UNIT 1

What is working capital?

Working capital is an indicator of the short-term financial position that measures
the overall efficiency of an organization. It is calculated by subtracting current
liabilities from current assets and listed directly in its balance sheet.
Current assets mean the money kept in a bank and assets that can be converted
into cash in case if any situation arises. Current liabilities represent debt that an
individual will pay within the prescribed year. Finally, working capital is the money
left after subtracting liabilities from an individual's money in the bank.
Current assets consist of cash, accounts receivable, and inventory. Current
liabilities include wages, taxes, interest owed.
In broader terms, working capital is also used to measure the company’s
financial health. If there is a larger difference between what a company owns and
what an individual owns for the short-term, the business will be healthier.
If the company owes more than they own, they will have negative working
capital, and their business might get closed.

Types of working capital

The types of working capital are mainly divided into different parts:

 Gross Working Capital

Gross working capital is the total value of the company’s current assets.
Current assets include cash, receivables, short-term investments, and
especially market securities.
The Gross working capital does not showcase the current liabilities.
Gross working capital can be executed by calculating the difference
between the existing assets and current liabilities.
The difference remaining is the actual working capital that the company
has to meet its obligations.
 Net Working Capital
Networking capital is the difference between the current assets and
current liabilities of the company. If the company’s assets are more than
current liabilities, it indicates a positive working capital, and the
company is in a financial position to meet its obligations.
However, if the company’s assets are less than current liabilities, it
indicates a negative working capital, and the company is facing financial
distress.
The key difference between gross and net working capital is that gross
working capital will always be a positive value. In contrast, networking
capital can either be a negative or positive value.

 Permanent Working Capital

Permanent working capital is the minimum amount of capital required to
carry on the operations without interruption or difficulty.
For example, a company will need minimum cash to keep the
operations smooth and running; here, the minimum amount of money
required will act as permanent working capital.

 Regular Working Capital

Regular working capital is the amount of funds businesses require to
fund its day to day operations. For example, cash needed for making
payment of wages, raw materials, salaries comes under regular working
capital.

 Reserve Margin Working Capital

Apart from conducting day-to-day activities, a business may need some
amount of capital to face unforeseen circumstances. Reserve margin
working capital is nothing, but the money kept aside apart from the
 regular working capital. These funds are held separately against
unexpected events like floods, natural calamities, storms, etc.

 Variable Working Capital

Variable working capital can be defined as the capital invested for a
temporary period in the business. Variable working capital is also called
fluctuating working capital.
Such capital differs with respect to changes in the business assets or
the size of the business. Furthermore, variable capital is subdivided into
two parts:

1) Seasonable Variable Working Capital

Seasonable variable working capital is the amount of capital kept aside
to meet the seasonal demand if the business is running seasonally.

2) Special Variable Working Capital

Special variable working capital is the temporary rise in the working
capital due to any unforeseen or occurrence of a special event.

Concept of Working Capital

For the proper understanding of Working Capital, it is necessary to understand the

various concepts of Working Capital. The main concepts of Working Capital are as

follows:

1.Quantitative or Gross Working Capital Concept;

2.Qualitative or Net Working Capital Concept.

 1- Quantitative or Gross Working Capital Concept;

According to this concept Working capital is the total of the entire current asset. This

view places more emphasis on the quantitative aspect of working capital rather than

its Qualitative aspect.

This concept is important due to the following reasons:

a)It enables the enterprise to provide correct amount of Working Capital at the right

time;

b)Every management is more interested in the total current assets with which it has

to operate than the sources from where it is made available;

c) The gross concept takes into consideration the fact that every increase in the

funds of the enterprise would increase its Working Capital;

d)The gross concept of Working Capital is more useful in determination the rate of

return on investments in Working Capital.

2- Qualitative or Net Working Capital Concept:

This concept gives more emphasis on the qualitative aspect rather than the quantitative aspect

rather than the quantitative aspect of working capital. According to this concept the excess of

the current assets over current liabilities is known as working capital. If the current assets and

current liabilities are equal; it indicates absents of working capital in the business.

The net working capital concept is important due to the following reasons:

a)It is a qualitative concept which indicates the firms ability to meet its operating expenses and

short term liabilities;

b)It indicates the margin of protection available to the short- term creditors, i.e., the excess of

current assets over current liabilities;

c) It is an indicator of the financial soundness of an enterprise;

d)It suggests the need for financing a part of the Working Capital requirements out of

permanent sources of funds.

Factor influencing the working of working capital

Some of the factors affecting the working capital of a

company are as follows:

Factors Affecting the Working Capital:

The firm must estimate its working capital very accurately because excessive working

capital results in unnecessary accumulation of inventory and wastage of capital whereas

shortage of working capital affects the smooth flow of operating cycle and business fails
to meet its commitment.

1. Length of Operating Cycle:

The amount of working capital directly depends upon the length of
operating cycle. Operating cycle refers to the time period involved in
production. It starts right from acquisition of raw material and ends
till payment is received after sale.

The working capital is very important for the smooth flow of operating
cycle. If operating cycle is long then more working capital is required
whereas for companies having short operating cycle, the working
capital requirement is less.
2. Nature of Business:
The type of business, firm is involved in, is the next consideration
while deciding the working capital. In case of trading concern or retail
shop the requirement of working capital is less because length of
operating cycle is small.

The wholesalers as compared to retail shop require more working

capital as they have to maintain large stock and generally sell goods on
credit which increases the length of operating cycle. The
manufacturing company requires huge amount of working capital
because they have to convert raw material into finished goods, sell on
credit, maintain the inventory of raw material as well as finished
goods.

3. Scale of Operation:
The firms operating at large scale need to maintain more inventory,
debtors, etc. So they generally require large working capital whereas
firms operating at small scale require less working capital.

4. Business Cycle Fluctuation:

During boom period the market is flourishing so more demand, more
production, more stock, and more debtors which mean more amount
of working capital is required. Whereas during depression period low
demand less inventories to be maintained, less debtors, so less
working capital will be required.

5. Seasonal Factors:
The working capital requirement is constant for the companies which
are selling goods throughout the season whereas the companies which
are selling seasonal goods require huge amount during season as more
demand, more stock has to be maintained and fast supply is needed
whereas during off season or slack season demand is very low so less
working capital is needed.

6. Technology and Production Cycle:

If a company is using labour intensive technique of production then
more working capital is required because company needs to maintain
enough cash flow for making payments to labour whereas if company
is using machine-intensive technique of production then less working
capital is required because investment in machinery is fixed capital
requirement and there will be less operative expenses.

7. Credit Allowed:
Credit policy refers to average period for collection of sale proceeds. It
depends on number of factors such as creditworthiness, of clients,
industry norms etc. If company is following liberal credit policy then it
will require more working capital whereas if company is following
strict or short term credit policy, then it can manage with less working
capital also.

10. Availability of Raw Materials:

If raw materials are easily available and there is ready supply of raw
materials and inputs then firms can manage with less amount of
working capital also as they need not maintain any stock of raw
materials or they can manage with very less stock.
Computation of working capital investment

Working capital = current assets – current liabilities.

Net working capital = current assets (minus cash) - current liabilities (minus debt).

Operating working capital = current assets – non-operating current assets.

Components of Working Capital

All components of working capital can be found on a company's balance sheet, though a
company may not have use for all elements of working capital discussed below. For example, a
service company that does not carry inventory will simply not factor inventory into its working
capital calculation.

Current assets listed include cash, accounts receivable, inventory, and other assets that are
expected to be liquidated or turned into cash in less than one year. Current liabilities include
accounts payable, wages, taxes payable, and the current portion of long-term debt that’s due
within one year.

Current assets are economic benefits that the company expects to receive within the next 12
months. The company has a claim or right to receive the financial benefit, and calculating
working capital poses the hypothetical situation of the company liquidating all items below into
cash.

 Cash and Cash Equivalents : All of the money the company has on hand. This includes
foreign currency and certain types of investments such as money market accounts with
very low risk and very low investment term periods.
 Inventory: All of the unsold goods being stored. This includes raw materials purchased
to manufacture, partially assembled inventory that is in process, and finished goods that
have not yet been sold.
 Accounts Receivable: All of the claims to cash for inventory items sold on credit. This
should be included net of any allowance for doubtful payments.
 Notes Receivable: All of the claims to cash for other agreements, often agreed to
through a physically signed agreement.
 Prepaid Expenses: All of the value for expenses paid in advance. Though it may be
difficult to liquidate these in the event of needing cash, they still carry short-term value
and are included.
  Others: Any other short-term asset. An example is some companies may recognize a
short-term deferred tax asset that reduces a future liability.

Current Liabilities

Current liabilities are simply all debts a company owes or will owe within the next twelve
months. The overarching goal of working capital is to understand whether a company will be
able to cover all of these debts with the short-term assets it already has on hand.

 Accounts Payable: All unpaid invoices to vendors for supplies, raw materials, utilities,
property taxes, rent, or any other operating expense owed to an outside third party.
Credit terms on invoices are often net 30 days, so essentially all invoices are captured
here.
 Wages Payable: All unpaid accrued salary and wages for staff members. Depending on
the timing of the company's payroll, this may only accrue up to one month's worth of
wages (if the company only issues one paycheck per month). Otherwise, these liabilities
are very short-term in nature.
 Current Portion of Long-Term Debt: All short-term payments related to long-term
debt. Imagine a company finances its warehouse and owes monthly debt payments on
the 10-year debt. The next 12 months of payments are considered short-term debt, while
the remaining 9 years of payments are long-term debt. Only 12 months are included
when calculating working capital.
 Accrued Tax Payable: All obligations to government bodies. These may be accruals for
tax obligations for filings not due for months; however, these accruals are usually
always short-term (due within the next 12 months) in nature.
 Dividend Payable: All authorized payments to shareholders. A company may decide to
decline future dividend payments but must fulfill obligations on already authorized
dividends.
 Unearned Revenue: All capital received in advance of having completed work. Should
the company fail to complete the job, it may be forced to return capital back to the
client.

Significance of working capital

The following are 4 importance of working capital:

1. Manage liquidity

Businesses need sufficient cash (liquidity) for their day-to-day running. Working capital
advantage is that it helps fulfill this need. By evaluating their working capital
requirements, the finance department gets a clear idea of their financial position. They
thus can arrange for the funds accordingly, thereby ensuring adequate liquidity and
cash flow for daily operations. Otherwise, liquidity issues could impact a company’s
operations and brand image.
2. Earn short-term profit

Sometimes, a company may have excess funds. On evaluating the working capital,if
the company has a high current assets ratio, then it means it has more funds than its
working capital requirements. The excess funds can be invested by the company to
earn short-term profits.

3. Aids decision making

Working capital is important for a business as it helps undertake sound decisions.

Working capital helps calculate the day-to-day fund requirements. It helps the company
evaluate its existing fund situation. A company can thus decide effectively on the
amount and source of funds. Availing of a working capital loan means, a businesscan
effectively manage to tide over any insufficiency in its working capital requirement to
fund its daily operations.

4. Value addition to business

An adequate working capital implies a company has cash and cash equivalents to
meet its day-to-day operations and short-term obligations. It improves the
creditworthiness of the business in the market. It ensures better bargaining power and
improved profitability. It adds value to the business, enhancing its chance of achieving
broader organizational goals.

With the importance of working capital being explained, it is necessary to evaluate the
advantages and disadvantages of working capital.

Advantages of sufficient working capital

Proper working capital management ensures adequate funds for financing daily
business operations and short-term obligations. Key working capital advantages for a
business are:

 Helps maintain solvency for a company by managing an uninterrupted process

cycle.
 Prompt payment to suppliers helps improve the goodwill and creditworthiness of
the business.
 Suppliers may provide cash discounts for timely payment of bills. It helps reduce
costs, thereby improving profits.
 Helps businesses avail loans based on improved creditworthiness in the market.
 Helps efficiently manage any sudden financial crisis or market volatility.
 Helps divert excess funds to productive ventures to generate more profits for the
business.
 Helps manage company expenses and bills like staff salary, taxes, and other
expenses.
There arethus various working capital advantages. Positive working capital can help
businesses turn favorable market conditions into an advantage for them. Especially in
terms of better business prospects and deals.

Improves overall business efficiency and competitiveness

Insufficient working capital, meaning liquidity issues, could impact business credibility.

Ways to increase working capital

Even after understanding the advantages of working capital, a business may not be
able to maintain it. Some of the ways to increase working capital are stated below.

Take loans

A business can take a working capital loan, meaning it is used to finance everyday
business operations. If you see the working capital loan meaning, it typically entails a
tenure ranging from 6 to 48 months.

· Reduce expenses

Operational efficiency can be achieved by reducing expenses wherever possible to

maintain adequate working capital loans, meaning a business has to work in a planned
way.

· Manage Inventory

Maximize inventory management process by reducing raw material and finished goods
overstocking.

· Automate Receivables Process

Automation will help improve cash flow from operations and reduce fund usage from
other sources for daily business operations.

· Sell illiquid assets

Selling illiquid assets will help improve the cash position within the business.
 UNIT 2
SOURCES OF FINANCE
What Are Accruals?

Accruals are revenues earned or expenses incurred that impact a company's net income on
the income statement, although cash related to the transaction has not yet changed hands.
Accruals also affect the balance sheet, as they involve non-cash assets and liabilities.

For example, if a company has performed a service for a customer, but has not yet received
payment, the revenue from that service would be recorded as an accrual in the company's
financial statements. This ensures that the company's financial statements accurately reflect its
true financial position, even if it has not yet received payment for all of the services it has
provided.

Accrual accounts include, among many others, accounts payable, accounts receivable, accrued
tax liabilities, and accrued interest earned or payable.

Here are some sources of finance or benefits that accrual accounting can provide:

1. Improved Creditworthiness:
 Accrual accounting can show a more accurate and favorable financial picture of a
company, which can enhance its creditworthiness. This, in turn, may lead to better terms
on loans or credit lines, providing a source of financing.
2. Better Investment Attractiveness:
 Companies with strong accrual-based financial statements may attract investors more
easily. Attracting investors can provide an infusion of equity financing.
3. Deferred Tax Liabilities:
 Accrual accounting may result in the recognition of deferred tax liabilities. These
liabilities can represent a source of finance if tax payments are deferred into the future.
4. Accrued Liabilities:
 Accrued liabilities represent expenses incurred but not yet paid. By delaying the payment
of these expenses while recognizing them as accruals, a company can free up cash for
other uses.
5. Enhanced Financial Planning:
 Accrual accounting enables better financial planning and forecasting. With accurate
financial data, a company can make more informed decisions about how to allocate
resources and manage its cash flow efficiently.
6. Depreciation Expense:
 Depreciation, a non-cash expense, reduces reported income on the inco
Trade credit
It refers to the credit extended by the supplier to the purchaser of goods or services. It promotes
the purchase of goods and services as the purchaser need not make immediate cash payments if
trade credit is extended. Trade credits are granted only to customers or traders who are
considered to be creditworthy by the supplier.

Merits of trade credit as a source of short-term finance:

(a) Trade credit helps a company to finance the accumulation of inventories for meeting future
increase in sales.

(b) As the trade creditors do not have any rights over the assets of the company, it can mortgage
its assets to raise money from other sources.

Demerits of trade credit as a source of short-term finance:

(a) Easy availability of trade credit can result in overtrading, which in turn increases the future
liabilities of the buyer.

(b) The amount of funds that can be generated through trade credit is limited to the financial
capacity of the supplier or the creditor.

Public Deposits
For this particular source of working capital finance, a business can invite the public to make
short term deposits for a high rate of return. According to the Reserve Bank of India, companies
can raise to 35% of their paid-up capital or the money received from selling stocks.

Public deposits refer to a type of borrowing arrangement where a company or organization raises
funds directly from the general public. These deposits are typically unsecured and represent a
form of financing that allows entities to access capital without resorting to traditional bank loans
or issuing bonds. Here are some key points about public deposits:

**Target Audience:** The primary target audience for public deposits is the general public,
including individuals, trusts, institutions, and other non-corporate entities. It provides an
investment option for those looking to earn a return on their surplus funds.
**Interest Rates:** The interest rates offered on public deposits can vary widely depending on
the issuer, prevailing market conditions, and the tenure of the deposit. Generally, companies
offer competitive interest rates to attract depositors.

**Maturity Periods:** Public deposits can have various maturity periods, ranging from a few

**Unsecured Nature:** Public deposits are typically unsecured, meaning they are not backed by
collateral or assets. This makes them riskier for depositors compared to bank deposits, which are
often secured up to certain limits.

**Regulatory Framework:** The acceptance of public deposits is subject to regulatory oversight

and compliance with relevant laws and regulations in the issuing country. Regulatory authorities,
such as the Reserve Bank of India (RBI) in India, prescribe rules and guidelines for raising
public deposits.

**Interest Payment Frequency:** Interest on public deposits is usually paid periodically,

such as monthly, quarterly, or annually, depending on the terms offered by the issuer.

**Ratings and Creditworthiness:** Investors often consider the creditworthiness and ratings of
the issuer when investing in public deposits. Companies with higher credit ratings are perceived
as lower risk.

**Prepayment Option:** Some issuers of public deposits may provide a prepayment option,
allowing depositors to withdraw their funds before the maturity date, subject to certain
conditions and penalties.

**Taxation:** Interest earned on public deposits may be subject to taxation, depending on the
tax laws of the issuing country. Depositors should be aware of the tax implications of their
investments.

**Documentation:** Public deposit schemes typically require investors to complete application

forms and provide relevant documentation, including Know Your Customer (KYC) information.

**Use of Funds:** Issuers of public deposits use the raised funds for various purposes, including
working capital, business expansion, project financing, or meeting specific financial needs.

**Risk Factors:** Investors should carefully assess the risk factors associated with public
deposits, including issuer credit risk, interest rate risk, and liquidity risk. Diversifying
investments and conducting due diligence are essential for risk mitigation.

**Liquidity:** Public deposits are relatively less liquid compared to traditional bank deposits, as
they may not be easily withdrawn before maturity without penalties.
Public deposits can be an attractive source of funding for companies and provide investment
opportunities for individuals and entities looking for fixed-income options. However, investors
and issuers should exercise caution, conduct proper due diligence, and adhere to regulatory
requirements to ensure the safety and legality of these transactions.

Working capital advance

Working capital advances forms major part of advance portfolio of banks. In determining
working capital requirements of a firm, the bank takes into account its sales and production plans
and desirable level of current assets.

Working capital advance is provided by commercial banks in three primary ways: (i) cash
credits/overdrafts, (ii) loans, and (iii) purchase / discount of bills.

Inter Corporate Deposits (ICDs

Inter Corporate Deposits (ICDs) are unsecured short-term loans from one corporation to another.
These corporations must be registered under the Companies Act 1956. A company with excess
funds would lend to another company in need of money.

Following are their main characteristics:

1) They are for a very short period of time i.e 3 months or 6 months.

2) They are unsecured source for raising funds.

3) They are not regulated by any law.

4) It is a relationship based borrowing made by the company.

5) They involve high risk and high returns

Short term loans from financial institutions

A Short Term Loan is a Business Loan that can finance temporary business requirements. You
repay the loan amount along with interest before your loan tenure ends. For Short Term Loans,
the loan tenure is usually three to five years.

The main sources of short-term financing are (1) trade credit, (2) commercial bank loans, (3)
commercial paper, a specific type of promissory note, and (4) secured loans.
 Advantages of Short Term Loans

There are many advantages for the borrower in taking out a loan for only a brief period of time,
including the following:

1. Shorter time for incurring interest

As short term loans need to be paid off within about a year, there are lower total interest
payments. Compared to long term loans, the amount of interest paid is significantly less.

2. Quick funding time

These loans are considered less risky compared to long term loans because of a shorter maturity
date. The borrower’s ability to repay a loan is less likely to change significantly over a short
frame of time. Thus, the time it takes for a lender underwriting to process the loan is shorter.
Thus, the borrower can obtain the needed funds more quickly.

3. Easier to acquire

Short term loans are the lifesavers of smaller businesses or individuals who suffer from less than
stellar credit scores. The requirements for such loans are generally easier to meet, in part because
such loans are usually for relatively small amounts, as compared to the amount of money usually
borrowed on a long term basis.

Disadvantage

The main disadvantage of short term loans is that they provide only smaller loan amounts. As the
loans are returned or paid off sooner, they usually involve small amounts, so that the borrower
won’t be burdened with large monthly payments.

Rights Debentures for Working Capital

A "right debenture" typically refers to a type of debenture that comes with certain rights or
privileges for the debenture holder. These rights can vary depending on the terms and conditions
outlined in the debenture agreement, but they often include:

1. Conversion Rights: Some debentures may have conversion rights, allowing the debenture
holder to convert their debt into a specified number of shares of the issuing company's common
stock. This can be advantageous if the company's stock price rises significantly.
2. Preemptive Rights: Preemptive rights, also known as rights of first refusal, give the debenture
holder the option to purchase additional debentures or securities issued by the company before
they are offered to other investors. This allows the debenture holder to maintain their ownership
stake in the company.
3. Voting Rights: In some cases, debenture holders may have limited voting rights in the company,
particularly if the debentures are convertible into common shares. These voting rights may be
exercised on certain matters affecting the company.
4. Priority in Liquidation: Debenture holders may have a higher claim on the company's assets in
the event of liquidation or bankruptcy, giving them priority over common shareholders.
5. Interest Rate and Payment Terms: The terms of interest payment, such as the interest rate,
frequency of payments, and method of calculation, can also be specified in the debenture
agreement.
6. Maturity Date: The debenture will have a specified maturity date, indicating when the issuer is
obligated to repay the principal amount to the debenture holder.

The debt: equity ratio, including the proposed debenture issue, should not exceed 1:1. The
debentures shall first be offered to the existing Indian resident shareholders of the company on a
pro rata basis.

Debentures are generally not considered an appropriate financing option for working capital
needs due to their long-term nature. Debentures are typically issued for raising long-term capital
and involve fixed interest payments over an extended period, often several years. Working
capital requirements, on the other hand, are for short-term operational needs, such as covering
day-to-day expenses, paying suppliers, and managing cash flow.

For working capital needs, businesses typically look for short-term financing options that offer
flexibility and are more aligned with the short-term nature of these requirements. Here are some
suitable options for meeting working capital needs:

1. Bank Overdrafts: A bank overdraft is a flexible credit facility that allows a business to
withdraw funds exceeding its account balance up to a predetermined limit. Interest is charged
only on the amount overdrawn.
2. Short-Term Loans: Businesses can obtain short-term loans from banks or other financial
institutions with repayment terms ranging from a few months to a year. These loans are designed
to provide quick access to funds for working capital needs.
3. Trade Credit: Negotiating favorable payment terms with suppliers can extend the time a
business has to pay its bills, improving working capital without incurring interest expenses.
4. Lines of Credit: Establishing a line of credit with a financial institution allows a business to
access funds as needed for working capital requirements. Interest is charged only on the
borrowed amount.
5. Invoice Financing: Factoring or invoice discounting involves selling accounts receivable to a
third party for immediate cash, allowing a business to bridge cash flow gaps caused by unpaid
invoices.
6. Merchant Cash Advances: This option provides a lump sum upfront in exchange for a
percentage of future credit card sales. It can be used for various working capital needs.
7. Inventory Financing: Some lenders offer loans specifically tailored for financing inventory
purchases. These loans can help businesses maintain adequate stock levels without tying up cash.
8. Supplier Financing: Collaborating with suppliers to extend payment terms or negotiate supplier
credit can effectively support working capital requirements.
When considering financing options for working capital, it's essential to assess the specific short-
term funding needs, the cost of borrowing, and the ability to repay the funds within the required
time frame. The choice of financing should align with the company's cash flow and liquidity
management strategy.

Debentures, with their long-term commitment and fixed interest payments, are better suited for
capital investments, expansion projects, or refinancing long-term debt. Companies should
carefully match their financing choices to their short-term and long-term financial needs and
objectives.

Commercial Paper
Commercial papers and factoring are two financial instruments that businesses can use to
manage their cash flow and obtain short-term financing. They serve different purposes and have
distinct characteristics:

**Commercial Papers:**

1. **Definition:** Commercial papers are unsecured, short-term debt instruments issued by

large corporations, financial institutions, and government entities. They are typically used to
raise funds for a company's short-term operational needs, such as inventory purchase, payroll, or
other immediate expenses.

2. **Maturity:** Commercial papers typically have maturities ranging from a few days to 270
days, with the most common maturities being 30, 60, or 90 days. They are considered a form of
short-term borrowing.

3. **Issuer:** Usually, only financially stable and creditworthy organizations with high credit
ratings can issue commercial papers. This makes them a relatively low-risk investment for
buyers.

4. **Interest Rate:** Commercial papers are typically issued at a discount to their face value.
The difference between the purchase price and face value represents the interest earned by the
investor. The interest rate is usually lower than that of traditional loans or bonds.

5. **Market:** Commercial papers are traded in the money market, making them a part of the
broader financial market. Investors can buy and sell them in secondary markets.

6. **Security:** They are unsecured, meaning they are not backed by collateral. Investors rely
on the issuer's creditworthiness to repay the principal amount at maturity.

**Factoring:**
1. **Definition:** Factoring is a financial transaction where a business sells its accounts
receivable (invoices) to a third-party financial institution, known as a factor, at a discount. The
factor then assumes responsibility for collecting payments from the customers on those invoices.

2. **Purpose:** Factoring is used by businesses to convert their accounts receivable into

immediate cash. It helps improve cash flow, allowing the company to meet its working capital
needs without waiting for customers to pay their invoices.

3. **Maturity:** Factoring transactions are typically short-term, as they involve the sale of
invoices with payment due in the near term (e.g., 30 to 90 days).

4. **Discount:** The factor buys the invoices at a discount, which is a fee for providing
immediate cash. The discount rate depends on factors such as the creditworthiness of the
customers, the size of the invoices, and the terms of the agreement.

5. **Credit Risk:** Factoring companies assume the credit risk associated with the accounts
receivable they purchase. If a customer doesn't pay, the factor bears the loss.

6. **Collection:** The factor takes responsibility for collecting payments from customers. This
can free up the business's resources and time for other activities.

In summary, commercial papers are short-term debt instruments used by companies to raise
funds by borrowing from the market, while factoring is a transaction where a company sells its
accounts receivable to a third party at a discount in exchange for immediate cash. Both serve as
valuable tools for managing cash flow and working capital, but they are used in different
contexts and have distinct characteristics. Commercial papers are a form of short-term
borrowing, while factoring involves the sale of accounts receivable to improve liquidity.

TYPES OF FACTORING

 Recourse factoring − In this, client had to buy back unpaid bills

receivables from factor.
 Non – recourse factoring − In this, client in which there is no
absorb for unpaid invoices.
 Domestic factoring − When the customer, the client and the factor
are in same country.
  Export factoring − It involves four parties, the exporter, the
export factor, the import factor and the importer. It is also called as
cross border factoring.
 Disclosed factoring − If factor name is represented on the invoice
of the goods or services and asks customer to pay the factor.
 Undisclosed factoring − Factor is not mentioned on the invoice of
the goods or services by manufacturer.
 Advance factoring − In this, advance is paid to the client by factor
against uncollected receivables.
 Maturity factoring − In this, bank collects money from the
customer and pays to firm on due date or before.
 Invoice discounting − Clients collects payments from customer
directly and pays to the factor.
 Bulk factoring − In this, full recourse can be done by client and
administration and collection is done by his own ways.
 Agency factoring − In this, finance and protection against bad
debts is done by factor, administration and collection is done by
client.

SOURCES OF WORKING CAPITAL:

A company has various sources of working capital. Depending upon its condition and
requirements, a company may use any of these sources of working capital. These sources may be
spontaneous, short-term, or long-term.

 Spontaneous Sources: The sources of capital created during normal business activity are
called spontaneous sources of working capital. The amount and credit terms vary from
industry to industry and depend on the business relationship between the buyer and seller.
 The main characteristic of spontaneous sources is ‘zero-effort’ and ‘negligible cost’
compared to traditional financing methods. The primary sources of spontaneous working
capital are trade credit and outstanding expenses.
 Short-term Sources: The sources of capital available to a business for less than one year
are called short-term sources of working capital.
 Long-term Sources: The sources of capital available to a business for a longer period,
usually more than one year, are called long-term sources of working capital.

SHORT-TERM SOURCES OF WORKING CAPITAL

Short-term sources of capital may further be divided into two categories – Internal Sources and
External Sources.

The short-term internal sources of working capital include provisions for tax and dividends.
These are essentially current liabilities that cannot be delayed beyond a point. All companies
make separate provisions for making these payments. These funds are available with the
company until these payments are made. Hence, these are called the internal sources of working
capital. However, this value is relatively small and thus not that significant.

On the other hand, the short-term external sources of working capital include capital from
external agencies like banks, NBFCs, or other financial entities. Some of the primary sources of
short-term external sources of working capital are listed below:

 Loans from Commercial Banks: Businesses, mostly MSMEs, can get loans from
commercial banks with or without offering collateral security. There is no legal formality
involved except creating a mortgage on the assets. Repayment can be made in parts or
lump sum at the time of loan maturity. At times, banks may offer these loans on the
personal guarantee of the directors of a country. They get these loans at concessional
rates; hence it is a cheaper source of financing for them. However, the flip side is that
getting this loan is a time-consuming process.
 Public Deposits: Many companies find it easy and convenient to raise funds for meeting
their short-term requirements from public deposits. In this process, the companies invite
their employees, shareholders, and the general public to deposit their savings with the
company. As per the Companies Act 1956, companies can advertise their requirements
and raise money from the general public against issuing shares or debentures. The
companies offer higher interest rates than bank deposits to attract the general public. The
 biggest of this source of financing is that it is simple and cheaper. However, its drawback
is that it may not be available during the depression and financial stringency.
 Trade Credit: Companies generally source raw materials and other items from suppliers
on credit. The amount payable to these suppliers is also treated as a source of working
capital. Usually, the suppliers grant their buyers a credit period of 3 to 6 months. Thus,
they provide, in a way, short-term finance to the purchasing company. The availability of
trade credit depends on various factors like the buyer’s reputation, financial position,
business volume, and degree of competition, among others. However, when a business
avails trade credit, it stands to lose the benefit of cash discount, which it would earn if
they make the payment within 7 to 10 days of making the purchase. This loss of cash
discount is treated as an implicit cost of trade credit.
 Bill Discounting: Just as business buys goods on credit, they offer credit to their buyers.
The credit period may vary from 30 days to 90 days and sometimes extends, even up to
180 days. During this period, the company funds get blocked, which is not good. Instead
of waiting that long, sellers prefer to discount these bills with a bank or NBFC. The
financial entity charges some amount as commission, called a ‘discount’, and makes the
balance payment to the sellers. This discount compensates them for the time gap between
disbursing and collecting the money on the maturity of the bill. This ‘discount’ charged
by the bank is treated as the cost of raising funds through this method. Businesses widely
use this method for raising short-term capital.
 Bank Overdraft: Some banks offer their esteemed customers and current account holders
a facility to withdraw a certain amount of money over and above the funds held by them
in their current account with the bank. The bank charges interest on the amount
overdrawn and the period it is withdrawn. The overdraft facility is also granted against
securities. The bank sets this limit and is subject to revision anytime, depending upon the
customer’s creditworthiness.
 Advances from Customers: One effortless way to raise funds to meet the short-term
requirement is to ask customers for some payment in advance. This advance confirms the
order and gives much-needed cash to the business. No interest is payable to the customer
for this advance. Even if any business pays interest, it is very nominal. Hence, this is one
of the cheapest sources of raising funds to meet companies’ short-term working capital
 requirements. However, this is possible only when the customers do not choose the terms
of the sellers.

LONG-TERM SOURCES OF WORKING CAPITAL

When the companies require funds for more than one year, it makes sense to go for long-term
sources, as they are generally cheaper than short-term sources.

Like short-term sources, long-term sources may also be classified as internal and external
sources. Retained profits and accumulated depreciation are internal sources wholly earned and
owned by the company itself. These funds are available to a company without any direct cost.

The external sources of long-term sources of working capital are listed below:

 Share Capital: The Company may raise funds by offering the prospective shareholders a
stake in their business. These shares may be held by the general public, banks, financial
institutions, or even other companies. The response depends on several factors, including
the company’s reputation, perceived profit potential, and general economic condition. In
return, the company offers dividends to their shareholders, which along with the floating
cost, is treated as the cost of sourcing. However, the company is not legally bound to pay
this dividend. Also, no rule prescribes how much dividend is to be given. All this makes
this a very cheap source of working capital. But, in reality, most companies do not use
this for meeting their working capital needs.
 Long-term Loans: Also called Working Capital Loans, these long-term loans may be
temporary or long-term. The long-term here is generally 84 months (7 years) or more.
This loan is not taken for buying long-term assets or investments and is used to provide
working capital to meet a company’s short-term operational needs. Experts advise using
long-term sources for permanent needs and short-term sources for temporary working
capital needs.
 Debentures: Like shares, debentures also include generating money from the general
public, financial institutions, and other companies. However, unlike shares, in the case of
debentures, the company has to declare the interest they will pay to their lenders openly.
The company is legally bound to pay the agreed interest. So, here, if the funds are unused
or even if the company runs into losses, they have to pay the lenders.

ADVANTAGES AND DISADVANTAGES
Short-term working capital finance is taken from banks and other NBFCs generally has a higher
interest rate than spontaneous and long-term sources. But they offer the businesses great time
flexibility, due to which finance managers prefer this. They can take the funds as and when
required and pay it whenever the cash position is better. This does not create a long-term liability
for them. In the case of long-term sources, the business has to hold funds and even pay for them
even when funds are not in use. This makes short-term loans cheaper.

SOURCES OF WORKING CAPITAL FOR SMALL BUSINESS

When it comes to a small business, there are several sources of working capital. One option is a
working capital loan based on your age in business, creditworthiness, and other industry factors.
Some of the main options are:

 Vendor and trade sources: The credit period offered by sellers is the most common
source of short-term working capital for MSMEs. However, even this may be a challenge
for start-ups. This is because the suppliers may ask for an advance or at the most cash-on-
delivery (COD). Once you establish some relationships with them, you can negotiate a
credit period of 15 to 30 days, which gives you some time to convert your inventory into
finished goods and ultimately into cash.
 If you are looking for funds to purchase equipment, try and search vendors who offer
financing or leasing as an option. While the interest rates may be high, it will
significantly reduce the amount to be paid upfront. One more option is to offer your
customers an ‘early bird discount’ if they pay before the usual credit period. Though you
may have to give away a 2% discount, it would be much lesser than the cost of borrowing
against a line of credit.
 Working capital loans from traditional lenders: Banks and NBFCs offer the most
affordable working capital loans if your business is eligible for them. For an SME, it’s
crucial to develop a healthy business relationship with the loan officer at your bank. Your
loan officer can advise you on what’s available and may help you with approval. Even if
it’s a small amount, it makes sense to avail it. Timely repayment of this amount will help
you open doors for bigger loans in the future. The overdraft facility is yet another tool to
improve the working capital situation. Like traditional loans and lines of credit, overdraft
agreements are negotiated in advance. Once signed, they enable you “borrow” money
 from the bank, as and when required, without any delay or kind of penalty. The bank
charges interest on the amount withdrawn until it is paid back.

 Banking Policy- The Tandon, Chore, and Marathe

Committee
 TandonCommittee
 A study group under the chairmanship of Shri P.L. Tandon was constituted in 1974 by
the RBI in order to frame guidelines for bank credit. The terms of reference of the
committee were as follows.

 Terms of reference

1. To suggest guidelines for commercial banks to follow up and supervise credit from the
point of view of ensuring proper end-use of funds and keeping a watch on the safety of
advances.

2. To make recommendations for obtaining periodical information that may be obtained

by banks from the borrower.

3. To make suggestions for prescribing inventory norms for different industries.

4. To suggest criteria regarding satisfactory capital structure and sound financial basis in
relation to borrowings.

5. To suggest whether the existing patterns of financing working capital requirements by

cash credit / overdraft system, etc. are required to be modified, if so, to suggest
modifications.

 Findings

On the basis of the reference given above, the committee studied the existing system of working
capital finance provided to industry and identified the following as its major weaknesses.

1. The banks do not have any credit appraisal or planning. It is the borrower who decides how
much he would borrow.

2. The security-based approach to lending has led to division of funds to purchase of fixed assets.

3. Bank credit is treated as the first source of finance rather than being taken as a supplementary
to other sources of finance.

4. The working capital finance should be made available only for a short period, as it has
otherwise, led to accumulation of inventories with the industry.

 Recommendations
The report was submitted on 9th August 1975 and it is a landmark in the history of financing
working capital by commercial banks in India. The Tandon Committee made comprehensive
recommendation regarding the bank lending practices, which can be broadly classified into four
groups’. Important features of the Tandon Committee recommendations based on the fixation of
norms for bank lending to industry are as follows.

Norms for Bank Lending

 1. Inventory and receivable norms

The borrowers are allowed to keep reasonable current assets particularly inventory and
debtors. The normal current assets based on economic ordering levels and certain level of
safety should be financed by banker. Finance to borrower in the form of working capital
should not be made available for profit making or to keep excess inventory. Similarly the
bank should finance the bills receivable, which are in line with the practices of the
borrower’s industry. The norms have been worked out according to the time element. The
limit of the raw materials is expressed as so many months of total consumption in the year.
The work-in-progress limit determined as so many months of cost of production, the finished
goods and bills receivable limits are determined by cost of sales and credit sales respectively.
The Tandon Committee has suggested norms for fifteen industries.

 2. Lending norms or Maximum Permissible Bank Finance (MPBF)

Tandon Committee introduced the concept of MPBF in the working capital finance by banker.
The Committee suggested that bank should attempt to supplement the borrowers’ resources in
financing the current assets. It has recommended that the current assets first should be financed
by trade creditors and other current liabilities. The remaining current assets, which is
called working capital gap, should be financed particularly by bankers in the form of bank
credit and through long-term borrowings or owner’s funds. In the context of this approach, the
committee has suggested three alternative methods for working out the MPBF. Each successive
method reduces the involvement of short-term bank credit to finance the current assets.

 First method

In the first method, 25% of the Working Capital Gap (CA-(CL excluding bank borrowing))
should be contributed by borrower through long-term funds and remaining 75% can be
financed from bank borrowings. This method will give a minimum current ratio of 1.17:1.
The term working capital gap refers to the total of CA less CL other than bank borrowings.
This can be understood with the help of the following examples.

Example 1

Amount of maximum permissible bank borrowings as per the first method can be ascertained
as follows:

 Second method

Under this method the borrower should provide 25% of the total current assets through long-
term funds and this will give a current ratio of 1.33:1
Example 2

The maximum permissible bank borrowings as per second method can be ascertained as
follows:

 Third method

In this method the borrower should contribute from long-term sources to the extent of
core current assets (Fixed Current assets) and 25% of the balance of the current assets.
The remaining of the working capital gap can be met from bank borrowings. This method
will further strengthen the current ratio.

 Example 3

The maximum permissible bank borrowings as per the third method can be ascertained as
follows:
 The committee recommended the first method mainly as a stop-gap method till borrowers
get used to the new approach of lending. The borrowers who are already in the second
method would not be allowed to revert to the first stage.

 3. Style of Credit

The Tandon committee also suggested that total MPBF should be bifurcated into two
components 1. Loan component represents the minimum level of borrowing throughout the
year and 2. Demand cash credit component, which would take care of the fluctuating needs
and is required to be reviewed periodically. The demand cash credit component should be
 charged slightly higher interest rate than the loan components. This would provide the
borrower an incentive for better planning. Apart from the loan component and cash credit
component, a part of the total financing requirements should also be provided by way of bills
limit to finance the seller’s receivables. The proposed system of lending and the style of
credit might be extended to all borrowers having credit limits in excess of ` 10 lakhs from the
banking system.

 4. Information and Reporting System

In order to ensure that the borrowers do not use the cash credit facility in an unplanned
manner and they keep only required level inventories and receivables, the committee
suggested a new information system. Under this system the borrowers are required to submit
the following documents to the bankers periodically.

1. A copy of the audited financial statements at the end of each year.

2. A copy of a projected financial statement and funds flow statement for the next year.

3. Quarterly budgeting cum reporting statements.

4. Monthly stock statement.

The Tandon committee further suggested that the information system might be introduced to
start with in respect of borrowers with limit of Rs1 crore and above from the entire banking
system and then extended progressively to others.

ChoreCommittee
Having implemented the recommendations of the Tandon committee, the RBI constituted
another working group under the chairmanship of Shri K.B. Chore, Chief Officer, Department of
Banking operation and development, RBI.
  Terms of reference

 The committee was asked to review the cash credit system in recent years with particular
reference to the gap between sanctioned limit and the extent of their utilisation.

 To suggest alternative types of credit facilities, which should ensure greater credit
discipline and enable the banks to relate credit limits to increase in output or other
production activities.

Recommendations

 Continuation of existing credit

The existing system of three types of lending namely, cash credits, loans and bills should be
retained.

No bifurcation of credit limit

Bifurcation of cash credit limit into a loan component and a fluctuating cash credit component
has not found acceptance either on the part of the banks or the borrowers. Therefore the
committee recommends withdrawing bifurcation of accounts.

Separate limit for peak and non-peak level requirements

 The banks have been asked to fix separate credit limits wherever feasible for the normal
non-peak level and peak level credit requirements and indicate the periods during which
the separate limits would be utilised by the borrowers. If, however, there is no
pronounced seasonal trend, peak-level and normal requirements should be treated as
identical and limits should be fixed on that basis. It should be noted that peak-level and
non-peak level concepts apply not only to agriculture-based industry but also to certain
other consumer industries where the demand may have pronounced seasonal tendencies.
Within the limits sanctioned for the peak-level and non-peak level periods the borrowers
should indicate before the commencement of each quarter the requirements of funds
during that quarters. The statement so submitted by the borrowers should form the basis
for quarterly review of the accounts.

Submission of Quarterly Statements

The quarterly statements should be submitted by all the borrowers enjoying working capital limit
of Rs.50 lakhs and above and they will have to bring gradual additional contribution based on
second method of lending as prescribed by the Tandon Committee.
  The RBI, in 1982, appointed a committee under the chairmanship of Marathe to review
the working of credit authorization scheme (CAS) and suggest measure for giving
meaningful direction to the credit management function of the RBI.

Marathe committee

 The RBI, in 1982, appointed a committee under the chairmanship of Marathe to review
the working of credit authorization scheme (CAS) and suggest measure for giving
meaningful direction to the credit management function of the RBI. The RBI with some
modifications has accepted the recommendations of the committee.

 Recommendations

 The principal recommendations of the Marathe committee include:

 1. The committee has declared the third method of lending as suggested by the Tandon
committee to be dropped, hence, in future, the banks would provide credit for working
capital according to the second method of lending.

 The committee has suggested the introduction of the ‘Fast-Track Scheme’ to improve the
quality of credit appraisal in banks. It recommended that commercial banks can release
without prior approval of the reserve bank 50% of the additional credit required by the
borrowers (75% in case of export oriented manufacturing units) where the following
requirements are fulfilled:

 The estimate/projections in regard to production, sales, chargeable current asset, current

liabilities other than bank borrowings, and net working capital are reasonable in terms of
the past trends and assumptions regarding most likely trends during the future projected
period.

 The classification of assets and liabilities as ‘current’ and ‘non-current’ is in conformity

with the guidelines issued by the Reserve Bank of India.

 The projected current ratio is not below 1.33:1.

 The borrower has been submitting quarterly information and operating statement (form 1,
form 2, and 3) for the past six months within the prescribed time and undertakes to do the
same in future also.
 The borrower undertakes to submit to the banks his annual account regularly and
promptly. Further, the bank is required to review the borrower’s facilities at least once in
a year even if the borrower does not need enhancement in credit facilities.
 Unit 3
 Holding cash and marketable securities
Holding cash and marketable securities (such as short-term investments) is an important
financial management decision for businesses and individuals. Several motives drive the
decision to hold these assets:

**1. Transaction Motive:**

- **Business:** This motive applies to businesses that need cash to conduct their day-
to-day operations. Companies require cash on hand to pay for routine expenses like
salaries, utilities, raw materials, and other operational costs. Maintaining cash and
marketable securities ensures they can meet these payment obligations promptly.

- **Individual:** Individuals also have transaction motives for holding cash. They need
cash to cover their everyday expenses, including groceries, rent or mortgage payments,
transportation costs, and discretionary spending.

**2. Precautionary Motive:**

- **Business:** Companies may hold cash and marketable securities as a precaution

against unexpected expenses or emergencies. Having a financial cushion helps them
avoid liquidity crises during economic downturns or when unforeseen events occur.

- **Individual:** Individuals similarly hold cash as a precautionary measure. They

keep emergency funds to cover unexpected medical bills, car repairs, or other urgent
needs without resorting to borrowing or selling assets.

**3. Speculative Motive:**

- **Business:** The speculative motive involves holding cash or marketable securities

with the expectation of taking advantage of favorable investment opportunities. For
example, if a company anticipates a market downturn or a potential acquisition, it might
hold more cash or short-term investments to be ready to capitalize on these opportunities.

- **Individual:** Individuals may hold cash or short-term investments as part of their

investment portfolio strategy. They might keep cash on hand, waiting for favorable
investment opportunities in stocks, bonds, or other assets.

**4. Compensation Motive:**

- **Business:** This motive is relevant when companies have uneven cash flows. They
may need to hold cash to compensate for timing differences between cash inflows and
outflows. For example, seasonal businesses may accumulate cash during peak periods to
cover expenses during slow seasons.

- **Individual:** Individuals with irregular income, such as freelancers or self-

employed individuals, may hold cash to smooth out their cash flow and ensure they can
meet financial commitments during lean periods.

**5. Hedging Motive:**

- **Business:** Companies operating internationally may hold foreign currencies as

marketable securities to hedge against currency exchange rate fluctuations. This helps
them manage currency risk associated with international transactions.

**6. Opportunity Cost:**

- **Business and Individual:** While holding cash and marketable securities provides
safety and liquidity, it also incurs an opportunity cost. Money held in cash or low-yield
marketable securities may not earn as much as it could through higher-yield investments.
Balancing the desire for liquidity with the opportunity to earn a return is an important
consideration for both businesses and individuals.
The specific motives for holding cash and marketable securities may vary based on individual
circumstances, financial goals, and risk tolerance. Effective cash and liquidity management
involves optimizing the balance between maintaining liquidity for immediate needs and
maximizing returns through investments when possible.

Factors determining cash balance

The optimal cash balance for a business is influenced by a variety of factors. Maintaining
an appropriate level of cash is crucial for meeting short-term obligations, seizing
investment opportunities, and ensuring financial stability. Here are the key factors that
determine a company's cash balance:

1. **Operating Cycle:** The length of time it takes for a company to convert its raw
materials into finished products, sell them to customers on credit terms, and collect cash
from those sales affects its cash needs. A longer operating cycle may require a higher
cash balance to cover expenses during the cycle.

2. **Sales and Revenue Patterns:** The seasonality of a business, sales volatility, and
revenue fluctuations can impact cash flow. Businesses with unpredictable or highly
seasonal sales may need to maintain larger cash reserves to weather lean periods.

3. **Accounts Receivable Management:** The average collection period for accounts

receivable affects cash flow. A more extended credit period or slow-paying customers
may necessitate a higher cash balance to cover expenses while waiting for payments.

4. **Accounts Payable Terms:** The terms offered by suppliers and the payment policy
of the company affect cash management. Longer accounts payable terms can help
conserve cash, while shorter terms may require maintaining higher cash balances to meet
obligations promptly.

5. **Capital Expenditure Plans:** Businesses planning significant capital expenditures or

investments may need to set aside cash to fund these projects. The timing and size of
these expenditures impact the required cash reserves.
6. **Debt Obligations:** The maturity dates and terms of outstanding loans and debt
obligations affect cash needs. Businesses must have cash on hand to service debt
payments and avoid default.

7. **Operating Expenses:** The regular operating expenses of the company, such as

payroll, rent, utilities, and other overhead costs, dictate the cash required for day-to-day
operations.

8. **Economic Conditions:** Economic factors, including inflation rates, interest rates,

and overall economic stability, can impact a company's cash management strategy. High
inflation may require higher cash balances to account for rising costs.

9. **Unexpected Expenses:** Companies must plan for unexpected events, such as

equipment breakdowns, legal disputes, or natural disasters, which may require immediate
cash outlays.

10. **Credit Access:** Access to short-term credit lines or revolving credit facilities can
provide a source of liquidity that reduces the need for maintaining high cash balances.

11 **Dividend Policies:** The company's dividend policy, including the timing and size
of dividend payments to shareholders, can impact cash availability.

12. **Regulatory Requirements:** Regulatory requirements, such as minimum cash

reserve ratios or liquidity requirements imposed by financial authorities, can influence a
company's cash management practices.

13. **Investment Opportunities:** If attractive investment opportunities arise, a

company may opt to hold less cash in favor of investments that offer higher returns.

14. **Risk Tolerance:** The company's risk tolerance plays a role in determining its
cash balance. Some businesses may prefer a more conservative approach with higher
cash reserves to ensure stability, while others may be willing to operate with lower cash
balances to maximize returns.
15. **Financial Planning:** Effective financial planning, including budgeting and cash
flow forecasting, helps businesses estimate their cash needs accurately.

Balancing these factors is essential for maintaining an optimal cash balance. Striking the
right balance between holding enough cash to cover obligations and deploying excess
cash for investment opportunities is a key challenge in cash management. Companies
often use cash flow forecasts and financial modeling to determine their ideal cash reserve
levels.

Effective cash flow management is crucial for the financial health and sustainability of
any business. It involves monitoring, analyzing, and optimizing the flow of cash into and
out of the company to ensure there's enough liquidity to cover operational expenses, meet
financial obligations, and pursue growth opportunities. Here are essential steps and
strategies for managing cash flow:

Managing cash flow

1. **Create a Cash Flow Forecast:**

- Develop a detailed cash flow forecast that projects your expected cash inflows and
outflows over a specific period (e.g., monthly, quarterly, or annually). This forecast helps
you anticipate periods of surplus or shortfall.

2. **Monitor Receivables and Payables:**

- Keep a close eye on accounts receivable (money owed to you by customers) and
accounts payable (amounts you owe to suppliers). Promptly follow up on overdue
payments from customers and negotiate favorable payment terms with suppliers.

3. **Improve Cash Collection:**

- Implement efficient billing and collection processes to accelerate cash inflows. Offer
incentives for early payments and send regular reminders for outstanding invoices.
4. **Extend Payables Strategically:**

- Negotiate favorable terms with suppliers to extend payment deadlines without

harming relationships. This can help you preserve cash for other purposes.

5. **Control Inventory Levels:**

- Maintain optimal inventory levels to prevent overstocking or understocking. Reducing

excess inventory can free up cash for other needs.

6. **Manage Operating Expenses:**

- Review and control operating expenses regularly. Identify areas where cost reductions
or efficiencies can be achieved without compromising quality or service.

7. **Plan for Seasonality:**

- If your business experiences seasonal fluctuations, plan ahead by setting aside cash
reserves during peak periods to cover expenses during slower times.

8. **Use Cash Flow Analysis Tools:**

- Utilize cash flow analysis tools and software to track and project cash flow trends.
These tools can help identify potential issues early on.

9. **Establish a Line of Credit:**

- Establish a revolving line of credit with a financial institution to provide a source of

funds during cash flow shortages. Use it as a safety net but avoid over-reliance on credit.

10. **Invest Excess Cash Prudently:**

 - Put excess cash into interest-bearing accounts, short-term investments, or other
instruments to earn a return on idle funds. Ensure investments are liquid enough to access
when needed.

11. **Cut Non-Essential Expenses:**

- In challenging times, consider cost-cutting measures, such as delaying discretionary

spending, postponing expansion plans, or temporarily reducing employee hours.

12. **Negotiate Payment Terms:**

- Negotiate payment terms with customers to encourage faster payments. This might
include offering discounts for early payments or requiring partial upfront payments.

13. **Plan for Capital Expenditures:**

- Budget for capital expenditures and equipment upgrades well in advance. Ensure you
have the necessary funds set aside or arrange financing as needed.

14. **Maintain a Cash Reserve:**

- Keep a cash reserve to cover unexpected expenses or emergencies. Having a financial

cushion can help you weather unforeseen challenges.

15. **Regularly Review and Adjust:**

- Continuously review your cash flow projections and financial statements. Adjust your
strategies and actions as circumstances change.

16. **Seek Professional Advice:**

- Consult with financial advisors or accountants for expert guidance in managing cash
flow and making financial decisions.

Effective cash flow management is an ongoing process that requires careful planning,
diligent monitoring, and adaptability to changing circumstances. By maintaining a strong
 focus on cash flow, businesses can ensure their financial stability and position themselves
for long-term success.

Types of Collection systems

Collection systems refer to the processes and methods organizations use to collect payments
from customers or clients. The type of collection system a business employs can vary depending
on its industry, customer base, and specific needs. Here are some common types of collection
systems:

1. **In-House Collection System:**

- In this system, the organization manages its collections internally, using its own employees
and resources. It may involve dedicated collection departments or teams responsible for
contacting customers and collecting payments.

2. **Third-Party Collection Agency:**

- When businesses are unable to collect payments from delinquent customers internally, they
may hire third-party collection agencies. These agencies specialize in debt collection and often
work on a contingency fee basis, receiving a percentage of the amount collected.

3. **Legal Collections:**

- In cases of severe delinquency or default, businesses may resort to legal collections. This
involves taking legal action, such as filing a lawsuit or obtaining a judgment against the debtor,
to enforce payment.

4. **Automated Collections:**

- Automation involves using software and technology to streamline the collection process.
Automated systems can send automated payment reminders, track payments, and manage
overdue accounts. They can also integrate with accounting and customer relationship
management (CRM) systems.

5. **Online Payment Portals:**

- Many businesses provide online payment portals that allow customers to make payments
conveniently through the company's website or a secure platform. These portals often support
various payment methods, including credit cards, electronic funds transfer (EFT), and digital
wallets.
6. **Direct Debit and Electronic Funds Transfer (EFT):**

- Companies can set up direct debit or EFT arrangements with customers, allowing payments
to be automatically withdrawn from the customer's bank account on specified due dates. This
method is commonly used for subscription services and recurring payments.

7. **Lockbox Services:**

- Lockbox services are offered by banks or financial institutions. They involve setting up a
lockbox address where customers send their payments. The bank processes the payments and
deposits them directly into the company's account, reducing processing time.

8. **Collection Letters and Phone Calls:**

- Sending collection letters or making phone calls to remind customers of overdue payments is
a traditional collection method. These reminders can be sent by mail or email and can be
automated or handled by collection agents.

9. **Settlement Negotiations:**

- In some cases, businesses may negotiate settlements with customers who are unable to pay
the full amount owed. This involves reaching an agreement for a reduced payment to satisfy the
debt.

10. **Payment Plans:**

- Offering payment plans allows customers to repay their debts in smaller, manageable
installments over time. Payment plans can be customized to suit the customer's financial
situation.

11. **Credit Reporting Agencies:**

- Organizations can report delinquent accounts to credit reporting agencies, which can impact
the debtor's credit score. This can serve as an incentive for debtors to settle their debts.

12. **Skip Tracing:**

- Skip tracing is the process of locating individuals or businesses that have moved or changed
contact information. It is often used when customers are difficult to reach.

The choice of collection system depends on the organization's specific circumstances, industry
regulations, and the nature of its customer relationships. Effective collection systems aim to
strike a balance between recovering outstanding payments and maintaining positive customer
relationships. It's essential to adhere to legal and ethical collection practices to avoid legal issues
and protect the organization's reputation.

Mailed payment collection system

A "mailed payment collection system" typically refers to a process or system used by
organizations to collect payments from customers or clients through the mail. This method is
often used for traditional payment methods, such as checks or money orders, where customers
physically send their payments to the organization by mail. Here's an overview of how a mailed
payment collection system works:

1. **Invoicing:** The process begins with the organization issuing invoices or bills to customers
for the products or services they have purchased. The invoice includes details such as the amount
owed, due date, payment instructions, and the mailing address where the payment should be sent.

2. **Customer Payment:** Customers review the invoice and prepare their payments. This
typically involves writing a check or obtaining a money order for the specified amount.

3. **Payment Enclosure:** Customers include the payment instrument (check or money order)
along with a payment stub or a copy of the invoice in an envelope.

4. **Mailing:** Customers seal the envelope and mail it to the organization's designated mailing
address. This address is typically a P.O. Box or a specific department within the organization
responsible for processing payments.

5. **Payment Processing:** Upon receiving the mailed payments, the organization's finance or
accounting department processes them. This involves opening the envelopes, verifying the
payment amount, and reconciling it with the corresponding invoice or account.
6. **Bank Deposits:** After verification, the organization deposits the received checks or money
orders into their bank account for clearance. This step ensures that the funds are collected and
made available for use.

7. **Account Updates:** The organization updates the customer's account to reflect the payment
received, marking the invoice as paid. This information is often recorded in accounting software
or systems.

8. **Communication:** Some organizations send acknowledgment letters or receipts to

customers to confirm the receipt and processing of their payments. This provides customers with
a record of their payment for their own records.

9. **Late Payment Handling:** If a customer's payment is received after the due date, the
organization may assess late fees or interest charges, as specified in their payment terms and
conditions.

10. **Record-Keeping:** Proper record-keeping is essential in a mailed payment collection

system. This includes maintaining records of all invoices, payments, and related correspondence.

It's important to note that while mailed payment collection systems are still used by many
organizations, especially for specific types of payments, such as utility bills or rent, they are
becoming less common due to the rise of digital payment methods. Many organizations now
offer online payment options, allowing customers to pay electronically via credit/debit cards,
bank transfers, or digital wallets, which can streamline the payment collection process and
reduce manual handling of physical checks and money orders.

Efficient payment collection systems are crucial for businesses to ensure a steady cash flow and
maintain good customer relations. Organizations often choose a combination of payment
methods to cater to the preferences of their customers and to make the payment process as
convenient as possible.
Other collection systems
In addition to mailed payment collection systems, there are several other methods and systems
that organizations use to collect payments from customers. These methods vary in terms of
convenience, speed, and cost, and organizations often employ a combination of them to
accommodate different customer preferences and streamline the payment collection process.
Here are some other collection systems and methods:

1. **Online Payment Processing:**

- **Credit/Debit Card Payments:** Organizations can set up online payment gateways to

accept credit and debit card payments securely over the internet. Customers can make payments
on the organization's website.

- **Digital Wallets:** Accepting payments through digital wallets like PayPal, Apple Pay,
Google Pay, and others can provide customers with a quick and convenient way to pay online.

- **Bank Transfers:** Organizations can provide bank account details for customers to make
payments via direct bank transfers or electronic funds transfers (EFT).

2. **Automatic Bank Withdrawals (ACH):**

- Organizations can set up automatic withdrawal agreements with customers, allowing them to
deduct payments directly from the customer's bank account on specified dates. This is often used
for recurring payments like subscriptions and loan repayments.

3. **Electronic Funds Transfer (EFT):**

- EFT allows organizations to initiate fund transfers electronically, collecting payments directly
from a customer's bank account with their authorization. This is commonly used for payments
like employee salaries and vendor payments.

4. **Mobile Payments:**
 - Customers can use mobile payment apps to make payments by scanning QR codes, providing
a secure and contactless payment option.

5. **Point of Sale (POS) Systems:**

- Retail businesses often use POS systems to accept payments at physical store locations. These
systems can process payments through cash, credit/debit cards, mobile wallets, and other
methods.

6. **Payment Kiosks:**

- Some organizations deploy payment kiosks in high-traffic areas, allowing customers to make
payments in person using cash, cards, or electronic methods

7. **Interactive Voice Response (IVR) Systems:**

- IVR systems allow customers to make payments or check their account balances over the
phone by following automated prompts and entering payment information using their keypad.

8. **In-Person Payments:**

- Customers can visit the organization's physical location to make payments in cash, check, or
card

9. **Online Payment Portals:**

- Organizations can provide customers with access to online payment portals, where they can
log in and make payments, view invoices, and manage their accounts.

10. **Payment Processing Services:**

- Third-party payment processing services, such as Stripe, Square, and PayPal, offer
businesses convenient and secure ways to accept payments online and in person.

11. **Collection Agencies:**

- In cases of delinquent payments, organizations may engage collection agencies to recover

outstanding debts from customers. Collection agencies specialize in debt collection and follow
legal procedures for debt recovery.

12. **Peer-to-Peer (P2P) Payment Apps:**

 - Customers can use P2P payment apps like Venmo, Zelle, or Cash App to transfer money to
organizations or individuals.

13. **Cryptocurrency Payments:**

- Some forward-thinking organizations accept payments in cryptocurrencies like Bitcoin and

Ethereum.

The choice of payment collection system or method depends on various factors, including the
nature of the business, customer preferences, regulatory requirements, and the organization's
technological capabilities. Many businesses today prioritize offering a range of payment options
to accommodate their customers' preferences and enhance the efficiency of their payment
collection processes.

Cash concentration strategies

Cash concentration strategies are financial tactics employed by businesses and organizations to
efficiently manage and consolidate their cash holdings. These strategies help optimize cash flow,
enhance liquidity management, and reduce the idle cash balance. Cash concentration strategies
are particularly important for larger businesses and those with multiple locations or subsidiaries.
Here are some common cash concentration strategies:

1. **Zero-Balance Accounts (ZBAs):** Zero-balance accounts are used to maintain a zero

balance or a very low balance in subsidiary accounts, such as branch or departmental accounts.
Funds are automatically transferred to or from a master concentration account, typically at the
end of each business day. This strategy reduces idle cash balances in subsidiary accounts while
centralizing funds for better investment or debt reduction opportunities.

2. **Notional Pooling:** Notional pooling is a technique that consolidates account balances for
calculation purposes, such as interest or fees, while maintaining separate physical accounts. The
organization can earn interest on the net balance of all accounts. Notional pooling is often used
to optimize interest income and minimize interest expense.

3. **Physical Cash Concentration:** In this strategy, the organization physically transfers funds
from subsidiary accounts to a central concentration account. This consolidation typically occurs
less frequently than ZBAs, such as weekly or monthly. It's a more manual process but allows for
greater control over cash movements.

4. **Automated Clearing House (ACH) Sweeps:** ACH sweeps automate the movement of
funds between accounts using the ACH network. Funds are typically transferred from subsidiary
accounts to a concentration account or vice versa. ACH sweeps are cost-effective and can be
scheduled at specific intervals, such as daily or weekly.

5. **Sweep Loans:** Some organizations use sweep loans to move excess cash into an
investment account or pay down a line of credit automatically. This strategy maximizes the use
of cash while minimizing interest expense or opportunity cost

6. **Multicurrency Cash Concentration:** For businesses operating internationally,

multicurrency cash concentration involves consolidating funds held in various currencies into a
single currency, often the company's base currency. This strategy helps mitigate foreign
exchange risk and simplifies cash management.

7. **Intercompany Loans or Transfers:** Businesses with multiple subsidiaries or divisions may

use intercompany loans or transfers to centralize cash. This involves lending or transferring
funds from one entity to another within the same organization, ensuring that cash is put to
productive use.

8. **Investment Sweeps:** Investment sweeps automatically move excess cash into interest-
bearing accounts, such as money market funds or short-term investments. This strategy
maximizes the return on idle cash while maintaining liquidity.

9. **Centralized Treasury Management System:** Implementing a centralized treasury

management system allows organizations to monitor and manage cash positions, transactions,
and cash concentration activities more efficiently. These systems provide real-time visibility into
cash flows and can automate many cash concentration processes.

10. **Cash Flow Forecasting:** Effective cash flow forecasting helps organizations anticipate
their cash needs and surpluses, enabling better cash concentration decisions. Accurate forecasts
can help align cash concentration activities with actual requirements.

11. **Risk Management:** Consideration of risk is essential when implementing cash

concentration strategies. Organizations should assess and mitigate risks associated with the
movement of cash, including operational, fraud, and market risks.

These cash concentration strategies can help organizations optimize their cash management,
improve liquidity, and make more informed financial decisions. The choice of strategy depends
on the organization's size, complexity, and financial goals. It's important to work with financial
experts and utilize appropriate technology to implement these strategies effectively while
complying with regulatory requirements.
Disbursement tools
Disbursement tools are financial instruments, methods, or systems that organizations use to make
payments or disburse funds to employees, suppliers, vendors, creditors, and other parties. These
tools are an essential part of financial management and can help organizations streamline their
payment processes, enhance efficiency, and improve cash flow management. Here are some
common disbursement tools:

1. **Checks:** Traditional paper checks remain a widely used method for making payments.
They are typically issued by organizations to pay employees, suppliers, and other entities.
Checks can be handwritten or printed, and they provide a paper trail of payments.

2. **Electronic Funds Transfer (EFT):** EFT is a secure and electronic method for transferring
funds from one bank account to another. It includes various forms of electronic payments, such
as direct deposits, wire transfers, and Automated Clearing House (ACH) transfers. EFT is often
used for employee payroll, supplier payments, and electronic bill payments.

3. **Prepaid Cards:** Organizations can issue prepaid debit cards to employees or vendors,
which can be loaded with a specific amount of funds. These cards are particularly useful for
travel expenses, per diems, and petty cash disbursements.

4. **Online Bill Payment Services:** Many organizations use online banking platforms and bill
payment services to make payments to suppliers and vendors. These services allow for the
electronic transfer of funds, often accompanied by payment scheduling and tracking features.

5. **Corporate Credit Cards:** Corporate credit cards are issued to employees for authorized
business expenses. Organizations can set spending limits and monitor card usage to manage
expenses effectively.

6. **Payment Gateways:** E-commerce businesses often use payment gateways to facilitate

online payments from customers. Payment gateways securely process credit card transactions
and other forms of online payments.
7. **ACH Debit Transactions:** Organizations can use ACH debit transactions to collect
payments directly from customers' bank accounts. This is common for recurring payments such
as utility bills and subscriptions.

8. **Cash Management Services:** Some financial institutions offer cash management services
that help organizations optimize their cash flows. These services may include automated
sweeping of excess funds, concentration of funds from subsidiary accounts, and investment
options.

9. **Mobile Payment Apps:** Mobile payment apps like PayPal, Venmo, and Cash App can be
used for making payments to individuals or businesses, especially in peer-to-peer (P2P) or small-
scale transactions.

10. **Wire Transfers:** Wire transfers are used for transferring funds domestically or
internationally. They are often used for high-value transactions and urgent payments.

11. **Third-Party Payment Processors:** Third-party payment processors like Stripe, Square,
and PayPal enable businesses to accept payments online and in-person. They offer APIs and
payment integration options for e-commerce and digital businesses.

12. **Cryptocurrency Payments:** Some forward-thinking organizations accept payments in

cryptocurrencies like Bitcoin and Ethereum.

13. **Checks via Remote Deposit Capture (RDC):** This technology allows organizations to
scan and deposit checks electronically without visiting a bank branch. It is a more efficient way
to process paper checks.

14. **Corporate Procurement Cards:** These cards are used for making business-related
purchases. They can have specific controls and reporting features to monitor and manage
expenses.
15. **Smart Contracts:** In blockchain and cryptocurrency ecosystems, smart contracts can be
used to automate disbursements based on predefined conditions and rules.

The choice of disbursement tool depends on various factors, including the type of payment, the
size of the organization, the frequency of payments, and security considerations. Organizations
often use a combination of these tools to meet their specific financial disbursement needs and
optimize their payment processes.

Investment in marketable securities, types of

marketable securities
Investing in marketable securities is a common strategy for individuals and organizations looking
to earn a return on their excess cash while maintaining liquidity. Marketable securities are
financial instruments that can be easily bought or sold in the financial markets with the intention
of generating short-term or long-term returns. These securities are considered "marketable"
because they can be readily converted into cash.

Here are some types of marketable securities:

1. **Treasury Bills (T-Bills):** These are short-term debt securities issued by the U.S.
Department of the Treasury with maturities ranging from a few days to one year. T-Bills are
considered one of the safest investments and are often used to park cash temporarily.

2. **Certificates of Deposit (CDs):** CDs are time deposits offered by banks and credit unions
with fixed terms and interest rates. They typically range from a few months to several years.
Early withdrawal may result in penalties.

3. **Commercial Paper:** Commercial paper is a short-term debt instrument issued by

corporations, financial institutions, and other entities to raise capital. It usually matures in less
than one year and is considered relatively safe.
4. **Money Market Funds:** Money market funds invest in a variety of short-term, low-risk
securities, such as T-Bills, CDs, and commercial paper. They offer liquidity and stability and are
a popular choice for cash management.

5. **Corporate Bonds:** Corporate bonds are issued by companies to raise capital. They have
longer maturities than T-Bills and CDs, typically ranging from several years to decades.
Corporate bonds offer higher yields but carry some credit risk.

6. **Municipal Bonds:** Municipal bonds, or "munis," are issued by state and local
governments to finance public projects. They are generally exempt from federal income taxes
and may be exempt from state and local taxes for residents of the issuing state.

7. **Treasury Notes (T-Notes):** Treasury notes are intermediate-term government debt

securities issued by the U.S. Department of the Treasury. They have maturities ranging from 2 to
10 years and pay fixed interest semiannually.

8. **Treasury Bonds (T-Bonds):** Treasury bonds are long-term government debt securities
with maturities of more than 10 years. Like T-Notes, they pay fixed interest semiannually.

9. **Agency Securities:** These are debt securities issued by government-sponsored enterprises

(GSEs), such as Fannie Mae and Freddie Mac. They carry the implicit backing of the U.S.
government and are often considered low-risk investments.

10. **Preferred Stocks:** Preferred stocks are hybrid securities that combine features of both
stocks and bonds. They offer a fixed dividend and are senior to common stock in the event of
liquidation.
11. **Exchange-Traded Funds (ETFs):** ETFs are investment funds that hold a diversified
portfolio of marketable securities, such as stocks, bonds, or commodities. They are traded on
stock exchanges like individual stocks.

12. **Money Market Instruments:** These include instruments like repurchase agreements
(repos) and commercial paper. Money market instruments are short-term, highly liquid, and
often used in cash management.

13. **Foreign Exchange (Forex) Reserves:** Some entities, such as central banks, hold foreign
currencies as part of their reserves. These currencies can be traded to manage exchange rate risk.

14. **Equity Securities:** Marketable equity securities include common stocks of publicly
traded companies. While they are not traditionally considered marketable securities, they can be
easily bought and sold in the secondary market.

Investing in marketable securities allows investors to earn returns on their cash holdings while
maintaining the flexibility to access funds when needed. The choice of marketable securities
depends on an individual's or organization's investment goals, risk tolerance, and time horizon.
It's important to consider factors such as credit risk, interest rate risk, and liquidity when
selecting marketable securities for an investment portfolio.

Forecasting cash flows

Forecasting cash flows is a critical financial management practice for both businesses and
individuals. Cash flow forecasting involves estimating the amount and timing of cash inflows
and outflows over a specific period, typically on a daily, weekly, monthly, or annual basis. This
helps in ensuring that there is enough cash on hand to meet financial obligations and make
informed financial decisions. Here's a step-by-step guide to forecasting cash flows:

**1. Define the Time Horizon:**

- Determine the period for which you want to forecast cash flows. Common timeframes include
monthly, quarterly, or annually. Shorter timeframes may be necessary for more accurate short-
term planning.
**2. Gather Historical Data:**

- Collect historical financial data, including past cash flow statements, income statements, and
balance sheets. This data serves as a starting point for your forecast.

**3. Identify Sources of Cash Inflows:**

- List all potential sources of cash inflows, such as sales revenue, investments, loans, and any
other cash receipts. Be specific and detailed.

**4. Estimate Cash Inflows:**

- For each source of cash inflow, make reasonable projections based on historical trends,
market research, sales forecasts, and other relevant data. Adjust for seasonality and economic
conditions.

**5. Identify Categories of Cash Outflows:**

- Identify categories of cash outflows, including operating expenses, loan payments, inventory
purchases, capital expenditures, and any other expenses or investments.

**6. Estimate Cash Outflows:**

- Estimate the timing and amounts of cash outflows for each category. Be sure to account for
variable and fixed expenses, debt service, and any other financial obligations.

**7. Include Non-Operating Cash Flows:**

- Consider any extraordinary or one-time cash flows, such as asset sales, tax refunds, or legal
settlements, that may impact your cash position during the forecast period.

**8. Analyze Working Capital Changes:**

 - Understand how changes in working capital (e.g., accounts receivable, accounts payable,
inventory) will affect cash flows. A decrease in working capital can release cash, while an
increase may tie up cash.

**9. Account for Seasonality and Economic Factors:**

- Adjust your forecasts for seasonal variations in cash flows and consider the impact of
economic factors, interest rates, and market conditions on your cash position.

**10. Create a Cash Flow Projection:**

- Use spreadsheet software or financial forecasting tools to create a cash flow projection.
Organize cash inflows and outflows by date to visualize your expected cash position over time.

**11. Monitor and Update Regularly:**

- Your cash flow forecast should not be a static document. Continuously monitor actual cash
flows against your projections and make necessary adjustments as conditions change. This
allows for proactive management of cash.

**12. Stress Test the Forecast:**

- Conduct sensitivity analysis to assess how changes in various assumptions (e.g., sales
volume, interest rates, operating costs) impact your cash flow. This helps in identifying potential
risks and mitigating strategies.

**13. Communicate with Stakeholders:**

- Share your cash flow forecasts with key stakeholders, such as business partners, lenders,
investors, and management. Transparency in your financial planning can build trust and support
informed decision-making.

**14. Scenario Planning:**

 - Develop multiple scenarios, including best-case, worst-case, and most likely scenarios. This
can help you prepare for different financial outcomes and make contingency plans.

Cash flow forecasting is a dynamic process that requires continuous attention and adjustment.
Accurate cash flow projections provide a foundation for financial planning, budgeting, and
ensuring that an individual or business has the necessary liquidity to meet obligations, seize
opportunities, and navigate financial challenges effectively.

Methods of financial forecasting

Financial forecasting is the process of estimating a company's future financial performance based
on historical data, current market conditions, and various assumptions. Accurate financial
forecasting is essential for making informed decisions, setting financial goals, and ensuring the
financial stability of a business. There are several methods and techniques for financial
forecasting:

1. **Historical Financial Analysis:**

- This method involves analyzing past financial statements (income statements, balance sheets,
and cash flow statements) to identify trends, patterns, and growth rates. Historical analysis is the
foundation for many other forecasting methods.

2. **Sales Forecasting:**

- Sales forecasting is crucial for revenue projection. It involves estimating future sales based on
historical sales data, market research, industry trends, and sales pipelines. Various techniques,
such as time series analysis and regression analysis, can be used for sales forecasting.

3. **Expense Forecasting:**

- Estimate future operating expenses, including fixed and variable costs. Consider inflation,
cost-saving measures, and the impact of business growth or contraction on expenses.

4. **Cash Flow Forecasting:**

 - Cash flow forecasting focuses on projecting the inflows and outflows of cash over a specific
period. It helps businesses ensure they have enough liquidity to cover their financial obligations.

5. **Budget-Based Forecasting:**

- Create a detailed budget for the upcoming period, including revenue, expenses, and capital
expenditures. The budget serves as a financial forecast and a plan for resource allocation.

6. **Scenario Analysis:**

- Develop multiple scenarios based on different assumptions and variables. This approach
helps in assessing the potential impact of various economic and business conditions on financial
performance.

7. **Driver-Based Forecasting:**

- Identify key drivers or variables that significantly impact financial performance, such as
customer acquisition rates, pricing strategies, or production costs. Forecast these drivers to
project financial outcomes.

8. **Rolling Forecasts:**

- Instead of creating an annual budget or forecast, rolling forecasts involve regularly updating
forecasts for the next few months or quarters. This allows for more agility in adapting to
changing circumstances.

9. **Market Research and External Data:**

- Incorporate market research, industry reports, and external economic data into your forecasts.
These sources can provide valuable insights into market trends and consumer behavior.

10. **Financial Modeling:**

 - Build financial models using spreadsheets or financial modeling software. These models can
incorporate various financial variables and scenarios to project future financial statements and
ratios.

11. **Regression Analysis:**

- Use statistical regression analysis to identify and quantify relationships between financial
variables and historical performance. This method can be particularly useful for sales forecasting
and expense forecasting.

12. **Pro Forma Financial Statements:**

- Create pro forma income statements, balance sheets, and cash flow statements based on
various assumptions. Pro forma statements help in estimating the impact of different business
decisions.

13. **Monte Carlo Simulation:**

- Monte Carlo simulations involve running thousands of random scenarios based on a set of
assumptions. This method provides a range of possible outcomes and probabilities, helping in
risk assessment.

14. **Expert Opinion and Delphi Method:**

- Consult with industry experts or conduct expert opinion surveys using the Delphi method to
gather input and insights for forecasting, especially in areas where data is scarce.

15. **AI and Machine Learning:**

- Advanced technologies like artificial intelligence (AI) and machine learning can analyze
large datasets and identify patterns to improve forecasting accuracy, particularly in complex
scenarios.

16. **Top-Down and Bottom-Up Approaches:**

 - Combine top-down (starting with an overall estimate and breaking it down by segments) and
bottom-up (starting with detailed estimates for each segment) approaches to arrive at a
comprehensive forecast.

Financial forecasting is not a one-size-fits-all process, and organizations may use a combination
of these methods based on their specific needs, industry, and available data. The choice of
method should align with the organization's goals and resources while providing actionable
insights for informed decision-making. Regularly reviewing and adjusting forecasts is crucial to
adapt to changing market conditions and ensure the accuracy of financial projections.

Forecasting daily cash flows

Forecasting daily cash flows is a critical financial management practice, especially for businesses
that require precise cash flow planning to meet daily financial obligations and manage liquidity
effectively. Here's a step-by-step guide to forecasting daily cash flows:

**1. Gather Historical Data:**

- Start by collecting historical daily cash flow data. This data should include daily inflows and
outflows, such as sales receipts, payments to suppliers, payroll, loan repayments, and other cash
transactions. Historical data serves as the foundation for your forecasts.

**2. Identify Sources of Cash Inflows:**

- List all potential sources of daily cash inflows, such as:
- Daily sales revenue
- Collections from accounts receivable
- Loan disbursements
- Investment income
- Any other daily cash receipts

**3. Estimate Daily Cash Inflows:**

- For each source of cash inflow, make reasonable projections based on historical trends, sales
forecasts, customer payment patterns, and other relevant data. Be as specific and accurate as
possible in your estimations.

**4. Identify Categories of Cash Outflows:**

- List categories of daily cash outflows, including:
 - Daily operating expenses (e.g., rent, utilities, salaries)
- Payments to suppliers and vendors
- Interest and loan payments
- Inventory purchases
- Any other daily cash disbursements

**5. Estimate Daily Cash Outflows:**

- Estimate the timing and amounts of daily cash outflows for each category. Take into account
both fixed and variable expenses, loan obligations, and any other financial commitments.

**6. Monitor Working Capital Changes:**

- Understand how changes in working capital, such as accounts receivable collections,
inventory turnover, and accounts payable, affect daily cash flows. A decrease in working capital
can increase cash availability, while an increase may tie up cash.

**7. Consider Seasonal Factors:**

- Adjust your forecasts for seasonal variations that may impact cash flows. Seasonal trends in
sales, expenses, and customer payment behavior should be factored into your daily cash flow
projections.

**8. Assess Economic Factors:**

- Consider the impact of economic conditions, interest rates, and market fluctuations on your
daily cash position. Economic events can influence both cash inflows and outflows.

**9. Create a Daily Cash Flow Projection:**

- Use spreadsheet software or specialized financial forecasting tools to create a daily cash flow
projection. Organize your cash inflows and outflows by date to visualize your expected daily
cash position over time.

**10. Implement a Buffer:**

- To ensure you have a safety net for unexpected expenses or shortfalls, maintain a buffer or
contingency reserve in your daily cash flow projections.

**11. Continuously Monitor and Update:**

- Daily cash flow forecasting is dynamic. Continuously monitor actual cash flows against your
projections and make necessary adjustments as conditions change. This allows for proactive cash
management.
**12. Analyze and Review Daily:**
- Conduct a daily review of your cash flow projections to ensure that you are on track.
Analyze any discrepancies between projected and actual cash flows and take corrective actions
as needed.

**13. Scenario Analysis:**

- Develop multiple scenarios, including best-case, worst-case, and most likely scenarios, to
prepare for different financial outcomes and potential risks.

**14. Communicate Internally:**

- Share daily cash flow projections and updates with key stakeholders, such as management,
finance teams, and anyone responsible for managing cash disbursements and collections.

**15. Use Financial Software:**

- Consider using financial management software or cash flow forecasting tools that can
automate data collection, analysis, and reporting, making the process more efficient and accurate.

Forecasting daily cash flows requires attention to detail, a deep understanding of your
organization's financial operations, and the ability to adapt to changing circumstances. Accurate
daily cash flow projections help businesses maintain liquidity, avoid financial crises, and make
timely financial decisions.

Sources of uncertainly in cash forecasting

Cash forecasting is a critical financial management practice, but it is inherently subject to various
sources of uncertainty. Understanding these sources of uncertainty is essential for creating more
accurate cash flow projections and making informed financial decisions. Here are some common
sources of uncertainty in cash forecasting:

1. **Sales Variability:** The level of uncertainty in sales projections can be significant,

especially for businesses with seasonal or cyclical sales patterns. External factors like market
demand, competition, and economic conditions can all impact sales.

2. **Customer Payment Timing:** The timing of customer payments can vary. Some customers
may pay promptly, while others may delay payments, affecting your cash inflows.
3. **Payment Delays:** Suppliers or vendors may delay sending invoices or extend payment
terms, which can affect your cash outflows. Negotiating payment terms and maintaining good
vendor relationships can help mitigate this uncertainty.

4. **Seasonal Variations:** Businesses that experience seasonal fluctuations in sales may find it
challenging to predict cash flows accurately. Seasonal factors can significantly impact both cash
inflows and outflows.

5. **Economic Factors:** Changes in the broader economy, such as interest rate fluctuations,
inflation, and economic downturns, can impact consumer spending, credit availability, and
business operations, affecting cash flows.

6. **Market Conditions:** Market conditions and competitive dynamics can influence pricing,
product demand, and sales volumes, leading to uncertainty in cash flow projections.

7. **Working Capital Changes:** Changes in working capital components, such as accounts

receivable, accounts payable, and inventory levels, can affect cash flows. For example, a delay in
collecting accounts receivable can tighten cash availability.

8. **Regulatory Changes:** Changes in tax regulations, trade policies, or industry-specific

regulations can impact cash flows by altering expenses or revenues.

9. **Unforeseen Expenses:** Unexpected expenses, such as equipment breakdowns, legal

disputes, or emergency repairs, can strain cash reserves and create uncertainty in cash
forecasting.

10. **Debt Service Obligations:** Loan repayment terms and interest rates can introduce
uncertainty into cash flow projections, particularly if interest rates fluctuate or debt covenants
must be maintained.

11. **Capital Expenditures:** Large capital expenditures or investments can introduce

variability into cash flow projections, especially if the timing of these expenditures is uncertain.

12. **Currency Exchange Rates:** For businesses operating internationally, fluctuations in

exchange rates can impact cash flows when dealing with foreign currencies.

13. **Natural Disasters and Catastrophic Events:** Unexpected events, such as natural disasters,
fires, or public health crises like pandemics, can disrupt business operations, leading to cash flow
uncertainty.
14. **Customer Defaults:** Customers who default on payments can affect cash inflows.
Businesses may need to allocate reserves for bad debt to account for this uncertainty.

15. **Supply Chain Disruptions:** Disruptions in the supply chain, such as delays in receiving
inventory or raw materials, can impact production and, consequently, cash flows.

16. **Tax Liabilities:** Changes in tax liabilities, including tax owed to various government
authorities, can affect cash flows.

17. **Investment Returns:** Returns on investments or cash reserves may not always meet
expectations due to market volatility or changes in investment strategies.

To mitigate the uncertainty associated with cash forecasting, it's essential to regularly review and
update your forecasts, conduct sensitivity analyses to assess the impact of different scenarios,
maintain a contingency reserve, and communicate with stakeholders within your organization.
Additionally, consider using financial modeling and forecasting software to enhance accuracy
and automate the process, especially for complex scenarios.

Hedging cash balances uncertainties

Hedging cash balances is a risk management strategy used by businesses and individuals to
protect against uncertainties and fluctuations in the value of their cash holdings. Hedging helps
ensure that the value of cash remains relatively stable and provides a level of financial security.
Here are some common strategies for hedging cash balances uncertainties:

1. **Interest Rate Hedging:**

- **Fixed-Rate Investments:** Invest a portion of cash in fixed-rate investments, such as

certificates of deposit (CDs) or Treasury bonds. These instruments provide predictable interest
income and help offset fluctuations in cash balances caused by changes in interest rates.

- **Interest Rate Swaps:** For businesses with substantial interest rate risk, interest rate swaps
can be used to exchange variable-rate cash flows for fixed-rate cash flows. This strategy helps
stabilize interest income or expense.
2. **Foreign Exchange Hedging:**

- **Forward Contracts:** If you hold cash in foreign currencies, use forward contracts to lock
in exchange rates for future conversions. This helps protect against adverse currency movements.

- **Currency Options:** Purchase currency options that give you the right, but not the
obligation, to exchange cash at a predetermined exchange rate. This strategy can limit potential
losses due to unfavorable currency fluctuations.

3. **Commodity Price Hedging:**

- **Futures Contracts:** If your cash balances are exposed to commodity price fluctuations
(e.g., due to raw material purchases), consider using futures contracts to lock in prices for future
deliveries.

4. **Derivative Instruments:**

- **Options and Swaps:** Explore the use of financial derivatives like options and swaps to
hedge against various financial risks, including interest rate risk and currency risk.

5. **Diversification:**

- Diversify your cash holdings across different asset classes to spread risk. This can include
investments in stocks, bonds, real estate, and other financial instruments that have historically
shown low correlation with each other.

6. **Liquidity Management:**

- Maintain a well-structured liquidity management strategy that includes various short-term and
long-term investments to ensure that you have access to cash when needed while optimizing
returns.

7. **Contingency Funds:**

- Create contingency funds or emergency reserves to cover unexpected expenses or shortfalls

in cash balances. These funds act as a buffer against uncertainties.

8. **Stress Testing:**

- Conduct stress tests to assess how various adverse scenarios might impact your cash balances.
Use these scenarios to identify potential vulnerabilities and implement hedging strategies
accordingly.
9. **Regular Review and Adjustments:**

- Continuously monitor your cash balances and review your hedging strategies. Be prepared to
adjust your hedges as market conditions change.

10. **Consult with Financial Experts:**

- Seek advice from financial professionals, including investment advisors and risk
management specialists, to help develop and implement effective hedging strategies tailored to
your specific circumstances.

11. **Insurance:**

- Consider insurance policies, such as business interruption insurance, that can provide
financial protection in case of unforeseen events that affect your cash flows.

Hedging cash balances can help protect your financial stability and mitigate risks associated with
market uncertainties. However, it's important to note that hedging strategies come with their own
costs and complexities, and they should be carefully planned and executed to align with your
financial goals and risk tolerance. Consulting with financial experts and staying informed about
market developments are essential components of an effective hedging strategy.

Hedging via interest rate

Hedging via interest rates is a common risk management strategy used by individuals and
businesses to protect themselves against fluctuations in interest rates. Interest rate risk can impact
both the cost of borrowing and the return on investments, making it important to employ hedging
techniques when necessary. Here are some ways to hedge against interest rate risk:

1. **Interest Rate Swaps:**

- An interest rate swap is a financial derivative contract in which two parties agree to exchange
interest rate cash flows. One party typically pays a fixed interest rate, while the other pays a
floating (variable) interest rate, such as the London Interbank Offered Rate (LIBOR). Interest
rate swaps can be used to convert variable-rate debt into fixed-rate debt or vice versa, depending
on your interest rate outlook.

2. **Forward Rate Agreements (FRAs):**

 - FRAs are forward contracts in which two parties agree to an interest rate for a future period.
These contracts allow you to lock in an interest rate today for a future loan or investment,
providing protection against potential rate increases.

3. **Interest Rate Options:**

- Interest rate options, such as interest rate caps, floors, and collars, provide the right but not
the obligation to buy or sell interest rate protection. Caps set a maximum interest rate, while
floors set a minimum rate. Collars involve a combination of both caps and floors.

4. **Fixed-Rate Investments:**

- Investing in fixed-rate securities, such as certificates of deposit (CDs), bonds, or Treasury

securities, can provide predictable interest income and protect your investments from falling
interest rates.

5. **Variable-Rate Investments:**

- Investing in variable-rate securities or money market instruments can provide flexibility and
the potential for higher returns if interest rates rise. However, this strategy can expose you to the
risk of falling rates.

6. **Asset and Liability Management (ALM):**

- For businesses, ALM involves matching the maturity and interest rate characteristics of assets
and liabilities. By aligning the terms of loans and investments, companies can reduce interest rate
risk.

7. **Repricing Strategies:**

- Businesses can structure loans and deposits with repricing periods to minimize the impact of
interest rate fluctuations. For example, loans may reprice annually, while deposits reprice
quarterly.

8. **Floating-Rate Debt:**
 - Instead of incurring fixed-rate debt, consider using floating-rate debt or variable-rate loans.
This can make your financing costs more responsive to changes in interest rates.

9. **Interest Rate Hedges in Investment Portfolios:**

- In investment portfolios, consider incorporating assets that have a negative correlation with
interest rates. For example, bonds tend to rise in value when interest rates fall, potentially
offsetting losses from other interest rate-sensitive investments.

10. **Interest Rate Risk Models:**

- Utilize interest rate risk modeling to assess the impact of different rate scenarios on your
financial position. These models can help you make informed hedging decisions.

11. **Continuous Monitoring and Adjustments:**

- Regularly monitor market conditions and your interest rate hedges. Adjust your hedging
strategies as needed to align with your goals and outlook.

12. **Consultation with Financial Advisors:**

- Work with financial advisors, including treasury and risk management experts, to develop
and implement effective interest rate hedging strategies tailored to your specific financial
situation.

It's important to note that while interest rate hedging can help mitigate risks, it also involves
costs and complexities. Businesses and individuals should carefully evaluate the benefits and
trade-offs of various hedging instruments and strategies and seek expert advice when necessary
to make informed decisions. Additionally, interest rate markets and regulations may evolve,
requiring ongoing adjustments to your hedging approach.

Baumol Model
The Baumol Model, also known as the Baumol-Tobin Model, is an economic theory and cash
management model developed by economists William J. Baumol and James Tobin in the 1950s.
This model is used to determine the optimal cash balance that minimizes the total cost of holding
cash while meeting a company's transactional cash needs. It is particularly relevant for
businesses and organizations that need to manage their cash balances efficiently.

The Baumol Model is based on two main cost components associated with holding cash:

1. **Transaction Costs (Ct):** These costs are incurred when a company converts non-cash
assets (such as investments) into cash to meet day-to-day operational expenses. Transaction costs
can include fees, time spent managing cash, and potential losses from selling investments.

2. **Opportunity Costs (Co):** Opportunity costs represent the potential earnings foregone by
holding cash rather than investing it in interest-bearing assets. These costs are a function of the
interest rate that could be earned on alternative investments.

The objective of the Baumol Model is to find the optimal cash balance (B) that minimizes the
total cost of holding cash (TC) while meeting the company's cash needs:

TC = Ct + Co

To find the optimal cash balance (B), the model uses the following formula:

B* = sqrt((2 * T * Co) / Ct)

Where:

- B* = Optimal cash balance

- T = Total cash needed over a period (e.g., a month or a year)

- Ct = Transaction cost per cash conversion

- Co = Opportunity cost per unit of cash per period (usually the interest rate)
Key concepts and assumptions of the Baumol Model:

1. **Constant Cash Needs:** The model assumes that a company has constant, predictable cash
needs over time.

2. **Fixed Transaction Costs:** Transaction costs are assumed to remain constant, regardless of
the cash balance.

3. **Fixed Opportunity Costs:** Opportunity costs are based on a constant interest rate for
alternative investments.

4. **Safety Buffer:** The model typically recommends a cash balance slightly higher than the
calculated optimal balance to account for unexpected fluctuations in cash needs.

5. **Cash Management Period:** The model considers a specific time period for cash
management, such as a month or a year.

6. **Simple and Practical:** The Baumol Model is relatively simple to apply and provides a
practical method for determining cash balances.

It's important to note that while the Baumol Model is a useful tool for managing cash balances
efficiently, it makes certain simplifying assumptions that may not always hold in real-world
situations. Businesses should consider their unique circumstances, cash flow patterns, and risk
tolerance when using the model as a guide for cash management decisions. Additionally, the
model assumes a constant interest rate, which may not reflect the dynamic nature of financial
markets.

Miller-Orr Model
The Miller-Orr Model is a cash management model developed by economists Merton H. Miller
and Daniel Orr in 1966. This model is designed to help organizations determine their optimal
cash balance, specifically for managing cash when there is a need to minimize transaction costs
while maintaining a buffer to handle unexpected fluctuations in cash flows. The Miller-Orr
Model is particularly useful for businesses and financial managers seeking to strike a balance
between cash liquidity and cost efficiency.

Key features and concepts of the Miller-Orr Model:

1. **Target Cash Balance (Z):** The model identifies a target cash balance, represented as "Z,"
which serves as the optimal level of cash to maintain. Z is determined based on transaction costs
and the desire to have a buffer to absorb cash fluctuations.

2. **Upper Limit (U) and Lower Limit (L):** In addition to the target cash balance Z, the model
calculates upper (U) and lower (L) control limits. These limits define the boundaries within
which cash balances should fluctuate before triggering cash management actions.

3. **Transaction Costs (C):** Transaction costs include the expenses associated with converting
non-cash assets (such as marketable securities) into cash or vice versa. These costs typically
encompass brokerage fees, transfer costs, and other expenses.

4. **Cost Efficiency:** The Miller-Orr Model aims to strike a balance between the cost of
holding excess cash and the cost of making frequent transactions to replenish cash reserves.

The formula for calculating the target cash balance (Z), upper limit (U), and lower limit (L) in
the Miller-Orr Model is as follows:

- Z = 3 * C * √(T/M)

Where:

- Z = Target cash balance

- C = Transaction cost per cash conversion

- T = Total variability of cash flows (e.g., standard deviation of daily cash flows)

- M = Opportunity cost per unit of cash per period (usually the interest rate)

To calculate the upper limit (U) and lower limit (L), you can use the following formulas:

- U = Z + 3/4 * C * √(T/M)

- L = Z - 3/4 * C * √(T/M)

Cash management decisions based on the Miller-Orr Model typically involve the following
actions:

- If the actual cash balance reaches the upper limit (U), the excess cash should be invested in
interest-bearing assets or marketable securities to bring the cash balance back to the target (Z).

- If the cash balance falls to the lower limit (L), it is advisable to replenish cash reserves by
converting marketable securities or other non-cash assets into cash.

The Miller-Orr Model is a valuable tool for optimizing cash management, particularly for
businesses with fluctuating cash flows. However, it is essential to recognize that the model's
assumptions may not always align perfectly with real-world conditions. Factors such as interest
rate fluctuations, changes in transaction costs, and shifts in cash flow patterns can impact the
effectiveness of the model. Therefore, businesses should use the Miller-Orr Model as a guideline
while considering their specific circumstances and risk tolerance.

Stone Model
It is also a cash management model that might not be as popular as the other two. The stone
model works similarly to the Miller-Orr model in terms of limits. However, unlike the previous
model, the stone model works on forecasting cash flows when hitting upper or lower limits
occurs. Instead of adding or drawing cash, it is analyzed if the cash corrects itself in the coming
days. For instance, the cash might be hitting a lower limit at a given time. However, there is the
expectation of cash inflow for the accounts receivables in 3 days. So, the model works on
forecasting whenever cash limits reach.
 UNIT 4
Receivable Management

Receivable Management: Meaning, Objectives,

Importance.

Receivable Management Meaning:

Receivables are all the amounts a company is supposed to receive for the invoice
raised for the products sold or services given.

It is the amount a company owes to its customers for the products or services given.
The company gives their products or services on the basis of credit and getting the
payments done before the due date can happen through proper receivables
management.

What are the main objectives of receivable

management?
Proper receivables management is very important for business organizations to improve
their finances.

Here are some important objectives of receivable management:

1. Timely collection of payment

The primary objective of accounts receivables management is to ensure the timely

collection of outstanding payments from customers.

This involves setting clear payment terms, sending invoices promptly, and following up
on overdue payments to minimize delays in cash inflow. It will help to bring timely
payments to the organization.
2. Minimize bad debts

Another objective is to minimize bad debts or uncollectible accounts. This can be

achieved by conducting proper credit assessments before extending credit to
customers, establishing credit limits, and implementing effective collection strategies to
reduce the risk of default.

Receivable management importance can be easily reflected as it gives a better

understanding of the customers.

3. Optimize cash flow

Managing accounts receivables effectively help optimize cash flow within an

organization. By reducing the average collection period (the time it takes to convert
receivables into cash), a company can free up cash for immediate use in meeting its
own financial obligations or reinvesting in the business.

4. Improve working capital management

Effective accounts receivables management contributes to efficient working capital

management. By reducing the amount of tied-up capital in accounts receivables, a
company can improve its liquidity position, fund operational expenses, and invest in
growth opportunities.

5. Enhance customer relationships

While managing accounts receivable, it is important to maintain good relationships with

customers. The objective is to balance the collection efforts with maintaining positive
customer experiences.

By providing excellent customer service, addressing customer inquiries and concerns

promptly, and offering flexible payment options, customer relationships can be
strengthened.

6. Optimize working capital

Accounts receivable management contributes to optimizing working capital, which is the

capital required to fund a company’s day-to-day operations.

By efficiently managing receivables and minimizing the cash tied up in unpaid invoices,
working capital can be optimized, allowing the business to invest in growth opportunities
or meet its financial obligations giving significant receivable management importance.
7. Improve financial reporting

Effective accounts receivable management ensures accurate and timely reporting of

accounts receivable balances.

Costs of Receivables Management:

Receivables management is the process of effectively managing a company's accounts

receivable, which refers to the money owed to the company by its customers or clients. Effective
receivables management is essential for maintaining a healthy cash flow and minimizing the risk
of bad debts. Here are some of the key aspects, including costs, benefits, and credit policies
associated with receivables management:

1. Costs of Receivables Management:

a. Administrative Costs: These include the expenses associated with managing accounts
receivable, such as employee salaries, software, and office supplies.

b. Opportunity Costs: Money tied up in accounts receivable is not available for other business
investments, potentially leading to missed opportunities.

c. Bad Debt Costs: If customers do not pay their invoices, it can result in bad debts, leading to
a financial loss.

Benefits of Receivables Management:

a. Improved Cash Flow: Efficient receivables management helps accelerate cash collection,
ensuring a steady flow of funds for operating expenses and investments.

b. Reduced Bad Debts: Effective credit policies and monitoring can help minimize the risk of
non-payment, reducing bad debt expenses.
 c. Stronger Customer Relationships: A well-managed receivables process can lead to better
customer satisfaction and long-term relationships.

d. Competitive Advantage: Managing receivables effectively can give a company a

competitive edge by offering better credit terms and improving relationships with suppliers and
creditors.

Credit Policies in Receivables Management:

a. Credit Evaluation: Establish criteria for evaluating a customer's creditworthiness, including

financial statements, credit reports, and payment history.

b. Credit Terms: Define the terms under which credit will be extended, including payment
periods, interest rates, and late payment penalties.

c. Credit Limits: Set credit limits for individual customers or businesses based on their
financial stability and risk factors.

d. Monitoring and Collections: Regularly review customer accounts to ensure they are in
compliance with credit terms. Implement a system for collections, which may involve reminders,
warnings, and ultimately, legal action if necessary.

e. Cash Discounts: Offer discounts for early payments to encourage customers to settle their
invoices promptly.

4. Technology and Software: Implementing accounting and customer relationship management

(CRM) software can streamline receivables management, making it more efficient and accurate.

5. Legal and Regulatory Compliance: Ensure that your credit policies and debt collection
practices comply with local and national laws and regulations, such as the Fair Debt Collection
Practices Act in the United States.

Effective receivables management involves striking a balance between offering favorable credit
terms to customers and minimizing the risk of non-payment. Companies must tailor their
approach to receivables management to their specific industry, customer base, and financial
goals, while also taking into account the associated costs and benefits.
Evaluation of credit applicants under Receivable
Management

Evaluating credit applicants is a crucial part of receivables management to minimize the risk of
extending credit to customers who may default on their payments. The evaluation process
typically involves assessing the creditworthiness of the applicant. Here are some key steps and
factors to consider when evaluating credit applicants under receivables management:

1. Application Form: Have a standardized credit application form that requires detailed
information from the applicant, including their legal name, contact information, business or
personal financial statements, tax identification number, and references.

2. Credit Report: Pull the applicant's credit report from a reputable credit reporting agency to
assess their credit history, payment history, outstanding debts, and any past delinquencies. This
can provide valuable insights into their financial stability and creditworthiness.

3. Financial Statements: Request financial statements from the applicant, which may include
income statements, balance sheets, and cash flow statements for businesses. For individuals, this
may include personal income statements and balance sheets.

4. Credit References: Contact the applicant's references to verify their creditworthiness and
payment history with other suppliers or creditors.

5. Credit Scoring Models: Use credit scoring models to assign a numerical score to each
applicant based on their financial data and credit history. Lenders often have their proprietary
scoring models, but there are also widely recognized models like FICO for individuals.
6. Risk Analysis: Conduct a thorough risk analysis based on the information gathered. Consider
the applicant's financial stability, industry trends, market conditions, and any external factors that
may impact their ability to repay the debt.

7. Collateral: Determine if the applicant can provide collateral, such as assets or property, to
secure the credit. Collateral can reduce the risk associated with credit extension.

8. Industry Research: Consider the applicant's industry and its overall health. Some industries are
more prone to economic downturns, which may impact their ability to pay.

9. Payment Terms: Decide on appropriate credit terms, including credit limit, interest rates, and
repayment schedules. These should be tailored to the applicant's creditworthiness.

10. Legal and Regulatory Compliance: Ensure that your credit evaluation process complies with
all relevant laws and regulations, including anti-discrimination laws.

11. Review Process: Establish a clear review process to periodically reevaluate the
creditworthiness of existing customers. Regular reviews help identify any emerging credit risks.

12. Document the Evaluation: Keep detailed records of the credit evaluation process, including
application forms, credit reports, financial statements, and communication with references. This
documentation can be invaluable if disputes or collection efforts become necessary.

13. Approval or Rejection: Based on the evaluation, make an informed decision to approve or
reject the credit application. If approved, communicate the credit terms to the applicant in a
formal agreement.

14. Continuous Monitoring: Continuously monitor the credit performance of customers with
outstanding balances to identify early warning signs of potential issues. This includes keeping an
eye on payment behavior and financial stability.
Effective credit evaluation is essential for responsible receivables management, as it helps
protect your company from financial losses due to bad debts. It also allows you to extend credit
to those who are most likely to pay on time, fostering strong customer relationships and
supporting your business's cash flow.

Credit terms and collections under Account Receivables

Credit terms and collections are critical aspects of accounts receivables management. They
define the conditions under which credit is extended to customers and the process for collecting
payments when they become due. Effective credit terms and collections policies are essential for
maintaining a healthy cash flow and minimizing bad debt. Here's an overview of credit terms and
collections in accounts receivables management:

1. Credit Terms:

Credit terms refer to the specific conditions under which a company extends credit to its
customers. These terms outline the terms of payment and the obligations of both the seller (your
company) and the buyer (the customer). Common components of credit terms include:

a. Payment Period: Specify the length of time customers have to pay their invoices. Common
terms include "net 30" (payment due within 30 days), "net 60," or "net 90."

b. Discounts: Offer early payment discounts (e.g., 2% discount if paid within 10 days) to
incentivize customers to settle their invoices promptly.

c. Interest Charges: If customers fail to pay within the specified time frame, you can impose
interest or late payment charges on the outstanding balance.
 d. Credit Limit: Set a maximum credit limit for each customer, beyond which they cannot
make additional purchases until their outstanding balance is paid.

e. Payment Methods: Specify acceptable payment methods, such as checks, credit cards,
electronic funds transfer, or other options.

2. Collections Process:

The collections process involves actions taken by the company to collect overdue payments.
Here's how to handle collections effectively:

a. Reminder Notices: Send polite reminder notices to customers as their payment due dates
approach. These notices should be clear about the amount due and the due date.

b. Follow-Up Calls: Make friendly but firm follow-up calls to customers who have not paid by
the due date. Inquire about the reason for the delay and offer assistance if necessary.

c. Collection Letters: Send formal collection letters if the customer remains delinquent. These
letters should become progressively more assertive as the situation escalates.

d. Escalation: If the customer still does not pay, escalate the matter to more senior personnel
within your organization or consider involving a collections agency.

e. Legal Action: As a last resort, take legal action to recover the outstanding debt. This may
involve filing a lawsuit, obtaining a judgment, or seeking assistance from a collection attorney.

f. Negotiation: Be open to negotiating payment arrangements with customers who may be

experiencing financial difficulties. This can help recover at least a portion of the outstanding
amount.
 g. Credit Hold: For repeat delinquent customers, consider placing them on credit hold, meaning
you do not extend further credit until they settle their outstanding debts.

3. Collection Software: Invest in collections software or customer relationship management

(CRM) software that can help automate and streamline the collections process, making it more
efficient and organized.

4. Compliance: Ensure that your collections practices adhere to relevant laws and regulations,
such as the Fair Debt Collection Practices Act in the United States.

5. Documentation: Maintain thorough records of all interactions with delinquent customers,

including copies of invoices, communications, and payment history.

Balancing effective credit terms and collections processes is crucial for managing accounts
receivables. It helps maintain a positive cash flow, reduces the risk of bad debt, and supports
healthy customer relationships.

How to improve your accounts receivable collections

While collecting on past due invoices is always a priority for most companies, it needs to be
done strategically. Ignoring the accounts receivable (AR) process can significantly reduce your
cash flow and hurt your company’s bottom line. Improving your accounts receivable collections
is not just about getting more money in the bank but also about improving customer relations.

There are many ways in which you can improve your accounts receivable collections including:

Research your cash flow history.

The first step is to look at your cash flow and identify the time period that has the highest
percentage of invoices that are beyond their terms. Using this information, you can then
determine whether an increase in collection efforts will help you improve your accounts
receivable collections and maximize profits.

Optimize your sales process.

One way is by properly managing the sales process and ensuring that your invoices reflect the
agreed payment terms and conditions between parties. You can also set up a system that will
automatically remind clients of their bills and send reminders for payment options.

Optimize payment options.

A great way to increase payment compliance is to make it easier for customers to pay. You can
do this by allowing customers to pay on your website, over the phone or through email invoices.

Offer past-due balance discounts and webinars.

Offer past-due balance discounts to incentivize consumers to pay off their balances early. You
can also offer webinars with experts who have studied the effects of debt on people's financial
lives to help them better understand how paying off debts can improve their financial situation in
the long term. Consider further incentivizing customers by offering them a discount or reward
for signing up for a webinar.

Use an automated AR workflow management software/solution.

Automated payments are the best way to increase compliance as paying paper invoices is
always a time-consuming process. This is because customers have to find your invoice, write a
check, and mail it in. Now with invoice automation software, customers can pay invoices from
anywhere. This eliminates the need to wait for the mailman or drive to the bank. Consider an AR
workflow management software or adopt an AR automation solution. These will help you track
balances and better monitor when customers need to pay their invoices, creating an optimal
accounts receivable management system for your business.

Formula for Average Collection Period

Average collection period is calculated by dividing a company's average accounts
receivable balance by its net credit sales for a specific period, then multiplying the
quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net

Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the
number of days of a period divided by the receivables turnover ratio . The formula below
is also used referred to as the days sales receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is simply the average accounts receivable balance
divided by net credit sales
Inventory Management

What Is Inventory Management?

Inventory management helps companies identify which and how much stock to
order at what time. It tracks inventory from purchase to the sale of goods. The
practice identifies and responds to trends to ensure there’s always enough stock to
fulfill customer orders and proper warning of a shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although

reported as an asset on the balance sheet) ties up cash. Therefore, too much stock
costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An

accounting measurement, inventory turnover reflects how often stock is sold in a
period. A business does not want more stock than sales. Poor inventory turnover
can lead to deadstock, or unsold stock.

Why Is Inventory Management Important?

Inventory management is vital to a company’s health because it helps make sure

there is rarely too much or too little stock on hand, limiting the risk of stockouts
and inaccurate records.

Public companies must track inventory as a requirement for compliance with

Securities and Exchange Commission (SEC) rules and the Sarbanes-Oxley (SOX)
Act. Companies must document their management processes to prove compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re able to
fulfill incoming or open orders and raises profits. Inventory management also:

 Saves Money:
Understanding stock trends means you see how much of and where you have
 something in stock so you’re better able to use the stock you have. This also
allows you to keep less stock at each location (store, warehouse), as you’re
able to pull from anywhere to fulfill orders — all of this decreases costs tied
up in inventory and decreases the amount of stock that goes unsold before
it’s obsolete.

 Improves Cash Flow:

With proper inventory management, you spend money on inventory that
sells, so cash is always moving through the business.

 Satisfies Customers:
One element of developing loyal customers is ensuring they receive the
items they want without waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much inventory
and not being able to sell it, not having enough inventory to fulfill orders, and not
understanding what items you have in inventory and where they’re located. Other
obstacles include:

 Getting Accurate Stock Details:

If you don’t have accurate stock details,there’s no way to know when to
refill stock or which stock moves well.

 Poor Processes:
Outdated or manual processes can make work error-prone and slow down
operations.

 Changing Customer Demand:

Customer tastes and needs change constantly. If your system can’t track
trends, how will you know when their preferences change and why?

 Using Warehouse Space Well:

Staff wastes time if like products are hard to locate. Mastering inventory
management can help eliminate this challenge.
What Is Inventory?

Inventory is the raw materials, components and finished goods a company sells or
uses in production. Accounting considers inventory an asset. Accountants use the
information about stock levels to record the correct valuations on the balance sheet.

Inventory vs. Stock

Inventory is often called stock in retail businesses: Managers frequently use the
term “stock on hand” to refer to products like apparel and housewares. Across
industries, “inventory” more broadly refers to stored sales goods and raw materials
and parts used in production.

Some people also say that the word “stock” is used more commonly in the U.K. to
refer to inventory. While there is a difference between the two, the terms inventory
and stock are often interchangeable.

What Are the Different Types of Inventory?

There are 12 different types of inventory: raw materials, work-in-progress (WIP),

finished goods, decoupling inventory, safety stock, packing materials, cycle
inventory, service inventory, transit, theoretical, excess and maintenance, repair
and operations (MRO). Some people do not recognize MRO as a type of inventory.

Inventory Management Process

If you produce on demand, the inventory management process starts when a

company receives a customer order and continues until the order ships. Otherwise,
the process begins when you forecast your demand and then place POs for the
required raw materials or components. Other parts of the process include analyzing
sales trends and organizing the storage of products in warehouses.

How Inventory Management Works

The goal of inventory management is to understand stock levels and stock’s

location in warehouses. Inventory management software tracks the flow of
products from supplier through the production process to the customer. In the
warehouse, inventory management tracks stock receipt, picking, packing and
shipping.

Inventory management techniques

If you are establishing a new inventory management process or looking to improve your existing
one, here are seven inventory management techniques that you may find helpful.

1. FIFO vs. LIFO

First in, first out (FIFO) and last in, first out (LIFO) are accounting methods (also known as
“costing”) based on how products move through your warehouse.

FIFO is a useful system for businesses that sell the oldest inventory first. If it was first into the
warehouse, it should also be first out the door when someone orders that product. This keeps
inventory as fresh as possible, which is essential for perishable or expiring goods.

LIFO is the opposite of FIFO, ensuring that the most recently received inventory is the first out
the door. FIFO is the default costing method, but LIFO makes sense for businesses that don’t
ship perishable goods, because the way this accounting method reports income has potential tax
advantages.

2. Demand forecasting

Demand forecasting (or sales projections) helps you understand how much of each product you
need to have on hand at all times to meet customer demand.

For established businesses, demand forecasting should be based on historical sales data. Newer
businesses might need to rely on assumptions and industry data until they have a sales history of
their own.

Demand forecasting is essential to inventory management because it helps you determine the
minimum amount of a product you should have on hand and set reorder targets when you reach
that number. You should revisit your demand forecast quarterly to adjust your minimum
quantities and reordering targets.

3. Minimum order quantity vs. economic order quantity

Minimum order quantity (MOQ) and economic order quantity (EOQ) are two methods a
business can use to determine when to reorder products.
MOQ focuses on maintaining the minimum possible amount of each product type a seller is
willing to fulfill. High-ticket items tend to have a lower MOQ, while low-cost items often have a
higher MOQ. It is important to take this into account when reordering products from suppliers;
consider a supplier’s MOQ for a particular product against your own sales projections.

The EOQ method is more common for manufacturers, which have to account for variable costs
like raw materials, production and fluctuating demand. It is designed for companies to keep costs
down by purchasing the greatest amount possible of multiple product units to minimize the need
to reorder items individually.

4. ABC analysis

An ABC analysis helps you understand which products are most profitable and which are most
costly. As the name suggests, it breaks products down into three categories:

 A: These products are the most valuable and cost the least to store long term. These
products contribute greatly to a business’s profitability.
 B: These are midrange products that are important sales to make, but not as big tickets
as products in the A category.
 C: These tend to be small-ticket items with high turnover. Individual sales of these
products are not as important to a business as items in the A or B categories, but high
volumes of C product sales are critical to profitability.

5. Safety stock inventory

Safety stock inventory is tied to your sales projections and influences your reorder quantities. It
is especially important for your bestselling or essential products.

Safety stock is the extra inventory you order beyond your expected demand. While over-ordering
is never advisable, it is useful to have a few more units than you expect you’ll need, especially if
you anticipate that item will continue to be a hot seller.

6. Dropshipping

Dropshipping is the process of receiving an order from a customer and having your supplier ship
the products directly to the customer. This cuts out the need for a storage facility or for keeping
any inventory on hand. It is best reserved for rare orders or items you cannot accommodate in
your warehouse, because it means your customer’s satisfaction is in the hands of your supplier
rather than your own business.

7. Cross-docking

Cross-docking is a method that prioritizes efficiency. A delivery truck will unload at your
facility, directly into trucks shipping your sales out to customers. This eliminates the need to
bring new items into your storage facility and bypasses your inventory management process.
Instead, the items go right out as you receive them. This method is best for items planned for
“just in time” shipping.

How to improve your inventory management process

Here are several policies you should put in place to ensure the efficient and accurate
management of your inventory.

1. Project accurate sales numbers.

The amount of inventory you keep on hand is directly related to how much you expect to sell and
how quickly.

For new businesses, projections might be a challenge. Glean whatever data you can find online
to establish a projected baseline, then adjust your expectations every 90 days based on real data.

If you’re an established business, use your sales history and growth projections to determine how
much inventory you should always have in stock and when you need to reorder each piece. Pay
special attention to your bestselling items.

2. Appoint a warehouse manager.

A warehouse manager oversees the daily operations of a warehouse and ensures all on-site
workers are regularly updating software systems and adhering to company policy. This includes
scanning products in and out of the correct locations when they arrive for delivery, when moving
products from one place in the warehouse to another and when they go out for delivery to a
customer. The warehouse manager also ensures quality assurance checks and regular inventory
audits are performed as planned.

3. Establish regular inventory cycle counts.

While inventory is sitting in storage, it is important to regularly take stock of the products you
have on hand. Without a recurring cyclical inventory process in place, Ali said, businesses could
lose 2 percent to 10 percent of their product to loss or theft each year. Regular inventory auditing
is critical to keep the percentage of vanished goods as low as possible.

4. Implement a tracking system.

Tracking can be done manually, but today it is far more effective to use an inventory
management system. This type of sophisticated software can help you automatically update your
inventory in real time by scanning items and locations around your storage facility.

For example, Singletary said, when 10 items are delivered, you’d scan them at the loading bay
door. The system updates to acknowledge these 10 items are waiting for pickup. When a worker
moves those items from the loading bay to Aisle 1, Bin 13, for example, they scan the items in,
and the system automatically updates. These scans should be performed every time a product is
moved. Then, the warehouse manager can reference the software to understand precisely where
everything should be in the warehouse and verify the accuracy of that information.

These are the bones of an inventory management process. Your exact process should be
influenced heavily by the unique circumstances of your business. For instance, manufacturers
often have raw materials and goods to account for as well, so this consideration should be central
to the development of their inventory management processes

Inventory Control
What is Inventory Control?

Inventory control is the practice of maintaining enough inventory and assets to keep
your business running smoothly. Good inventory control means keeping the “just right”
balance of inventory; you want to make sure you have enough inventory in stock
so that you can keep customers happy, but you don’t want to waste money
ordering inventory that might not sell. Inventory control helps your business
maintain the right amount of inventory while reducing costs.
Accurate inventory control provides important information about your business that you
don’t want to “ballpark.” You can find out which products are selling and which ones
aren’t, which items you need to have in stock, and specifically how much is needed.

What are the three most common inventory control models?

Three of the most popular inventory control models are Economic Order Quantity
(EOQ), Inventory Production Quantity, and ABC Analysis.
Each inventory model has a different approach to help you know how much inventory
you should have in stock. Which one you decide to use depends on your business.

Economic Order Quantity (EOQ)

The Economic Order Quantity inventory management method is one of the oldest and
most popular. EOQ lets you know the number of inventory units you should order to
reduce costs based on your company holding costs, ordering costs, and rate
of demand.
Here’s how to calculate your EOQ:

Take the square root of (2SD) / Production Cost

S is your setup (order) costs
D is your demand rate (units)
But the EOQ makes some big assumptions that won’t work for every company. It
assumes your rate of demand, ordering costs, and unit price of inventory is constant. So
if you tend to have periods of time where the demand for your products is a lot lower or
higher than other periods, the EOQ number will be meaningless.

Inventory Production Quantity

Also known as Economic Production Quantity, or EPQ, this inventory control model tells
you the number of products your business should order in a single batch, in hopes of
reducing holding costs and setup costs. It assumes that each order is delivered by your
supplier in parts to your business, rather than in one full product.
This model is an extension of the EOQ model. The difference between the two models
is the EOQ model assumes suppliers are delivering inventory in full to your customer or
business.
Here’s how to calculate your Inventory Production Quantity:

Take the square root of (2SD) / Production Cost (1 – x)

S is your setup (order) costs
D is your demand rate (units)
X is your Demand Rate / Production Rate
This model could be a good fit for your business if:
 Your business tends to order inventory from suppliers in parts rather
than one full order, such as for an automotive company.
 Demand for products is consistent over periods of time.

ABC Analysis

The more money specific inventory brings you, the more important it is to you. ABC
analysis categorizes your inventory based on levels of importance. By knowing which
inventory is the most important, you know where to focus your attention. To be most
effective, ABC Analysis is frequently used with other inventory management strategies,
such as the Just in Time method.
Inventory is categorized into either group A, B or C. So how do you know which
category to put inventory under? It’s based on the 80/20 rule, also known as the Pareto
Principle.

Inventory control responsibility

Inventory control is a critical function within businesses, and it involves managing a
company's inventory to ensure efficient operations and profitability. Responsibility for
inventory control typically falls on specific roles within an organization, and these
responsibilities can vary based on the company's size, industry, and structure. Here are
some key responsibilities associated with inventory control:

1. **Inventory Manager or Director:** This individual is typically in charge of

the overall inventory management strategy. Their responsibilities include setting
inventory policies, optimizing inventory levels, and ensuring that inventory turnover is
efficient.

2. **Purchasing Manager or Buyer:** The purchasing manager or buyer is

responsible for procuring inventory, ensuring that it is ordered in the right quantities, and
at the right time. They need to maintain relationships with suppliers, negotiate prices, and
evaluate the quality of goods received.

3. **Warehouse and Logistics Manager:** This role is responsible for the

physical storage and movement of inventory. They need to ensure that items are stored
correctly, that there's a system for tracking items, and that items are picked, packed, and
shipped efficiently.

4. **Inventory Analyst:** Inventory analysts are often responsible for monitoring

and analyzing inventory data. They use tools and software to forecast demand, track
stock levels, and generate reports to assist in decision-making.

5. **Accounting and Finance Teams:** These teams have responsibility for

tracking the financial aspects of inventory, including valuing inventory, reconciling
inventory counts, and managing the cost of goods sold (COGS).

6. **Sales and Marketing Teams:** While not directly responsible for inventory
control, sales and marketing teams play a crucial role in influencing demand. They need
to provide accurate sales forecasts and collaborate with inventory management to ensure
the right products are available.

7. **Quality Control and Inspection:** In industries where product quality is

essential, quality control and inspection teams are responsible for ensuring that inventory
items meet quality standards before they are accepted into stock.

8. **IT and Software Teams:** These teams are responsible for implementing
and maintaining inventory management software, barcoding systems, and other
technologies that help streamline inventory control processes.
 9. **Compliance and Regulatory Teams:** In industries subject to strict
regulations, there may be teams responsible for ensuring that inventory management
practices comply with all relevant laws and regulations.

10. **Cross-Functional Teams:** Inventory control often requires collaboration

among various departments to address issues like slow-moving or obsolete stock,
stockouts, and other challenges. Cross-functional teams may be formed to address these
issues.

Responsibility for inventory control is distributed across various roles and

departments, with the goal of achieving efficient inventory levels, reducing carrying
costs, preventing stockouts, and ensuring that the right products are available to meet
customer demand while maximizing profitability. The specific structure and
responsibilities within an organization can vary widely, but the overarching goal is to
manage inventory effectively to support the company's overall business objectives.

Inventory control other devices

When it comes to inventory control, there are various devices and technologies that can be
employed to streamline and enhance the management of inventory. These devices help with
tracking, monitoring, and managing inventory efficiently. Here are some of the common devices
and technologies used for inventory control:

1. **Barcode Scanners:** Barcode scanners are handheld devices that can read barcodes on
products or packaging. They are used to quickly and accurately input item information into an
inventory management system, allowing for easy tracking of items and reducing data entry
errors.

2. **RFID (Radio-Frequency Identification) Technology:** RFID tags and readers use radio
waves to identify and track items. They provide real-time data on the location and movement of
inventory, making them particularly useful for high-value items and industries with complex
supply chains.

3. **Mobile Devices:** Smartphones and tablets can be equipped with inventory management
apps or software. Warehouse staff and managers can use these mobile devices to perform tasks
like checking inventory levels, receiving shipments, and updating stock records on the go.

4. **POS Systems (Point of Sale):** Retail businesses often use POS systems to track sales and
inventory levels in real-time. These systems automatically update inventory as products are sold,
helping businesses maintain accurate stock levels.

5. **IoT (Internet of Things) Sensors:** IoT sensors can be placed on inventory shelves, storage
areas, and products to monitor environmental conditions (e.g., temperature, humidity) and alert
staff to potential issues that could affect inventory quality.

6. **Inventory Management Software:** Inventory control software provides a centralized

platform for tracking and managing inventory. These software solutions can integrate with other
business systems, automate reordering, and generate reports to help with decision-making.

7. **Handheld Inventory Counting Devices:** These specialized devices are designed for
conducting physical inventory counts. They often have features like batch scanning, wireless
connectivity, and durable construction for use in warehouse environments.

8. **Drones and Robots:** Some large warehouses and distribution centers use drones and
robots to perform inventory audits and stock checks. These automated devices can efficiently
navigate large spaces and provide real-time data.

9. **POS Barcode Printers:** These devices allow businesses to generate their own barcode
labels for products and packaging. They can be especially useful for labeling items that don't
come with pre-printed barodes.
10. **Telematics Systems:** For businesses with a fleet of vehicles involved in inventory
management and distribution, telematics systems can be used to track vehicle locations, monitor
driver behavior, and optimize routes for efficient delivery and restocking.

11. **Voice-Picking Systems:** These systems use voice commands to guide warehouse
workers through the picking process, improving accuracy and productivity.

12. **Augmented Reality (AR) and Virtual Reality (VR):** AR and VR technologies can be
used to provide warehouse workers with visual cues and information as they navigate storage
areas and pick items, reducing errors and speeding up the process.

The choice of devices and technologies depends on the specific needs and scale of the business.
Small retailers may use basic barcode scanners and mobile devices, while large distribution
centers may employ a combination of RFID, IoT sensors, drones, and advanced inventory
management software to maintain control over their inventory.

What Is Inventory Management?

Inventory management helps companies identify which and how much stock to order at what
time. It tracks inventory from purchase to the sale of goods. The practice identifies and responds
to trends to ensure there’s always enough stock to fulfill customer orders and proper warning of a
shortage.

Once sold, inventory becomes revenue. Before it sells, inventory (although reported as an asset
on the balance sheet) ties up cash. Therefore, too much stock costs money and reduces cash flow.

One measurement of good inventory management is inventory turnover. An accounting

measurement, inventory turnover reflects how often stock is sold in a period. A business does not
want more stock than sales. Poor inventory turnover can lead to deadstock, or unsold stock.

Why Is Inventory Management Important?

 Inventory management is vital to a company’s health because it helps make sure there is rarely
too much or too little stock on hand, limiting the risk of stockouts and inaccurate records.

Public companies must track inventory as a requirement for compliance with Securities and
Exchange Commission (SEC) rules and the Sarbanes-Oxley (SOX) Act. Companies must
document their management processes to prove compliance.

Benefits of Inventory Management

The two main benefits of inventory management are that it ensures you’re able to fulfill
incoming or open orders and raises profits. Inventory management also:

 Saves Money:
Understanding stock trends means you see how much of and where you have something in stock
so you’re better able to use the stock you have. This also allows you to keep less stock at each
location (store, warehouse), as you’re able to pull from anywhere to fulfill orders — all of this
decreases costs tied up in inventory and decreases the amount of stock that goes unsold before
it’s obsolete.
 Improves Cash Flow:
With proper inventory management, you spend money on inventory that sells, so cash is always
moving through the business.
 Satisfies Customers:
One element of developing loyal customers is ensuring they receive the items they want without
waiting.

Inventory Management Challenges

The primary challenges of inventory management are having too much inventory and not being
able to sell it, not having enough inventory to fulfill orders, and not understanding what items
you have in inventory and where they’re located. Other obstacles include:

 Getting Accurate Stock Details:

If you don’t have accurate stock details,there’s no way to know when to refill stock or which
stock moves well.
 Poor Processes:
Outdated or manual processes can make work error-prone and slow down operations.
 Changing Customer Demand:
Customer tastes and needs change constantly. If your system can’t track trends, how will you
know when their preferences change and why?
 Using Warehouse Space Well:
Staff wastes time if like products are hard to locate. Mastering inventory management can help
eliminate this challenge.

Learn more about the challenges and benefits of inventory management.

What Is Inventory?

Inventory is the raw materials, components and finished goods a company sells or uses in
production. Accounting considers inventory an asset. Accountants use the information about
stock levels to record the correct valuations on the balance sheet.

Inventory vs. Stock

Inventory is often called stock in retail businesses: Managers frequently use the term “stock on
hand” to refer to products like apparel and housewares. Across industries, “inventory” more
broadly refers to stored sales goods and raw materials and parts used in production.

Some people also say that the word “stock” is used more commonly in the U.K. to refer to
inventory. While there is a difference between the two, the terms inventory and stock are often
interchangeable.

What Are the Different Types of Inventory?

There are 12 different types of inventory: raw materials, work-in-progress (WIP), finished goods,
decoupling inventory, safety stock, packing materials, cycle inventory, service inventory, transit,
theoretical, excess and maintenance, repair and operations (MRO). Some people do not
recognize MRO as a type of inventory.

Inventory Management Process

If you produce on demand, the inventory management process starts when a company receives a
customer order and continues until the order ships. Otherwise, the process begins when you
 forecast your demand and then place POs for the required raw materials or components. Other
parts of the process include analyzing sales trends and organizing the storage of products in
warehouses.

How Inventory Management Works

The goal of inventory management is to understand stock levels and stock’s location in
warehouses. Inventory management software tracks the flow of products from supplier through
the production process to the customer. In the warehouse, inventory management tracks stock
receipt, picking, packing and shipping.

Inventory Management Techniques and Terms

Some inventory management techniques use formulas and analysis to plan stock. Others rely on
procedures. All methods aim to improve accuracy. The techniques a company uses depend on its
needs and stock.

Find out which technique works best for your business by reading the guide to inventory
management techniques. Here’s a summary of them:

 ABC Analysis:
This method works by identifying the most and least popular types of stock.
 Batch Tracking:
This method groups similar items to track expiration dates and trace defective items.
 Bulk Shipments:
This method considers unpacked materials that suppliers load directly into ships or trucks. It
involves buying, storing and shipping inventory in bulk.
 Consignment:
When practicing consignment inventory management, your business won’t pay its supplier until
a given product is sold. That supplier also retains ownership of the inventory until your company
sells it.
 Cross-Docking:
Using this method, you’ll unload items directly from a supplier truck to the delivery truck.
Warehousing is essentially eliminated.
 Demand Forecasting:
This form of predictive analytics helps predict customer demand.
 Dropshipping:
In the practice of dropshipping, the supplier ships items directly from its warehouse to the
customer.
 Economic Order Quantity (EOQ):
This formula shows exactly how much inventory a company should order to reduce holding and
other costs.
 FIFO and LIFO:
First in, first out (FIFO) means you move the oldest stock first. Last in, first out (LIFO) considers
that prices always rise, so the most recently-purchased inventory is the most expensive and thus
sold first.
 Just-In-Time Inventory (JIT):
Companies use this method in an effort to maintain the lowest stock levels possible before a
refill.
 Lean Manufacturing:
This methodology focuses on removing waste or any item that does not provide value to the
customer from the manufacturing system.
 Materials Requirements Planning (MRP):
This system handles planning, scheduling and inventory control for manufacturing.
 Minimum Order Quantity:
A company that relies on minimum order quantity will order minimum amounts of inventory
from wholesalers in each order to keep costs low.
 Reorder Point Formula:
Businesses use this formula to find the minimum amount of stock they should have before
reordering, then manage their inventory accordingly.
 Perpetual Inventory Management:
This technique entails recording stock sales and usage in real-time. Read “The Definitive Guide
to Perpetual Inventory” to learn more about this practice.
 Safety Stock:
An inventory management ethos that prioritizes safety stock will ensure there’s always extra
stock set aside in case the company can’t replenish those items.
 Six Sigma:
This is a data-based method for removing waste from businesses as it relates to inventory.
 Lean Six Sigma:
This method combines lean management and Six Sigma practices to remove waste and raise
Demand Planning and Inventory Management

Demand planning is an important part of successful inventory management. It is the process of

determining how much of each item you anticipate selling, and when. Once demand is
determined, inventory management follows the flow of goods from the supplier through
production and ultimately fulfilling customer orders.

Inventory Management Formulas

Understanding inventory management formulas is crucial to optimizing stock levels. Multiple

inventory and accounting professionals have vetted formulas to make inventory calculations
easier.

Inventory Management KPIs

Effective inventory management plays an important role throughout the supply chain. There are
many key performance indicators for measuring inventory management success throughout the
different organizations in the business. Understand which calculations return the most insight
into your business processes is important. To learn more, see inventory management KPIs.

How Is Inventory Management Different From Other

Processes?
People sometimes confuse inventory management with related practices. Inventory management
controls all stock within a company. Supply chain management manages the process from
supplier to delivering the product to the customer. Warehouse management is a part of inventory
control and focuses on stock in a specific location.

Inventory Management vs. Inventory Control

inventory control is a part of the overall inventory management process. Inventory control
manages the movement of items within the warehouse.

Learn more about how these practices work together in our article on inventory control vs.
inventory management.
Inventory Management vs. Inventory Optimization

Inventory optimization is the process of using inventory in the most efficient way, and as a result
minimizing the dollars spent on stock and storing those items.

You can also think about inventory optimization as seeing inventory across all locations and
selling channels, being able to use any of it to fulfill customer orders—in doing so, you can hold
less stock overall.

Inventory Management vs. Order Management

Inventory management is responsible for ordering and tracking stock as it arrives at the
warehouse. Order management is the process of receiving and tracking customer orders.
Software often combines both tasks.

Inventory management plays an important role in order management. As orders are received,
inventory can be allocated to specific orders, and then the status can be changed in the inventory
record to essentially put it “on hold” for that order. Furthermore, when the order management
system and inventory system are integrated, the inventory system can recommend which location
should fulfill the order, based on where all the items in the order are available—this eliminates
multiple shipments for a single order.

Inventory Management vs. Supply Chain Management

Supply chain management is a process of managing supply relationships outside a company and
the flow of stock into and through a company. Inventory management may focus on trends and
orders for the company or a part of the company.

Inventory management is essential for a properly running supply chain. Inventory management
follows the flow of goods to, through and out of the warehouse. The supply chain includes
demand planning, procurement, production, quality, fulfillment, warehousing and customer
service—all of which require inventory visibility.

Inventory Management vs. Warehouse Management

Warehouse management complements inventory management. Warehouse management

organizes stock in a warehouse. Inventory management manages stock and trends for many
warehouses or an entire company.
The key to streamlining your warehouse operations is a thoughtfully laid out and meticulously
organized facility. When each product has a specific place in the warehouse, it prevents staff
from moving about inefficiently and maximizes labor efficiency. But these processes are only as
good as the inventory records that drive them.

Inventory Management vs. Logistics

Logistics is the practice of controlling processes in a warehouse and in the replenishment and
delivery systems. Inventory management maintains stock levels and manages stock location.

Inventory management is a crucial part of how companies manipulate their logistics. The
relationship between inventory management and logistics is interdependent. Logistics need
inventory management to perform their activities. Good logistics systems improve warehouse
and operational activities.

Inventory Management vs. ERP

An enterprise resource planning (ERP) system is software that manages business activities such
as accounting, purchasing, compliance and supply chain operations. By contrast, inventory
management is a part of a modern ERP system, providing insight into stock levels, inventory en
route and the status of current inventory—this makes it visible across the organization in real
time.

Inventory management helps to properly plan a company’s replenishment orders. ERP systems
give companies accurate inventory data, so they have the most current information for their
inventory management plan. ERP systems optimize the data so inventory management is
successful.

Inventory Evaluation
Inventory evaluation, also known as inventory valuation, is the process of assigning a monetary
value to the items a company holds in its inventory. Proper inventory evaluation is important for
financial reporting, tax purposes, and making informed business decisions. There are several
methods for inventory valuation, and the choice of method can significantly impact a company's
financial statements and profitability. Here are some commonly used inventory valuation
methods:

1. **FIFO (First-In, First-Out):** Under the FIFO method, it is assumed that the first items
added to inventory are the first ones sold. The cost of goods sold (COGS) is calculated using the
cost of the oldest inventory, and the ending inventory is valued at the cost of the most recently
acquired items.

2. **LIFO (Last-In, First-Out):** LIFO assumes that the most recently acquired inventory items
are the first ones sold. As a result, the cost of goods sold is calculated using the cost of the most
recent purchases, and the ending inventory is valued at the cost of the oldest items.

3. **Weighted Average Cost:** This method calculates the cost of goods sold and the value of
the ending inventory by taking the weighted average cost of all inventory items. The cost is
based on the total cost of all inventory items divided by the total quantity of items.

4. **Specific Identification:** Under specific identification, each item in inventory is

individually tracked and valued based on its actual cost. This method is often used for high-value
or unique items.

5. **Standard Cost:** Companies using the standard cost method assign a predetermined cost to
each inventory item. The actual cost may differ from the standard cost, and any variances are
recorded separately.

6. **Lower of Cost or Market (LCM):** LCM requires companies to value their inventory at the
lower of its cost or its market value. This method allows for the recognition of inventory write-
downs if the market value of inventory falls below its original cost.

7. **Retail Inventory Method:** Commonly used in the retail industry, this method values
inventory based on the retail price and a cost-to-retail ratio. It is a combination of cost and retail
price.
The choice of inventory valuation method can have significant implications for a company's
financial statements, taxes, and profits. Different methods can result in varying amounts for the
cost of goods sold, gross profit, and taxable income. Companies must choose a method that
aligns with their business needs, industry practices, and tax regulations. In some cases,
regulatory authorities or accounting standards may prescribe specific methods or require
consistency in their application.

Inventory evaluation is a crucial aspect of financial management, and businesses should carefully
consider the implications of their chosen method on financial reporting, taxes, and decision-
making processes. Consulting with accountants or financial professionals is often necessary to
make informed choices regarding inventory valuation methods.