q18. Annual requirement – 75000 units, Usage per month – 6250 units, Cost per unit Rs. 1.50,
Carrying cost (20 %) – Rs. 0.30, Ordering cost Rs. 18 per order. Lead Time – 45 days. Find
the following –
 EOQ
 No. of orders
 Reorder Level
 EOQ if the cost per unit is Rs. 4.50.

Q19. A manufacturer buys certain material from outside supplier @ Rs. 30 per unit. Total annual
needs are 3,200 units. The following data is further available:
 Annual Return on Investment :10%
 Rent, Insurance, Tax per unit per annum : Re. 0.50
 Cost of Placing an Order : Rs. 50
Calculate the EOQ. Further, if supplier is ready to give a discount of 10% for four equal
deliveries in a year, should the offer be accepted? Show detailed calculations.

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