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BLOCK 2. MANAGEMENT OF CORPORATE LIQUIDITY, RECEIVABLES AND INVENTORY
This unit presents to you the concepts and approaches to management of corporate liquidity, receivables and inventory.
Unit 1 highlights Liquidity management and financial flexibility. Importance of liquidity management will be explained and the liquidity management process will be discussed in a step by step way. Liquidity management strategy will be dealt with special focus to credit risk and liquidity perseverance. Various ratios related to liquidity measurement will be described including cash ratio, current ratio, working capital ratio etc. Finally, financial flexibility, project based budgeting and planning will be discussed in detail.
Unit 2 throws light on management of cash balances. Motives for holding cash will be discussed and cash management policy will be described in detailed manner. Determination of the appropriate levels of cash balances and investment of surplus or idle cash are highlighted followed by Baumol model of cash management; Miller and Orr model and Stone model of cash management. Short term investment decisions with special focus on project based investments, net present values; internal rate of return, accounting rate of return and pay
Unit 3 focuses on receivables management. After a brief introduction about receivables management, unit moves on discussing performance measures to manage receivables. Accounts receivable policy will be discussed in detail and receivables analysis with marginal approach will be tackled in the next section. Credit analysis and credit policy will remain other areas of discussion of this unit.
Unit 4 highlights principles of inventory management. It discusses reasons and objectives for keeping inventory and explains the costs of holding inventory. Kinds of inventory will be listed followed by principle of inventory proportionality. Some other areas of consideration of this unit are high level inventory management; accounting for inventory and inventory credit.
Last unit that is unit 5 discusses inventory valuation, control and short term financing. In a step by step way, unit explains and discusses inventory valuation methods; balancing inventory and costs; classic economic order quantity model for inventory control; other lot sizing and inventory control models; ABC analysis for inventory control; Short term financing and the future of inventory management
UNIT 1
CORPORATE LIQUIDITY AND FINANCIAL FLEXIBILITY
Objectives
After completing this unit, you should be able to:
• Understand the concept of liquidity management and its importance
• Become aware of the liquidity management process
• Understand the relevance of liquidity management strategy
• Know the concept and importance of liquidity measurement ratios
• Appreciate the financial flexibility and use of project based budgeting and planning to achieve better financial flexibility
1.1 INTRODUCTION
Liquidity refers to how quickly and cheaply an asset can be converted into cash. Money (in the form of cash) is the most liquid asset. Assets that generally can only be sold after a long exhaustive search for a buyer are known as illiquid.
We normally understand liquidity to mean stocks that have high trading volumes. But that is not always true. So, what is liquidity? It refers to the ability to buy or sell shares quickly at or near the current market price. Take Reliance Industries. Suppose there are buyers for one lakh shares at prices ranging from Rs 499 to Rs 501 and there are sellers for 1.5 lakh shares at prices ranging from Rs 500.50 to Rs 502. The current price is Rs 500.
What will happen if a mutual fund wants to buy 10 lakh shares? The price should go up because the demand for the shares is more than the supply. But what if more sellers enter the market, observing the additional demand for 10 lakh shares of Reliance? The increased supply of shares will prevent the stock price from rising sharply.
Suppose the mutual fund buys 10 lakh shares at an average price of Rs 501. Note that there is only a small price change due to sharp change in the demand for the shares. This change in price is called the impact cost. Stocks with low impact cost are said to be liquid.
Now, take a situation where the stock market is trending down. During such times, sellers outnumber buyers. Suppose 10 lakh shares of Reliance have already been traded. You now want to sell 10,000 shares at the market price of Rs 450. You may not be able to find buyers at that price. Why? Because the market is trending down, buyers want to pay a lower price. You cannot execute your order immediately at or near the current price. The impact cost will be high. The stock is, hence, not liquid. The volumes will yet be high.
One of the most important decisions a financial manager makes is how liquid a firm’s balance sheet should be. A manager can choose to reinvest the cash in physical assets, to distribute the cash to investors, or to keep the cash inside the firm. In fact, managers choose to hold a substantial portion of their assets in the form of cash and other liquid securities.
It is important to understand why firms hold substantial amounts of cash, which earns little or no interest, rather than channeling those funds towards capital investment projects or dividends to shareholders. In an environment with no market imperfections, firms can tap into financial markets costlessly and need not hold cash Keynes (1936) as cash has a zero net present investment value Modigliani and Miller (1958). However, in the presence of financial frictions, firms do not undertake all positive net present value projects, but rather choose to save funds for transactions or precautionary motives. In that sense, firms facing market imperfections must choose their level of liquidity at each point in time while taking into account current and future capital investment expenditures.
Management of liquidity plays a vital role in times of financial distress. A general view of financial distress is that it results from a mismatch between the currently available liquid assets of a firm and its current obligations under its "hard" financial contracts. Liquid assets constitute a considerable portion of total assets and have important implications for the firm's risk and profitability. For instance, Baskin reports that, among his sample of 338 major U.S. corporations, 9.6% of invested capital was held in cash and marketable securities in 1972. In his book on liquidity management, Kallberg provides six stages of decreasing liquidity as follows: (i) meeting current obligations from current cash flows, cash balances and short-term investments; (ii) using short-term credit; (iii) careful management of cash flows, e.g., through management of credit policy and inventory levels; (iv) renegotiation of debt contracts; (v) asset sales; and (vi) bankruptcy. In this unit we focus some of the important aspects of corporate liquidity and financial flexibility.
1.2 LIQUIDITY MANAGEMENT
Cash is the lifeblood of organisations. Better position of liquidity in organisation ensures regular flow of cash to the business. Effective liquidity management will enable an organisation to derive maximum benefits at minimal cost. The first thing in liquidity management is managing the cash in hand. This basically constitutes of the cash that is usually kept at home for emergency. This comes handy, in case of instant hospitalization, where you have to pay money at the time of admission.
Though the amount kept as cash-in-hand will vary depending upon the number of family members and the expected requirements. However, a minimum of Rs 25,000-30,000 is essential because it is the bare requirement in most situations. This provides an element of safety for the individual. It is very important that this amount is kept away from daily expenses and if used, replenished quickly.
We often hear the word liquidity used in combination with cash management. Liquidity is a firm's ability to pay its short-term debt obligations. In other words, if the firm has adequate liquidity, it can pay its current liabilities such as accounts payable. Usually, accounts payable are debts owe to our suppliers.
There are methods we can use to measure liquidity. Financial ratio analysis will help us determine how liquid firm is or how successful it will be in meeting its short-term debt obligations. The current ratio will help us determine the ratio of current assets to current liabilities. Current assets include cash, accounts receivable, inventory, and occasionally other line items such as marketable securities. We need to have more current assets than current liabilities on our balance sheet at all times.
The quick ratio will allow determining if we can pay your short-term debt obligations, or current liabilities, without having to sell any inventory. It's important for a firm to be able to do this because, if we sell have to sell inventory to pay bills that means we have to find a buyer for that inventory. Finding a buyer is not always easy or possible.
There is various other measure of liquidity that you will want to use to determine our cash position. When your business is just starting up, we essentially run it out of a check book, which is an example of cash accounting. As long as there is cash in the account, our business is solvent. As business becomes more complex, we will have to adopt financial accounting. However, we have to keep a focus on liquidity and cash management even though our track net income through financial accounting.