Financial Management & Cost Accounting

Lesson 33. RECEIVABLES MANAGEMENT, CASH MANAGEMEN

Module 6. Working capital management

Lesson 33

RECEIVABLES MANAGEMENT, CASH MANAGEMENT

33.1 Introduction

The assessment of working capital requirements for the future can be made by determining the amount of current assets and current liabilities: The assessment of working capital requirements can be made on the basis of the current assets required for the business and the credit facilities available for the acquisition of such current assets, i.e., current liabilities. The broad categories of the 'current assets' and the 'current liabilities' have already been explained.

33.2 Credit Policy Variables

The important dimensions of a firm's credit policy are :

· Credit standards

· Credit period

· Cash discount

· Collection effort

These variables are related and have a bearing on the level of sales, bad debt loss, discounts taken by customers, and collection expenses. For purposes of expository convenience we examine each of these variables independently.

Credit Standards

A pivotal question in the credit policy of a firm is ; What standard should be applied in accepting or rejecting an account for credit granting? A firm has a wide range of choice in this respect. At one end of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating may be. At the other end, it may decide to grant credit to all customers irrespective of their credit rating. Between these two extreme positions lie several possibilities, often the more practical ones.

Credit Period

The credit period refers to the length of time customers are allowed to pay for their purchases. It generally varies from 15 days to 60 days. When a firm does not extend any credit, the credit period would obviously be zero. If a firm allows 30 days, say, of credit, with no discount to induce early payments, its credit terms are stated as net 30.

Lengthening of the credit period pushes sales up by including existing customers to purchase more and attracting additional customers. This is, however, accompanied by a larger investment in debtors and higher incidence of bad debt loss. Shortening of the credit period would have opposite influences. It tends to lower sales, decrease investment in debtors, and reduce the incidence of bad debt loss.

Cash Discount

Firms generally offer cash discounts to induce customers to make prompt payments. The percentage discount and the period during which it is available are reflected in the credit terms. For example, credit terms of 2/10, net 30 mean that a discount of 2 percent is offered if the payment is made by the tenth day; otherwise the full payment is due by the thirtieth day.

Collection Effort

The collection programme of the firm, aimed at timely collection of receivables, may consist of the following:

• Monitoring the state of receivables
• Despatch of letters to customers whose due date is approaching
• Telegraphic and telephonic advice to customers around the due date
• Threat of legal action to overdue accounts
• Legal action against overdue accounts

A rigorous collection programme tends to decrease sales, shorten the average collection period, reduce bad debt percentage, and increase the collection expenses. A lax collection programme, on the other hand, would push sales up, lengthen the average collection period, increase the bad debt percentage, and perhaps reduce the collection expense.

33.3 Cash Management

Why does a firm need cash? As John Maynard Keynes put forth, there are three possible motive for holding cash.

Transaction Motive: Firms need cash to meet their transaction needs. The collection of cash (from sale of goods and services, sale of assets, and additional financing) is not perfectly synchronized with the disbursement of cash (for purchase of goods and services, acquisition of capital assets, and meeting other obligations). Hence, some cash balance is required as a buffer.

Precautionary Motive:There may be some uncertainty about the magnitude and timing of cash inflows from sale of goods and services, sale of assets, and issuance of securities. Likewise, there may be uncertainty about cash outflows on account of purchases and other obligations. To protect itself against such uncertainties, a firm may require some cash balance.

Speculative Motive: Firms would like to tap profit making opportunities arising from fluctuations in commodity prices, security prices, interest rates, and foreign exchange rates. A cash-rich firm is better prepared to exploit such bargains. However, for most firms their reserve borrowing capacity and marketable securities would suffice to meet their speculative needs.

33.4 Cash Budgeting

Cash budgeting or short – term cash forecasting is the principal tool of cash management. Cash budgets, routinely prepared by business firms, are helpful in:(i) estimating cash requirements, (ii) planning short – term financing, (iii) scheduling payment in connection with capital expenditure projects, (iv) planning purchases of materials, (v) developing credit policies, and (vi) checking the accuracy of long – term forecasts.

Firms use multiple short – term forecasts, of varying length and detail, suited to meet different needs. The commonly used designs for short – term cash forecasts are : (i) one year divided into quarters or months, (ii) one quarter divided into months, and (iii) one months divided into weeks. A firm hard pressed with liquidity crunch, may even prepare a weekly cash forecast divided into days.

The point to be emphasized here is that these multiple formats serve differing purposes and should not be regarded as mutually exclusive.

Receipts and Payment Method

The cash budget prepared under this method shows the timing and magnitude of expected cash receipts and payments over the forecast period. It includes all expected receipts and payments irrespective of how they are classified in accounting. The items of cash receipts and cash payments and the bases for estimating them are shown in Exhibit 33.1.

From exhibit 33.1 it is clear that the receipts and payments method of cash forecasting inter alia calls for information about estimated sales, production plan, purchasing plan, financing plan, and capital expenditure budget. The most crucial input in the entire process, of course, is the figure of estimated sales because various business plans are closely related to estimated sales.

Illustration

The preparation of cash budget may be illustrated with an example. ABC Company manufactures plastic bags. Its estimated sales for the period January 2010 through of course, I would not like to press the point further for an already hard pressed firm.

Table 33.1 Items of Cash Receipts and Payments and the Basis of Their Estimation

Items	Basis of Estimation
Cash sales	Estimated sales and its division between cash and credit sales.
Collection of accounts receivable	Estimated sales, its division between cash and credit sales, and collection pattern.
Interest and dividend receipts	Firm's portfolio of securities and return expected from the portfolio.
Increase in loans/deposits and issue of securities Sale of assets Cash Purchases	Financing plan. Proposed disposal of assets. Estimated purchases and its division between cash and credit purchases.
Payment of purchases	Estimated purchases, its division between cash purchases and credit purchases, and terms of credit purchases
Wages and salaries	Manpower employed and wages and salaries structure.
Manufacturing expenses General, administration and selling expenses Capital equipment purchases Repayment of loans and retirement of securities	Production Plan. Administration and sales personnel and proposal sales promotion and distribution expenditure. Capital expenditure budget and payment pattern associated with capital equipment purchases. Financing plan.

June 2010 are as follows : Rs. 100,000 per month from January through March and Rs. 120,000 per month from April through June. The sales for November and December of the previous year have been Rs. 100,000 each. Cash and credit sales are expected to be 20 percent and 80 percent respectively. The receivables, on an average, one month from the date of sale and the balance 50 percent, on an average, two months from the date of sale. No bad debt losses are expected to occur. Other anticipated receipts are : (i) Rs. 50,000 from the sale of a machine in March, and (ii) Rs. 2,000 interest on securities in June. Given this information, the forecasted cash receipts have been tabulated in Table 33.2(exhibit 33.3).

We no consider the forecast of cash payments. ABC company plans to purchase materials worth Rs. 40,000 in January and February and materials worth Rs. 48,000 each month from March through June. The payments for these purchases are made approximately a month after the purchase. The purchases for the December of the previous year have been Rs. 40,000 for which payment will be made in January 2010. Miscellaneous cash purchase of Rs. 2,000 per month are planned from January through June. Wage payments are expected to be Rs. 15,000 per month; general administrative and selling expenses are expected to be Rs. 10,000 per month. Dividend payment of Rs. 20,000 and tax payment of Rs. 20,000 are scheduled in June 2010. A machine worth Rs. 50,000 is proposed to be purchased on cash in March, 2010. Given this information, the proposed payments are shown in Table 37.3. (exhibit 37.3)

Table Exhibit 33.2: Forecast of Cash Receipts

	January	February	March	April	May	June
1.Sales	1,00,000	1,00,000	1,00,000	1,20,000	1,20,000	1,20,000
2.Credit Sales	80,000	80,000	80,000	96,000	96,000	96,000
3.Collection of accounts receivable	80,000	80,000	80,000	80,000	88,000	96,000
4.Cash Sales	20,000	20,000	20,000	24,000	24,000	24,000
5.Receipt from sale of equipment			5,000			2,000
6.Interest
Total Cash receipts ( 3 + 4 + 5 + 6 )	1,00,000	1,00,000	1,05,000	1,04,000	1,12,000	1,22,000

Table Exhibit 33.3 Forecast of Cash Payments

	January	February	March	April	May	June
1.Material purchase	40,000	40,000	48,000	48,000	48,000	48,000
2.Credit material purchases	40,000	40,000	48,000	48,000	48,000	48,000
3.Payment of accounts payable	40,000	40,000	40,000	48,000	48,000	48,000
4.Miscellaneous cash purchases	2,000	2,000	2,000	2,000	2,000	2,000
5.Wages	15,000	15,000	15,000	15,000	15,000	15,000
6.Manufacturing expenses	20,000	20,000	20,000	20,000	20,000	20,000
7.General administrative and selling expenses	10,000	10,000	10,000	10,000	10,000	10,000
8.Dividend	-	-	-	-	-	20,000
9.Tax	-	-	-	-	-	20,000
10. Capital expenditure	-	-	-	-	-	-
(3+4+5+6+7+8+9+10)	87,000	87,000	1,37,000	95,000	95,000	1,35,000

Assuming that the cash balance on 1^st January, 2010 is Rs. 22,000 and the minimum cash balance required by the firm is Rs. 20,000, we can now prepare a summary statement. This statement, shown in Exhibit, 27.4, calculates the surplus / deficit in relation to the minimum required. From exhibit 33.4 it can be seen that a cash shortage is expected to occur during March and it would disappear in April as the business operations result in cash inflows. The storage expected in March is due to the proposed capital expenditure of Rs. 50,000. The management can avoid this shortage by adopting one or more of the following means : (i) postponement of asset acquisition to April, (ii) deferring a portion of the payment for the capital asset to April, and (iii) resorting to short-term borrowing for the month of March.

Exhibit 33.4 Summary Cash Forecast

	January	February	March	April	May	June
11. Opening cash Balance	22,000
12. Receipts	1,00,000	1,00,000	1,05,000	1,04,000	1,12,000	1,22,000
13. Payments	87,000	87,000	1,37,000	95,000	95,000	1,35,000
14. Net Cash flow (2-3)	13,000	13,000	(32,000)	3,000	17,000	(13,000)
15. Cumulative net cash flow	13,000	26,000	(6,000)	9,000	20,000	7,000
16. Opening Cash Balance + Cumulative net Cash Flow (1 + 5)	35,000	48,000	16,000	25,000	42,000	29,000
17. Minimum cash balance required	20,000	20,000	20,000	20,000	20,000	20,000
18. Surplus or deficit in relation to the minimum cash balance required (6-7)	15,000	28,000	4,000	5,000	22,000	9,000