Working Capital Management

Working capital is the capital invested in the current assets of a firm needed for its day-to-day operations. Gross working capital is the total of current assets, and net working capital is current assets minus current liabilities:

$NWC = CA - CL$

Maximum inventory is the order quantity plus the safety stock:

$\text{Maximum inventory} = EOQ + \text{Safety stock} = 1{,}200 + 500 = 1{,}700 \text{ units}$

Average inventory:

$\text{Average inventory} = \frac{EOQ}{2} + \text{Safety stock} = \frac{1{,}200}{2} + 500 = 1{,}100 \text{ units}$

Gross working capital is the total of current assets:

$GWC = 150{,}000 + 100{,}000 + 100{,}000 = \text{Rs } 350{,}000$

Net working capital:

$NWC = CA - CL = 350{,}000 - 250{,}000 = \text{Rs } 100{,}000$

Permanent working capital is the minimum level of current assets (cash, receivables, inventory) that a firm must always hold to carry on its operations, whatever the season or level of sales. It is also called fixed or core working capital and is usually financed from long-term sources.

Maximum inventory = EOQ + safety stock = 1,800 + 1,000 = 2,800 units

Average inventory = EOQ/2 + safety stock = 1,800/2 + 1,000 = 1,900 units

Gross working capital = total current assets = 200,000 + 100,000 + 200,000 = Rs 500,000

Net working capital = current assets − current liabilities = 500,000 − 300,000 = Rs 200,000

The cash conversion cycle (CCC) is the length of time between paying for raw materials and receiving cash from the sale of the finished goods. It equals the operating cycle minus the average payment period:

$CCC = ICP + ACP - APP$

where ICP is the inventory conversion period, ACP the average collection period and APP the average payment period.

Two motives for holding cash are:

• Transaction motive: to meet day-to-day payments such as wages, purchases, taxes and dividends.
• Precautionary motive: to hold a reserve for unexpected needs or emergencies.

(Speculative motive: to take advantage of unexpected profitable opportunities such as bargain purchases.)

In the credit term 2/10 net 30:

• 2 is the cash discount of 2% given if the customer pays within the discount period.
• 10 is the discount period: the discount is available if payment is made within 10 days of the invoice date.
• Net 30 means the full invoice amount is due within 30 days if the discount is not taken.

Inventory ordering cost is the cost incurred each time an order is placed and received. It includes the cost of preparing and processing the purchase order, communication, transportation, inspection, receiving and handling. It is fixed per order and falls per unit as order size rises, so total ordering cost rises with the number of orders.

Four functions of a credit manager:

• Setting the credit policy: credit standards, terms and period.
• Evaluating the creditworthiness of customers and deciding credit limits.
• Monitoring accounts receivable and collecting overdue accounts.
• Controlling bad debts and reporting on receivables.

(Others: deciding on discounts and arranging credit insurance.)

Four factors to consider in working capital financing:

• Cost of financing: the interest rate and other charges of each source.
• Maturity matching: financing should be matched with the duration for which funds are needed.
• Risk and flexibility: the risk of non-renewal and the ability to repay early or draw more.
• Availability and conditions: security required, covenants and the firm's credit standing.

(Others: nature of the business and control considerations.)

Net float is the difference between the firm's book (ledger) cash balance and the bank's balance. It equals disbursement float minus collection float:

$\text{Net float} = \text{Disbursement float} - \text{Collection float}$

Illustration: a firm issues cheques of Rs 50,000 that have not yet cleared (disbursement float, since the bank balance is higher than the book balance) and deposits cheques of Rs 30,000 that the bank has not yet credited (collection float). Net float = 50,000 - 30,000 = Rs 20,000, which means the firm's bank balance is Rs 20,000 higher than its book balance. A positive net float lets the firm hold less cash.

The size of working capital depends on the following factors.

• Nature and size of business: manufacturing firms need more working capital than service firms. Larger operations need more.
• Length of the operating cycle: the longer the cycle from buying raw material to collecting cash, the more working capital is needed.
• Production policy and seasonality: seasonal or level production changes the inventory and cash needs.
• Credit policy: liberal credit to customers increases receivables, while longer credit from suppliers reduces the need.
• Growth and expansion: growing firms need more working capital to finance inventory and receivables.
• Inventory policy and turnover: high inventory levels and slow turnover increase the need.
• Profit margin and dividend policy: high profit retention provides internal funds, while heavy dividends use up cash.
• Price level and inflation: rising prices need more funds for the same volume.
• Availability of credit and competition: easy bank credit allows lower working capital, while competition forces generous credit and inventory.

Working capital policy affects both profitability and risk. There is a trade-off between them.

• Higher current assets: holding more cash, inventory and receivables reduces the risk of stock-outs and lets the firm give credit and sell more. But funds are tied up in assets that earn little or no return, so return on investment falls and carrying costs rise.
• Lower current assets: a lean level of current assets reduces the investment and carrying cost, so profitability and ROA rise. But the risk of shortage of cash, stock-outs and lost sales also rises.
• Financing mix: short-term financing is cheaper than long-term financing, so more current liabilities raise profit, but it increases the risk of renewal and liquidity. Long-term financing is safer but costs more, which lowers profit.
• Efficiency measures: faster inventory turnover, quicker collection and taking trade credit shorten the cash conversion cycle, free cash and raise profit.

Hence, the firm must hold the level of working capital that balances profitability against liquidity.

The credit policy of a firm sets the rules for giving credit to customers. Its elements are:

• Credit standards: the minimum creditworthiness of customers to whom credit is given, judged by the five Cs: character, capacity, capital, collateral and conditions. Loose standards raise sales and bad debts, while strict standards reduce both.
• Credit terms: the credit period (length of time allowed for payment), the cash discount and discount period (for example 2/10 net 30). They influence sales and the speed of collection.
• Collection policy: the procedures to collect dues, such as reminders, calls, legal action and the treatment of overdue accounts. A strict policy reduces bad debts but may annoy customers.
• Credit analysis and limits: evaluating each applicant from financial statements, credit reports and past records, then setting a credit limit.

The policy should balance extra profit from sales against the cost of receivables and bad debts.

(a) Inventory conversion period:

$ICP = \frac{360}{8} = 45 \text{ days}$

$\text{Operating cycle} = ICP + ACP = 45 + 60 = 105 \text{ days}$

$CCC = 105 - 35 = 70 \text{ days}$

(b) Daily cash operating expenditure:

$\frac{3{,}500{,}000}{360} = \text{Rs } 9{,}722.22$

Resources invested to support the cash conversion cycle:

$9{,}722.22 \times 70 = \text{Rs } 680{,}555.56$

(c) Shortening the CCC by 20 days reduces the investment by:

$9{,}722.22 \times 20 = \text{Rs } 194{,}444.44$

Increase in annual profit:

$194{,}444.44 \times 0.14 = \text{Rs } 27{,}222.22$

Given: $F =$ Rs 100, $i = 0.02\% = 0.0002$ per day, $\sigma =$ Rs 90 so $\sigma^2 = 8{,}100$, lower limit $L =$ Rs 1,000.

Spread:

$\text{Spread} = 3\left(\frac{3F\sigma^2}{4i}\right)^{1/3} = 3\left(\frac{3 \times 100 \times 8{,}100}{4 \times 0.0002}\right)^{1/3}$

$= 3\left(3{,}037{,}500{,}000\right)^{1/3} = 3 \times 1{,}448.2 = \text{Rs } 4{,}344.7$

Target cash balance:

$Z = L + \frac{\text{Spread}}{3} = 1{,}000 + 1{,}448.2 = \text{Rs } 2{,}448.2$

Upper limit:

$H = L + \text{Spread} = 1{,}000 + 4{,}344.7 = \text{Rs } 5{,}344.7$

When the cash balance rises to the upper limit of about Rs 5,345, the company should buy marketable securities worth $H - Z = 5{,}344.7 - 2{,}448.2 =$ Rs 2,896.5 (about Rs 2,897), which brings the cash balance back to the target of Rs 2,448. If cash falls to Rs 1,000, it should sell securities to return to the target.

(a) Cost of the DTC: the funds are not available for 3 days, so the opportunity cost is

$2{,}500{,}000 \times 0.12 \times \frac{3}{365} = \text{Rs } 2{,}465.75$

$\text{Total cost of DTC} = 2{,}000 + 2{,}465.75 = \text{Rs } 4{,}465.75$

Cost of wire transfer = Rs 5,000 (funds available at once, so there is no lost interest).

The DTC costs less by about Rs 534, so Mathema should use the mail depository transfer check.

(b) At the indifference amount $X$, the interest lost on the DTC equals the extra fee of the wire transfer:

$X \times 0.12 \times \frac{3}{365} = 5{,}000 - 2{,}000 = 3{,}000$

$X = \frac{3{,}000 \times 365}{0.12 \times 3} = \text{Rs } 3{,}041{,}667$

For transfers above about Rs 3.04 million the wire transfer is cheaper, and for smaller amounts the DTC is cheaper.

Current policy (buying at EOQ):

$EOQ = \sqrt{\frac{2 \times A \times O}{C}} = \sqrt{\frac{2 \times 100{,}000 \times 1{,}000}{2}} = 10{,}000 \text{ units}$

Number of orders = 100,000 / 10,000 = 10

$\text{Ordering cost} = 10 \times 1{,}000 = \text{Rs } 10{,}000$

$\text{Carrying cost} = \frac{10{,}000}{2} \times 2 = \text{Rs } 10{,}000$

Total inventory cost = Rs 20,000.

Under the discount (order size 20,000):

Number of orders = 100,000 / 20,000 = 5

$\text{Ordering cost} = 5 \times 1{,}000 = \text{Rs } 5{,}000$

$\text{Carrying cost} = \frac{20{,}000}{2} \times 2 = \text{Rs } 20{,}000$

Total inventory cost = Rs 25,000, an increase of Rs 5,000.

Saving from the discount: $100{,}000 \times 0.50 =$ Rs 50,000.

Net benefit = 50,000 - 5,000 = Rs 45,000.

The company should accept the offer, since the saving in purchase cost exceeds the extra inventory cost.

Concept of working capital

Working capital is the funds a firm invests in its short-term (current) assets to run daily operations. It is viewed in two ways.

• Gross working capital: the total investment in current assets such as cash, marketable securities, receivables and inventory.
• Net working capital: current assets minus current liabilities, $NWC = CA - CL$. A positive NWC shows that part of the current assets is financed by long-term funds.

Working capital can also be classified as permanent (the minimum level needed all the time) and temporary or variable (the seasonal, extra need). The firm's operating cycle, the time from buying raw materials to collecting cash from sales, determines how much it needs. Working capital management is the management of current assets and current liabilities to maintain a balance between profitability and liquidity.

Importance of working capital management

In general:

• It ensures liquidity, so the firm can pay obligations on time and keep its creditworthiness.
• It avoids both shortage of funds and idle funds, and so improves profitability.
• It supports smooth operations and lets the firm take advantage of discounts and opportunities.
• It affects the survival of the firm: most business failures are due to poor working capital management.

In a manufacturing firm:

• Large funds are tied up in raw material, work-in-process and finished goods, so inventory control (EOQ, safety stock) is vital.
• The operating cycle is long (purchase, production, sale, collection), so the firm needs more working capital and careful financing.
• Smooth production needs timely supply of materials, wages and power; shortage stops production and causes lost sales.
• Credit sales and collection need good management to maintain the cash flow.

In a trading firm:

• Current assets, mainly inventory and receivables, form the major part of total assets, since fixed assets are small. So working capital management is the core of financial management.
• The operating cycle is shorter, so fast stock turnover and quick collection give high returns.
• Proper stock levels meet customer demand and avoid stock-outs, while limiting carrying cost and obsolescence.
• Use of trade credit from suppliers can finance a large part of the business.

Thus, in both types of firm effective working capital management supports liquidity and profit, though the weight differs: manufacturing firms need to manage all three types of inventory and a longer cycle, while trading firms mainly manage stock and receivables.

Current assets are of two kinds: permanent current assets (the minimum level always required) and temporary (fluctuating) current assets (the seasonal part). The financing approaches differ in how they finance these using long-term and short-term sources.

1. Matching (hedging) approach

• Maturity of financing is matched with the life of the asset.
• Permanent current assets and fixed assets are financed with long-term sources (equity, debentures, term loans).
• Temporary current assets are financed with short-term sources (bank overdraft, trade credit, commercial paper).
• Risk and cost are moderate. It avoids paying for long-term funds that are not needed, and avoids refinancing risk, but exact matching is difficult in practice.

2. Conservative approach

• Long-term financing is used for fixed assets, permanent current assets and also part (or all) of the temporary current assets.
• Short-term financing is used only in peak or emergency needs.
• Risk is low, because there is little dependence on short-term funds and liquidity is high. But the cost is high, since long-term funds are costlier and are idle in slack seasons, so profitability is low.

3. Aggressive approach

• Short-term financing is used to finance all the temporary current assets and even part of the permanent current assets.
• Long-term funds are used for fixed assets and the remaining part of permanent current assets.
• Cost is low, because short-term funds are cheaper, so profit is high. But risk is high: the firm must keep renewing short-term loans, interest rates may rise and liquidity may be short.

The choice depends on management's attitude to risk, the cost of funds, the nature of the business, and the availability of credit.

Assumption: The question does not give the forecast sales, so the commonly used figures are taken: May Rs 100,000, June Rs 100,000, July Rs 120,000, August Rs 100,000.

Working notes

• Collections: 50% cash in the month of sale; 25% in the first following month and 25% in the second following month.
• Cost of goods manufactured is 70% of sales (March Rs 56,000, April Rs 56,000, May Rs 70,000, June Rs 70,000); 90% is paid in the month after production and 10% in the second month.
• Sales and administrative expenses = Rs 10,000 + 10% of sales.

Cash budget (Rs)

Payments for goods: May $=0.9(56{,}000)+0.1(56{,}000)=56{,}000$; June $=0.9(70{,}000)+0.1(56{,}000)=68{,}600$; July $=0.9(70{,}000)+0.1(70{,}000)=70{,}000$.

Borrowing is necessary in June (Rs 19,600) and again in July (Rs 61,000), a cumulative loan of Rs 80,600 by the end of July.

Evaluation of the financing options for Rs 200,000 for 30 days

1. Line of credit: commitment fee $=0.5\%\times200{,}000=1{,}000$; interest $=200{,}000\times0.15\times30/360=2{,}500$. Total cost Rs 3,500, which is 1.75% for the month, or 21% a year.
2. Forgo trade discount (2/10, net 40): cost $=\frac{2}{98}\times\frac{360}{30}=24.5\%$ a year; for the month about Rs 4,082.
3. 30-day commercial paper at 13.8%: interest $=200{,}000\times0.138\times30/360=$ Rs 2,300, which is 13.8% a year.
4. 60-day commercial paper at 14%: interest $=200{,}000\times0.14\times60/360=4{,}667$. Earnings on securities for one month $=200{,}000\times0.13/12=2{,}167$, less fee Rs 1,000, giving Rs 1,167. Net cost $=4{,}667-1{,}167=$ Rs 3,500, or about 21% a year.

(a) The cheapest is the 30-day commercial paper at 13.8% (cost Rs 2,300).

(b) The lowest expected cost source is not necessarily the one to select. Other factors matter:

• Availability and size of market: commercial paper can be issued only by firms with a strong credit rating, and the market may not absorb the issue. A line of credit assures availability.
• Flexibility and certainty: a line of credit can be used only if and when needed, whereas commercial paper must be issued in full.
• Risk: the 30-day paper must be repaid or rolled over on the date, with refinancing risk. Forgoing a discount may damage supplier relations and credit rating.
• Relationship and effects on future borrowing, interest rate uncertainty, and other non-cost issues like the time and cost of arranging the finance.

Thus the final decision should weigh cost with availability, flexibility, risk and the firm's long-term financing policy.

(a) Days sales outstanding (DSO)

Current policy: $0.6(10)+0.4(30)=6+12=$ 18 days

Proposed policy: $0.7(20)+0.3(45)=14+13.5=$ 27.5 days

(b) Bad debts, discounts and carrying cost

Sales: current Rs 18,000,000; proposed Rs 24,000,000.

(c) Incremental profit

Tax at 40%: $792{,}800\times(1-0.40)=$ Rs 475,680 incremental profit after tax.

The incremental profit is positive, so on this analysis the credit policy should be changed to 3/20, net 45.

(d) Effect of relaxing credit standards (in words)

Relaxing credit standards means granting credit to less creditworthy customers. Expected sales increase because more customers qualify. Bad debt losses increase because of the greater share of customers who fail to pay. The opportunity cost (cost of carrying receivables) increases because more receivables are outstanding for a longer time, and collection costs rise. The firm should relax standards only as long as the profit from additional sales is more than these extra costs.

A conservative working capital policy means holding a high level of current assets (cash, inventory, receivables) relative to sales and financing part of the temporary current assets with long-term funds. It gives low risk and high liquidity but lower profitability, because of the idle funds and higher financing cost.

A lock box system is a cash collection technique in which customers send payments to a post office box near them, and a local bank collects the cheques several times a day and deposits them in the firm's account. It reduces mailing and processing float and so speeds up the collection of cash.

Inventory conversion period is the average time needed to convert raw materials into finished goods and sell them, i.e. the average number of days inventory is held.

$\text{ICP} = \frac{\text{Average inventory}}{\text{Cost of goods sold}} \times 365$

For example, if average inventory is Rs 100,000 and annual COGS is Rs 730,000, then ICP = $(100{,}000/730{,}000)\times 365 = 50$ days.

Safety stock is the extra inventory held over and above the expected demand during the lead time, as a buffer against uncertainty in demand or delays in delivery. It reduces the risk of stock-outs, although it adds to carrying cost.

The nature of the business strongly determines the size of working capital. A manufacturing firm needs large investment in raw material, work-in-process and finished goods, and so needs more working capital. A trading firm needs a moderate amount, mainly inventory and receivables. A service firm or public utility (electricity, transport) holds little inventory and mostly cash sales, so it needs the least. Firms selling on credit also need more than cash-based firms.

Discount = 2,000,000 − 1,800,000 = Rs 200,000, so the cost for 90 days is

$\frac{200{,}000}{1{,}800{,}000} = 11.11\%$

Effective annual rate:

$\left(1+0.1111\right)^{360/90}-1 = (1.1111)^4 - 1 = 52.42\%$

(The simple nominal rate is 11.11% × 4 = 44.44%.)

Working capital management is the management of current assets and current liabilities. Its importance is as follows.

• Maintains liquidity and solvency: adequate working capital lets the firm pay its short-term obligations on time and protects its credit standing.
• Smooth operations: regular supply of raw materials, wages and expenses keeps production and sales running without interruption.
• Profitability: efficient use of cash, inventory and receivables lowers idle funds and carrying costs and raises return on investment.
• Goodwill and credit: prompt payment helps the firm get supplies on better terms and loans from banks easily.
• Takes advantage of opportunities: the firm can buy at cash discounts and in bulk, and meet unexpected needs or recession.
• Survival: many business failures are caused by poor working capital management rather than lack of long-term profit.
• Time of the finance manager: a large part of the financial manager's time goes to day-to-day working capital decisions.

Credit policy is the set of rules that decide the extent to which a firm sells on credit and collects it. Its main elements are as follows.

• Credit standards: the minimum financial strength (character, capacity, capital, collateral, conditions) required of customers to get credit. Tight standards reduce bad debts and sales; loose standards raise both.
• Credit period: the length of time allowed to customers to pay, such as net 30. A longer period increases sales but also receivables and bad debts.
• Cash discount: a discount for early payment, such as 2/10, net 30, to speed up collection. It lowers receivables but also reduces the revenue.
• Collection policy: the procedures followed to collect overdue accounts, such as reminders, calls, legal action. A strict policy lowers bad debts but may annoy customers.

(a) Taking the 22 days as the inventory conversion period:

$\text{CCC} = \text{ICP} + \text{RCP} - \text{PDP} = 22 + 40 - 30 = 32 \text{ days}$

(b) Daily cost of production = 1,500 × Rs 6 = Rs 9,000.

$\text{Working capital to be financed} = 32 \times 9{,}000 = \text{Rs } 288{,}000$

(c) With payables deferral of 35 days, CCC = 22 + 40 − 35 = 27 days, so working capital = 27 × 9,000 = Rs 243,000.

Reduction in financing need = 288,000 − 243,000 = Rs 45,000 (5 days × Rs 9,000).

(a) Baumol model:

$C^* = \sqrt{\frac{2FT}{k}} = \sqrt{\frac{2 \times 40 \times 3{,}750{,}000}{0.12}} = \sqrt{2{,}500{,}000{,}000} = \text{Rs } 50{,}000$

(b) Average cash balance = C*/2 = 50,000/2 = Rs 25,000

(c) Number of transfers = T/C* = 3,750,000 / 50,000 = 75 transfers per year

(a) Collection float = mail float + processing float + clearing float = 2.5 + 1.5 + 3 = 7 days

(b) Reducing the float by 3 days frees cash of

$3 \times 65{,}000 = \text{Rs } 195{,}000$

Annual benefit at 11% = 195,000 × 0.11 = Rs 21,450.

Annual fee = Rs 16,500, so net gain = 21,450 − 16,500 = Rs 4,950.

Since the benefit exceeds the fee, it is economically advisable to pay the fee.

Annual usage S = 2,600,000 bushels; ordering cost per order O = Rs 5,000; carrying cost per unit C = 2% × 5 = Rs 0.10.

(a)

$\text{EOQ} = \sqrt{\frac{2 \times 2{,}600{,}000 \times 5{,}000}{0.10}} = \sqrt{2.6\times 10^{11}} \approx 509{,}902$

Purchases must be in multiples of 2,000, so the order size is 510,000 bushels.

• Number of orders = 2,600,000 / 510,000 = 5.098
• Ordering cost = 5.098 × 5,000 = Rs 25,490
• Average inventory including safety stock = 510,000/2 + 200,000 = 455,000
• Carrying cost = 455,000 × 0.10 = Rs 45,500

$\text{Total inventory cost} = 25{,}490 + 45{,}500 \approx \text{Rs } 70{,}990$

(b) Weekly usage = 2,600,000/52 = 50,000 bushels. Usage during 6 weeks delivery time = 300,000.

$\text{Reorder level} = 300{,}000 + 200{,}000 = 500{,}000 \text{ bushels}$

The size of working capital of a manufacturing firm depends on many factors.

1. Nature and size of business: a manufacturing firm needs a large investment in raw materials, work-in-process and finished goods. A larger scale of operation needs more working capital.
2. Length of the operating cycle: the longer the time from buying raw material to collecting cash from sales, the larger the working capital needed.
3. Production policy and process: a long and complex production process, or a policy of steady production in a seasonal business, increases inventory and so working capital.
4. Credit policy: liberal credit sales and long collection periods raise receivables, while longer credit received from suppliers reduces the need.
5. Inventory policy and availability of raw materials: if materials are scarce or imported with long lead time, larger stocks (and safety stock) are needed.
6. Seasonal and cyclical fluctuations: in boom and peak seasons more working capital is required; in recession less.
7. Growth and expansion: a growing firm needs more working capital to support higher sales.
8. Profit margin and dividend policy: high profits and retained earnings provide internal funds, while high dividends drain cash.
9. Price level changes: inflation raises the cost of materials and so the working capital required for the same volume.
10. Operating efficiency and credit availability: efficient use of assets speeds up turnover and reduces working capital; easy bank credit allows the firm to hold less cash.

(a) Net purchases per day = 3,650,000/365 = Rs 10,000. Taking the discount means paying on day 10.

$\text{Average payables} = 10{,}000 \times 10 = \text{Rs } 100{,}000$

(b) No. When the firm takes the discount, the trade credit used (10 days) is free; there is no explicit cost, as the discount is earned.

(c) Not taking the discount and paying on day 30:

$\text{Average payables} = \frac{3{,}724{,}490}{365}\times 30 = 10{,}204 \times 30 \approx \text{Rs } 306{,}122$

Cost of non-free trade credit:

$\frac{2}{98} \times \frac{365}{30-10} = 0.020408 \times 18.25 = 37.24\%$

(d) If payment is stretched to 40 days:

$\frac{2}{98}\times\frac{365}{40-10} = 0.020408\times 12.167 = 24.83\%$

Working notes

• Collections: 60% of the month's sales in cash, plus 20% of sales of each of the previous two months.
• Cost of goods manufactured = 75% of sales; 80% is paid one month later and 20% two months later.
• Half-yearly interest = 450,000 × 12% × 6/12 = Rs 27,000 (July).

Conclusion: No borrowing is needed in May (surplus of Rs 6,000 above the minimum). Borrowing is necessary in June (Rs 46,500, because of the fixed asset purchase) and again in July (Rs 24,750, because of interest and tax). Total borrowing by the end of July is Rs 71,250.

(a) Bank loan

Net proceeds = Loan − interest (12%, discount basis) − compensating balance (15%) = 0.73 × Loan.

$L = \frac{100{,}000}{0.73} = \text{Rs } 136{,}986$

Factoring

Interest for one month in advance = 10%/12 = 0.8333%. Net advance = F × (1 − 0.03 − 0.008333) = 0.961667F.

$F = \frac{100{,}000}{0.961667} = \text{Rs } 103{,}986 \text{ of receivables to be factored}$

(b) Annual costs

Bank loan: interest = 12% × 136,986 = Rs 16,438 a year (effective cost 16.44% on the Rs 100,000 received).

Factoring (monthly, so 12 times a year):

• Commission: 3% × 103,986 = Rs 3,120 a month
• Interest: 0.8333% × 103,986 = Rs 867 a month
• Total = Rs 3,986 a month, i.e. Rs 47,834 a year

Savings under factoring: credit department 2,000 × 12 = Rs 24,000, and bad debts avoided 10% × (103,986 × 12) = Rs 124,783.

$\text{Net annual cost of factoring} = 47{,}834 - 24{,}000 - 124{,}783 \approx -\text{Rs } 100{,}950$

So factoring involves a gross cost of Rs 47,834, but after the savings it gives a net benefit of about Rs 100,950, while the bank loan costs Rs 16,438. On the figures, factoring is better.

(c) Non-cost considerations

• Factoring removes the burden of credit administration and collection and provides advice on credit; a bank loan does not.
• A bank loan keeps the customer relationship direct, whereas customers may dislike dealing with a factor and the firm may lose control over customer contact.
• Factoring (non-recourse) transfers credit risk, and does not add debt to the balance sheet. A bank loan adds a liability and needs collateral and a compensating balance.
• Availability and certainty of funds: factoring finance grows with sales, while a bank loan is a fixed limit that must be renewed.
• Dependence: the factor will accept only good accounts, and abolishing the credit department makes returning to in-house credit difficult.

Assumptions: 360-day year; investment in receivables = variable cost × receivables; required return 16%; tax 40%.

(a) Net income under the present policy

• Receivables = 10,000,000/360 × 30 = Rs 833,333
• Investment in receivables = 80% × 833,333 = Rs 666,667
• Carrying cost = 16% × 666,667 = Rs 106,667

(b) Proposal 1: relaxed policy (net 30, sales Rs 11 million, DSO 45 days)

• Receivables = 11,000,000/360 × 45 = Rs 1,375,000; investment = 80% = Rs 1,100,000; carrying cost = Rs 176,000
• Bad debts = 2% × 10,000,000 + 4% × 1,000,000 = Rs 240,000

Change in net income = 1,040,400 − 986,000 = +Rs 54,400

(c) Proposal 2: restricted policy (net 20, sales Rs 9 million, DSO 22 days)

• Receivables = 9,000,000/360 × 22 = Rs 550,000; investment = Rs 440,000; carrying cost = Rs 70,400
• Bad debts = 1% × 9,000,000 = Rs 90,000

Change in net income = 953,760 − 986,000 = −Rs 32,240

(d) Decision

The relaxed policy raises net income by Rs 54,400, while the restricted policy lowers it by Rs 32,240. DEC should therefore adopt Proposal 1 (lengthen the credit period to net 30) and not tighten credit.

Role of the credit manager

• Sets and recommends credit standards, credit period, discount and collection policy.
• Evaluates customers' creditworthiness (the five Cs) and fixes credit limits.
• Monitors receivables through ageing schedules and DSO, and follows up overdue accounts.
• Controls bad debts and balances the sales growth against the cost and risk of credit.
• Coordinates with the sales and finance departments and advises the CFO on the effect of credit decisions on profit and cash flow.