Goals of Cash ,Receivable and Payable Management

Goals of Cash Management:

Precisely speaking, the primary goal of cash management in a firm is to trade-off between liquidity and profitability in order to maximise long-term profit. This is possible only when the firm aims at optimizing the use of funds in the working capital pool.

This overall objective can be translated into the following operational goals:

 (i) To satisfy day-to-day business requirements;

(ii) To provide for scheduled major payments;

(iii) To face unexpected cash drains;

(iv) To seize potential opportunities for profitable long-term investment;

 (v) To meet requirements of bank relationships;

(vi) To build image of creditworthiness;

(vii) To earn on cash balance;

(viii) To build reservoir for net cash inflow till the availability of better use of funds by conscious planning;

(xi) To minimize the operating cost of cash management.

Functions of Cash Management:

So as to achieve the objectives stated above, a finance manager has to ensure that investment in cash is efficiently utilised. For that matter, he has to manage cash collections and disbursements efficaciously, determine the appropriate working cash balances and invest surplus cash. 

Efficient cash management function calls for cash planning, evaluation of benefits and costs, evaluation of policies, procedures and practices and synchronization of cash inflows and outflows.

It is significant to note that cash management functions, as depicted, are intimately interrelated and inter-wined.

Linkage among different cash management functions has led to the adoption of the following methods for efficient cash management:

1. Use of techniques of cash mobilisation to reduce operating requirements of cash;

2. Major efforts to increase the precision and reliability of cash forecasting;

3. Maximum efforts to define and quantify the liquidity reserve needs of the firm;

4. Development of explicit alternate sources of liquidity;

5. Aggressive search for relatively more productive uses for surplus money assets.

The above approaches involve the following actions which a finance manager has to perform:

1. To forecast cash inflows and outflows;

2. To plan cash requirement;

3. To determine the safety level for cash;

4. To monitor safety level of cash;

5. To locate the needed funds;

6. To regulate cash inflows;

7. To regulate cash outflows;

8. To determine criteria for investment of excess cash;

9. To avail banking facilities and maintain good relations with bankers.

Thus, for achieving the goals of cash management, a finance manager have to, first of all, plan cash needs of the firm. This is followed by the management of cash flows, determination of optimum level of cash and finally, investment of surplus cash.

Importance of Cash Management:

Cash management is one of the critical areas of working capital management and assumes greater significance because it is most liquid asset used to satisfy the firm’s obligations but it is a sterile asset as it does not yield anything. Therefore, finance manager has to so manage cash that the firm maintains its liquidity position without Jeopardizing the profitability.

Problem of prognosticating cash flows accurately and absence of perfect coincidence between the inflows and outflows of cash add to the significance of cash management. In view of the above, at one time a firm may experience dearth of cash because payments of taxes, dividends, seasonal inventory, etc. build up while at other times, it may have surfeit of cash stemming out of large cash sales and quick collections of receivables.

It is interesting to observe that in real life, management spends his considerable time in managing cash which constitutes relatively a small proportion of a firm’s current assets. This is why in recent years a number of new techniques have been evolved to minimize cash holding of the firm.

 

Management of Cash: Subject Matter, Motives and Other Details

Cash is the medium of exchange on the common purchasing power and which is the most important component of working capital. It includes coins, currency and cheques held by the firm and the balances in its bank accounts. Sometimes, near-cash items are also included. Cash is the basic input required to keep the firm running on a continuous basis. At the same time it is the ultimate output expected to be realised by selling goods and services. A firm should hold sufficient cash, neither more, nor less.

Excessive cash remains idle which simply increases the cost without contributing anything towards the profitability of the firm, and in the opposite case, trading and/or manufacturing operation will be disrupted. Not only that, it largely upholds, under given condition, the quantum of other ingredients of working capital, viz., inventories and debtors, that may be needed for a given scale and type of inventories and debtors, that may be needed for a given scale and type of operation.

Cash is, no doubt, a most important asset and that is why a firm wants to get hold of it in the shortest time possible. In the absence of sufficient quantity of cash at the proper time, payment of bills, including dividend and others may not be made. 

It is interesting to note that cash management involves three factors:

 (i) Ascertainment of a minimum cash balance;

(ii) Proper arrangement to be made for collection and payment of cash in such a way that minimum balance can be maintained; and

(iii) Surplus cash to be invested to temporary investments or to be invested in fixed assets.

Similarly, cash is not productive directly like other assets, viz., it is sterile. For example, fixed assets are acquired for the purpose of earning revenue. Accounts receivables are generated by granting credit to customers, etc.

Apart from the fact that it is the most liquid current asset, cash is the common denominator to which all current assets can be reduced because the other major current asset, viz., receivables, inventories, etc. get converted eventually into cash.

It is the significance of cash management which is the key area of working capital management.  Cash management is important since it is very difficult to estimate correctly the inflow f cash. Practically, it is not easy to make a proper synchronisation of inflows and outflows of cash.

For this purpose, the firm should develop some strategies for cash management for the following:

(a) Cost Planning:

A cash budget should be prepared for ascertaining the cash surplus or deficit for each period of planning through the inflows and outflows of cash.

 (b) Managing the Cash Flows:

The flow of cash (inflow and outflow) should properly be managed so that the synchronisation between inflow and outflow is possible.

(c) Optimum Cash Level:

The optimum level of cash should always be maintained, i.e. the appropriate level of cash balance should be determined.

(d) Investing Idle Cash:

The excess or idle cash should properly be invested in order to earn profit.

Motives for Holding Cash:

Keynes has identified three motives for holding cash:

1. The Transactions Motive;

2. The Precautionary Motive; and

3. The Speculative Motive.

1. The Transactions Motive:

This motive refers to the holding of cash in order to meet the day-to-day transactions which a firm carries on in the ordinary course of the business. Primarily, these transactions include purchase of raw materials, wages, operating expenses, taxes, dividends etc. A firm may enter into a variety of transactions to accomplish its objectives. Similarly, there is regular inflow of cash from revenues. Thus, the receipts and payments constitute a continuous two-way flow of cash. Since the inflow and outflow of cash do not perfectly synchronize, an adequate or a minimum cash balance is required to uphold the operations if outflow exceeds the inflow. Therefore, in order to meet the day-to-day transactions, the requirement of cash is known as Transaction Motive. So, it refers to the holding of cash to meet anticipated obligations when timing is not perfectly synchronised with the inflow of cash. Although a major part of transaction balance is held in cash, a part may also be held in the form of marketable securities whose maturity conforms to the timing of the anticipated payments, such as payment of taxes, dividends etc.

2. The Precautionary Motive:

This motive for holding cash has to do with maintaining a cushion or buffer to meet unexpected contingencies.

The unexpected cash needs at short notice may be the result of:

(i) Uncontrollable circumstances, such as floods, strikes, droughts etc.;

(ii) Bills which may be presented for settlement earlier than expected;

(iii) Unexpected delay in collection of trade dues;

(iv) Cancellation of some order for goods due to inferior quality; and

(v) Increase in the cost of material, labour etc.

Precautionary balances are the cash balances which are held as reserve for random and unforeseen fluctuations in cash flows, i.e., this motive implies the need to hold cash to meet unpredictable obligations. The more predictable the cash flows, the less precautionary balances that are needed, and vice versa. Moreover, the need for this type of cash balance may be reduced if there is already borrowing power in order to meet the emergency cash outflows. Sometimes a portion of such cash balances may be held in marketable securities, i.e., near- money assets.

3. The Speculative Motive:

This motive refers to the holding of cash for taking advantages of expected changes in’ security price. In other words, when the rates of interest are expected to fall, cash may be invested in different securities so that the firm will benefit by any subsequent fall in interest rates and rise in security prices. On the other hand, when the rates of interest are expected to rise, the firm should hold cash until the rise in interest rates ceases. The precautionary motive is defensive in nature while speculative motive represents a positive and aggressive approach.

The speculative motive helps to take advantages of:

(i) An opportunity to purchase raw materials at a reduced price against immediate payment, i.e., benefit of cash discounts;

(ii) A change to speculate on interest rate movements by purchasing securities when rates of interest are expected to decline;

(iii) The purchase at favourable prices.

Level of Cash Balance:

Adequate cash balance should always be maintained by a firm. But it does not mean that the firm should hold excessive cash balance since it is a non-earning asset. Excessive cash balance will not only impair the firm’s profitability but alos give a lower asset turnover ratio.

Therefore, optimum cash balance should be maintained by a firm. For this pupose, two factors are to be considered, viz., (a) Compensating Balances, and (b) Self-Imposed Balances.

1. Compensating Balances:

Banks serve different types of service to the firms, e.g., clearance of cheque, transfer of funds, against a nominal commission or fee. Generally, clients (firms) are required to maintain a minimum cash balance at the bank which cannot be utilised by them for transaction purposes. The bank can use the same to earn a return. In other words, in order to compensate the services rendered by the banks, clients/firms are required to keep a balance which will be sufficient to earn a return equal to the cost of services. Such balances are known as compensating balances. Sometimes, compensating balances are also maintained when loans are granted by a bank to its customers, particularly when the supply of credit is restricted and the rate of interest is rising. In short, a borrower must maintain a minimum balance at bank in order to compensate the bank against the risk of interest rate.

Therefore, compensating balances take the following forms:

(i) An absolute minimum:

Say Rs. 10 lakhs, below which the bank balance will never be allowed to fall.

(ii) A minimum average balance:

Say Rs. 10 lakhs, over a particular period, e.g., one month.

2. Self-Imposed Balances:

Self-imposed balance is determined in order to consider:

(i) The need for cash and its predictability;

(ii) Interest rate or borrowing rate on marketable securities;

(iii) The fixed cost of effecting a transfer between cash and marketable securities.

Managing of Receivables

Managing of receivables consists of the following four factors:

1. Credit policy variables

2. Credit evaluation

3. Credit granting decision

4. Control of receivables

1. Credit policy variables:

The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and 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.

i) Credit standards:

A firm has a wide range of choice in this respect. At one and 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 grand credit to all customers irrespective of their credit rating. Between these two extreme positions lie several positions, often the more practical ones.

In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff-credit standards have opposite effects. They tend to depress sales, reduce the incidence of bad debt loss, decrease the investment in receivables, and lower the collection cost.

ii) 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 inducing existing customers to purchase more and attracting additional customers. This is, however, accompanied by a larger investment in receivables and a higher incidence of bad debt loss. Shortening of the credit period would have opposite influences: It tends to lower sales, decrease investment in receivables, and reduce the incidence of bad debt loss.

iii)Cash discount:

Firms generally offer cash discounts to induce customers to made 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 per cent is offered if the payment is made by the tenth day; otherwise the full payment is due by the thirtieth day.

Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount period are lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly), and increase the cost of discount.

iv) Collection Effort:

The collection programmed of the firm, aimed at timely collection of receivables consisting of – monitoring the state of receivables, dispatch 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 and legal action against overdue accounts.

2. Credit evaluation:

Before granting credit to a prospective customer the firm should see the credit worthiness of the customer. For knowing the credit worthiness, three basic factors of – character, capacity and collateral are to be seen. Character refers to the willingness of the customer to honour his obligations. Capacity refers to the ability of the customer to pay on time. Collateral represents the security offered by the firm in the form of mortgages.

By analysing the financial statements, by obtaining bank reference by analysing the firm’s experience and by taking numerical credit scoring of a customer the credit worthiness of the customer can be found.

3. Credit granting decision:

After knowing the credit worthiness of the customer, the decision of granting credit should be taken. For taking the decision for credit the under shown decision tree will be useful.

4. Control of receivables:

Traditionally two methods have been commonly suggested for monitoring accounts receivable:

(i) days sales outstanding and

(ii) aging schedule.

While these methods are popularly used, they have a serious deficiency; they are based on an aggregation of sales and receivables. To overcome the weakness of the traditional methods, the payment pattern approach has been suggested.

Traditional methods:

1. Days’ Sales Outstanding (DSO):

The average days’ sales outstanding at a given time may be defined as the ratio of receivables outstanding at that time to average daily sales

Accounts receivable at time t = Average daily sales

The average daily sales figure is obtained by taking the average of sales during the preceding 30 days, 60 days, 90 days or some other relevant period.

According to this method, accounts receivables are deemed to be in control if the DSO is equal to less than a certain norm.

If the value of DSO exceeds the specified norm, collections are considered to be slow.

2. Aging schedule:

The aging schedule (AS) classified outstanding receivables at a given point of time into different age brackets. An illustrative AS is given below:

Age group (in days)	% of receivables
0-30	35
31-60	40
61-90	20
> 90	5

The actual AS of the firm is compared with some standard AS to determine whether accounts receivables are in control. A problem is indicated if the actual AS shows a greater proportion of receivables, compared with tile standard AS, in the higher age groups.

Limitations:

1. DSO and AS are both influenced by the pattern of sales

2. DSO is sensitive to the averaging period

3. AS is distorted when the payment relating to sales in any month is unusual, even though payments relating to sales in other months are normal.

Modern method:

Payment pattern approach: the principal weakness of the DSO and AS procedures is that they aggregate sales and receivables over a period of time. Such an aggregation makes it difficult to detect changes in pattern of payment. The payment of pattern approach overcomes this deficiency and focuses on payment behavior, the key issue in monitoring accounts receivable.

Payment pattern is defined in terms of proportions or percentages. To illustrate its calculation, consider a firm which sells god worth Rs. 10,000 on credit in the month of January and receives collection as follows: Rs. 1,000 in January, Rs. 4,000 in February, Rs. 3,000 in March, and Rs. 2,000 in April.

The pattern of payments and receivables outstanding may be expressed in terms of percentages as shown in the following table:

By matching collections and receivables to sales in the month of origin the payment pattern approach overcomes the principal weakness of DSO and AS methods which results from the aggregation of sales and collections.

The payment pattern approach is not dependent on sales level. It focuses on the key issue, the payments behavior, it enables one to analyze month-by-month payment pattern as against the combined sales and payment patterns.

A limitation of this method is that the conversion matrix cannot be prepared on the basis of published financial statements alone – internal financial data are required for it. However, the payment pattern approach is not more data-demanding than the aging schedule method. The latter also requires internal financial data.

Over and Under Trading:

Over-Trading:

Over-trading arises only when the capital employed is inadequate in comparison with the volume of business. In other words, it is an expansion of sales without adequate support from capital.

That is to say, the company with limited resources tries to increase the volume of business which, ultimately, suffers from acute shortage of liquid funds.

This results in a Low Proprietary Ratio, Low Current Ratio and Liquid Ratio with inadequate working capital. Under this condition, the company does not maintain the adequate level of inventories and, as a result, it has to depend on regular supplies. On the other hand, payments of expenses (Wages, Salaries etc.) and Creditors including taxes cannot be made in time since there is a serious shortage of cash.

Whether or not the company is over-trading can easily be known after analysing certain ratios, viz., Current Ratio, Liquid Ratio, Debtor’s Turnover Ratio, and Inventory Turnover Ratio etc. In the case of over-trading, however, the Current Ratio and Liquid Ratio will be lower than their standard of normal ratios but the turnover ratios will be higher than their standard of normal ratios.

The symptoms of over-trading are discernible when:

(a) A company takes a comparatively long time to pay-off its creditors or the amount of creditors increases in comparison with debtors, or creditors increase more rapidly or fall more slowly than debtors.

(b) The amount of profit declines.

(c) The company increases the rate of borrowings in a way which is quite excessive in relation to the assets owned by the shareholders.

(d) A company is buying fixed or non-current assets out of short-term funds.

(e) Bills Payable are recorded which is not customary, and unaccounted reduction is made in Bills Receivable which indicates discounting.

Under-Trading:

Under-trading is a condition contrary to over-trading. It is an application of idle funds. Too much investment in current assets and smaller amount of current liabilities results in under- trading.

The symptoms of under-trading, however, are to show:

(a) A very high Current Ratio and Liquid Ratio.

(b) Lower Turnover Ratios.

The consequence of under-trading are:

(a) Reduction in profits.

(b) Reduction in the rates of return on capital employed.

(c) Loss of Goodwill.

(d) Fall in the prices of the shares in the market.

 

Account Payables Management

Account Payables Management refers to the set of policies, procedures, and practices employed by a company with respect to managing its trade credit purchases.

In summary, they consist of seeking trade credit lines, acquiring favorable terms of purchase, and managing the flow and timing of purchases so as to efficiently control the company’s working capital.

The account payables of a company can be found in the short-term liabilities section of its balance sheet, and they mostly consist of the short-term financings of inventory purchases, accrued expenses, and other critical short-term operations.

 WHY COMPANIES FINANCE THEIR PURCHASES

Purchasing inventory, raw materials, and other goods on trade credit allows a company to defer its cash outlays, while accessing resources immediately.

When managed appropriately financing purchases can contribute to effective working capital management.

A company that employs best practices with regards to payables management can reap the benefits of stable operating cycles that provide a stable source of operating cash flows and place it in a good liquidity position with respect to its competitors.

 OBTAINING TRADE CREDIT

Companies seeking trade credit must demonstrate that they meet certain criteria with respect to their creditworthiness and financial condition.

This typically entails credit analysis by the supplier.

The financial statements of the company are analyzed, paying particular attention to its working capital, short-term liquidity and short and long-term debt to gauge its ability to meet obligations.

The final product of such analysis is usually some form of a credit risk rating.

 PURCHASE AND PAYMENT TERMS

The purchase and credit terms obtained will depend on the company’s risk assessment above.

Companies that are financial stable can benefit from favorable terms (e.g. lengthy repayment periods).

For example, a company might be offered a sales on credit term of 5/10 net 30 implies a 5% discount on the purchase amount if payment is made within 10 days of billing date.

If the discount is not taken, the full invoiced amount is due in 30 day.

 MANAGING PAYMENTS

After entering into purchase agreements with a supplier, the company has the responsibility of fulfilling its payment obligations.

The Accounts Payable department is accountable for this function, and performs tasks such as communicating with suppliers, sending payments and reconciling bank records, as well as updating and performing related accounting entries

Managing payables also include the expense administration with respect to the company’s own employees.

Expenses such as employee travelling, meals, entertainment, and other costs related to doing business for the company are administered by the payables department and must be managed appropriately.

 EVALUATING THE PERFORMANCE OF PAYABLES MANAGEMENT

Accounts payable are one of 3 main components of working capital, along with receivables and inventory.

Understanding how these 3 accounts interact among each other and the resulting effects on working capital levels, cash flow, and the operating cycle can help in managing and evaluating payables management.

An appropriate balance must be struck, whereby the advantage of deferring cash outlays using trade credit is weighted against the risk of excessive short-term credit.

It is therefore important to maintain optimal utilization of credit lines and timing of payments, and create a balance between the need for cash, working capital, and liquidity.

A number of metrics and short-term financial ratios can be used to evaluate the performance payables management.

  Payables Turnover Ratio

Management can use this ratio to measure the average number of times a company pays its suppliers in a particular period.

A higher number than the industry average indicates the company pays its suppliers at a faster rate than its competitors, and is generally conducive to short-term liquidity.

 Days in Payables Outstanding (DPO)

Measuring the average length of time it takes a company to pay for its short-term purchases in a period, the DPO can be used by management to determine an optimal timing of payments for its payables.

 Cash Conversion Cycle

An important measure of the length of time required to turn inventory purchases into sales, and subsequently into cash receipts.

Using the CCC, management can assess the interaction of payables with the 2 other working capital accounts: receivables and inventory, and the resulting effects on cash flow.

A low CCC is highly desirable. A company can shorten the CCC by for example, lengthening its terms of purchases.

 Net Working Capital (NWC)

NWC is the difference between current assets and current liabilities. High levels are desirable for short-term liquidity.

A decreasing pattern or trend in NWC can be attributed to increasing levels of payables, and thus can serve as a warning sign of excessive short-term credit.

A negative NWC (particularly when persistent) is a red flag for a lack of liquidity or potential insolvency.

 Current and Quick Ratio

Two other liquidity measures, the current ratio expresses the NWC equation above as a ratio between current assets and current liabilities. Holding all else equal, rising A/P levels will reduce both the current and quick ratio. These ratios can be used to assess the impact of increasing payables on short-term liquidity.

 CONCLUSION

The Accounts payable of a company is an important working capital account. Effective payables management can enhance a company’s short-term cash flow position through the design of optimal timing of payments to suppliers.

However, important considerations should be given to excessive financing, as that has a direct impact on the credit risk of the company and its short-term liquidity.