Showing posts with label Accounting. Show all posts
Showing posts with label Accounting. Show all posts

Meaning And Advantages Of Term Loan

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Meaning Of Term Loan

A term loan is a loan from financial institutions having an initial maturity of more than one year. Term loan is a contract under which a borrower agrees to make a series of interest and principal payments in an interval of specific period. Generally, term-loans have maturities of 5 to 10 years. However, term loans may have maturities of 2 years or more. Funds raised from term loan is typically used to finance permanent working capital, to pay for fixed assets or to discharge other loans.
A formal term loan agreement is signed between the borrower and lender. It specifies various terms and conditions such as maturity period, payment date, interest rate, restrictive provisions, collateral etc. 

Advantages Of Term Loans
Term loans have some specific advantages over public offerings. It can be raised in relatively short period, because term loans are negotiated directly between the lender and the borrower, and documentation is minimized.But public offering of long-term securities involves lengthy process. Another advantage of term loan is flexibility. Terms and conditions of term loan can be revised on by mutual agreement between the lender and borrower. Another advantage of term loan is lower issuance costs. Firms can avoid flotation costs such as underwriting fee, commission, printing charges of certificate, advertisement cost etc.  

Factors Affecting Business Risk Of A Firm

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The business risk of a firm is measured by the variability in operating income of the firm. Larger variability in operating income denotes larger business risk. The firm's business risk changes over time and it varies from firm to firm. Some factors affecting business risk of a firm are as follows: 

1. Variability In Demand
The operating income of the firm fluctuates widely if variability in demand for firm's product is larger. Thus, a firm with larger variability in demand is more exposed to business risk.

2. Variability In Selling Price
A firm's product does not sell at constant price. The selling price of the firm's product may be volatile because of alternative demand and supply conditions, nature of competitions and so on. Thus, larger the variability in selling price wider will be the fluctuations in operating income leading to higher business risk.

3. Uncertainty Of Input Costs
Cost of input keeps on changing over time, affecting the total cost of output. The total operating cost of the firm widely fluctuates if the uncertainty associated to input cost is larger. This exposes the firm to high business risk.

4. Ability To Price Adjustment
When there is an increase in input costs, the selling price must also increase to maintain the stability in firm's operating income. However, the speed with which selling price is adjusted in response to the change in input costs, depends on price adjustment capacity of the firm.Thus, higher the firm's ability to price adjustment, lower will be the business risk.

5. Speed Of Technological Changes
The firm should adapt to changing technology over the years. If the speed of technological changes is greater and the firm is not able to adapt to changing technology, demand for firm's product will be adversely affected. The level of business risk associated to such firm is larger.

6. Extent Of Fixed Operating Costs
If larger portion of the firm's costs are fixed, the firm has to make larger sales to meet the fixed costs. At lower sales level such firm is not able to meet the fixed cost. There larger fixed cost exposes the firm to larger degree of business risk.

Sales Forecasting Methods

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There are several methods of sales forecasts. Some of them are as follows:

1. Sales persons
A firm can employ its sales persons to provide a close forecast of sales. These sales person are employed at many places where firm's products are offered. They collect market information personally from customers, collect customer's response to the firm's product and thus provide an estimate if likely sales that the firm can achieve in the future.

2. Customer Survey
It is a formal process of sales forecasts applied by the firm on the basis of survey of customers in many places. Firm employs some survey people to visit many customers of many places and takes the response of existing as well as prospective customers on the basis of direct interview and questionnaire.Existing and prospective customers are asked to give their opinion verbally or in written format about the product offered by the firm. On the basis of opinion survey of customers, these survey people provide an estimate of future sales.

3. Time Series Model
Time series model is a mathematical model of sales forecasts. This model assumes that level of sales varies according to change in time period. A time series model states that the relationship between two variables, one of them being the time period and another being sales. A series of time period is regarded as independent variable and the level of sales over several time periods is used as dependent variable. Under this method, past sales data are arranged chronologically and statistical analysis of these chronological sales data is made to forecast the level of sales in some future date. Here the sales level is regarded as a function of time period. The time series model is stated as below:

Yt = f(t)

Where, 'Yt' represents the value of sales in time 't'.

4. Econometric Model
Econometric model is an important model used in sales forecasting. This method assumes that sales of firm are influenced by many factors such as level of inventory, advertisement expenses, cost of production, cost of quality control, research and development expenditure and so on. Sales are regarded as dependent variable and all other factors under considerations are regarded as independent variables. Once these variables are identified, they are into the following model to provide a forecast of sales.

Y = a+b1X1+b2X2+b3X3+...........+bnXn+e

Y = Estimated sales
X1,X2,X3 = value of independent variables influencing sales
b1,b2,b3 = the coefficient of respective independent variables
a = the intercept constants
e = standard random error term.

Concept Of Sales Forecast And Factors To Be Considered For Sales Forecasting

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Concept Of Sales Forecast

Financial forecasting is a significant part of financial planning process. The financial forecasting begins with sales forecast. Sales forecast is a forecast of firm's future sales both in terms of volume and value. The sales forecast always begins with analyzing the historical trends in sales over the past periods. It also takes to consideration the future economic prosperity if given line of business. To determine the forecasted sales growth, the firm must rely on competitive market conditions, customers' tastes and preferences, change in technology and future possibilities of market expansion. Nowadays, several statistical methods like regression analysis, time series analysis, econometric models are used to consider all these factors in providing sales forecasts.

Factors To Be Considered For Sales Forecasting

Some factors that should be considered while developing sales  forecast are as follows:

1. Provide a projection of divisional sales based on historical growth and combine the divisional sales forecasts to provide a approximate corporate sales forecast.

2. Forecast the level of economic activity in each market area of the firm along with the change in population and their economic growth.

3. Estimate the market share of the firm that is expected in each market area depending on the firm's production and distribution capacity, capacity of competitors, possibility of new product and so on.

4. Forecast the effect of future rate of inflation in the consumer's purchasing power and price of products.

5.Consider the effect of advertisement campaigns, price discounts, credit terms and so on.

6. Provide the ultimate forecasts of sales for each division in aggregate and on an individual product basis.

The accurate sales forecast must be as accurate as possible. If it is overly optimistic, the firm may have idle plant capacity and unnecessary investment in inventories. If the sales forecast is overly pessimistic, it may result into loosing the customers because of failure to meet demand. Both of these conditions result into low profit margin, low return on assets, low return on equity and decline in market price of share. Therefore, accurate sales forecast is significant to improve profitability of the firm. 

Concept Of The Cost Of Money And Factors Affecting It

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Concept Of The Cost Of Money
The cost of money refers to the price paid for using the money, whether borrowed or owned. Every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below:

Factors Affecting The Cost Of Money

1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money.

2. Time Preference For Consumption
Time preference for consumption refers to the preference of consumers for current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer  to consume in current period or in future period.  If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa.

3. Risk
Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase.

4. Inflation
Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increasing in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation.

Relationship Of Corporate Finance With Related Discipline

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Finance is concerned with the acquisition and use of the firm's financial resources. It is an integral part of the overall management. Therefore, it should be studied along with other disciplines. It is because finance derives heavily the conceptual and analytic foundations from other disciplines particularly from economics and accountancy.

1. Relationship With Economics
The relationship between corporate finance and economics can be viewed from two basic aspects of economics macroeconomics and microeconomics.
Macroeconomics is concerned with broad aspects of an economy such as output, employment and income. Every business firm operates within the economy. It is imperative for financial managers to understand the broad economic framework. He must also be alert about the consequences of varying levels of economic activities, and recognize and understand the effect of monetary policy on the cost and availability of funds. The financial managers should evaluate various financing and investment alternatives in a macroeconomic framework.
Microeconomics is concerned with the economic issues relating to individual firms operating within the economy. It deals with the economic problems related to individual firms. Many principles associated to microeconomics such as demand and supply analysis, profit maximization strategies, pricing theories have practical application in finance. In this sense, finance is regarded as applied microeconomics. The principle of marginal analysis technique of microeconomics is widely used in finance for decision making.

2. Relationship With Accounting
The relationship between finance and accounting is quite close. Accounting is basically concerned with collecting, presenting and processing necessary financial data, whereas finance is concerned with decision-making. The financial manager, as per the requirements, recasts the statements prepared by accountants, generates additional data, and makes decisions on subsequent analysis.

3. Relationship To Other Disciplines
Besides its direct relationship to economics and accounting, finance is also related to other disciplines, such as mathematics production and quantitative techniques . In fact, it draws heavily on mathematics and quantitative techniques. The use of several quantitative and mathematical techniques have been extremely useful for solving complex financial problems of a firm.

Managerial Finance Functions Or The Functions Of Financial Manager

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Managerial finance functions are functions that require managerial skills in their planning, execution and control. The managerial finance functions are as follows:

1. Investment Decision
Investing decision is the managerial decision regarding investment in long-term proposals. It includes the decision concerned with acquisition, modification and replacement of long-term assets such as plant, machinery, equipment, land and buildings. Long term assets require huge amount of capital outlay at the beginning but the benefits are derived over several periods in the future. Because the future benefits are not known with certainty, long-term investment proposals involve risks.The financial manager should estimate the expected risk and return of the long-term investment and then should evaluate the investment proposals in terms of both expected returns and risk. The financial manager accepts the proposal only if the investment maximizes the shareholders wealth.

2. Financing Decision
Financing decision which is also known as capital structure decision, is concerned with determining the sources of funds and deciding upon the proportionate mix of funds from different sources. It calls for raising of funds from different sources maintaining appropriate mix of capital. The sources of long-term funds include equity capital and debt capital. A particular combination of debt and equity may be more beneficial to the firm than any others. The financial manager should decide an optimal structure of debt and equity capital.

3. Dividend Decision
Dividend decision is the decision about the allocation of earnings to common shareholders. It is concerned with deciding the portion of earnings to be allocated to common shareholders. The net income after paying preference dividends belongs to common shareholders. The financial manager has three alternatives regarding dividend decision:
* Pay all earnings as dividend
* Retain all earnings for reinvestment
* Pay certain percentage of earning and retain the rest for reinvestment.
The financial manager must choose among the above alternatives. The choice should be optimum in the sense that it should maximize the shareholders wealth. While taking dividend decisions, the financial manager should consider the preferance of shareholders as well as the investment opportunities available to the firm.

4. Working Capital Decision
Working capital decisions refers to the commitment of funds to current assets and deciding on their financing pattern. It refers to the current assets investment and financing decision. Investment in current assets affects firm's profitability and liquidity. More investment in current assets enhances liquidity. Liquidity refers to the capacity to meet short-term obligation of the firm. At the same time more investment in current assets negatively affects the profitability because current assets earn nothing or they earn much less than their cost of capital. Similarly, less investment in current assets negatively affects the firm's liquidity and the firm may lose its profitable opportunities. So, a financial manager should achieve a proper trade-off between liquidity and profitability which requires maintaining optimal investment in current assets.

Concept Of Reverse Stock Splits

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The company may want to reduce the number of share outstanding if its share price falls substantially. Number of share is reduced by reverse stock split. The reduction of the number of outstanding share increases both the par value per share and market price per share. Reverse stock split also increases earning per share and dividend per share. It is just opposite of stock splits.


Suppose, total shareholder's account of a firm is as follows:

A. Common stock (10,000 Shares @ $ 10).........................= $ 100,000
B. Additional paid in capital...................................................= $ 100,000
C. Retained earnings..............................................................= $ 300000
Total shareholder's equity....................................................= $ 500,000

Now let us assume that the firm announced 2-for-5 reverse stock split, which results into decrease in number of outstanding shares from 10,000 shares to 4,000 shares (i.e. 10,000 shares x 2/5) and increase in the par value from $10 per share to $ 25 per share ( i.e. $10 x 5/2). This keeps the value of common stock constant at $ 100,000 ( i.e. 4,000 x $25). Thus, total shareholder's equity account of the firm after 2-for-5 reverse stock splits appear as:

A. Common stock (4,000 shares @ $25 each).......................= $ 100,000
B. Additional paid in capital .....................................................= $ 100,000
C. Retained earnings ................................................................= $ 300,000
Total shareholder's equity (A+B+C)......................................= $ 500,000.

Concept Of Stock Splits And Its Value To Shareholders

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A stock split is similar to a stock dividend in economic sense. When a company announces stock splits, it results into an increase in number of outstanding shares with a proportionate decrease in par value and market price of the stocks. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company's share. With a stock split, total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings.

Suppose, a firm has the following total shareholder's equity account before stock split:

A. Common stock ( 4000 shares @ $10)...................=$ 40,000
B. Additional paid-in capital........................................= $ 20,000
C. Retained earnings ....................................................= $ 90,000
Total shareholder's equity (A+B+C)...........................= $ 150,000

If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder's equity accounts of the firm after 2-for-1 stock splits announcement appears as:

A. Common stocks ( 8,000 shares @ $ 5 each)....................= $ 40,000
B. Additional paid in capital.....................................................= $ 20,000
C. Retained earnings................................................................= $ 90,000
Total shareholder's equity (A+B+C)......................................= $ 150.000

Unlike in stock dividend, stock split does not involve transfer of funds from retained earnings to paid-in capital and common stock accounts.
Stock splits do not change the proportionate ownership of the company. Therefore, stock splits has no economic value to the investors or shareholders. When the number of shares held by shareholders increases, because of stock splits, the market price of the stock should decrease proportionately to remain the total value of common stock unchanged.

Concept Of Stock Dividend And Its Value To Investors

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A stock dividend refers to the dividend paid to existing stockholders in the form of additional shares of common stock. Unlike cash dividends it does not result into the cash outflows. The purpose of stock dividend is to conserve cash in the firm, so that it can be used in new projects. It involves simple book keeping transfer from retained earnings to the capital stock account. The stock dividend does not affect the equity position of stockholders; rather it represents a recapitalization of a company which takes place in the form of transfer of certain amount from firm's retained earnings to capital stock account.

Suppose a firm has following total shareholder's equity account before a 20 percent stock dividend announcement:
A. Common stock (100,000 shares of $ 10 par) .........= $ 1,000,000
B. Additional paid in capital.............................................= $ 200,000
C. Retained earnings........................................................= $ 1,800,000
Total shareholder's equity(A+B+C)..............................= $ 3,000,000

If the firm announces 20% stock dividends, the firm has to issue additional 20,000 shares in common stock. To illustrate the effect of stock dividend on total shareholder's equity accounts, let us assume that current market price of the stock is $ 40. So, amount of stock dividend will be $ 800,000 (i.e. $40 x 20,000 shares). The total amount of dividend is transferred to common stock account and additional paid-in capital from retained earnings. Since par value of common stock is $ 10 a total of $ 200,000 (i.e. $10 x 20,000 shares) is transferred to common stock account and rest $ 600,000 (i.e $ 30 x 20,000 shares) is added to paid-in capital. Thus, the total amount of shareholder's equity remains the same. total shareholder's equity account after 20% stock dividend appears as follows:

A. Common stock( 120,000 Shares of $ 10 par)...............= $1,200,000
B. Additional paid-in capital.................................................= $ 800,000
C. Retained earnings.............................................................= $ 1,000,000
Total shareholder's equity (A+B+C)..................................= $ 3,000,000

Stock dividend generally has no economic significance as it only results into change in capitalization keeping total equity position constant. Stock dividend simply results into an increase in outstanding shares of common stock. In the above example, with a 20% stock dividend, there is an increase in outstanding shares of common stock from 100,000 shares to 120,000 shares.

Factors Affecting Dividend Policy Of A Firm

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A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements
There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2. Firm's liquidity position
Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need
A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return
If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning
If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control
When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market
If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation
For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.

Dividend Payment Procedures Of A Firm

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The dividend payment procedures of a firm can be outlined as follows:

1. Declaration Date
The board of directors of the company announces that a specified amount of dividend will be paid to the stockholders. It is paid to the stockholders who will be on the record on the company's record at some particular future date. The date on which directors meet and announce dividend is called declaration date. Generally, the dividend is announced as a percentage on the par value of the stock. However, in some cases, it can be the absolute amount as $ 2 dividend per share.

2. Date Of Record
Along with the dividend announcement, the board of directors also specifies a date of record. For example, if the board of directors meets on June10, 2010, and declares a 10 % cash dividend to the stockholders of record on September 15; the July 10 is called declaration date and the September 15 is called date of record. The company prepares a list of stockholders from the stock transfer book at the close of business on the date of record. All the stockholders of the record date are entitled to receive dividend as declared by the board. The new stockholders would receive dividend if the shareholders' name is recorded in the shareholders' registered on or before the date of record. But, if the company were notified of the transfer after the date of record, the old owner of the stock would receive the dividends.

3. Ex-dividend Date
There can be delay of several days from the time a transfer takes place to the time the firm is informed of the transfer. Therefore, shares transferred on, say September 12, would not generally recorded on the company's book. In normal practice, the buyer and seller of the stocks have four business days to settle the transactions prior to the date of record. For example, if the date of record is September 15, the transaction must take place before September 11 to entitle the new holder to receive dividend. Thus, the date when the right to the dividend leaves the stock for new owner is called ex-dividend date. In our example if stock is bought on or after September 11, the new shareholder is not entitled to receive dividend. As a result of this, we normally expect that stock price will decline exactly by the amount of dividend per share on the ex-dividend date.

4. Payment Date
At the time of dividend announcement, the board of directors also specifies the date on which the payment of dividend is actually made and it is called the payment date. On this date the company actually pays the dividend to all the stockholders of the date of record.

Concept And Meaning Of Dividend Policy

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Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm's financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm's earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends:
1. It can distribute all of its earnings in the firm of cash dividends,

2. It can retain all of its earnings for reinvestment,

3. It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose.

When dividends are paid to the stockholders the firm's cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm's dividend policy is closely related with the firm's investment and financing decisions.
Determining the part of earnings to be distributed as dividends is a key decision that affects the value of firm's common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
It should be recognized that a firm's dividend payout ratio depends on many factors. For example, it may be affected by the volatility in firm's cash flows and changing investment needs over time. If the firm's cash flow is volatile, it may prefer to set a minimum level of regular cash dividends that can be maintained even at low profits. Similarly, if the firm has profitable investment opportunity it prefers to retain more amount by reducing dividend payout ratio.

Significance Of The Concept Of Time Value Of Money

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Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The concept of time value of money contributes to this aspect to a greater extent. The significance of the concept of time value of money could be stated as below:

Investment Decision
Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flow from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models while making investment in securities such as stock and bonds. These security valuation models consider time value of cash flows from securities.

Financing Decision
Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, especially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of two alternatives are compared against each other to decide on appropriate source of financing.

Besides, the concept of time value of money is also used in evaluating proposed credit policies and the firm's efficiency in managing cash collection under current assets management.

Concept Of Time Value Of Money

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The concept of tome value of money suggests that the money received at different point of time has different value. The financial manager must appreciate this fact and understand why they are different and how they are made comparable.

Time value of money is a concept to understand the value of cash flows occurred at different point of time. If we are given the alternatives whether to accept $ 100 today or one year fro now, then we certainly accept $ 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposited $ 100 in saving account at 5% annual rate of interest, it will increase to $ 105 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive in future has less purchasing power than the money that we have at present due to the inflation. What happens if there is no inflation? Still, money received at present is preferred, it is because most of us have a fundamental behavior to prefer current consumption to future consumption. Thus, i) The reinvestment opportunity or the earning power of the money, ii) the risk of inflation, and iii) an individual's preference for current consumption to future consumption are the reasons for the time value of money.

The concept of time value of money is useful in addressing our real life problems relating to planning for future family expenditure. For instance, if we need $ 50,000 after the retirement from job in 15 years, the amount we need to deposit at interest every year from now until the retirement is conveniently determined by using the time value of money concept.

Many financial decisions of the firm require a consideration regarding time value of money. The corporate manager must always concentrate on maximizing shareholders wealth. Maximizing shareholders wealth, to a larger extent, depends on the timing of cash flows from investment alternatives. In this regard, time value of money concept deserves serious considerations on all financial decisions.

Determinants Of Investment In Receivables

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The size of investment in receivables is influenced by number of factors. Among them two factors, the volume of credit sales, and the average length if time between sales and collection are important.
To illustrate, suppose National Enterprise, a newly established firm makes a credit sales of $ 5000 per day and its customers are allowed 15 days of credit. At the start of business i.e. in the first day, it sold $ 5000 on credit so that its end-of-day accounts receivables stand $ 5000 in the firm's book. During the second day, it sold another $ 5000 on credit increasing the book receivables to $10,000. If it goes on granting a credit of $ 5000 per day for 15 days, its account receivable will increase to $ 75,000 at the end of 15th day. However in 16th day it will make another $ 5000 credit sales, but payments for sales made on first day will reduced receivables by $ 5000, so that total account receivable will remain constant at $ 75000 in 16th day and the each day thereafter throughout the year. The average account receivable the firm must carry during the year is, therefore $ 75000.
Account receivable = Credit sales per day X Average length of collection period
= $ 5000 X 15 days = $ 75000.

Above illustration shows that the change in credit sales or change in collection period or both will affect the investment in account receivable. However in turn, the volume of credit sales and collection is affected by several factors such as industrial norms, credit standards, credit terms, collection policy, payment habits of customers, nature of business, size of enterprise, cost of investment in receivables and so on. Therefore, the financial manager must be able to look in depth and analyze the impact of these factors in volume of sales and the cost-benefit trade off associated to credit decisions.

Costs Of Maintaining Receivables And Their Calculation

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Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection expenses and cash discount. Costs related with receivables and their calculation are as follows:

1. Cost Of Investment In Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:
Cost of receivables = Investment in receivables X Opportunity costs
investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.

2. Bad Debt Losses
This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:

Bad debt losses = Annual credit sales X Percentage default customer

3. Collection Expenses
This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid for telephone and communication and so on.

4. Cash Discount
It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:

Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount

Roles Of The Credit Manager

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Investment in account receivable of any firm depends on how much it sells in credit and how long it takes for collection of receivables. Efficiency of receivable management is judged against its capacity to expand sales and profitability with reasonable investment in receivables. The credit manager is expected to play a significant role for this purpose. The roles of credit manager in receivable management are as follows:

1. Setting Up Credit Standard And Terms
The credit manager has to set up credit standards to grant the credit. Credit standard refers to the minimum criteria for the extension of credit to customers. The credit standards set by the credit manager may vary from firm to firm. It may be loose or tight as per the condition of the firm. The credit manager should set such a standard, which minimizes the bad debt expenses and increases firm's profitability. Having determined the credit standard, the credit manager should also fix the credit terms. The credit terms include, credit period, discount, if any, for early payment and discount period. The length of credit period has significant impact on the cost of investment in accounts receivables. Longer credit period increases both cost of investment in account receivables and bad debt losses. Therefore, the credit manager may offer cash discount to stimulate customers for early payment.

2. Credit Analysis And Evaluation
Another important role to be played by credit manager is to analyze and evaluate very carefully the credit proposals. Any credit proposal involves some sort of risk and profitability. If not analyzed well, a good customer may be misclassified as a poor credit risk customer and a bad customer as a good credit risk customer.

3. Credit Granting Decision
Once creditworthiness of a customer is analyzed and evaluated on the basis of available information, the credit manager should decide upon whether to grant credit or not. This depends on the result obtained from credit evaluation. Credit granting decision involves certain degree of risk. This risk is perhaps the risk of default. When credit is granted the credit manager either receives the payment in some future date or does not receive at all. If customers pay, firm is benefited by the amount equal to difference between sales revenue and cost. If customers do not pay than amount equal to cost of sales will have to be sacrificed, which otherwise would have been eliminated by refusing credit. Considering these profitabilities, the credit manager make credit-granting decision.

4. Controlling Account Receivables
Once credit is granted to customers, the role of credit manager becomes more important and challenging because the risk of default and cost of investment in account receivables begins with credit granting decision. Therefore, the credit manager should monitor and control accounts receivables periodically. Monitoring and controlling of account receivables involves different techniques, such as preparation of aging schedule, collection matrix and schedule of day's sales outstanding. The credit manager, on the basis of these techniques, should look at the receivable positions and compare it with the past position. If any customer is found to be stretching out the payment, the credit manager should make collection efforts through sending letter, telephone calls, emails, personal visit or legal action against default customers.

Introduction To Receivable Management And Its Purpose And Significance

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Introduction To Receivable Management
Receivables, also termed as trade credit or debtors are component of current assets. When a firm sells its product in credit, account receivables are created.
Account receivable are the money receivable in some future date for the credit sale of goods and services at present. These days, most business transactions are in credit. Most companies, when they face competition, use credit sales as an important tool for sales promotion. As a sales promotion tool, credit sale enhances firm's sales revenue and ultimately pushes up the profitability. But after the credit sale has been made, the actual collection of cash may be delayed for months. As these late payments stretch out over time, they may cause substantial drop in a company's profit margin. Since the extension of credit involves both cost and benefits, the firm's manager must be able to measure them to determine the ultimate effect of credits sales. In this prospective, we define the receivable management as the aspect of a firm's current assets management, which is concerned with determining optimum credit policy associated to a firm, such that the benefit from extension of credit is greater than the cost of maintaining investment in accounts receivables.

Significance And Purpose Of Receivable Management
The basic purpose of firm's receivable management is to determine effective credit policy that increases the efficiency of firm's credit and collection department and contributes to the maximization of value of the firm. The specific purposes of receivable management are as follows:

1. To evaluate the creditworthiness of customers before granting or extending the credit.

2. To minimize the cost of investment in receivables.

3. To minimize the possible bad debt losses.

4. To formulate the credit terms in such a way that results into maximization of sales revenue and still maintaining minimum investment in receivables.

5. To minimize the cost of running credit and collection department.

6. To maintain a trade off between costs and benefits associated to credit policy.

Factors Affecting The Size Of Investment In Inventories Or Determinants Of Inventories

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The size of investment in inventories is affected by a number of factors. Some of them are as follows:

1. Level Of Safety Stock
If a firm maintains high level of safety stock because of relatively larger degree of uncertainty associated to production and sales, the size of investment in inventories is also higher.

2. Carrying Costs
If the costs of holding inventories in stock is relatively low, the firm keeps larger stocks of inventories.

3. Economy in Purchase
If the firm is likely to receive certain benefits in the form of cash discount for purchase made currently, the size of investment in inventories is also likely to be larger because of larger quantity purchase.

4. Possibility Of Price Rise
If the price of materials is likely to rise in near future, the firm makes larger quantity purchase at present.

5. Cost And Availability Of Funds
If the cost of funds to be invested in inventories is relatively cheaper and they are conveniently available at present, the firm makes large purchase of inventories.

6. Possibility Of Rise In Demand
If the firm has anticipated the increased demand of its products in future, it maintains larger stocks of inventories at present.

7. Length Of Production Cycle
If the length of production cycle is relatively longer, the firm has to maintain investment in work-in-progress inventories for longer duration of time as a result of which the size of investment in inventories increases.

8. Availability Of Material
If certain kind of materials are only available in a particular season only, the firm has to increase the investment in inventories to keep larger stocks in the season.

9. Nature And Size Of Business
If the firm deals with the business of perishable products, the size of investment in inventories become lower. For a firm with relatively larger size and wide market coverage, the investment in inventories is larger.