Inventory Management Policy

Inventory Management Policy



Working capital management is one of the major issues of corporate finance. The success of any manufacturing company largely relies on the efficient management of working capital. There are different theoretical developments and empirical issues but there is no unified rule that can determine the optimal level of working capital. From the viewpoint of developing country like Bangladesh the role of working capital should be highly emphasized. But our country is characterized by low level of capital market development and inefficiency of financial market. In such a situation, it is hardly possible to have the desired funds to maintain the liquidity of business by collecting and investing funds as and when required.

The available literature suggests that static focusing on working capital management is not extensive in Bangladesh. The study although will not give a clear idea to draw a conclusion about the working capital management policy and practice of Bangladeshi Firms but will definitely give an overall idea about working capital management practice of the particular industry in Bangladesh.

This report focuses on the working capital management of a reputed textile firm of Bangladesh. In this regard, we have selected Square Textile Ltd. We tried to link our findings in working capital in Square Textile Ltd. and theoretical aspects. We have found some similarities and some dissimilarity in this regard. We have particularly pointed in the inventory management, liquidity management and credit policy of the company. Overall working capital management of square textile has been stated in detailed.

Objectives of the Study:

The purpose of the study is to analyze the working capital management practices of Square textile ltd. The main objectives of the study are as follows:

  • To observe profitability and liquidity in case of working capital management.
  • To observe the position of debt fund out of total fund.
  • To appraise the performance of this company through ratio analysis.
  • To determine problems & provide suggestion which would help to improve the situation.

Methodology of the Study

The report is mainly based on secondary data that we have collected from various sources. The major source of information was the Annual Report of the company under study. The other sources include Internet. The details of all the books and journals being used in this report are shown in the bibliography.

Scope of the Study

The focus of this report is based on management of Working Capital practices in the selected company. We have focused on different organizational strategies that have been observed in this company to find out the general working capital management practices.

Limitations of the Study

We have faced some usual constraints during the study. These are as follows:

  • Relevant papers and documents were not available with sufficient data.
  • Enough information was not found to make a comprehensive study.
  • We had to complete this study within a very short time, which was not sufficient.
  • In spite of our sincerity, some mistakes might have been occurred. We admit our responsibility for those inadvertent mistakes, if any.


The report is prepared considering different quantitative aspect of the Square Textile Ltd.

Financial statement of the Square Textile Ltd has been used. A brief profile of Square Textile Ltdis presented below:


Working capital management is one of the central issues of corporate finance. The success of any manufacturing company largely relies on the efficient management of working capital. There are different theoretical developments and empirical issues but there is no unified rule that can determine the optimal level of working capital. From the viewpoint of developing country like Bangladesh the role of working capital should be highly emphasized. But our country is characterized by low level of capital market development and inefficiency of financial market. In such a situation, it is hardly possible to have the desired funds to maintain the liquidity of business by collecting and investing funds as and when required.

Working Capital Management

Financial management of an organization involves three major functions

  1. Management of long-term assets
  2. Accumulation or management of long-term capital funds
  3. Management of day-to-day operation

The first function involves capital budgeting issues. The second function involves the capital structure and dividend issues. The third one deals with management of working capital or current assets and current liability management issues. The working capital of a firm includes:

a) Current Assets

b) Current Liability

Current Assets includes

  • Cash
  • Marketable Recurities
  • Account Receivables
  • Inventory
  • Prepaid Expenses etc.

Current Liability includes

  • Accounts Payable
  • Wages Payable
  • Different Accruals
  • Bank Over Draft and Short term Loans
  • Commercial Paper Issued
  • Unpaid Dividend etc.

In general working capital refers to all of these assets and liabilities. Frequently by the concept of working capital it is meant that the net amount of working capital which is the difference between current assets and current liabilities.

Approaches of Working Capital Management

  • Conservative Approach
  • Matching Approach
  • Aggressive Approach

Conservative Approach: When a firm follows a conservative approach, it depends more on long-term funds for financing needs. The firm finances its fixed assets, permanent current assets and also a portion of temporary current assets with long term financing. This approach is also known as traditional approach. In this approach, the Current ratio (Current Assets : Current Liabilities) of a firm should be 2:1.

Matching Approach: Under matching approach, long term financing is used to finance fixed assets and permanent current assets and short term financing is used to finance temporary current assets, thereby making the average net working capital equal to zero.

Aggressive Approach: Under this approach, firm uses more short term financing. The firm finances its temporary current assets and also a part of permanent current assets with short term financing. Some extremely aggressive firm may also finance a portion of fixed assets with short term financing. Theoretically it implies negative working capital or a situation where firm’s long-term assets are financed through short term capital.

Necessity of working capital

Basically working capital is required for the day-to-day operation of the firm. It involves –

  • Getting right raw material supplied in right time.
  • Wages and utility bills are properly cleared.
  • Customers are smoothly getting their demanded good and services regularly.

In a perfect world with equal borrowing & lending rate along with completely certain forecast of demand & supply of goods of sold $ services, there is no need for having inventory accruals & other Current Assets & Liabilities. But in real world situation with full of uncertainty costly information, limitation in production capacity expansion, and the manager must maintain provisions for the enforcing events that is the manager must maintain some inventory of liquidity as well as inventory of raw material and finished goods.

Working Capital Cycle

The working capital cycle can be defined as the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer

Cash flow is the business’s life blood and every manager’s primary task is to help keep it flowing and to use the cash flow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn’t generate surpluses, the business will eventually run out of cash and expire.

The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. The cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm’s total profits.

The dotted part of the above diagram shows in a simplified form the chain of events in a manufacturing firm. Each of the boxes in the dotted box of the diagram can be seen as a tank through which funds flow. These tanks, which are concerned with day-to-day activities, have funds constantly flowing into and out of them.

  • The chain starts with the firm buying raw materials on credit.
  • In due course this stock will be used in production, work will be carried out on the stock, and it will become part of the firm’s work in progress (WIP).
  • Work will continue on the WIP until it eventually emerges as the finished product.
  • As production progresses, labor costs and overheads will need to be met.
  • Of course at some stage trade creditors will need to be paid.
  • When the finished goods are sold on credit, debtors are increased.
  • They will eventually pay, so that cash will be injected into the firm.

Each of the areas- stocks (raw materials, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into and from which funds flow.

Working capital is clearly not the only aspect of a business that affects the amount of cash:

  • The business will have to make payments to government for taxation.
  • Fixed assets will be purchased and sold.
  • Lessors of fixed assets will be paid their rent.
  • Shareholders (existing or new) may provide new funds in the form of cash.
  • Some shares may be redeemed for cash.
  • Dividends may have to be paid.
  • Long-term loan creditors (existing or new) may provide loan finance, loans will need to be repaid from time to time, and
  • Interest obligations will have to be met by the business.

Unlike movements in the working capital items, most of these ‘non-working capital’ cash transactions are not everyday events. Some of them are annual events (e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others (e.g. new equity and loan finance and redemption of old equity and loan finance) would typically be rare events.

Sources of additional Working capital Sources of additional working capital include the following:

  • Existing cash reserves
  • Profits
  • Payables
  • New equity or loans from shareholders
  • Bank overdrafts or lines of credit
  • Long-term loans

If any firm has insufficient working capital and try to increase sales, we can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include:

  • Pressure on existing cash
  • Exceptional cash generating activities e.g. offering high discounts for early cash payment
  • Bank overdraft exceeds authorized limit
  • Seeking greater overdrafts or lines of credit
  • Part-paying suppliers or other creditors
  • Paying bills in cash to secure additional supplies
  • Management pre-occupation with surviving rather than managing

Reason for Holding Cash and Marketable Securities

Cash is the least productive asset of any firm. They are not the part of any assets relating to production or selling process. However, every firm needs cash in order to perform the following activities of the firm :

Daily Transaction Needs – Cash in the form of non-interest bearing currency and checking deposits is being hold by the firm for transaction demand. Since debts are settled by the exchange of cash, the firm must hold some cash in the bank to pay suppliers.

Cash for Hedging – The firms future cash needs for transactions purposes are often quite uncertain. The firm needs immediate cash if emergency arises. So, the firm must hedge against the possibility of those unexpected needs. One of the hedging strategies is to hold extra cash and near cash assets to fulfill the emergency transaction demand.

Temporary Investments – Many firm experiences some seasonality in sales. When such firms have excess cash that will be needed later, the firm will temporarily invest the cash in interest earning marketable securities from the time the cash is available until the time it is needed. Proper planning and investment selection for this strategy can yield a reasonable return on such temporary investments.

Cash Forecasting Necessity of cash forecasting Cash forecasting is necessary for –

  • Estimation of borrowing and lending needs.
  • Dealing with uncertainties during these periods.
  • Future planning.
  • Cash support for operation.
  • Liquidity management.
  • Corporate objectives.
  • Financial planning.
  • Capital budgeting.
  • Operational budgeting.
  • Production planning

Sources of uncertainty in cash forecasting

  • Sales revenue uncertainty
  • Collection rate uncertainty
  • Production cost uncertainty
  • Capital investment and cash inflow uncertainty

Hedging cash balance uncertainties The following techniques generally used by a firm to overcome cash balance uncertainty :

  • Holding a stock of extra cash.
  • Holding a stock of near-cash assets.
  • Extra borrowing capacity.
  • Investing temporary surpluses in near-cash assets.
  • Using option and future market.

Trade credit

It is one of the oldest forms of credit arrangements. From ancient time traders allowed its trusted customers to buy goods on credit. In modern age the trade credit is considered as the integral part of all business activities. The trade credit is extended not surely for historical reasons.

In general three reasons are shown to argue in favor of trade credit. These are –

a)      opportunity for financial arbitrage

b)      Informational gap regarding product / service quality.

c)      To facilitate payments through systematic and reliable means.

Credit Granting Decisions

Credit granting decisions involved with two decisions. These are – which customer of the firm will be granted credit in exchange of goods or services and which customer will be required to pay cash.

Factors Affecting Credit Granting Decisions of the Firm

  • Solvency of the firm and the owner.
  • Length of life of the firm and the industry.
  • Whether it is a related or unrelated industry.
  • Security deposit.
  • Length of loan.
  • Past dealings with the firm.
  • Frequency of dealings with the firm and other competitors in the industry.
  • Whether the party is genuine or fake.

Traditional Approach of Credit Granting Decisions

This approach is based on 5 C’s which are as follows:

  • Capital of the customer or firm.
  • Character of the customer.
  • Collateral of the customer or firm.
  • Capacity of the customer or firm.
  • Conditions (Industry).

Problems with Traditional Approach

  • No Analytical framework.
  • No link to shareholder’s wealth maximization.
  • No consistency of analysis.
  • Difficult for the inexperienced analyst to execute.
  • Rely on subjective judgments.

Aggregate Liquidity Analysis

The overall relationship between a firm’s available cash and its potential cash needs (i.e. for liabilities) is known as firm’s liquidity position. This liquidity position represents a firm’s gross hedge to meet cash needs for current liabilities to minimize chances of a cash stock out situation.

Traditional Measurement of Liquidity:

  • Analysis of Liquidity Ratios
    • Current Ratio
    • Quick Ratio or Acid Test Ratio
    • Super Quick Ratio
    • Net Working Capital Ratio
    • Profitability Analysis
      • Gross Profit Margin
      • Net Profit Margin
      • Return on Assets
      • Return on Equity
      • Leverage Analysis
        • Total Debt to Equity
        • Lt. debt to Equity
      • Analysis of Efficiency /Activity Ratios
        • Accounts Receivables Turnover Ratio
        • Inventory Turnover  Ratio
        • Inventory Conversion Period
        • Average Collection Period

Sophisticated Techniques for Measuring Aggregate Liquidity:

  • Cash Conversion Cycle: Operating Cycle Time & Payment Deferral Period 
  • Net Liquid Balance (NLB)

Inventory management:

Inventory itself is physical in nature but its management is absolutely financial issue. The other types of current assets include account receivable, prepayments etc which are absolutely financial in nature.

The inventory can arise through 

  1. Purchases from other firms
  2. Production from within the firm
  3. Extraction from natural sources

Whatever may be the sources of such inventory, as it involves bulk area pretty often and involves significant portion of current assets of a firm so it deserves special attention.

Economic Order Quantity

Economic Order Quantity is the most advantageous amount for the firm to order each time. It is only applicable to those inventory situations when the above assumptions are undertaken.

  • There are only two types of cost: carrying cost and ordering cost. There are no cost that are indirectly proportional to the amount of inventory held and the price per unit of inventory obtained does not vary with the amount of inventory received. Stock out cost are modeled separately are not considered in the EOQ model.
  • There are no lead times of any length.
  • There is no risk.
  • The replenishment rate is finite.
  • The Economic Order Quantity (EOQ) formula is as follows:

Where,    P = Unit purchase cost

S = Yearly Demand of Materials

C = Annual carrying cost as % of Inventory

F = Per order fixed cost

Inventory Management Policy of Square Textile Ltd.

Inventory Procurement Policy:

Inventory of the firm mainly consists of raw materials of the products and packing materials.

Square Textile Ltd. mainly concentrates on inventory of raw materials and packing materials. But its inventory stocks consists of raw materials, packing materials, raw materials in transit, work-in-process, finished goods, waste cotton, spares& spares in transit.. Inventories are bought from foreign market as well as from local market. All packing materials are purchased from local market.

Reasons for holding different kinds of inventory:

Reasons for holding raw materials inventory:

  • It makes production scheduling easier
  • It helps to avoid price changes for these goods.
  • The firm may keep extra raw materials inventory to hedge against supply shortages
  • The firm may order and keep additional inventories of raw materials to take advantage of quality discount.

Reasons for holding work in process inventory:

  •  A major reason that firm keeps work in process inventory beyond the minimum level is to buffer production.

Reasons for holding finished goods inventory:

  • One reason to keep finished goods inventory is to provide immediate service to the customers.
  • A second reason to keep finished goods inventory is to stabilize production.

Costs that are considered in inventory procurement policy:

Different types of costs are discussed in the following paragraphs:

Cost directly proportional to amount of inventory held:

Carrying cost of inventory or holding cost of inventory.  The formula for this type of costs are Cost = (a) (amount of inventory)

Where, a is a coefficient representing the sum of all costs that are directly proportional to the level of inventory.

 Cost not directly proportional to the amount of inventory held:

There are group of costs that varies with inventory size but not in direct proportionality. The formula for these costs is:

Cost = f (inventory level)

Where, f (inventory level) means that cost is a function of inventory level, with the particular mathematical relationship depending upon the type of cost being considered.

Cost directly proportional to the number of orders:

There are costs to the ordering, delivering and payment processes. These costs depend directly on the number of times the orders are placed and received. Cost of this sort include set o[ costs on machines to produce inventory, costs of generating a purchase order for the inventory, costs of writing a cheque and mailing it in payment for the order, fixed costs of unloading the order and so forth. The formula for this type of cost is:

Cost = © (number of orders)

Where, c is a coefficient representing the sum of all the costs in this type. The price per unit of inventory obtained:

Due to quantity discounts and economics of scale in production, the price per unit of goods purchased or produced for inventory may vary with the amount ordered. The formula for the total cost of the inventory is:

Where Pa is the unit price for the quantity ordered by the firm and S is the yearly usage of the good.

Another cost that is dependent on the firm’s inventory strategy is stockout cost. Stockout cost occurs when immediate service is required but inventory is unavailable.

Usually a minimum amount of spoilage occurs for holding inventory. But ordering cost and carrying cost of inventory is considerable in case of materials purchased from foreign market. Materials that are purchased from local market incur less amount of both direct and indirect cost of holding inventory.

Stock out cost is a common problem for the firm. This happens because of low predictions about market demand. A good prediction about market demand and safety stock position can alleviate the problem. But the firm does not have a good policy for maintaining adequate safety stock. Another problem for not meeting up the market demand is a long lead time, which helps to fail the fulfillment of demand.

Inventory Store Management:

The management of inventory is one of the oldest concerns of management science. Like all other assets inventory represents a costly investment to the firm. There are some reasons why a firm may want to carry inventory. Square Textiles Ltd. follows the periodic inventory system for managing the inventory records. The problem that they face with stocks is somewhat related to dynamic inventory problem where the goods have value beyond the initial period; they do not lose their value completely over time. The process of followed by Square textiles Ltd for managing inventory is as follows:

Where the cost of merchandise purchased during the year is debited to a Purchases account, rather than to the inventory account. When merchandise is sold to a customer, an entry is made recognizing the sales revenue, but no entry is made to reduce the inventory account or to recognize the cost of goods sold. The inventory on hand and the cost of goods sold for the year are not determined until year end. At the end of the year, all goods on hand are counted and priced at cost. The cost assigned to this ending inventory is then used to compute the cost of goods sold. The only computation that is kept up to date in the accounting records is the purchases account. The amounts of inventory at the beginning and end of the year are determined by annual physical observation.

Sources and level of risk in inventory management:

Uncertainty plays a significant role in inventory management. Uncertainty usually involve

  1. Lead time during creation lag

The creation of inventory whether on cash or credit purchase requires some time to be delivered. This time from order placing to delivery at firms shipping dock is called creation lag. If this time lag prolongs than expected then it affects the overall inventory turnover ration of the firm. Hartals, and strikes particularly in the port area make the creation lag possible to be longer. For this reason Square Textile considers this lag significantly while making any inventory decision.

  1. The level of demands during the storage lag:

Once an inventory is delivered, it is not out right sold out. It requires some time for these inventory to be resold before that it must be either subject to further production or otherwise waiting for being sold. This time from delivery by supplier to delivery to the customers are known a storage lag. This lag can further subject to production lag. Square Textile tries to forecast the market demand of its goods and then takes inventory decision to minimize risks.

Inventory Valuation Method:

The break up of Inventory Stock of Square Textile ltd for the year 2004 is as follows:

The break up is under:

Raw materialsTk.336456255
Raw material in transitTk 2442980
Packing MaterialsTk 2898296
Work in ProcessTk 6570867
Finished GoodsTk 20740646
Spares at StoreTk 32539232
Spares in TransitTk 698685
Waste CottonTk 3102848

The basis of inventory valuation is as follows:

Inventory stocks comprise of raw materials, packing materials, raw materials in transit, work-in-process, finished goods, waste cotton, spares& spares in transit. Stocks are valued at the lower of cost and net realizable value. Value of stock other than stock of finished goods represents weighted average cost. Finished goods are valued at lower of cost or net realizable value and include allocation of production overheads while works in process are valued at material cost. Factors in deciding inventory level:

Before deciding the level of inventory to be hold, the firm considers the following factors:

A} Sales Forecasts: Sales forecast helps the firm to plan for production which ultimately helps in deciding the level of inventory to hold.

B} Production Plan: As described above, the production or sale plan of a firm determines how much inventory will be required by a firm for its production or sales purpose.

C} Socio Economic Factors: Some factors fiscal and monetary policy of the country, political instability are considered by the square textile to forecasts sales volume which finally affect the inventory management decision.

D} Technological Consideration: Inventory in textile industry involves highly sophisticated items. Hence the possibility of obsolescence enhances and so the level of inventory should be kept low.

Credit Policies of Square Textile Ltd:

In credit policy of square textile, we have mainly focuses on-

  • Terms of sales
  • Credit granting Decision 

Terms of Sales Decision

Rational behind trade credit:

Trade credit is the oldest system of granting credit. In ancient periods, the sellers grants only to trustworthy customers to allow trade credit. But now it is usual for all business purpose. Other than historical reasons, there are three reasons of granting trade credit:

  1. Opportunity for financial arbitrage
  2. Information gap regarding product quality
  3. To facilitate payments through systematic and reliable means
  4. Other reasons.

These issues are discussed in short in below:

1. Opportunity for financial arbitrage:

Arbitrage is a process. If there exists perfect market and if there are also any distortions in the market, then this price difference is avail by the traders. If firms operated in perfectly competitive capital markets, there would be no financial impetus for trade credit. But in reality capital markets are most of the times are not perfectly competitive. Buying firms may not be able to economically replicate the delay in payment that is inherent in the trade credit. When such imperfection occurs, trade credit can serve as a conduit for funds from the capital markets to buying firms. Sellers can borrow in the capital markets then lend to buyers via trade credit. This process of borrowing cheaply by the sellers in order to re-lend to buyers substitutes for buyer excess to the capital market and thus it is a kind of financial arbitrage.

2. Information gap regarding product quality:

The buyer’s imperfect knowledge regarding the quality of the products purchased is another possible function of the trade credit. Trade credit is helpful in the following reasons regarding this:

  • when the payment is delayed until some time after the goods have been received, the buyer has the opportunity to count and inspect the goods.
  • If the goods are not up to the required standards, the buyer may pay partially or not pay at all until the defect is fixed.
  • It the buyer pay cash for the goods then much of the leverage is lost.

3. To facilitate payments through systematic and reliable means:

It is less costly and less risky from both the buyer and seller point of view if payment is made on credit rather than in cash. Because of;

  • Theft can occur if employees deal with large sums of money.
  • Delivery personnel can loss certified check presented on delivery.

4. Other reasons:

There are more complex explanations for the existence of the trade credit. These are:

i) Estimation of demand of the product: firms use terms of sales to stimulate demand for its product by lengthening the payment period when demand is less than expected. Similarly, firms shorten terms of sales to curtail demand when it is more than expected.

ii) Buyer’s default: This explanation centers on the use of cash discount amount, cash discount date and net date to obtain information regarding the probability of buyer’s default. Buyers who don’t take advantage of generous cash discount may be more prone to default.

Factors affecting trade credit:

The factors that one should consider in determining trade credit are as follows:

  1. Terms of sale: terms of sales must be same in almost all cases for all customers.
  2. Consistent with law: terms of law must not violate any law of land. Example: anti trust law to protect from monopoly business.
  3. Setting parameters: terms of sales decision involves setting of three parameters:
  1.  The cash discount -the amount of discount allowed for payment within a specified period of time.
  2. The period of time this discount is to be allowed.
  3. The net date –the due date of invoice is the cash discount is not taken.
  1. Optimum terms of sales: Firm has a set of optimum terms of sales that results in the highest possible net present value to the selling firm. Firm must find out those optimum terms of sales that maximizes its wealth.

Purposes of changes in trade credit:

Every commitment of financial resources in a firm should contribute to the goal of wealth maximization. In support of this objective, we can identify 3 goals of maintaining trade credit or terms of sales:

  1. To achieve the growth in sales
  2. To increase in profit
  3. To meet competition

Factors that are affected by trade credit:

The various types of costs and revenues that may be affected by the firm’s trade credit decision are as follows:

  • Collection on sales
  • Investment in inventory
  • Discount and bad debt expenses
  • Collection cost
  • Timing and capital expenditure
  • Income tax

Methods of finding optimum credit policy:

To find optimum credit policy, mostly 2 methods are used:

  1. Traditional one period evaluation technique: it is also known as standard approach for change in term of sale.
  2. 2. Multi period approach

Square textile Ltd does not follow strictly any 2 of these methods. They mainly follow industry norm and experience in this business arena. Terms of sale decision in case Square Textile Ltd:

What will be the terms of sale –this decision is influenced mainly by the industry norm the market condition and Size of the account Minimum credit period Square Textile is 180 days. They do their aging of receivables in the following way:

Above 180 days———amount

Below 180 days———amount

Credit Granting Decision:

Sources of credit Information:

Square Textiles has many foreign buyers as well as local buyers to whom it grants credits. Local buyer do not hold a good percentage of total sales. Some significant foreign buyers for Square Textile ltd are PUMAH, GAPE etc. In a wealth maximizing approach to the credit granting decision, the selling firm evaluates the cash flow that would result from granting credit to a credit applicant versus that would result it credit were not granted to that applicant. As in terms of sale analysis these cash flow results from the cost and revenue effect of the decision. These are changer in sales and collection the cost of production, bad debt expense and so forth that are contingent on the granting or not granting credit.

Estimates of these costs and revenues can be collected from different. These sources vary in their cost and the type of information they provide. Several sources of information are as follows:

1. Seller’s prior experience with the customer:

One of the cheapest and most reliable sources about expected future payment patterns extracted from the customer’s history of dealing with the seller.

2. Credit agency and Reports: The professional credit information sources such as financial information about vary wide range of buyer including individuals and firms.

3. Personal Contact with the Applicant’s Bank and other Creditor’s: Expensive way of gathering information from credit applicant’s bank and other creditors but these sources is reliable too.

4. Analysis of financial statements: It is testing the ability of generating the ability or repayment of debt.

5. Customer visit: One of the most expensive source that give information about the management of the of the firm directly

Approaches Of Taking Credit Granting Decision:

Two approaches:

Traditional Approach:

Objective of the approach: Assessing the credit worthiness of the customer.

Process of the approach: I a traditional approach to the credit granting decision credit analysis synthesize all information that has been collected and reach a judgment regarding the credit worthiness. For the synthesizing the applicant is characterizing along 5 dimensions called five C’s –

1. Capital: This refers to the financial position of the firm such as: Liquidity position, leverage position, asset to debt position, capital invested and size of business.

2. Character: In assessing character the credit analyses consider all the information that relates to the willingness to pay by the management.

3. Collateral: Information on secure borrowing is gleaned from the applicant’s financial statements, banks, credit reports on the applicant or directly from conversation with the applicant.

4. Capacity: Information gathered relating to the following 3 dimensions:

a) Managerial Capacity to run the business.

b) Production and selling capacity

c) Product capacity to add profit margin.

5. Conditions: Synthesizing information about the industry of the applicant.

Problems with the method:

a) Subjective judgment,

b) Time value of money ignored.

Credit granting through wealth- maximizing approach:

Objective: Taking credit granting decision by using value of money as the base. Here decision is taken using a decision tree format.

Process of the approach: The following formula is used:

Credit granting decision and Square textile:

Credit granting decision in case of foreign buyers:

Type of information:

a)payment pattern of the buyers.

b) Financial condition of the buyers

c) History of the buyer

d) Default probability of the buyers

Sources of credit Information:

Always in case of foreign buyers collecting information is very limited the acronym fits the best is the LESS, where

L for limitation of sources.

E for expensive

S for slow (distance language barrier)

S for suspect (neutral information)

Ad they deal with the foreign buyers the main source is the

a) Company website then

b) Bankers statement

c) Other sources

Past experience of dealing with the same buyer Past experience of dealing with the buyer of other manufacturers.

Approaches of Taking Credit Granting Decision:

Qualitative analysis:

Square textile collects information about the buyers and synthesizes that in the following way

Buyer’s character that is the willingness in case of payment of credit.

Buyer’s financial strength to generate future cash flow

Payment procedure

Paper processing and attitude in ealing transaction.

Quantative analysis:

Square textile while accepting a buyer look after

The Price they are offering

The quality they are demanding

Probability of default and its effect in case of expected cash flow.

Analyze whether the offer would add value after deducting the cost factors.

Credit granting decision in case of local buyers:

Type of information:

a)payment pattern of the buyers.

b) Financial condition of the buyers

c) History of the buyer

d) default probability of the buyers

Sources of credit Information:

a) past experience of dealing with the customer

b) Banker statement

c) Personal visit

Approaches of Taking Credit Granting Decision in case of local buyers:

Qualitative analysis:

Collected information is also assessed here to get conception about the

1. Capital, 2. Character, 3. Collateral, 4. Capacity of the buyer.

Quantitative analysis:

As the local buyers are so few Quantitative  analysis is not almost done.


Aggregate Liquidity Analysis

The overall relationship between a firm’s available cash and its potential cash needs (i.e. for liabilities) is known as firm’s liquidity position. This liquidity position represents a firm’s gross hedge to meet cash needs for current liabilities to minimize chances of a cash stock out situation.

Traditional Measurement of Liquidity

To measure the liquidity position of the selected companies, some traditional measures are used in this section. The ratios along with their formula are as follows:

Profitability Analysis

Profitability is concerned with how effectively an organization has used its available resources profitability ratios are normally presented as a percentage and in general, the higher the profitability percentage, the better in the organizations performance and measures management overall effectiveness as shown by the return generated on sales and investment. Following are the important profitability ratios:

Efficiency Analysis

Efficiency analysis measures how efficiently the firm utilizes its resources to generate sales. To determine the asset management efficiency of these three different  company, the following ratios have been used:

Accounts Receivable Turnover = Sales/Accounts Receivable

Inventory Turnover= Cost of Goods Sold/Inventory

Inventory Conversion Period =360/Inventory Turnover

Average Collection period=360/A/R Turnover.

Sophisticated Techniques for measuring Liquidity

These techniques can overcome most limitations of the traditional techniques and yet give a comprehensive insight into a firm’s liquidity position.

  • Cash Conversion Cycle
  • Comprehensive Liquidity Index
  • Net Liquid Balance
  • Lambda Index

Cash Conversion Cycle

This technique attempts to identify the average time taken by a firm to convert its inventories into cash flow using Spontaneous sources of funds. According to this model, the lower the time taken, the more liquid is the firm. The model has two segments:

  • Operating Cycle Time (OCT)
  • Payment Deferral Time  (PDT)

 Net Liquid Balance (NLB)

In this technique, Account receivable and inventory are considered as additional assets to be financed. The accounts payable and other accruals that are part of the current liabilities are treated not as maturing obligations but as part of the firm’s permanent financing package and only notes payable are treated as maturing obligations.

NLB = (Cash + Marketable Securities – Notes Payable) / Total assets


Level of Aggregate Liquidity of Square Textiles Limited:

The overall relationship between total short term assets and short term liabilities determine the size of gross hedge of a firm. This overall relationship between the potentially available cash and its potential cash needs is called the firm’s aggregate liquidity position.

Traditional Measures of the Aggregate Liquidity of the Firm:

Liquidity can be thought as the firm’s ability to quickly generate cash versus the firm’s need for cash on short notice. The following ratios are traditionally used to measure the liquidity position of a firm, though each of the ratios has some limitations.


Financial statement analysis is a judgmental process. One of the primary objectives is identification of major changes in trends & relationships and the investigation of the reasons underlying those changes. The judgment process can be improved by experience and the use of analytical tools. Probably the most widely used financial analysis technique is ratio analysis, the analysis of relationships between two or more line items on the financial statement. Financial ratios are usually expressed in percentage or times. Generally, financial ratios are calculated for the purpose of evaluating aspects of a company’s operations.

In this report we have tried to use different aspects of financial performance analysis to determine the better usage of available resources and how well it manages its cash and other working capital in day-to-day operations of the firm.

Terms of sale decision in case Square Textile Ltd:

What will be the terms of sale –this decision is influenced mainly by the

  1. industry norm
  2. the market condition and
  3. Size of the account

Minimum credit period Square Textile is 180 days.

They do their aging of receivables in the following way:

  1. Above 180 days———amount
  2. Below 180 days———amount

We have conduct time series analysis to measure the aggregate liquidity position of square textiles ltd. from this analysis we have found that the traditional measures  shows a good liquidity position but when we have calculated the improved indices for measurig liquidity, all the indices except net liquid balance are showing the firms weakness in management of liquidity.


Success in working capital management can be achieved through:

  • Managing inventories efficiently using computerized database management.
  •  Reducing the cost of sales by efficient management practice.
  • Managing the company’s fixed as well as current asset efficiently to generate smooth operation.
  • Accelerating the sales volume through effective marketing and distributing channel.
  • Accounts Receivable Turnover Ratio is showing that the company is requiring lesser time to collect cash from its creditors. In spite of increased receivables the increment in the ratio is an indicator of improvement in the efficiency of turning the receivables into cash quickly and is a good sign for the company and it will be able to avoid liquidity crisis.
  • Restructuring the capital format in such a way so as to the company can add some leverage to its capital structure.

Inventory Management Policy