CREDIT MANAGEMENT
In most business-to-business purchases, companies extend credit facilities to their customers. Credit is a crucial tool for attracting and keeping customers. However, if not well managed, credit facilities can affect cash flow management. Poorly managed credit can result in delays in converting sales into cash.
Credit policy
The term credit policy here refers to the decision variables that influence the amount of credit that a company may extend to customers. Those variables include the length of credit period to be extended, the quality of goods to be given on credit, cash discount to be given and any terms to be offered to the customers.
A lenient credit policy (or relatively liberal credit policy). This will result in a high level of receivables. A lenient credit policy will result in greater defaults in making payments by the financially weak customers and this will result in the increasing size of receivables. This policy encourages even those financially strong customers to delay making payments which will result in increasing the size of account receivables.
Strong credit policy (aggressive credit policy): Such a policy ensures that those who owe a company pay on time. There are staffs whose core role is debt correction – by physically walking into clients and picking the cheques.
Determinants of credit policy
- Competition: The credit terms offered by a company should be at par or better than those offered by the competition. This competition analysis is a value-added service offered and does not increase the outsourced credit control cost.
- Customer types: Having one credit policy for all customers will make it very restrictive. Since customer types differ, it is best to have different credit terms set for the same. To determine these credit terms outsourced credit control Manchester service providers conduct an exhaustive credit check on customers of their clients.
- Merchandise offered: Fast-moving products and services require a shorter credit period while those that are slow-moving need longer credit periods. Classification of the merchandise is another area where outsourced credit control UK can be of great help.
- Profit margins: A company operates at different profit margins for different products. Determining the same requires extensive market research. Companies can factor in this requirement when discussing the cost of outsourcing credit control so that they can formulate a well-rounded credit policy.
- Unit price: For goods with a low unit price, profits can only be realised when the movement occurs in bulk. This increases the credit exposure of a company. Thus, for every such order placed, an outsourced credit control Suffolk service provider needs to conduct a detailed analysis before enabling credit approval.
WORKING CAPITAL MANAGEMENT
Working capital management is defined as the relationship between a company’s short-term assets and commitments. It tries to ensure that a company’s day-to-day operational expenses can be met while simultaneously investing its resources in the most profitable way possible. Management of working capital is mainly about making sure that a business has enough cash flow to pay its short-term debts and cover its short-term running costs. The current assets minus the current bills of a business make up its working capital. Anything that can be easily turned into cash within a year is considered a current asset. These are the company’s assets that can be quickly sold. Cash, accounts due, inventory, and short-term investments are all examples of current assets. Current liabilities are debts that are due within the next 12 months. Some examples are accruals for operational expenses and current parts of payments on long-term debt.
Objectives of working capital management
- To increase the profitability of the organization, and
- Ensure the organization has sufficient liquidity to meet short term obligations as they fall due
- Working capital is the cash needed to pay for the day–to–day operations of the business. It is the difference between the current assets and the current liabilities of a business.
Current Assets = Assets held in cash form e.g. at bank or those that can be quickly converted into cash
Less
Current liabilities = Money owned by a business that will need to be paid in the next 12 months
Equals
Working capital
Net working capital: current assets minus current liabilities
Current assets: may include stocks of raw materials, work in progress and finished goods, trade receivables, short term investment, and cash.
Current liabilities: may include trade payables, overdrafts and short term loans
| current asssets Stock(raw materials working in progress, finished goods) Debtors: cash at bank, short term investment | Less | Current liabilities Trade creation(taxation,Dividends, short term loans) | Equals working capital |
Level of working capital
- Aggressive policy: With regard to the level of investment in working capital, an aggressive policy means that an organization will choose to operate with a lower level of inventory, trade receivables and cash for a given level of activity or sales. Such policy will increase the profits of the organization since less cash will be tied up in current assets. But such a policy could increase risks since the possibility of cash reserves shortages and running out of physical inventory is increased.
- Conservative policy: Under this policy, there is a more flexible working capital policy up to a given turnover. It is associated with maintaining a larger cash balance (probably even investing in short term securities, offering generous credit terms to customers, and holding higher levels of inventory). This kind of policy will likely give a lower risk of financial/ cash problems, and inventory problems. It is however, likely to reduce on the level of profitability.
- Moderate policy: This is the policy which is in the middle of both the aggressive policy and conservative policy. An organization decides on such a policy for fear of the extremes of the first two policies
Calculating working capital M/s Moode Enterprises
| Less Current Liabilities Equal Working Capital (CA-CL) | Cash Prepayments Creditors Taxes Dividends Short term Loans | 100000 250000 150000 50000 550000 200000 100000 30000 120000 450000 100000 |
Advantages of adequate working capital
- Solvency of the business: this ensures uninterrupted flow of production. Continuous production keeps business in the market serving their customers.
- Good will: good will is as important as a good name or brand in the market. With sufficient working capital a company is able to make prompt payments and in turn will help it create and maintain good will.
- Getting loans on favorable terms. A business that has adequate working capital and is solvent with good credit standing can obtain bank loans on easy and favourable terms.
- Regular supply of raw materials, adequate working capital enables a business to ensure regular supply of raw materials and hence continuous production.
- Regular payment of operational expenditures (salaries and wages, day to day expenditure).Timely payment of salaries and wages raises employee morale and their efficiency and ultimately business realizes increased production and sales performance.
- Cash discounts on purchases. A business with sufficient working capital usually obtains cash discounts on purchases; which reduces its costs.
- Buying in bulk and enjoying economies of scale in production
Disadvantages of excessive working capital
- Presence of ideal funds earning no profits for the business(no proper rate of return on its inventory)
- Unnecessary purchasing and hold of large inventories possibly causing chances of pilferage, theft, waste and losses. (Don’t forget the costs of inventory).
- Redundant working capital may give rise to speculative transaction motives which could backfire.
- Some businesses may fail to keep good working relationships with financial institutions because they have excessive working capital. This is bad because in future they may not attract loans on favourable terms.
- A business with redundant working capital may become too lenient with its credit policy. Normally a business should pressurize those who have bought on credit so as to have a healthy cash flow.
- The value of shares may fall due to the low rate of return on investments.
Dangers of inadequate working capital
- Failure to pay short term liabilities as they fall due; on time.
- It cannot buy in bulk and enjoy associated advantages
- Failure to pay day-to-day expenses which can result in poor employee morale and inefficiency
- Underutilization of the fixed assets. The business may fail to produce at optimum (but at excess capacity). This means that the equipment or machines are not being utilized efficiently.
- The rate of return on investments will fall with a shortage of working capital.
Summary of Working Capital Finance Instruments
| FINANCE INSTRUMENT | DESCRIPTION |
|---|---|
| Line of Credit | Maximum loan limit established. Firm draws on loan as needed up to limit. |
| Accounts Receivable (AR) Loan | Loan secured by accounts receivable |
| Factoring | Sale of accounts receivable to a third-party collector (factor).Factor bears collection risk. |
| Inventory Loan | Loan secured by inventory |
| Term Loan | Medium-term loan. Principal repaid over several years based on a fixed schedule. |
Determinants of working capital Internal factors:
- Nature and size of business: A small business will not require the same amount as a large business.
- Volume of sales: With the increase in sales, there is more demand for working capital needed for production offinished goods and payment of debtors.
- Production policy: In case of seasonal fluctuations in sales, production will fluctuate accordingly and ultimately requirement of working capital will also fluctuate.
- Conditions of supply: In situations where the supply of stocks is prompt and ample, fewer funds will be
required. Where supply is unpredictable (or even seasonal) more funds will have to be invested in inventory. - Availability of credit:
- Changes in the general price level: inflation.
- Firm’s Credit policy: A business that follows a lenient or liberal credit policy to all customers requires more
funds. - Management and coordination activities in the business: Working capital requirements will depend upon the organization and coordination between production and distribution activities.
- Growth and expansion of the business: The working capital requirements of an enterprise tend to increase with growth in sales volume, and growth in fixed assets.
- Profit margin and dividend policy: The size of working capital in a business is dependent upon its profit margin and the dividend policy.
External environmental factors
- Business cycles and fluctuations: Business cycles in business include boom, slum, and even a recession. During a recession, the overall purchasing power is very low.
- Taxation policies: Tax policies of the government can affect the level of working capital of a business. If the government imposes high taxes on the businesses, they will be left with minimum profits for maybe distribution and retention purposes.
- Import policies and regulations:
- Changes in the levels of technology: Technological changes and advancements
in the area of production can affect the levels of working capital. When a business acquires and installs a new machine (replacing the old one) and the machine can utilize less expensive raw materials (or uses less raw materials), this may reduce the levels of inventory levels required. This will in turn reduce working capital needs.
Sources of working capital
| Short-term source | Long-term source |
|---|---|
| Overdrafts | Own Capital |
| Short-term bank loans | Debentures |
| Trade credit | Long term loans |
Operating cycle: SME manufacturing entity
Principles of working capital
- The principle of risk variation: This principle assumes a definite relationship between the degree of risk and the rate of return. As a business assumes more risk so does the opportunity for profit (or losses) increases. As the level of working capital relative to sales decreases, the opportunity for gain (profit) and loss also increase.
- The principle of cost of capital: The principle asserts that different sources of finance have different costs of capital. The cost of capital moves inversely with risk, and therefore additional risk capital will likely result in a decline in the cost of capital.
- The principle of maturity of payment: Every business should endeavour to ensure that maturity of payments (of its short term debt instruments) relate to its flow of internally generated funds. To lessen risk, there should be the least disparity between maturity of payments and the flow of internally generated funds.
- The principle of equity position: This principle states that the amount of working capital invested in each unit of business should be justified adequately by the enterprises/ company equity position. It simply implies that every dollar invested in the working capital should contribute to the net worth of the company.
Control of working capital
Working capital requirement depends upon the level of operation and the length of operating cycle. In this context, the following points should be borne in mind: The duration of the raw material stage depends on regularity of supply, transportation time, price fluctuations and economy of bulk purchase. For imported materials it takes a longer time.
- The duration of the work-in-process depends on the length of manufacturing cycle, consistency in capacities at different stages, and efficient coordination of various inputs.
- The duration of the finished goods depends on the pattern of production and sales. If production is fairly uniform throughout the year but sales are highly seasonal or vice versa. The duration of finished goods tends to be long.
- The duration at the debtors’ stage depends on the credit period granted, discounts offered for prompt payment, and efficiency and rigour of collection efforts.
