CHAPTER-6

Short Term Financial Management

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 LEARNING OBJECTIVES
Underline the need for investing in current assets, and
elaborate the concept of operating cycle
Explain the reasons for holding cash
Underline the need for cash management
Suggest methods of monitoring receivables
Highlight the need for and nature of inventory
Explain the techniques of inventory management
Explain the benefits and costs of trade credit

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Concepts of Working Capital
 Working Capital refers to that part of the firm’s
capital which is required for financing short-term or
current assets such as cash, marketable securities,
debtors and inventories.
 WC is also known as revolving or circulating
capital or short-term capital or current capital.
 Concepts of Working Capital (Cont’d)
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 There are two concepts of working capital: Gross

and Net.
a) Gross working capital (GWC)
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, debtors, (accounts receivable or book
debts) bills receivable and stock (inventory).
 Concepts of Working Capital (Cont’d)
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b) 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 creditors (accounts
payable), bills payable, and outstanding expenses.
 NWC can be positive or negative.
 Positive NWC = CA > CL
 Negative NWC = CA < CL
 Concepts of Working Capital (Cont’d)
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GWC focuses on
 Optimisation of investment in current assets
 Financing of current assets
NWC focuses on
 Liquidity position of the firm
 Judicious mix of short-term and long-tern financing
 Operating Cycle
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 Operating cycle is the time duration required to

convert sales, after the conversion of resources into
inventories, into cash. The operating cycle of a
manufacturing company involves three phases:
 Acquisition of resources such as raw material, labour,
power and fuel etc.
 Manufacture of the product which includes conversion of
raw material into work-in-progress into finished goods.
 Sale of the product either for cash or on credit. Credit sales
create account receivable for collection.
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Operating cycle of a manufacturing company

Raw WIP
Materials

Operating Cycle in Finished

Cash
Manufacturing firm Goods

Debtors SALES
 Cont…
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 Thelength of the operating cycle of a manufacturing

firm is the sum of:
 Inventory conversion period (ICP).
 Debtors (receivable) conversion period (DCP).

Operating cycle of a manufacturing firm

 Gross Operating Cycle (GOC)
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 The firm’s gross operating cycle (GOC) can be

determined as inventory conversion period (ICP)
plus debtors conversion period (DCP). Thus, GOC
is given as follows:
 Inventory conversion period
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 Inventory conversion period is the total time

needed for producing and selling the product.
Typically, it includes:
 Raw Material Conversion Period (RMCP)
 Work-in-process Conversion Period (WIPCP)
 Finished Goods Conversion Period (FGCP)
 Debtors (receivables) conversion period (DCP)
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 Debtors conversion period (DCP) is the average

time taken to convert debtors into cash. DCP
represents the average collection period. It is
calculated as follows:

 Debtor days = (Trade receivables ÷ Annual

credit sales) x 365 days
 Creditors (payables) deferral period (CDP)
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 Creditors(payables) deferral period (CDP) is the

average time taken by the firm in paying its
suppliers (creditors). CDP is given as follows:
 Cash Conversion or Net Operating Cycle
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 Netoperating cycle (NOC) is the difference between

gross operating cycle and payables deferral period.

 Netoperating cycle is also referred to as cash

conversion cycle.
PERMANENT AND VARIABLE WORKING CAPITAL
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 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.
 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.
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Permanent

Permanent and temporary working capital

 Determinants of Working Capital
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1. Nature of business
2. Market and demand
3. Technology and manufacturing policy
4. Credit policy
5. Supplies’ credit
6. Operating efficiency
7. Inflation etc.
 Estimating Working capital
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Current assets holding period

 To estimate working capital requirements on the basis of average
holding period of current assets and relating them to costs based
on the company’s experience in the previous years. This method is
essentially based on the operating cycle concept.
Ratio of sales
 To estimate working capital requirements as a ratio of sales on the
assumption that current assets change with sales.
Ratio of fixed investment
 To estimate working capital requirements as a percentage of fixed
investment.
 Working Capital Finance Policies
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 There are three types of working capital finance

policies which a firm may adopt i.e.
a) Moderate working capital policy
b) Conservative working capital policy
c) Aggressive working capital policy.
 Working Capital Finance Policies (Cont’d)
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a) Moderate working capital policy

A moderate strategy, sometimes referred to as
hedging, involves moderate risks and moderate
profitability. With this approach, the fixed assets and
the permanent working capital are financed from
long-term sources while the variable working capital
is sourced from the short-terms sources.
 According to this approach, the maturity of the
sources of the funds should match the nature of the
assets to be financed.
 Matching Approach
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Financing under matching plan

 Working Capital Finance Policies (Cont’d)
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b) Conservative Approach
 This approach suggests that the estimated
requirement of total funds should be met from long
term sources; the use of short term funds should be
restricted to only emergency situations or when there
is an unexpected outflow of funds.
 The conservative strategy involves low risk and low
profitability. With this approach, the permanent and
the variable working capital are financed from the
long-term sources.
 Conservative Approach
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Conservative financing
 Working Capital Finance Policies (Cont’d)
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c) Aggressive approach
A working capital policy is called an aggressive
policy if the firm decides to finance a part of the
permanent working capital by short term sources.
The aggressive policy seeks to minimize excess
liquidity while meeting the short term requirements.
The firm may accept even greater risk of insolvency
in order to save cost of long term financing and thus
in order to earn greater return.
 Aggressive approach (Cont’d)
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 By taking higher risks, the main goal of an

aggressive strategy is to maximize profits.
 With this approach, all of the variable working
capital, part or all of the permanent working capital
and occasionally even the fixed assets are funded
from short-term sources.
 An aggressive effort to maximize profit results in
lower cost capital and significantly higher risks.
 Aggressive Approach
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Aggressive financing
 Techniques of analysis of working capital
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 The analysis of working capital can be conducted

through a number of devices such as
a) Ratio analysis
• Current Ratio
• Acid test ratio/quick ratio/liquid ratio
• Cash Position ratio/absolute liquid ratio
• Inventory turnover ratio
• Receivable turnover ratio
• Payable turnover ratio
• Working capital turnover ratios may be used for this purpose
 Techniques of analysis of working capital (Cont’d)
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b) Fund flow analysis

 Fund flow analysis is a technical device designated to
study the sources from which fund were derived and
the use to which these sources were put.
 It is an effective management tool to study change in
the financial position of business.
The fund flow analysis consists of
• Preparing schedule of change in working capital
• Statement of sources and application of funds
 Techniques of analysis of working capital (Cont’d)
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c) Working capital Budgeting

 Working capital budget as a part of total budgeting
process of a business, is prepared estimating future
long term and short term working capital need and the
sources of finance them.
 The objective of a working capital budget is to ensure
availability of fund as and when needed and to ensure
effective utilization of these resources.
CASH MANAGEMENT
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 Management of cash is of major importance in any

business, because cash is the only means of acquiring
desired goods and services.
 Cash management is concerned with the managing of:
 cash flows into and out of the firm,
 cash flows within the firm, and
 cash balances held by the firm at a point of time by financing
deficit or investing surplus cash
 Cash Management Cycle
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 Cash management cycle is defined as “ the process of

identifying various cash inflows and making them
available to business needs as cash outflows,
maintaining the objective of liquidity and
profitability”.
 It seeks to accomplish the objective of cost
minimization by achieving liquidity and profitability.
 Cash management cycle
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 Four Facets of Cash Management
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 Cash planning-the process of estimating cash

inflows and outflows to project cash surplus or
deficit for future planning period. A cash budget is
used to serve this objective.
 Managing the cash flows-The cash flows should
be properly managed to avoid the variance
between planned event to actual event.
Accelerating cash inflows and decelerating cash
outflows can achieve this.
 Four Facets of Cash Management (Cont’d)
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 Optimum cash level- It is always essential to

determine appropriate cash balance. The cost of
excess of cash holding and also the danger of cash
deficiency should be matched to determine the
optimum level of cash balance.
 Investing surplus and Borrowing deficit- The
surplus cash balance over and above the minimum
balance should be always be invested in the
profitable ventures, while the deficit balance should
be arranged from various financing sources.
 Motives for Holding Cash
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 The transactions motive-has an objective of holding

cash to meet the day-to-day requirements like making
payments to suppliers, purchase of materials,
payment of wages and salaries, and other operating
expenses. Cash is also used in standing payments
like taxes, dividends and other payments.
 The precautionary motive-of holding cash is to
meet the unexpected business expenses. Cash is held
to meet contingencies in future like emergencies.
 Motives for Holding Cash (Cont’d)
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The speculative motive-serve the objective of

holding cash for investing in profit-making
ventures. Such opportunities are unusual within
the business operations; hence they may throw
more options outside the business like,
investment in the bank, purchase of shares and
bonds with an intention to resale, and purchase
of government bills.
Managing Cash Collections and Disbursements
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 Accelerating Cash Collections

 Decentralised Collections
 Lock-box System
 Controlling Disbursements
 Disbursement or Payment Float
RECEIVABLES MANAGEMENT
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 Trade credit happens when a firm sells its products or

services on credit and does not receive cash
immediately.
 A credit sale has three characteristics:
 First, it involves an element of risk that should be carefully
analyzed.
 Second, it is based on economic value.
 Third, it implies futurity.
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FACTORS AFFECTING THE SIZE OF RECEIVABLES

a) Level of Sales
This is the most important factor in determining the size of
accounts receivables. Generally in the same industry, a firm
having in a large volume of sales will be having a large level of
receivables as compared a firm with a small volume of sales.
b) Credit Policy
Credit Policy is a set of decisions that include a firm’s credit
period, credit standards, collection procedures and discounts
offered.
The term credit policy refers to those decisions variables that
influence the amount of trade credit i.e., the investment of
receivables.
 CONT.. 40
Credit Policy, in turn, consists of these variables
such as:
i. Credit Period
Which is the length of time buyers are given to pay
for their purchases. Credit period is terms of the
duration of time for which trade credit is extended.
 During this period over due amount must be paid
by the customers. If the policy of a company states
“Net 30” , It refers to a payment period, meaning the
customer has a 30-day length of time to pay the total
amount of their invoice.
 CONT.. 41

ii. Cash Discounts

Cash discounts given for early payment, including the discount
percentage and how rapidly payment must be made to qualify for
the discount. If any, which the customer can take advantage, of
that is, the overdue amount will reduce by this amount.
Credit terms 5/15 net 90
▪ 5 represents the cash discount offered
▪ 15 represents the number of days for which this discount is
valid
▪ If payment is not made within 15 days, then the customer
should make full payment within 90 days of sale.
Cash discount; increase sales, reduced collection period and
increase cost of discount.
 CONT.. 42
iii. Credit Standards
Credit Standards which refer to the required financial strength of
acceptable credit customers. Credit standards are the criteria
which a firm follows in selecting customers for the purpose of
credit extension.
The firms credit standards generally determined by the five “C “s
▪ Character –denotes the integrity of the customers i.e., his
willingness to pay for the goods purchased.
▪ Capacity – Ability to repay( earning capacity)
▪ Capital – Capital denotes high financial soundness or position.
▪ Collateral – The type and kind of assets pledged
▪ Conditions – Economic conditions & competitive factors that
may affect the profitability of the customer.
 Optimum Credit Policy
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 Estimation of incremental profit

 Estimation of incremental investment in receivable
 Estimation of incremental rate of return (IRR)
 Comparison of incremental rate of return with required
rate of return (RRR)
 Optimum credit policy: IRR = RRR
CREDIT EVALUATION OF INDIVIDUAL ACCOUNTS
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 Credit Information
 Financial statement
 Bank references
 Trade references
 Other sources
 Credit Investigation and Analysis
 Analysis of credit file
 Analysis of financial ratios
 Analysis of business and its management
INVENTORY MANAGEMENT
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 Inventory is material that the firm obtains in advance of

need, holds until it is needed, and then used, consumes,
incorporates into a product or sells.
 Stocks of manufactured products and the material that
make up the product.
 Components:
 raw materials
 work-in-process
 finished goods
 stores and spares (supplies)
 Objectives of Inventory Management
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To maintain a large size of inventories of raw

material and work-in-process for efficient and
smooth production and of finished goods for
uninterrupted sales operations.

 To maintain a minimum investment in

inventories to maximize profitability.
An effective inventory management should:
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 ensure a continuous supply of raw materials, to facilitate

uninterrupted production
 maintain sufficient stocks of raw materials in periods of
short supply and anticipate price changes
 maintain sufficient finished goods inventory for smooth
sales operation, and efficient customer service.
 minimize the carrying cost and time, and
 control investment in inventories and keep it at an
optimum level.
 Inventory Investment Analysis
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Estimation of incremental operating profit

Estimation of incremental investment in
inventory
Estimation of the incremental rate of return
(IRR)
Comparison of the incremental rate of return
with the required rate of return (RRR)
Optimum inventory: IRR = RRR
 INVENTORY CONTROL SYSTEMS
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Just-in-Time (JIT) Systems

ABC Inventory Control System
Out-sourcing
Computerized Inventory Control Systems
 CONT. 50

1) Just In Time (JIT)

In a JIT systems, material or the manufactured
components and parts arrive to the manufacturing sites or
stores just few hours before they are put to use. The
delivery of material is synchronized with the
manufacturing cycle and speed. JIT system eliminates the
necessity of carrying large inventories, and thus, saves
carrying and other related costs to the manufacturer. The
system requires perfect understanding and coordination
between the manufacturer and suppliers, in terms of the
timing of delivery and quality of material.
 CONT. 51

2) A B C Approach
The ABC approach is a simple approach to inventory
management where the basic idea is to divide inventory into
three (or more) groups.
Classifying inventory according to some measure of
importance and allocating control efforts accordingly.
Importance measure= price x annual sales
A-very important
B-mod. Important
C-least important
 CONT. 52

3) Out-sourcing
Is a system of buying parts and components from outside
rather than manufacturing them internally.
4) Computerized inventory control system
It enables a company to easily track large items of
inventories. It is an automatic system of counting
inventories, recording withdrawals and revising the
balance. There is an in-built system of placing order as
the computer notices that the reorder point has been
reached. The computerized inventory system is inevitable
for large retail stores, which carry thousand items
 Inventory Management Process
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 Explicitly state the inventory policy

 Create an inventory monitoring cell
 Management group for controlling purchases
 Periodic meetings between purchase, materials planning
and production executives
 Monthly reviews of total inventory at plant/corporate
level
 Dovetail inventory control to the total budgeting system
 Identify critical inventory items for closer scrutiny
WORKING CAPITAL FINANCE
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Short-term Sources of Finance

 Trade Credit
 Accrued Expenses and Deferred Income
 Bank Borrowings
 Factoring of receivables
 Commercial Paper
 Trade Credit and Credit Terms
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 Refers to the credit that the customer gets from

supplier of goods in normal course of business.
 An informal arrangement, granted on an open
account basis, not formally acknowledge as a
debt.
 Trade credit may also take the form of bills
payable.
 Credit Terms refers to the conditions of due
date and cash discount.
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Benefits and Costs of Trade Credit
 Benefits
1. Easy Availability. Suppliers sometimes offer cash discount to
buyers for making prompt payment. Buyer
2. Flexibility.
should calculate the cost of foregoing cash
3. Informality. discount to decide whether or not cash
discount should be availed. The following
formula can be used:
 Costs
1. Implicit Cost.
2. Stretching A/P can prove to be very costly.
 ACCRUED EXPENSES AND DEFERRED INCOME
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 Accrued Expenses
 Accrued expenses represent a liability that a firm has to
pay for the services which it has already received.
1. Accrued Wages and Salaries.
2. Accrued taxes and Interest.
 Deferred Income
 Deferred income represents funds received by the firm for
goods and services which it has agreed to supply in future.
1. Advance Payments.
 Bank Finance for Working Capital
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 Overdraft
 Cash Credit
 Purchase or Discounting of Bills
 Letter of Credit
 Working Capital Loan
 End of Chapter 6

Thank you

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