Significance Of The Concept Of Time Value Of Money

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 importance or 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

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

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

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

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

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

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. Therefore, carrying cost is also one of the key determinant 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.

Objectives Of Holding Inventories

Every firm must hold adequate inventory. The main objective of holding inventories is to reduce the cost associated with investment in inventory and maintaining efficiency in production and sales operations. If a firm does not hold sufficient inventory, and makes purchases only when it is needed for production and sale arises, then the firm will not be able to offer timely delivery according to customers order.

Objectives of holding inventory may be specified as below:

1. To Avoid Losses Of Sales

One of the main objectives of holding inventory is to avoid the losses of sales. If the firm holds inadequate inventory of finished goods, the form could not satisfy customer's demand timely. As a result, the customers requiring immediate supply of goods will move to the competitors, which is known as stock-out problem.

2. To Gain Quantity Discounts

Suppliers usually offer a quantity discount on bulk purchase of materials. Therefore, if a firm has relatively lower holding cost of material, it could maintain relatively larger investment in inventories to gain from the quantity discount offered by suppliers. However, it should be noted that the benefit from quantity discount must be greater than the cost of maintaining inventories.

3. To Reduce Order Costs

If a firm's ordering cost is relatively higher for order placed each time, frequent purchasing in small quantity is not economical. Therefore, placing lessor number of orders in relatively large quantity each time could reduce the variable costs associated to ordering of material.

4. To Achieve Efficient Production Run

When a firm schedules production. the firm has to maintain a fixed production set up costs for each time. Therefore, by maintaining adequate inventories the firm can set up relatively longer run of the machines so as to reduce set up cost per unit.

Introduction And Importance Of Inventory Management

Introduction To Inventory Management

The term inventory refers to the goods or materials used by a firm for the purpose of production and sale. It also includes the items, which are used as supportive materials to facilitate production.
There are three basic types of inventory: raw materials, work-in-progress and finished goods. Raw materials are the items purchased by firms for use in production of finished product. Work-in-progress consists of all items currently in the process of production. These are actually partly manufactured products. Finished goods consists of those items, which have already been produced but not yet sold.

Inventory constitutes one of the important items of current assets, which permits smooth operation of production and sale process of a firm. Inventory management is that aspect of current assets management, which is concerned with maintaining optimum investment in inventory and applying effective control system so as to minimize the total inventory cost.

Importance Of Inventory Management

Inventory management is important from the view point that it enables to address two important issues:

1. The firm has to maintain adequate inventory for smooth production and selling activities.

2. It has to minimize the investment in inventory to enhance firm's profitability.

Investment in inventory should neither be excessive nor inadequate. It should just be optimum. Maintaining optimum level of inventory is the main aim of inventory management. Excessive investment in inventory results into more cost of fund being tied up so that it reduces the profitability, inventories may be misused, lost, damaged and hold costs in terms of large space and others. At the same time, insufficient investment in inventory creates stock-out problems, interruption in production and selling operation. Therefore, the firm may loose the customers as they shift to the competitors. Financial manager, as he involves in inventory management, should always try to put neither excessive nor inadequate investment in inventory. The importance or significance of inventory management could be specified as below:

* Inventory management helps in maintaining a trade off between carrying costs and ordering costs which results into minimizing the total cost of inventory.

* Inventory management facilitates maintaining adequate inventory for smooth production and sales operations.

* Inventory management avoids the stock-out problem that a firm otherwise would face in the lack of proper inventory management.

* Inventory management suggests the proper inventory control system to be applied by a firm to avoid losses, damages and misuses.

Functions Of Cash Management

Cash management is concerned with the management of cash inflows, outflows and cash flows within the firm. It also includes the matters relating to financing of deficit and investment of surplus cash so as to maintain optimum cash balance. The functions of cash management start when a customer writes cheques to pay the firm on its account receivable. The function ends when a supplier, an employee or the government realizes funds from the firm on an account payable or accruals. The basic issue of cash management is to enable a firm to maintain sufficient liquidity and also at the same time improve its profitability.

If cash flows were accurately predicted, the firm would not have to give much attention on management of cash. Cash outflows to some extent are certain but cash inflows cannot be predicted accurately. There is no perfect synchronization between cash inflows and cash outflows.Sometimes, cash outflows exceeds cash inflows due to unusual payment of obligation and non-seasonal build up in inventories and receivables. And sometimes cash inflows will be more due to excessive sales than expectation and rapid conversion of receivables into cash.

To overcome the uncertainty about cash flow prediction and to maintain coincidence in cash inflow and outflow, the firm's cash management function should consist of following strategies:

1. Turn over inventory as quickly as possible, avoiding stock-out that may result in a loss of sales.

2. Pay accounts payable as late as possible without deteriorating the firm's credibility, but take advantage of any favorable cash discount.

3. Collect account receivables as quickly as possible without loosing future sales due to high-pressure collection techniques. Cash discounts, if any are economically justifiable, may be used to accomplish this objectives.

4. Involve in cash planning to determine deficit or surplus cash in each period.

5. Surplus cash must be invested into marketable securities.

Advantages Of Holding Adequate Cash

Cash should not be hold more or less than requirement and it must be just adequate. The holding of cash in adequate amount offers the following advantages:

1. Advantage Of Cash Discount
Most business purchases are made in credit basis. The duration of credit period generally ranges from 15 days to 90 days. Suppliers of trade credit must be paid within the due date. But sometimes the suppliers may offer cash discount for the early payment. Therefore, adequate cash balance needs to be held to take the benefit of cash discount offered by suppliers. Whether to take or forgo the cash discount depends on the comparative cost benefit analysis of cash discount foregone. Generally, forgoing the cash discount involves higher opportunity cost than the cost of short-term bank loan.
To be more clear, let us suppose a firm makes credit purchase under the credit term 3/10, net 40. This states that the payment of credit purchase must be made within 40 days. If the payment is made within 10 days, the firm gets 3% cash discount. With this discount offer, if the firm fails to pay within 10 days discount period, it will be paying extra 3% for using the funds for an additional 30 days. The annual cost of fund used for additional 30 days is calculated as:
Percentage cost = (Discount %/100 - Discount %) X 360/Final due date - Discount period
= (3/100-3) X 360/40-10 = 0.3763 = 37.63%

Thus annual cost of cash discount foregone is 37.63 percent, which is much higher than the cost of short-term borrowing. Hence paying the trade credit within the discount period, the firm could take the benefit of cash discount offer. For this reason, the holding of adequate cash is beneficial as it enables the firm to take this benefit.

2. Favorable Credit Rating
Holding adequate cash also enables a firm to maintain favorable credit rating. Short-term credit standing of a firm is determined mostly on the basis of current and quick ratio position. Suppliers of short-term funds evaluate the firm's short-term solvency position in terms of its ability to meet the standard line of business. Holding of adequate cash maintains the current and quick ratio at favorable position so that the firm will be able to meet the standard of credit analysis of the supplier of short-term funds.

Besides, these benefits, holding of adequate cash helps the firms to take the advantage of reduced price offer at immediate cash payment, and also maintain precaution against some emergencies such as strikes and lock-up, flood, fire, malpractices of competitors etc.

Motives For Holding Cash

Cash is known as most liquid and less productive assets of a firm. If cash remains idle, earns nothing but involves cost in terms of interest payable to finance it. Although cash is least productive current assets, firm should hold certain amount of cash for marketable securities. Mainly, there are three motives for holding cash.

1. Transaction Motive Of Holding Cash

Transaction motive refers to the need to hold cash to satisfy normal disbursement collection activities associated with a firm's ongoing operation. Transaction means the act of giving and taking of cash or kinds in the ordinary course of business. A firm frequently involves in purchase and sales of goods or services. A firm should make payment in terms of cash for the purchase of goods, payment of salary, wages, rent, interest, tax, insurance, dividend and so on. A firm also receives cash in terms of sales revenue, interest on loan, return on investments made outside the firm and so on. If these receipts and payments were perfectly synchronized, a firm would not have to hold cash for transaction motive. But in real, cash inflows and outflows cannot be matched exactly. Some times receipts of cash exceeds the disbursement whereas at other time disbursement exceeds the receipt. Because of this reason, if disbursement exceeds the receipt, a firm should hold certain level of cash to meet current payment of cash in excess of its receipt during the period.

2. Precautionary Motive Of Holding Cash

Precautionary motive refers to hold cash as a safety margin to act as a financial reserve. A firm should hold some cash for the payment of unpredictable or unanticipated events. A firm may have to face emergencies such as strikes and lock-up from employees, increase in cost of raw materials, funds and labor, fall in market demand and so on. These emergencies also bound a firm to hold certain level of cash. But how much cash is held against these emergencies depends on the degree of predictability associated with future cash flows. If there is high degree of predictability, less cash balance is sufficient. Some firms may have strong borrowing capacity at a very short notice, so that they can borrow at the time when emergencies occur. Such a firm may hold very minimum amount of cash for this motive.

3. Speculative Motive Of Holding Cash

The speculative motive refers to the need to hold cash in order to be able to take advantage of bargain purchases that might arise, attractive interest rates and favorable exchange rate fluctuations. Some firms hold cash in excess than transaction and precautionary needs to involve in speculation. Speculative needs for holding cash require that a firm possibly may have some profitable opportunities to exploit, which are out of the normal course of business. These opportunities arise in conditions, when price of raw material is expected to fall, when interest rate on borrowed funds are expected to decline and purchase of inventory occurs at reduced price on immediate cash payment.