How Working Capital Affects Performance Of Retail Industry Finance Essay
The main aim of this dissertation is to study how working capital management affects the performance of retail industry. This dissertation concentrates on one of the important areas of finance the working capital management. Working capital management is the management of both the current assets and current liabilities. Management of working capital is considered as an important function for any kind of organization. Without proper management of working capital the company can’t perform their day to day operations smoothly. So each organization in the industry performs several activities to manage their working capital as efficiently as possible in order to compete from each other.
Companies in retail industry depends heavily on working capital for their daily operating activities and therefore it is essential for managing their working capital in order to gain profitability and also to avoid solvency. Improper management of working capital can also lead to bankrupt and there are also some retail companies in the past to explain this fact is true. The main problem and issue in working capital management it is to determine the optimum level to be maintained in the current assets and current liabilities and also to determine whether the firm should invest heavily in current assets or in fixed assets. These issues can seriously affect the profitability and liquidity of the organization and it should be carefully considered in order to compete in the industry.
It is very necessary for the organization to know the level of funds to be invested in each component of the current assets such as cash, inventory, accounts receivable and marketable securities. Funds invested in current assets are generally turned back into cash in the end of the working capital cycle which is normally within one year. Therefore investing high or low in current assets affects the profitability and liquidity of the firm and it should be maintained in such a way which satisfies the exact needs of the business. It is also necessary to know how to investment these currents assets which are either by short term financing or by long term financing. For these decisions to be made efficient working capital management is essential.
It has been discussed in many journals that working capital management has a direct relationship with the profitability and liquidity of the organization. Therefore managing the working capital components is very critical to maintain the firm profitability and liquidity. For example in the case of cash which the company holds if it holds more it is going to lose the profit which can be earned by investing the excess cash in current assets and if the company has low level of cash it is going to miss the business opportunities when they arrive. In the case of inventory investing more in inventory can reduce the profit if the company cant able to sell the goods quickly and also investing less in inventory can lead to loss of sales.
Accounts receivable and account payable also has a huge impact on the profitability of the firm. The company credit policies have a great impact on the volume of good sold. If the firm grants a longer credit period for the customers it is going to encourage the sales which thereby increase the profit. On the other hand company’s which delays the payments to their suppliers can use that cash for in some other asset and could earn from that investment. But delaying the payment should not exceed the granted period given by the suppliers otherwise the firm may lose the discounts provided by the supplier for early payments.
The main objectives of this study is to,
To measure the working capital management performed in retail companies and then analysing the performance of retail companies.
To determine the working capital cycle for the retail company.
To determine what kind of working capital policy is practiced in retail industry.
To determine whether the working capital management practices really affects the profitability of the firm.
The first chapter of this dissertation is the introduction which is a short description explaining the basic idea behind this research. It will give the problems and issues associated with the research topic and it also explains the aims and objectives accomplished by this research. The second chapter is the literature review which discussed the theoretical concepts in working capital management. This chapter explains the importance of working capital management, the working capital cycle and the different working capital approaches followed in different industries. It also explains the management of each of the working capital components such as cash, inventories, accounts receivable and marketable securities in detail and the objectives satisfied by managing these working capital components. In the end of this chapter the various sources which finance the working capital are discussed. The third chapter is the research methodology which explains the research methodology adopted for this dissertation. It explains what kind of research method followed in this dissertation and also shows the different data collection methods and tools used to complete the dissertation.
The fourth chapter is the findings and analysis. In this chapter the performance of the retail industries is analysed and then the findings are discussed. The different analyses performed in this chapter are ratio analysis, correlation analysis and regression analysis. By ratio analysis the performance of the retail companies are analysed and then by correlation and regression analysis it is analysed to see whether the inventory holding days, accounts receivable days, accounts payable days and cash conversion cycle affects the return on capital employed. Finally the last chapter concludes and gives recommendation based on the results analysed.
1.0 Working Capital:
Working capital is the capital which satisfies the short term financial requirements of any business enterprise. It is capital which is engaged in the operations of the business for not more than one year. Every organization whether it is profit oriented or not needs working capital for the day to day operations of the business. Managers when making investment decisions not only plans for the long term such as buying new building or machine but also considers the need to have additional current assets in the short term for any expansion of activity that the organization is planning to do. For example if the organization is planning to increase the level of production the organization needs to hold a greater level of raw materials similarly if the organization increases the sales there will be an increase in level of debtors. All these investment decisions can bring the organization to level of risk. So it is very necessary for an organization to manage this working capital effectively to avoid the company fall into risk (Mclaney 2006).
1.1 Importance of Working Capital Management:
The management of working capital is very important for several reasons.
According to Padachi (2006), working capital management is very important for the financial health of the business of any size. He also suggested that the funds invested in the working capital are high in proportion to the total assets employed. Therefore it should be managed in effective and efficient way. Also working capital management directly affects the liquidity and profitability of the firm. Therefore managing the working capital should be done in such a way that it should create a balance between the liquidity and profitability (Falope, I and Ajilote, T 2009).
The main advantage of working capital management is the flexibility of it. That is it has the ability to change with the rise and fall in seasonal demands of the product or service, and with the rise and fall in economic and market conditions (Mathur, B 2003). Largay, A and Stickney, P (1980) studied the bankruptcy case of a large retail store in the year 1980. From their study they found that the bankruptcy should have occurred because of the poor cash flow from their operation during the last few years of their bankruptcy. So managing the working capital is very necessary for the survival of the business
1.2 Components of Working Capital:
Working capital which is also called as current capital or circulating capital is the capital that the managers put it to work for the day to day operations of the organization. There are two important concepts in the working capital management that is the gross working capital and the net working capital. Gross working capital is the capital that includes only the current assets used in the day to day operations of the organization and net working capital is the capital which includes the current assets less the current liabilities. The components which comprise the current assets are the following, (Brigham, F and Houston. F 2007).
These currents assets are financed using the following sources such as,
Short term bank loans
Commercial paper etc.
The degree to which an organization invests in current assets depends on several factors such as the type of business and products the organization do. For example retail companies mostly invest a lot of funds in their current assets such as inventory and they invest less in long term assets such as buying plant and equipment. But in the case of some manufacturing companies more is invested in long term assets such as machines and equipment as they are very necessary for the organization. The length of operating cycle also is an important factor. The longer the operating cycle the more is invested in the current assets. The level of uncertainty in the business also is one of the important factors. So depending upon the industry practices the organization invests more in current assets or in long term assets (Fabozzi, J 2003).
2.0 Working capital cycle:
Working capital cycle is the time taken for the capital invested by the organization turning back into cash. Generally the working capital cycle for a manufacturing business starts when the organization buys the raw materials on credit followed by working on these raw materials to produce the final goods, and selling of the finished goods. During this cycle the organization also needs to pay the creditors. As the organization sells the final product on credit, the debtors are increased and when the customers started to pay it will increase the amount of cash in the business (Myddelton, D 2000).
Figure1: Working capital cycle of a Retail Business (Reynolds, Cuthbertson and Bell 2004)
The above figure shows the general working capital cycle of a retail business and it explains how the operating process is performed in a retail business. The first stage in the operating process is where the suppliers provide the merchandise to the retailers. Large retail companies manufacture their own products under their brand name. After all the merchandise is received from the suppliers the retailers makes the store ready, and other arrangements for the received products to be sold. The products which are available to be sold become the inventory. In the next stage the customers buys the products which generates cash into the company (Reynolds, Cuthbertson and Bell 2004).
2.1 Cash Conversion Cycle:
An important cycle which is embedded in the working capital cycle is the cash conversion cycle. When the organization buys raw materials from their suppliers they don’t pay them immediately. They usually have a credit period contracted by the supplier and before that they need to pay. This is known as the creditor’s payment period. Also not all customers pay the cash immediately when they buy a product. Some buy them on credit and they should pay the certain amount within a particular period. This period which is granted by the business to the customer is known as the debtor’s payment period. The gap between these two periods is known as the cash conversion cycle. It is the cycle where the invested cash that is the cash invested in the suppliers turns back into cash when the customers pay the money during the debtor’s collection period (Arnold 2005).
Work-in Progress Period
Finished goods inventory period
Debtor Collection Period
Creditor Payment Period
Stock Conversion Period
Cash Conversion Cycle
Figure2: Cash Conversion Cycle (Arnold 2005)
The above figure shows the cash conversion cycle. The length of the cash conversion cycle depends on three factors,
Stock conversion period
Debtor collection period
Creditor payment period
Stock conversion period is the period where the raw material bought from the supplier are processed and converted into finished goods. Therefore the duration of a cash conversion cycle is found by,
Cash conversion cycle =
Stock Conversion period + Debtors collection period – Creditors payment period
In an article Jose, Lancaster and Stevens (1996) suggest the importance of cash conversion cycle in the profitability and liquidity of the organization. They explained that for an aggressive approach to liquidity management the organization should reduce the cash conversion cycle by reducing their inventories and debtor collection period while increasing their creditor’s payment period. Managing the cash conversion cycle this way may involve tradeoffs between liquidity and profitability. If the business reduces the inventory and the debtors collection period they will lose the sales because of stock running out so early and also losing customers who usually buys in credit. Also if the firm increases the creditor collection period they will lose the discounts available for early payments and also the flexibility of pay debts in the future. So cash conversion holds an important role in maintaining the liquidity and profitability of the organization.
3.0 Working capital policy:
Working capital policy is the policy made by the organization for making decisions on two important things, which are how much should the firm invest in each component of current assets and how these investments should be financed. Any business for managing their working capital efficiently should make decisions on what level of cash they should hold, what level of inventory they should maintain, what level of accounts receivable can be allowed and they should also decide whether to finance these current assets either with short term funds or with long term funds. These decisions made by the organization together make up the working capital policy (Correia et al. 2007). According to Vishnani and Shah (2007) working capital policies had a great impact on the firm’s performance. They suggest the importance of working capital policies for maintaining the firm’s liquidity and profitability. An unnecessary investment in current assets can reduce the rate of return thereby affecting the profitability. Also it is very necessary for maintaining the liquidity for a normal running of the business. If the firm holds too much liquidity it explains that the firm is not using its funds efficiently and on the other hand if they have inadequate liquidity it will affect their credit worthiness. So it is very essential to determine the optimal level of working capital.
3.1 Permanent and Temporary Working Capital:
A working capital policy is affected because of the firms varying requirements of current assets. The working capital requirements of a firm do not always remain stable through out the year and it varies from time to time. Because of the seasonal demands of some product the firm changes their level of production and holdings of inventories. Due to these conditions the currents assets in the firm also varies. But a certain amount of current assets is always maintained regularly in the business to meet the minimum day to day operations of the business to continue without any difficulties. This minimum requirement of current assets is known as the permanent working capital. On the other hand the amount which is invested in current assets due to the varying seasonal requirements is known as the temporary working capital (Van Horne, C and Wachowicz, M 2008).
Amount of working capital
Permanent working capital
Temporary working capital
Figure 3: Permanent and Temporary working capital (Source: Van Horne, C and Wachowicz, M 2008)
Generally permanent working capital remains the same for whole year and the temporary working capital is the one which varies over time. But for some growing business the permanent working capital also rises steadily over time to meet the expansion activities of the business which is described by the figure above.
3.2 Approaches in Working Capital Policies:
There are three different approaches in working capital policies and they are moderate, aggressive and conservative approaches. A firm which follows a moderate approach uses both long term and short term financing to finance their assets. The main aim of this moderate approach is to create a balance between the risk and the return. The firm which follows an aggressive approach tends to use a more of short term funds and less of long term funds to finance its current assets. Even though short term interest rates are lower than long term interest rates short term financing is more risky than long term financing because they should be paid off in a short time period. Therefore following an aggressive approach increases the risk of liquidity and it also increases the possibility of higher profits. The firm which follows a conservative approach uses a less of short term funds and more of long term funds. Therefore it reduces the liquidity risk and also the possibility to achieve higher profits (Gallagher, J and Andrew, D 2007). Weinraub, J and Visscher (1998) examined the relative relationship between the aggressive and conservative approach by studying on ten different industry groups and found that each of these industries were following a unique and different working capital management polices. From their research they also found that the relatively aggressive working capital management appear to be balanced by the relatively conservative working capital management.
3.3 Factors Determining the Working Capital Requirements:
Financial managers should manage their working capital in such a way that it should not be surplus or excessive. For this the managers the managers need to know the working capital requirements of the organization to make sure to provide the perfect financing. The working capital requirements of any business depends among several factors and generally some of the factors which should be considered while determining the working capital requirements are the following (Banerjee 2005),
Nature of the business: The general nature of the business itself affects the working capital requirements of the business. In the case of manufacturing industry they will invest significantly in both fixed and working capital. But in other industries such as trading and financing firms invest a small amount fixed assets and a large in working capital. Some firms needs to have a large amount of inventory and debtor balances because of their nature of business.
Growth and Expansion of Business: The level of investments in working capital depends upon the size of the business. The more the business expands its activity the more working capital requirement is needed.
Production Cycle: Production cycle is the period where the raw materials are converted into their finished product. The longer the period to convert these raw materials into finished product the larger is the working capital.
Business Cycle: The business cycle is an important factor in considering the working capital requirement. The business has to pass through a period of good times and bad times such as recession. During the good times where the business is growing the business needs to increase their working capital requirements because of the increased sales and during the bad times the business needs to reduce their working capital because of reduced sales.
Production Policy: The demands of certain products are seasonal in nature. So during the peak season the working capital requirements are higher while during the off-season the working capital is kept lower. Therefore depending upon the seasonal demands of the product or service the working capital requirements varies.
Credit Policy: Credit policy has a direct impact on the working capital requirements. When the business reduces the credit period it will reduces the volume of sales which leads to the reduction of working capital requirements. But when the business grants a longer credit period it encourages the sales and there by needing to increase the working capital requirements.
Price Level Changes: The varying price level also affects the working capital requirements. When the price level increases the business also needs to increase their working capital to maintain their same volume of activity.
Operating Efficiency: Operating efficiency is an important factor to be considered by the business. The business can maintain their working capital to a minimum level only when they are able to manage or control their operating costs and utilise their working capital efficiently.
4.0 MANAGEMENT OF CURRENT ASSETS:
As discussed before working capital management is the management of both current assets and the current liabilities. The main objective of working capital management it is to maintain an optimum balance of each of the working capital components and to develop the optimum level between the current assets and the current liabilities. The optimum level is the level where a balance is created between risk and efficiency (Filbeck and Krueger, M 2005). In the following paragraphs the management of currents assets such as cash, marketable securities, inventories and accounts receivables are discussed.
4.1 Cash Management:
Cash management is defined as the management of cash inflows and cash outflows. The cash flows out of the firm when the business buys goods and services from its suppliers and cash flows into the firm when the customer pays for the product they purchased. The term cash refers the cash like assets like currency, bank balances etc. The cash is often considered as non earning assets because they do not provide earnings but the cash provides safety from insolvency. Cash is very important for the day to day operations of the business and to meet the liabilities when they are due (Besley and Brigham 2005).
There are several reasons for a business to hold cash (Besley and Brigham 2005),
Transaction balance: Cash balance is very essential for the operations of the business. Cash is used for paying their employees wages, buying raw materials, fixed assets, and also to pay their taxes.
Compensating balance: It is the minimum bank balance that the firm should maintain for the services provided by the bank such as check clearing and cash management advice.
Precautionary balance: It is the cash kept as reserve by the firm because the company cannot predict the future cash flow. The amount which is kept as reserve depends upon the predictability of the cash flow. The less cash predicted the more cash balance is maintained.
Speculative balance: These are cash maintained by the firm to take advantage of any profit opportunity when arises in the business.
Ferreira, A and Vilela, S (2004) suggest that the level of cash holdings is positively affected by the investment opportunity and cash flows of the firm and it is negatively affected by the liquid assets, leverage and size of the firm. Firms with high investment opportunity needs to hold a high level a cash to take the benefits of the immediate opportunities available to them and also if the firm has a unpredictable cash flow the firm holds a high levels of cash. On the other hand firms which has high level of liquid assets holds low level of cash because the firm convert the liquid assets into cash when they are needed. Also firms with higher leverage that is the ability of the firm to raise debts will hold less level of cash. And at last the size of the firm affects the level of cash holdings. Large firms hold less level of cash than smaller firms because borrowing funds by smaller funds is expensive when compared to larger firms. So smaller tend to hold more cash to avoid borrowing funds.
The two main goals of cash management practices is (Fabozzi, J 2003)
To have adequate cash in hand to meet the immediate needs of the firms and
To receive the cash from those to owe it as early as possible and to pay the cash which the business owes as late as possible.
To determine the level of investment in cash is a very important function. The firm cannot hold too much cash because of the holding cost associated with it. Holding cost is the cost that the business would have earned if the cash is invested in some form of asset. The level of investment in the cash depends upon the firm’s liquid assets, debt levels, and rate of return and economic conditions. There are two models used by the firms to determine the adequate level of cash needed to be maintained. One is the Baumol model which assumes that the cash is used uniformly through the period and based on this assumption the amount of cash to be maintained is measured. But by the second model which is called as Miller model assumes that the cash flow varies in an unpredictable manner and based on this assumption the amount of cash to be invested is measured. These two models help in satisfying the first goal of cash management (Fabozzi, J 2003).
To achieve the second goal of cash management which is to reduce the period cash inflow and to increase the period of cash outflow, several ways are being followed.
The following techniques help reduce the period of cash inflow (Shim, K and Siegel, G 2000).
Lockbox System- In this system the customer instead of mailing the check to the firm send their checks to a nearby post office box which is controlled by the firm’s bank. The firm’s bank then collects the check from the post office and deposits the check. Due to this process the time the check spends in the mail and also since the bank itself receives the check it avoids the time the check spends when received by the firm and thus saves the processing time of the checks in the firm.
Pre-Authorised Debits- In this system the cash is collected from customers by obtaining permission from customers to have pre authorised debits automatically charged to their bank accounts. Thereby it eliminates the time the check spends in the mail and the processing time of the check.
Wire Transfer- In this system the cash is transferred quickly between banks and thus eliminates the transferring time of the cash. Wire transfers are done though computer terminal and telephone.
So far we have discussed the ways to reduce the period of cash inflow. Now let’s discuss the ways to increase the period of cash outflow.
Zero-balance account- Zero balance account as the name suggest it requires no balance. It is an arrangement between the bank and the firm to achieve controlled disbursement which is to pay exactly what the company owes. When the check is offered to the bank the bank just transfers the money from the firms account. By this system the firm can pay the exact amount which covers the check. This system also increases the period of cash flowing out (Bragg, M 2007).
Payable through drafts- Payables through drafts is similar to the checks. But a draft works in a different way. When a draft is offered to the bank the bank sends to the firms which issued the draft and waits for its approval. Only after receiving the approval from the firm the bank deposits funds into the receivers account. Due to complex procedure when using drafts it takes a long time for the amount to be transferred in to the receiver account (Shim, K and Siegel, G 2000).
4.2 Management of Marketable Securities:
Management of marketable securities is just a continuation of cash management. We know that cash does not earn any return so instead of holding these cash firms just invest these cash in marketable securities for a short period of time. When the firms feel that they need some they just convert these marketable securities back into cash. Depending upon the yield curve the security earns the return. When the yield curve rises the firm gains a higher return. For example if the firm invest in a security for one year period of time then the return it would be getting is measured by (Puxty, G and Dodds 1988)
R = P2 - P1 + I
Where R is the return, P2 is the maturity value of the security, P1 is the purchase price and I is the interest paid.
There are several factors which the firms consider when investing on securities and they are as follows (Chandra 2005),
Safety – The most important factor which the firm consider when investing in any kind of security is safety. The firm before investing in any security first checks whether they will get back the amount invested. T-bills or the treasury bills are considered as the safest investment because the obligation are promised by the government. But investing in other securities depends upon the type of security and the issuer.
Liquidity- The liquidity refers to the ability of the investor to convert the security back into cash without acquiring any loss. For a traded security a large and active secondary market ensures liquidity while a non traded security liquidity risk is high.
Yield- The yield represents the return which the security is going to gain by way of interest, dividend and capital gain.
Maturity- Maturity represents the expiry time of the security. The longer the maturity period the higher will be the yield. But securities like t-bills provide a fixed return when they are matured.
Some of the marketable securities where the firms generally invest are the following, (Fabozzi, J 2003)
Treasury Bills- These are securities issued by the US government and as a maturity period of one, three and six months. Investing in this type of security is risk free but it provides a lower rate of return.
Certificates of deposits- These are debts issued by the bank in large amounts and have a maturity period up to one year. Investing in this type of security is highly risky because some times the issuer will not pay the interest and principal as promised.
Commercial paper- These are debts issued by firms in large amounts and have a maturity period generally up to thirty days. Investing in this security is also risky but this risk is minimized by the back up lines of credit offered by commercial banks. Commercial paper is very attractive because of the higher returns it provides than when compared to the return provided by t-bills.
Holding cash and marketable securities offers both advantage and disadvantage for a firm. The advantage is, it reduces the transaction cost because there is no need to issue security or borrow cash and holding cash or marketable securities provides opportunities to take advantage of immediate growth opportunities. The disadvantage of holding cash and marketable security is the after tax return of both cash and marketable security is considerably very low (Brigham, F and Houston. F 2007).
According to Opler, C et al (1999) suggest that firms which has high growth opportunity will be in trouble if they don’t maintain enough cash or marketable securities as they cant take advantage of opportunities available to them. For these purpose firms with high growth opportunity tends to hold a large amount of cash and invest largely on marketable securities. Also firms with unpredictable cash flow maintain a high level of cash and marketable security. But on the other hand firms which have the maximum access to the capital market maintain a lower level of cash.
4.3 Management of Inventories:
Inventory management is a set of polices which controls and monitor the levels of inventory and decides what level of inventory to be maintained, when they should be restocked, and also to decide what level of stocks to be ordered. Inventories in an organization can be classified as (Chase, B, Davis, M and Aquilano, J 2003).
Raw Materials- these are items purchased from.
Work in Process- these are products not yet completed and still in the processing stage
Finished goods- these are completed product which are under the control of the firm.
Organizations should generally maintain some level of inventory which should satisfy the continuous demand of the customer’s. The main task of inventory management it is to provide a continuous supply of a product to the customer at all times without disruption. To achieve this task there should be close coordination between the sales, purchasing, production, and the financial departments. The sales department observe the changing demand of the product and then the purchasing and production department works on these changes while the financial department arranges the finance to set up the inventory. Improper coordination between these departments can cause serious problems (Wild 2002).
There are three types of cost involved in inventories and these costs should be taken into consideration when making decisions with inventories. The three costs are, (Berk and DeMarzo 2007)
Carrying costs- Carrying costs is the cost of holding the inventory in storage and also their depreciation and obsolescence cost. When inventories are stored they need to insured and the firm needs to pay the insurance and property tax. Depreciation and obsolescence cost is the cost where the value of the product is reduced over time.
Ordering Cost- These are the cost involved when the inventories needed to be replenished. For the inventories to be restocked the firm needs to place orders with a supplier. Telephone charges, delivery costs, set up and production cost are the cost included in the ordering cost.
Stock-out costs- Stock-out cost is occurred when the firm inventories become shortage. Due to this shortage the firm will loss the sales and goodwill of the customer.
Reasons for Holding Inventory:
There are several reasons for organization maintaining the inventory. Some of the reasons which firms generally consider are the following, (Muller 2003)
Varying Demands- The main reason why inventory are stored because of the varying demands of the product. Firms should be able to satisfy the needs of the customer on time. Also the demand of the product or service will vary from time to time so because of this varying it is always better for the firm to hold some level of inventory in order to avoid any kind cost associated with it.
Unreliability of Supply- Suppliers can cause troubles to the firm by delaying the supplies or providing low supplies. So in order to be safe firms hold inventories in order to avoid the stock out costs.
Inflation: Inflation is also another reason for firms to hold inventories. Buying and storing inventories at appropriate times helps the firm the firm to avoid the cost of inflation.
Lower Ordering Costs: In order to lower the ordering costs firms buy inventories in large quantities less frequently thereby reducing the ordering costs such as delivery cost etc.
As discussed above holding inventories is costly and many organizations try to minimize the cost of holding inventory. In an article Tully and Miller (1994) studied that many organizations are working to minimize the cost of inventory. Some firms do long tem forecast of orders and they manufacture their products a week or month in advance creating big inventories and will fulfil the orders. Also some firm started manufacture the product only when needed. This system is known as demand based management or just in time inventory management. The main advantage of performing just in time inventory is the firms hold less level of inventory which reduces the storage cost.
4.4 Management of Accounts Receivables:
Accounts receivables are developed when the firms allows the customers to pay for the product or services at a later date. Generally firms like to receive cash immediately for the products but in order to be competitive and to increase the sales they offer credit. The management of accounts receivables involves making decisions on whether to offer credit or not and also to monitor and control the accounts receivables in the business. Even accumulating accounts receivables involves cost. Firms offering credits are going to miss those funds for a certain period and thus there is an opportunity cost involved when offering credit. Also firms should monitor what is owed to the firm. Thus there is a cost involved in monitoring the accounts receivable called as the administering cost (Fabozzi, J 2003).
Firms in order to be compete with other firm’s offers credit to the customers so that they can increase the sales. So managers set their credit policy on the basis of increasing the sales. The following aspect which is considered when setting the credit policy is as follows, (Brigham, F and Houston. F 2007)
Credit Period- It is the period which is granted by the firm to the customers to pay for the purchases.
Discounts- Discounts are sometimes given by the firm for early payments. A certain percentage of discount is offered for the purchase when the payment is done before a certain period.
Credit Standards- Credit standards are standards set by the firm for acceptable credit customers. Normally the evaluation of an customer’s creditworthiness is measured using the four C’s such as (Fabozzi, J 2003)
Capacity- This measures the customer’s capacity to earn the money to repay the obligation.
Character- This measures the customer’s willingness to pay the debt.
Collateral- This measures the customer’s assets which can be liquidated if bad debt occurs.
Conditions- This measures the customer’s ability to pay to the varying economic and market factors.
Collection Policy- These are policies which are set by the firm to collect the slow paying accounts.
5.0 Short Term Financing:
As far we have discussed the components of the current assets and the optimal level to maintain it. Now we will discuss how those current assets are financed. Generally all the components of the current assets require investment of funds of different levels depending upon the level of each component required from time to time. Based on this level of funds required the short term financing is provided. Some of the sources of short term financing are (Mathur, B 2003)
Bank Loans and
Accruals are amounts which the firm owes to a person or to an organization which are not yet paid. Generally expenses such as wages, taxes and interest for liabilities which are not yet by the firm for the services provided by it are known as accruals. Wages represent the amount owed by the firm to its employees. Taxes represent the firm’s tax such as income tax and sales tax. Generally firms pay the wages and tax on a weekly basis or on a monthly basis. Also firms need to pay interest for the bonds issued and it is known as accrued interest. Therefore all these expenses are noted in the balance sheet as accrued expenses and they are not yet paid. Also no interest is paid in these expenses and they are all treated as interest free source of financing (Bhalla 2005).
Accounts payables also known as trade credit are amounts which the firm owes to a supplier. When a firm purchase raw materials from suppliers the suppliers usually grants a certain period for the payment to be settled by the firm. This period is known by the firms as the creditors’ payment period. Trade credit is considered as the most important source of short term financing especially for smaller businesses as they unable to obtain funds from banks and other financial institutions (Bhalla 2005). Suppliers before granting credit period always checks the firms credit worthiness. Like in the accounts receivable we discussed earlier where firms checks the credit worthiness of the customer, here the supplier checks the firm’s credit worthiness. The supplier examines the firm’s ability to pay for the raw materials they bought. The various aspects which the firms generally consider are the following, (Mathur, B 2003)
Profitability- Profitability is one of the important factors which are considered when examining the credit worthiness of the business. The supplier will also look whether the business is able to plough back a significant amount back into the business. This will indicate whether the business will continue in the long term.
Liquidity- Liquidity is also another important factor considered when examining the credit worthiness. Liquidity ratios are calculated and it tells whether the business will be able to fulfil the commitments of payments when they fall due.
Also judging the honesty and willingness of the firm to pay back its dues is checked. This is done by enquiring with previous suppliers.
Bank loans are considered as the second important source of financing next to the trade credit. Bank loans are funds which are financed by the bank when asked by the firm when the need to increase its activities. The key features involved when offering bank loans to a firm are as follows, (Brigham, F and Houston. F 2007)
Maturity- Almost all bank loans have a maturity of less than one year.
Promissory Note: This is a note which is signed by the firm agreeing certain terms and condition when the loan is offered to the firm. The note contains the borrowed amount, interest rate, repayment schedules and any collateral which is taken as security for the loan.
Compensating Balance- It is the balance which the firms should deposit or maintain with the bank in order for the loan to be offered to the firm. Generally the amount to be maintained is 20 to 30 percent of the total amount of the loan.
Line of Credit- Line of credit is an informal agreement made between the bank and the firm where the bank agrees to lend the firm a certain amount during a specified period.
Revolving Credit Agreement- It is a formal agreement made by the bank and the borrower agreed to lend a certain amount.
Commercial paper is a short term unsecured promissory note issued by firms which are then sold to other firms, banks and other financial institutions. The maturity of the commercial will be below one year and the interest rate varies depending upon the demand. The interest rate of the commercial paper is below the prime rate. Only firms which have good credit ratings will be able to borrow funds through the sale of commercial paper. Commercial papers are usually sold at a discount and it pays the full amount during the maturity. Commercial paper is not always a dependable source of finance because if the firm faces any financial difficulties no investor will be interested in buying the commercial paper issued by the firm. Also commercial paper can only paid during the maturity. Even if the firm doesn’t need any funds they must still pay the interest for the commercial paper issued (Fabozzi, J 2003).