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Working_Capital_Management-4.pdf - Module IV Management of...

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Unformatted text preview: Module IV: Management of Creditors 4.1 Management of Current Liabilities Balance sheet is an indicator of the financial position of a business concern in terms of assets and liabilities. Balance sheet is always prepared in such a way that the true and fair financial position of a business is revealed, which will be easily readable and more quickly understood form. Balance sheet represents the nature and value of assets of the business, the nature and value of all liabilities and residual in the form of owner’s fund. Today in this competitive age, only that enterprise can get success which is managing its current liabilities in a proper form. If the company is not properly arranging the amount to pay its current liabilities, its financial position can be said sound. The Balance sheet of each and every organization or enterprise includes various types of assets on one side and liabilities on the other side. Current assets and current liabilities of each organization play an important role in forming the working capital. Each organization is liable to pay its current liabilities within a year, so the organization has to manage its current liabilities and its payment in an effective manner. 4.2 Current Liabilities In accounting, current liabilities are considered liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle, whichever period is longer. An operating cycle is the average time that is required to go from cash to cash in producing revenues. For example, accounts payable for goods, services or supplies that were purchased for use in the operation of the business and payable within a normal period of time would be current liabilities. Bonds, mortgages and loans that are payable over a term exceeding one year would be fixed liabilities or long-term liabilities. However, the payments due on the long-term loans in the current fiscal year could be considered current liabilities if the amounts were material. The proper classification of liabilities is essential when considering a true picture of an organization's fiscal health. 4.3 Differnt Current Liabilities Current Liability Amounts owed (within one year) for goods and services purchased on credit terms. This means payment for goods and services is due at a date later than the date of sale. Current liabilities can be classified as:Trade creditors, which is the name we give to amounts owed to suppliers. Accruals, which is the name we give to amounts still owed at the year end and not yet recorded in the books of account. Proposed items such as Dividends proposed, which means amounts the business promises to pay in the coming year. Payable items such as Tax payable which is payable within the coming year. Overdraft, which is amounts owed to the bank. Short term loans. Accounts Payable - The Most Popular Current Liability Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. Accounts payable, or A/P as it is often shorthanded, is one of the largest current liabilities a company will face because they are constantly ordering new products or paying vendors for services or merchandise. Really well managed companies attempt to keep accounts payable high enough to cover all existing inventory, meaning that the vendors are paying for the company's shelves to remain stocked, in effect. Accrued Benefits and Payroll as a Current Liability This item in the current liabilities section of the balance sheet represents money owed to employees as salary and bonus that the company has not yet paid. Short Term and Current Long Term Debt These current liabilities are sometimes referred to as notes payable. They are the most important item under current liabilities section of the balance sheet and most of the time, they represent the payments on a company's bank loans that are due in the next twelve months. Borrowing money in itself is not necessarily a sign of financial weakness; an intelligent department store executive may work out short term loans at Christmas so she can stock up on merchandise before the Holiday rush. If demand is high, the store would sell all of its inventory, pay back the short term loans, and pocket the difference. This is known as utilizing leverage. The department store used borrowed money to make a profit. So how can you ever hope to tell if a company is wisely borrowing money (such as our department store), or recklessly going into debt? Look at the amount of notes payable on the balance sheet (if they aren't classified under 'notes payable', combine the company's short term obligations and long term current debt). If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned. If, on the other hand, the notes payable has a higher value than the cash, short term investments, and accounts receivable combined, you should be seriously concerned. Unless the company operates in a business where inventory can quickly be turned into cash, this is a serious sign of financial weakness. Other Current Liabilities Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10k. Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bond holders in the short term. Consumer Deposits Are Liabilities to Banks If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits". Often, they will be will lumped under other current liabilities. This is the amount that customers have deposited in the bank. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability. 4.4 Tests of a company's financial strength and liquidity The strength of every company depends upon many factors. Following methods of its valuation are as under:1. Working Capital: Current Assets - Current Liabilities 2. Working Capital per Dollar of Sales: Working Capital ÷ Total Sales 3. Current Ratio: Current Assets ÷ Current Liabilities 4. Quick / Acid Test / Current Ratio: Current Assets minus inventory called "Quick Assets) ÷ Current Liabilities 5. Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity 4.5 Creditors A creditor is a party (e.g. person, organization, company, or government) that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption (usually enforced by contract) that the second party will return an equivalent property or service. The second party is frequently called a debtor or borrower. The first party is the creditor, which is the lender of property, service or money. The term creditor is frequently used in the financial world, especially in reference to short term loans, long term bonds, and mortgage loans. In law, a person who has a money judgment entered in their favor by a court is called a judgment creditor. The term creditor derives from the notion of credit. In modern America, credit refers to a rating which indicates the likelihood a borrower will pay back his or her loan. In earlier times, credit also referred to reputation or trustworthiness. 4.6 Trade Credit Definition: An arrangement to buy goods or services on account, that is, without making immediate cash payment For many businesses, trade credit is an essential tool for financing growth. Trade credit is the credit extended to you by suppliers who let you buy now and pay later. Any time you take delivery of materials, equipment or other valuables without paying cash on the spot, you're using trade credit. When you're first starting your business, however, suppliers most likely aren't going to offer you trade credit. They're going to want to make every order c.o.d. (cash or check on delivery) or paid by credit card in advance until you've established that you can pay your bills on time. While this is a fairly normal practice, you can still try and negotiate trade credit with suppliers. One of the things that will help you in these negotiations is a properly prepared financial plan. When you visit your supplier to set up your order during your startup period, ask to speak directly to the owner of the business if it's a small company. If it's a larger business, ask to speak to the CFO or any other person who approves credit. Introduce yourself. Show the officer the financial plan you've prepared. Tell the owner or financial officer about your business, and explain that you need to get your first orders on credit in order to launch your venture. Depending on the terms available from your suppliers, the cost of trade credit can be quite high. For example, assume you make a purchase from a supplier who decides to extend credit to you. The terms the supplier offers you are two-percent cash discount with 10 days and a net date of 30 days. Essentially, the suppliers are saying that if you pay within 10 days, the purchase price will be discounted by two percent. On the other hand, by forfeiting the two-percent discount, you're able to use your money for 20 more days. On an annualized basis, this is actually costing you 36 percent of the total cost of the items you are purchasing from this supplier! (360 ( 20 days = 18 times per year without discount; 18 ( 2 percent discount = 36 percent discount missed.) Cash discounts aren't the only factor you have to consider in the equation. There are also late-payment or delinquency penalties should you extend payment beyond the agreedupon terms. These can usually run between one and two percent on a monthly basis. If you miss your net payment date for an entire year, that can cost you as much as 12 to 24 percent in penalty interest. Effective use of trade credit requires intelligent planning to avoid unnecessary costs through forfeiture of cash discounts or the incurring of delinquency penalties. But every business should take full advantage of trade that is available without additional cost in order to reduce its need for capital from other sources. Trade credit for example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders. There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives. For example:- The operator of an ice cream stand may sign a franchising agreement, under which the distributor agrees to provide ice cream stock under the terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10 days. This means that the operator has 60 days to pay the invoice in full. If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and make an extra 20% on the ice cream sold. However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days, obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days. The ice cream distributor can do the same thing. Receiving trade credit from milk and sugar suppliers on terms of Net 30, 2% discount if paid within ten days, means they are apparently taking a loss or disadvantageous position in this web of trade credit balances. Why would they do this? First, they have a substantial markup on the ingredients and other costs of production of the ice cream they sell to the operator. There are many reasons and ways to manage trade credit terms for the benefit of a business. The ice cream distributor may be well-capitalized either from the owners' investment or from accumulated profits, and may be looking to expand his markets. They may be aggressive in attempting to locate new customers or to help them get established. It is not on their interests for customers to go out of business from cash flow instabilities, so their financial terms aim to accomplish two things: Allow startup ice cream parlors the ability to mismanage their investment in inventory for a while, while learning their markets, without having a dramatic negative balance in their bank account which could put them out of business. This is in effect, a short term business loan made to help expand the distributor's market and customer base. By tracking who pays, and when, the distributor can see potential problems developing and take steps to reduce or increase the allowed amount of trade credit he extends to prospering or faltering businesses. This limits the exposure to losses from customers going bankrupt who would never pay for the ice cream delivered. 4.6.1 Advantages and disadvantages of trade credit Advantages of trade credit Following are the main advantages of trade credit:1. Reduced capital requirements, this means that if a new business setting up has trade credit, they will obviously require less money in capital to start up the business. This is a major advantage to someone who has very little money but has a good idea about starting a new business. 2. Trade credit with improve the cash flows and therefore provide smoother operation for the business. 3. Businesses can buy now and pay later which means even if they don't have the money at first they can purchase items, sell them as a business and then make the payments at the end of the month when the products have been sold and a profit has been made. 4. Businesses can look to grow without having to worry of needing to make immediate payments which may set them back. 5. With trade credit, the business can focus on other areas such as sales, marketing and research rather than worrying about meeting targets just to have enough money to pay the bills. Disadvantages of trade credit 1. If repayments are not made by certain deadlines, the business will receive a poor credit history which will be a big blow to any business as they will not trusted in the future if they require any loans, trade credit, credit cards or leasing. 2. Only companies with a good credit history will get trade credit and these can often be hard to build up, especially for new businesses. 4.7 Current Liabilities Management Spontaneous Liabilities Spontaneous liabilities arise from the normal course of business. The two major spontaneous liability sources are accounts payable and accruals. As a firm’s sales increase, accounts payable and accruals increase in response to the increased purchases, wages, and taxes. There is normally no explicit cost attached to either of these current liabilities. Spontaneous Liabilities: Accounts Payable Management Accounts payable are the major source of unsecured short-term financing for business firms. The average payment period has two parts: The time from the purchase of raw materials until the firm mails the payment. Payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account The firm’s goal is to pay as slowly as possible without damaging its credit rating. Spontaneous Liabilities: Analyzing Credit Terms Credit terms offered by suppliers allow a firm to delay payment for its purchases. However, the supplier probably imputes the cost of offering terms in its selling price. Therefore, the firm should analyze credit terms to determine its best credit strategy. If a cash discount is offered, the firm has two options—to take the cash discount or to give it up. Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount. Giving Up the Cash Discount If a firm chooses to give up the cash discount, it should pay on the final day of the credit period. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. Giving Up the Cash Discount Giving Up the Cash Discount Cost % Discount 365 100% - % Discount Credit Period - Discount Period Cost 2% 365 100% - 2% 30 10 37.24% Giving Up the Cash Discount The preceding example suggest that the firm should take the cash discount as long as it can borrow from other sources for less than 37.24%. Because nearly all firms can borrow for less than this (even using credit cards!) they should always take the terms 2/10 net 30. Spontaneous Liabilities: Effects of Stretching Accounts Payable Stretching accounts payable simply involves paying bills as late as possible without damaging credit rating. This can reduce the cost of giving up the discount. Spontaneous Liabilities: Accruals Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. While payments to the government cannot be manipulated, payments to employees can. This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible. Spontaneous Liabilities: Accruals Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. While payments to the government cannot be manipulated, payments to employees can. This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible. Unsecured Sources of Short-Term Loans: Bank Loans The major type of loan made by banks to businesses is the short-term, self-liquidating loans which are intended to carry firms through seasonal peaks in financing needs. These loans are generally obtained as companies build up inventory and experience growth in accounts receivable. As receivables and inventories are converted into cash, the loans are then retired. These loans come in three basic forms: single-payment notes, lines of credit, and revolving credit agreements. Loan Interest Rates. Most banks loans are based on the prime rate of interest. which is the lowest rate of interest charged by the nation’s leading banks on loans to their most reliable business borrowers. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrowers “riskiness.” Fixed & Floating-Rate Loans On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate and remains at that rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established and is then allowed to float with prime until maturity. Like ARMs, the increment above prime is generally lower on floating rate loans than on fixed-rate loans. Unsecured Sources of Short-Term Loans: Commercial Paper Commercial paper is a short-term, unsecured promissory note issued by a firm with a high credit standing. Generally only large firms in excellent financial condition can issue commercial paper. Most commercial paper has maturities ranging from 3 to 270 days, is issued in multiples of $100,000 or more, and is sold at a discount form par value. Commercial paper is traded in the money market and is commonly held as a marketable security investment. Unsecured Sources of Short-Term Loans: International Loans The main ...
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  • Spring '16
  • Ashish
  • Balance Sheet, Debt, Credit card, Generally Accepted Accounting Principles, Credit rating

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