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Strategies and Techniques

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Formerly, Professor of Finance and ControlIndian Institute of Management Calcutta

Delhi-1100922014

WORKING CAPITAL MANAGEMENT: Strategies and Techniques, Third EditionHrishikes Bhattacharya

© 2014 by PHI Learning Private Limited, Delhi. All rights reserved. No part of this bookmay be reproduced in any form, by mimeograph or any other means, without permissionin writing from the publisher.

ISBN-978-81-203-4904-9

The export rights of this book are vested solely with the publisher.

Sixteenth Printing (Third Edition) � � February, 2014

Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111,Patparganj Industrial Estate, Delhi-110092 and Printed by Baba Barkha Nath Printers,Bahadurgarh, Haryana-124507.

Dedicated to

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— the Good Samaritan

Preface xvPreface to the Second Edition xviiPreface to the First Edition xixAcknowledgements xxiii

1. Working Capital: A Techno-Financial Analysis 1–29

Introduction 1Nature of Current Assets 1The Controversy 2Gross Working Capital vs Gross Current Assets 3Limitations of Operating Cycle Theory: Currentness Concept 5Limitations of Operating Cycle Theory: Projection of

Working Capital 7Reversibility Test 8Cash Concept of Operating Cycle 9

Towards an Alternative Theory of Working Capital 11Total Systems View 12Systems Approach: Pipeline Inventories 13Productive System 13Distributive System 14Pipeline Inventories 15

Discrete Operating Inventories 16Cycle Inventories 16Buffer Inventories 18Other Discrete Assets 20

Techno-Financial Approach 20Core Working Capital (CWC) 22Allocation of Overheads 23

Projection of Working Capital 24Current Liabilities 25

Characteristics of Core Working Capital 26Control Mechanisms 27Summary 28

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2. Service Business: Risk Analysis and Working CapitalAssessment 30–56

Introduction 30Value Added Model 31Development of Services Sector 33

Innovations and Competition 33Traditional Sector 33New Ideology of Segmentation and Superspecialisation 34Who Pays for the Services? 35Logistical Services and Knowledge Services 35Banking Services 36Human Resource Assets vs Capital Assets 37Characteristics of Services 37Quality of Human System 38

Classification of Service Business 38Changes in Economic Environment 39

Risk Factors 40Working Capital 48

Service Generation Process 48The Pipeline 49Discrete Blockage of Funds 51Techno-Financial Approach 53Characteristics of CWC Multipliers 55

Summary 55

3. Theories of Trade Credit 57–69

Introduction 57Financing Theory 57Liquidity Theory 59Financial Distress Theory 59Quality Guarantee Theory 60Transaction Costs Theory 62Price Discrimination Theory 63Product Differentiation Theory 64Market Power Theory 65Summary 68

4. Management of Accounts Receivable 70–182

Introduction 70Creation of Accounts Receivable 70General Trends in Accounts Receivable 71Trade Credit: Marketing-Finance Trade off 72Distribution Channels 73Credit Information 75From Sellers’ Market to Buyers’ Market 75Motives for Extending Trade Credit 76

Operating Motive 77

Contents ���

Marketing Motive 78Financial Motive 78Financial Market Tariff 79

Limitations 83Marginal Cost Consideration 83Tax Considerations 83Determining Maximum Length of Trade Credit 85

Elements of Trade Credit Policy 86Importance of Written Trade Credit Policy Document 86

Credit Limit 88Goal and Functions of Accounts Receivable Management 89

Credit Terms 89Opportunity Cost 90Receivables at Cost or Sale Price 91Short-Term Credit Policy Changes 92Long-Term Credit Policy Changes 94Projected Sales 95

Capital Budgeting Approach 96Changing Credit Standards 98Changing the Credit Period 101

Shortening the Credit Period 103

Discount Policy 104Impact on Bad-Debt Losses 105Preamble to Policy Formulation 105

Determination of Maximum Rate of Cash Discount 106Cash Discount that Alters the Timing of Cash Flows 106Break-Even Point 107Cash Discount Affecting both Timing of Payment and Sales

Volume 108Optimal Discount Rate 111

Cash Discount and Bad-Debt Losses 113Selecting the Customers 114

Types of Customer 115Sources of Credit Information 119

Bank Checks 119Supplier Checks 120

Financial Statement Analysis 121Ratio Analysis 121Liquidity 123

Operating Management 123Fixed Assets Turnover Ratio 123Return on Investments (ROI) 124Gross Profit Ratio 125

Financial Management 126Equity to Total Debt Ratio 126Equity-Short Term Debt Ratio 127Finished Goods Inventory Turnover Ratio 127Receivables Turnover Ratio 129

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Creditors Turnover Ratio 130Current Ratio 131Debt-Service Coverage Ratio (DSCR) 133

Application 133Operating Management of XYZ Ltd. 137Financial Management of XYZ Ltd. 138

Credit Scoring 140Lessons from Earlier Studies 141Framework of a Credit-Scoring Model 144Credit Decision Rules 146Subjective Considerations 147Customer Classification 149

Collection and Monitoring 150Organisation and Procedure 150

Payment Pattern 153Collection Costs 154Monitoring and Control 158

Average Age of Receivables 158Daily Sales Outstanding (DSO) 161Receivables Aging Schedule 163Percentage Collection and Accounts Receivable Matrix 166Percentage Cash Flow Matrix (PCFM) 167Percentage Accounts Receivable Matrix (PARM) 170

Forecasting of Accounts Receivable 172Bad-Debts 173

Bad-Debt Reserve 174Predicting Accounts Receivable Behaviour—The Markov Process

Approach 175Notes on Matrix 179

Perforfance Monitoring and Control 180Summary 182

5. Inventory Strategies and Techniques 183–309

Introduction 183Inventory and Price Behaviour 184Motives for Holding Inventory 184

Transaction Motive 184Precautionary Motive 184Speculative Motive 185

Inventory Behaviour 185Market Imperfection 187Types of Organisation Holding Inventories 187Inventory Costs 188

Purchase or Acquisition Cost 188Ordering or Set-up Costs 188Holding Cost 189Stock-out Cost 189

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Valuation of Inventories 189Valuation Methods 191

Inventory Recording and Accounting System 199Periodic Recording System 199Perpetual or Continuous Recording System 200

Goal of Inventory Management 202Integrated System 203

Inventory Strategies and Techniques 203Cost Leadership Strategy 204Differentiation Strategy 205Focus Strategy 206

Techniques of Inventory Management 207Independent Demand Structure 207

Quantity Discounts 223All Units Discount Offer 224

Present Value Approach 228Special Features of Wealth Maximisation Framework 229

Ordering Intervals 233Fixed Order System 233Periodic Order System 239Batch Production 240Single Product 241Multiple Products 243

Buffer Inventory 247Anticipation Stock 247Safety Stock 264

Stock-Out Costs 267Known Stock-out Costs 267Variable Demand 269Factoring the Costs 270Variable Lead Time 271Variable Lead Time and Variable Demand 272Unknown Stock-out Costs 276

Excess Inventory 280Working Capital Restrictions 284Centralisation vs. Decentralisation 286

Supply Chain 286Advantages and Disadvantages of Centralisation 288

Material Requirements Planning (MRP I) 289Demand Characteristics 290Master Production Schedule 290Bill of Materials 290Inventory Status Record 292

Just-In-Time (JIT) 294Toyota System 295Customer Focus 295Push vs Pull System 295Bullwhip Effect 297Inventory Holding Under JIT 302

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Vendors Selection 302In-plant Storage 302Moving the Materials 304Control of Production Line 304Reduction of Wastes 304

Performance Criteria and Measurement 306Summary 306Annexure The Standard Normal Probability Distribution (Areas Under the Normal Curve) 309

6. Liquidity and Cash Management 310–415

Introduction 310Cash vs Profit 310Cash Flow, Cash Stock and Cash to Current Assets Ratio 311Accounting Standards—Cash Flow Presentation 313Funds Flow Analysis 314Relevant Information from the Schedules Annexed to Profit and Loss

Accounts and Balance Sheets of LMN Limited 319Net Operating Cash Flow and Priority Outflows 327

Priority Obligation Ratio 328Discretionary Outflows 329Cash Abstract 329

Funds Analysis and Financial Structure 330Funds Flow Presentation 330Net Working Capital 332Cash Gap Vs Funds Gap 333

Management of Liquidity 335Shiftability Theory 335Liquidity Newly Defined 335Liquidity Crisis and Firm-Level Actions 336

Measurement of Liquidity 338Current Ratio and Quick Ratio 338Window-Dressing 339Other Ratio Measurements 340Turnover Ratios 340Adjusted Current Ratio 340Sales Cash Conversion Cycle (SCCC) 341Uncertainties 342Long-Term and Short-Term View 349

Health Ratio––A Single Liquidity Measure 351Amount of Liquidity 355

Costs of Liquidity 355Forms of Liquidity 358

Maintaining Cash Balance 358Certainty Model—Baumol 358Uncertainty Model—Miller and Orr 361Uncertainty Model—Stone 364Cash Flow Forecasting 366

Contents ��

Operating Revenue 368Pattern of Sales 370Realisable Price 371Sales Realisation 372

Operating Expenditure 373Materials 373Salaries and Wages 373Other Variable Expenses 374Fixed and Semi-Variable Expenses 374

Non-operating Revenues 374Financial Flows 375Fixed Assets 376Other Expected Cash Flows 376

Drawing Up Cash Flow Statement 377Payment for Purchases 379

Sensitivity Analysis 386Working Notes 388

Cash Collection Systems 391Cost of Float 392External Float 392Wholly-owned Collection System 393Contracting Out 394Bank as Collection Agent 394Analytical Approach 398

Lockbox System 400(1) Customer-concentration Approach 402(2) Greedy Approach 404Cash Pooling 407Notional Cash Pooling 409Cross-country Cash Pooling 409

Other Instruments for Cash Collection 411Preauthorised Cheques 411Electronic Funds Transfer 411Settlement Payments 412

Summary 412

7. Management of Accounts Payable 416–430

Introduction 416Trade Credit 416

Implicit Credit to Large Companies 417Managing Accounts Payable 419

Terms of Purchase 419Stretching Accounts Payable 420Cost of Stretching 421

The Model 422Effect of Cash Discount 423

Disbursement Float Management 424Supplier Relationship 426

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Other Accruals 426Variable and Fixed Expenses 427Taxes 427Dividends 427Limited Flexibility 427

Overtrading and the Need for a Good Information System 428Validation 428Scheduling of Payment 428Outsourcing 429

Summary 429

8. Financing Working Capital Gap 431–500

Introduction 431Financial Structure 431New Notion of Liquidity 432Bank Finance 433Principles of Lending 433

Tandon Committee’s Recommendations 434The Norms 434

Expression of Norms 435Methods of Lending 436Chore Group 439

Shortcomings of Cash Credit System 439Loan System 441Bills System 442Chore Group’s Recommendations 442

Abandoning the ‘Core’ Concept 443Quarterly Information System 443

Lending Policies of Commercial Banks During Post-LiberalisationPeriod 444

Small-Scale Borrowers 445Export Credit 445Loan Component 445

Consortium and Syndication 446Exposure Limits 447

Priority Sectors 448Working Capital Requirement and Assessment Methodology of

Commercial Banks 448Assessment of Working Capital Requirement of OSB Ltd. 457Cash Budgeting Approach 461Other Short-Term Sources of Financing 462

Commercial Paper (CP) 462Securitised Commercial Paper 468

Factoring 468Administration of Sales Ledger and Collection 472Credit Information and other Advisory Services 472Cost of Factoring Services 473Forfaiting 473

Contents ����

Inter-corporate Deposit (ICD) 475Interest Rate Swaps and Forward Rate Agreement 475

Interest Rate Swaps (IRS) 475IRS in the Domestic Market 478Characteristics of Interest Rate Swaps 479Risk Element 479

Forward Rate Agreement 480Summary 481Annexure 1 Norms for Inventories and Receivables 484Annexure 2 Drawee Bill System 491Annexure 3 Classifications of Current Assets and Liabilities 495

9. Channel System, Logistics and Channel Financing 501–525

Introduction 501The Channel System 501Logistics 502

In-bound and Out-bound Logistics 502Interdependence 503Economics of Transportation 504Choice of Appropriate Modes of Transport 505Safety Stocks 507Least Cost Warehousing Network 508Conflict Resolution under Channel Management 509

Relationship Management 510Adjustment and Sacrifice 511

Channel Membership 512Specialisation 512Rising Power of Retailers 513

Channel Financing 514Conventional Financing vs Channel Financing 515Buyer’s Credit 515Problems of SMEs and the Credit Channel Effect 516Inventory Flow—The Ultimate Liquidity of the Channel 518Financial Integration of the Channel System 518Receivables Financing vs Payables Financing 519Drawee Bill System 520

Books of Accounts of the Manufacturer 521Books of Accounts of the Dealer 523Summary 524

Bibliography 527

Author Index 529– 531

Subject Index 533– 560

Working Capital Management-Strategies And Techniques

Publisher : PHI Learning ISBN : 9788120349049 Author : Bhattacharya

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