Working capital management (1)

UNIT – I

WORKING CAPITAL MANAGEMENT(FINANCE)

Q. Explain Working Capital. What do you mean by Gross Working Capital and Net

Working Capital?

Ans. Introduction:- Working capital plays the same role in the business as the role of heart

in the human body. Just like heart gets blood and circulates the same in the body, in the

same way in working capital, funds are generated and then circulated in the business. As

and when this circulation stops the business becomes lifeless. Thus, prudent management

of Working capital is necessary for the success of a business.

Meaning of Working Capital:-Working capital management is an important aspect of

financial management. In business, money is required for fixed assets and working capital.

Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed

assets are acquired to be retained in the business for a long period and yield returns over the

life of such assets. The main objective of working capital management is to determine the

optimum amount of working capital required. Generally, management of working capital

means management of current assets.

Concepts of Working Capital:-There are two concepts of working capital-

(1) Gross Working Capital Concept

(2) Net Working Capital Concept.

(1) Gross working capital: Gross working capital; refers to firm's investment in current

assets. Current assets are the assets which can be converted into cash within an

accounting year and include cash, short-term securities, debtors, bill receivables and

stock. According to this concept, working capital means Gross working Capital which

is the total of all current assets of a business. It can be represented by the following

equation:

Gross Working Capital = Total Current Assets

Definitions favouring this concept are:-

According to Mead, Mallot and Field : "Working Capital means total of Current Assets".

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According to Bonneville and Dewey

"Any acquisition of funds which increases the current assets increases working capital, for

they are one and the same".

Arguments in favour of Gross Working Capital Concept:- Persons acknowledging the

total of current assets as working capital give the following arguments in their favour:-

(i) Just as fixed assets are considered as the symbol of fixed capital, current assets must

also be considered as symbol of working capital.

(ii) Any acquisition of funds increases the working capital. This statement proves true

according to this concept whereas it does not hold true according to the second

concept.

(iii) Most of the managers plan their business operations according to the current assets

concept because these are the assets used in day-to-day business operations.

(2) Net Working Capital Concept: Net working capital refers to the difference between

current assets and current liabilities. Current liabilities are those claims of outsiders

which are expected to mature for payment within an accounting year and include

creditors, bills payables, and outstanding expenses. Net working capital can be

positive or negative. A positive net working capital will arise when current assets

exceed current liabilities. A negative Net working capital occurs when current liabilities

are in excess of current assets.

Net Working Capital = Current Assets - Current Liabilities

Definitions Favouring Net Working Capital Concept:-

According to C.W.Gestenbergh

"It has ordinarily been defined as the excess of current assets over current liabilities".

According to Lawrence. J. Gitmen

" The most common definition of net working capital is the difference of firm's current assets

and current liabilities".

Arguments in Favour of Net Working Capital Concept:-

(i) This concept gives the true information about the liquidity of a concern. According to

first concept, the working capital appears to be increased merely by taking a short-

term loan whereas in the second concept working capital remains unchanged by

doing so. Thus, the second concept looks more logical.

(ii) Excess of current assets over current liabilities will indicate whether or not the concern

will be able to meet its current liabilities when they fall due. First concept does not

disclose this fact.

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(iii) It is on the basis of this concept that the short-term lenders, bankers etc. calculate the

safety margin regarding the timely payment of their debt.

(iv) Excess of current assets over current liabilities will determine whether or not the

concern will be able to face the depression or any other contingent need of the

business.

(v) According to this concept a comparison can be made between the financial position of

two firms whose current assets are equal.

As discussed, net working capital is the excess of current assets over current

liabilities. There are three conditions:-

(i) When Current assets are equal to current liabilities, then working capital will be

zero.

(ii) When current assets are more than current liabilities, then working capital will be

positive.

(iii) When current assets are less than current liabilities, then working capital will be

Negative.

Current Assets:- Current assets mean those assets which are converted into cash

within a short period of time not exceeding one year e.g. Cash, Bank balance, Debtors,

Bills Receivables, Stock, Accrued Income etc.

Current Liabilities:- Current liabilities means those liabilities which have to be paid

within a short period of time in no case exceeding one year, e.g. Creditors, Bills

payable, Outstanding Expenses, Shot-term loans etc.

Q. What is the need of Working Capital?

Ans. Meaning of Working Capital:- Working capital management is an important aspect

of financial management. In business, money is required for fixed assets and working

capital. Fixed assets include land and building, plant and machinery, furniture and fittings

etc. Fixed assets are acquired to be retained in the business for a long period and yield

returns over the life of such assets. The main objective of working capital management is to

determine the optimum amount of working capital required. Generally, management of

working capital means management of current assets.

NEED FOR WORKING CAPITAL: Along with the fixed capital almost every Small-Scale

industries requires working capital though the extent of working capital requirement differs in

different businesses. Working capital is needed for running the day-to-day business

activities. When a business is started, working capital is needed for purchasing raw

materials. The raw material is then converted into finished goods by incurring some

additional cost on it. Now goods are sold. Sales do not convert into cash instantly because

there is invariably some credit sales. Thus, there exists a time lag between sales of goods

and receipts of cash. During this period, expenses are to be incurred for continuing the

business operations. For this purpose working capital is needed. Therefore, sufficient

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working capital is needed which shall be involved from the purchase of raw materials to the

realization of cash. The time period which is required to convert raw materials into finished

goods and then into cash is known as operating cycle or cash cycle. The need for working

capital can also be explained with the help of operating cycle. Operating cycle of a

manufacturing concern involves five phases:

ØConversion of cash into raw material

ØConversion of raw material into work-in-progress

ØConversion of work-in-progress into finished goods

ØConversion of finished goods into debtors by credit sales

ØConversion of debtors into cash by realising cash from them.

Operating Cycle: Thus the operating cycle starts from cash, finishes at cash and then again

restarts from cash. Need for working capital depends upon period of operating cycle.

Greater the period, more will be the need for working capital. Period of operating cycle in a

manufacturing concern is greater than period of operating cycle in a trading concern

because in trading units cash is directly converted into finished goods.

Cash

Debtors and Bills Receivables Raw Materials

Finished Goods Work-in-Progress

Diagram: Operating Cycle

Working capital in a business is needed because of operating cycle. But the need for

working capital does not come to an end after the cycle if completed. Since the operating

cycle is a continuous process, there remains a need for continuous supply of working

capital. However, the amount of working capital required is not constant throughout the year,

but keeps fluctuating. On the basis of this concept, working capital is classified into two

types:-

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(1) Permanent Working Capital:- The need for working capital fluctuates from time to

time. However, to carry on day-to-day operations of the business without any

obstacles, a certain minimum level of raw materials, work-in-progress, finished goofs

and cash must be maintained on a continuous basis. The amount needed to maintain

current assets on this minimum level is called permanent or regular working capital.

The amount involved as permanent working capital has to be met from long-term

sources of finance, e.g.

(i) Capital

(ii) Debentures

(iii) Long-term loans.

(2) Temporary or Variable Working Capital:- Any amount over and above the

permanent level of working capital is called temporary, fluctuating or variable working

capital. Due to seasonal changes, level of business activities is higher than normal

during some months of year and therefore additional working capital will be required

alongwith the permanent working capital. It is so because during peak season,

demand rises and more stock is to be maintained to meet the demand.Both types of

working capital is necessary to run the business smoothly. The distinction between

permanent and temporary working capital is illustrated in the following diagram:-

SHOWING PERMANENT AND TEMPORARY WORKING CAPITAL:

Time

SHOWING PERMANENT AND TEMPORARY WORKING CAPIRAL IN A GROWING

CONCERN:

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Q. What is the meaning of Working Capital? Explain the factors affecting the

working capital requirements of a business.







working capital means management of current assets

DETERMINANTS OF WORKING CAPITAL: A firm should have neither too much nor too

little working capital. A large number of factors, each has a different importance, influencing

working capital needs of firms. The importance of factors also changes for a firm over time.

Therefore, an analysis of relevant factors should be made in order to determine total

investment in working capital. The following is the description of factors which generally

influence the working capital requirements. The working capital requirement is determined

by a large number of factors but, in general, the following factors influence the working

capital needs of an enterprise:

(1) Nature of Business :- Working capital requirements of an enterprise are largely

influenced by the nature of its business. For instance, public utilities such as railways,

transport, water, electricity etc. have a very limited need for working capital because

they have invested fairly large amounts in fixed assets. Their working capital need is

minimal because they get immediate payment for their services and do not have to

maintain big inventories. On the other extreme are the trading and financial

enterprises which have to invest fewer amounts in fixed assets and a large amount in

working capital. This is so because the nature of their business is such that they have

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to maintain a sufficient amount of cash, inventories and debtors. Working capital

needs of most of the manufacturing enterprises fall between these two extremes, that

is, between public utilities and trading concerns.

(2) Size of Business:- Larger the size of the business enterprise, greater would be the

need for working capital. The size of a business may be measured in terms of scale of

its business operations.

(3) Growth and Expansion:- As a business enterprise grows, it is logical to expect that a

larger amount of working capital will be required. Growing industries require more

working capital than those that are static.

(4) Production cycle:- Production cycle means the time-span between the purchase of

raw materials and its conversion into finished goods. The longer the production cycle,

the larger will be the need for working capital because the funds will be tied up for a

longer period in work in process. If the production cycle is small, the need for working

capital will also be small.

(5) Business Fluctuations:- Business fluctuations may be in the direction of boom and

depression. During boom period the firm will have to operate at full capacity to meet

the increased demand which in turn, leads to increase in the level of inventories and

book debts. Hence, the need for working capital in boom conditions is bound to

increase. The depression phase of business fluctuations has exactly an opposite

effect on the level of working capital requirement.

(6) Production Policy:- The need for working capital is also determined by production

policy. The demand for certain products (such as woolen garments) is seasonal. Two

types of production policies may be adopted for such products. Firstly, the goods may

be produced in the months of demand and secondly, the goods may be produces

throughout the year. If the second alternative is adopted, the stock of finished goods

will accumulate progressively upto the season of demand which requires an

increasing amount of working capital that remains tied up in the stock of finished goods

for some months.

(7) Credit Policy Relating to Sales:- If a firm adopts liberal credit policy in respect of

sales, the amount tied up in debtors will also be higher. Obviously, higher book debts

mean more working capital. On the other hand, if the firm follows tight credit policy, the

magnitude of working capital will decrease.

(8) Credit Policy Relating to Purchase:- If a firm purchases more goods on credit, the

requirement for working capital will be less. In other words, if liberal credit terms are

available from the suppliers of goods (i.e., creditors), the requirement for working

capital will be reduced and vice versa.

(9) Availability of Raw Material:- If the raw material required by the firm is available

easily on a continuous basis, there will be no need to keep a large inventory of such

materials and hence the requirement of working capital will be less. On the other hand,

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if the supply of raw material is irregular, the firm will be compelled to keep an excessive

inventory of such raw materials which will result in high level of working capital. Also,

some raw materials are available only during a particular season such as oil seeds,

cotton, etc. They would have to be necessarily purchased in that season and have to

be kept in stock for a period when supplies are lean. This will require more working

capital.

(10) Availability of Credit from Banks:- If a firm can get easy bank facility in case of need,

it will operate with less working capital. On the other hand, if such facility is not

available, it will have to keep large amount of working capital.

(11) Volume of Profit:- The net profit is a source of working capital to the extent it has been

earned in cash. Higher net profit would generate more internal funds thereby

contributing the working capital pool.

(12) Level of Taxes:- Full amount of cash profit is not available for working capital purpose.

Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits

available for working capital.

(13) Dividend Policy:- Dividend policy is a significant element in determining the level of

working capital in an enterprise. The payment of dividend reduces the cash and,

thereby, affects the working capital to that extent. On the contrary, if the company does

not pay dividend but retains the profits, more would be the contribution of profits

towards capital pool.

(14) Depreciation Policy:- Although depreciation does not result in outflow of cash, it

affects the working capital indirectly. In the first place, since depreciation is allowable

expenditure in calculating net profits, it affects the tax liability. In the second place,

higher depreciation also means lower disposable profits and, in turn, a lower dividend

payment. Thus, outgo of cash is restricted to that extent.

(15) Price Level Changes:- Changes in price level also affect the working capital

requirements. If the price level is rising, more funds will be required to maintain the

existing level of production. Same level of current assets will need increased

investment when prices are increasing. However, companies that can immediately

revise their product prices with rising price levels will not face a severe working capital

problem. Thus, it is possible that some companies may not be affected by rising prices

while others may be badly hit.

(16) Efficiency of Management:- Efficiency of management is also a significant factor to

determine the level of working capital. Management can reduce the need for working

capital by the efficient utilization of resources. It can accelerate the pace of cash cycle

and thereby use the same amount working capital again and again very quickly.

Q. Define Working Capital and give its classification.

Ans. Introduction:- Working capital plays the same role in the business as the role of heart

in the human body. Just like heart gets blood and circulates the same in the body, in the

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same way in working capital, funds are generated and then circulated in the business. As

and when this circulation stops the business becomes lifeless. Thus, prudent management

of Working capital is necessary for the success of a business.

Meaning of Working Capital:-

Working capital management is an important aspect of financial management. In business,

money is required for fixed assets and working capital. Fixed assets include land and

building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be

retained in the business for a long period and yield returns over the life of such assets. The

main objective of working capital management is to determine the optimum amount of

working capital required. Generally, management of working capital means management of

current assets.

Classification of Working Capital:-

Working Capital can be classified in two ways, firstly, on the basis of concept, and secondly,

on the basis of its need.

(1) On the Basis of Concept: On this basis working capital may be of two types:

(i) Gross Working Capital

(ii) Net Working Capital

(2) On the Basis of Need:- On this basis also working capital may be of two types:

(i) Permanent Working Capital

(ii) Temporary Working Capital.

Q. Define Working Capital. Briefly explain the techniques used in making working

capital forecast or Estimating Working Capital Requirements







working capital means management of current assets.

WORKING CAPITAL FORECASTING TECHNIQUES OR COMPUTATION OF

WORKING CAPITAL:

A number of methods are used to determine working capital needs of a business. The

important among them are:

(1) Operating Cycle Method:- Operating cycle is the time span the firm requires in the

purchase of raw materials, conversion of raw materials into work in progress and

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finished goods, conversion of finished goods into sales and in collecting cash from

debtors. Larger the time span of operating cycle, larger the investment in current

assets. Hence, time period of each stage of operating cycle is estimated and then

working capital needed in each stage is computed on the basis of cost of each item.

Following factors should be taken into consideration while forecasting working capital

requirement on the basis of operating cycle method:

ØCost of raw materials, wages and overheads.

ØPeriod during which raw material remains in store before it is issued for

production purpose.

ØPeriod of Production cycle.

ØPeriod during which finished goods is stored before sale.

ØPeriod of credit allowed to debtors and period of credit allowed by suppliers.

ØTime lag in payment of wages and overheads.

ØMinimum cash balance required to be maintained.

A certain percentage for contingencies may also be added to the above estimates to

determine the working capital requirement.

On the basis of operating cycle, the working capital can be forecasted in the following way:

STATEMENT SHOWING WORKING CAPITAL REQUIREMENT

Current Assets:

ØStock of Raw-Materials:

Average Inventory holding periodCost of yearly consumption (weeks/months) Of raw material x ----------------------------------------------- = -------- 52 weeks / 12 months

ØWork in Progress:

Average time span of work in processCost of yearly consumption (weeks/months) Of raw material x ---------------------------------------------------------- 52 weeks/ 12 months

Average time span of work in process 50 (weeks/months) + Yearly wages x --------- x -------------------------------------------------------- 100 52 weeks/ 12 months

+ Yearly manufacturing and administrative overheads (excluding dep.)

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Average time span of work in process 50 (weeks/ months)x -------- x ----------------------------------------------------- = --------- 100 52 weeks/ 12 months

Note: While calculating work in process it will be assumed that full Unit of raw material is

required in the beginning of the process Whereas wages and overhead expenses accrue

evenly throughout the production cycle. Hence, raw material cost is taken at 100% and

wages and overheads are taken at 50% on an average basis.

ØStock of Finished Goods:

Cost of goods produced (i.e., yearly cost of raw materials +Wages + manufacturing &

administrative overheads(excluding depreciation)

Average finished goods holding period (weeks / months

x ------------------------------------------------ = ---------- 52 weeks/ 12 months

ØDebtors:

Working Capital tied up in debtors should be estimated on the basis of cost of sales

(excluding depreciation):

Average debt collection period Cost of goods produces (weeks / months)(i.e., raw materials + wages x ----------------------------------- = ---------+ manufacturing, administrative 52 weeks/ 12 months & selling overhead)

ØCash and Bank Balance:

(i.e., minimum cash balance required to be maintained = --------

Less: Current Liabilities

(the working capital are lower to the extent such requirements are met through current

liabilities)

ØTrade Creditors:

Credit period allowed by creditors Cost of yearly consumption (weeks/ months) Of raw material x -------------------------------------------------- = --------

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Ø

Average time lag in payment of wages (weeks/ months)Yearly wages x ------------------------------------------------------- = ----------

52 weeks/ 12 months

Note: If wages are paid at the end of each month, the average time lag in the payment of

wages will approximate to half-a- month. This is so, Because 1st day's wages are paid on the

30th day of the month, extending credit for 29 days, the 2nd days wages are, again, paid on

the 30th, extending credit for 28 days, and so on. Thus, average time lag will approximate to

half a month.

ØOverheads:

Average time lag in payment of overheadsYearly Overheads(other (weeks/ months) Than Depreciation) x -------------------------------------------------- = ----------

52 weeks/12 months ______

Working Capital (Current Assets - Current Liabilities) ----------

Add: Provision for Contingencies ----------

________

Estimated Working Capital Requirement ----------

________

(2) Forecasting of Current Assets and Current Liabilities Method:- According to this

method, an estimate is made of forthcoming period's current assets and current

liabilities on the basis of factors like past experience, credit policy, stock policy and

payment policy of the previous years. First of all, such estimate is made for each

current asset on the basis of each month and then monthly requirements are

converted into yearly requirement of current assets. The estimated amount of current

liabilities is deducted from this amount in order to estimate the requirement of working

capital. A certain percentage for contingencies may also be added to this amount.

(3) Cash Forecasting Method:- Under this method, an estimate is made of cash receipts

and payments for the next period. Estimated cash receipts are added to the amount of

working capital which exists at the beginning of the year and estimated cash payments

are deducted from this amount. The difference will be the amount of working capital.

(4) Percentage of Sales Method:- Under this method, certain key ratios based on past

year's information are established. These ratios can be ratio of sales to raw material

stock, ratio of sales to semi-finished goods stock, ratio of sales to finished goods stock,

ratio of sales to debtors, ratio of sales to cash balance etc. After this, sales for the next

year will be estimated and the requirement of working capital will be determined on the

basis of these ratios.

Wages:

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(5) Projected Balance Sheet Method:- Under this method, an estimate is made of

assets and liabilities for a future date and a projected balance sheet is prepared for

that future date. The difference in current assets and current liabilities shown in

projected balance sheet will be the amount of working capital.

Q. What are the advantage of Adequate working capital?

Ans. ADEQUATE WORKING CAPITAL: The firm should maintain a sound working capital

position. It should have adequate working capital to run its business operations. Both

excessive as well as inadequate working capital positions are dangerous from firm's point of

view. Excessive working capital means holding costs and idle funds which earn no profit for

the firm. Paucity of working capital not only impairs the firm's profitability but also results in

production interruptions and inefficiencies and sales disruption

Advantage of Adequate Working Capital:

(1) Availability of Raw Materials Regularly:- Adequacy of working capital makes it

possible for a firm to pay the suppliers of raw materials on time. As a result it will

continue to receive regular supplies of raw materials and thus there will be no

disruption in production process.

(2) Full Utilization of Fixed Assets:- Adequacy of working capital makes it possible for a

firm to utilize its fixed assets fully and continuously. For example, if there is inadequate

stock of raw material, the machines will not be utilized in full and their productivity will

be reduced.

(3) Cash Discount :- A firm having the adequate working capital can avail the cash

discount by purchasing the goods for cash or by making the payment before the due

date.

(4) Increase in Credit Rating :- Paying its short-term obligations in time leads to a strong

credit rating which enables the firm to purchase goods on credit on favourable terms

and to maintain its line of credit with banks etc. it facilities the taking of loan in case of

need.

(5) Advantages of Favourable Business Opportunities:- Whenever there are

chances of increase in prices of raw materials, the firm can purchase sufficient

quantity if it has adequate of working capital. Similarly, if a firm receives a bulk order for

the supply of goods it can take advantage of such opportunity if it has sufficient

working capital.

(6) Facility in Obtaining Bank Loans:- Banks do not hesitate to advance even the

unsecured loan to a firm which has the sufficient working capital. This is because the

excess of current assets over current liabilities itself is a good security.

(7) Increase in Efficiency of Management:- Adequacy of working capital has a

favourable psychological effect on the managers. This is because no obstacle arises

in the day-to-day business operations. Creditors, wages and all other expenses are

paid on time and hence it keeps the morale of managers high.

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(8) Meeting Unseen Contingencies :- Adequacy of working capital enables a company

to meet the unseen contingencies successfully.

Q. What are the disadvantage of excessive and inadequate working capital?

Ans. EXCESSIVE AND INADEQUATE WORKING CAPITAL: A business enterprise

should maintain adequate working capital according to the needs of its business operations.

The amount of working capital should neither be excessive nor inadequate. If the working

capital is in excess if its requirements it means idle funds adding to the cost of capital but

which earn nom profits for the firm. On the contrary, if the working capital is short of its

requirements, it will result in production interruptions and reduction of sales and, in turn, will

affect the profitability of the business adversely.

Disadvantage of Excessive Working Capital:-

(1) Excessive Inventory:- Excessive working capital results in unnecessary

accumulation of large inventory. It increases the chances of misuse, waste, theft etc.

(2) Excessive Debtors:-Excessive working capital will results in liberal credit policy

which, in turn, will results in higher amount tied up in debtors and higher incidence of

bad debts.

(3) Adverse Effect on Profitability:-Excessive working capital means idle funds in the

business which adds to the cost of capital but earns no profits for the firm. Hence it has

a bad effect on profitability of the firm.

(4) Inefficiency of Management:-Management becomes careless due to excessive

resources at their command. It results in laxity of control on expenses and cash

resources.

Disadvantage of Inadequate Working Capital:

(1) Difficulty in Availability of Raw-Material:- Adequacy of working capital results in

non-payment of creditors on time. As a result the credit purchase of goods on

favourable terms becomes increasingly difficult. Also, the firm cannot avail the cash

discount.

(2) Full Utilization of Fixed Assets not Possible: Due to the frequent interruption in the

supply of raw materials and paucity of stock, the firm cannot make full utilization of its

machines etc.

(3) Difficulty in the Maintenance of Machinery: Due to the inadequacy of working

capital, machines are not cared and maintained properly which results in the closure of

production on many occasions.

(4) Decrease in Credit Rating: Because of inadequacy of working capital, firm is unable

to pay its short-term obligations on time. It decays the firm's relations with its bankers

and it becomes difficult for the firm to borrow in case of need.

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(5) Non Utilization of Favourable Opportunities: For example, a firm cannot purchase

sufficient quantity of raw materials in case of sudden decrease in the prices. Similarly,

if the firm receives a big order, it cannot execute it due to shortage of working capital.

(6) Decrease in Sales: Due to the shortage of working capital, the firm cannot keep

sufficient stock of finished goods. It results in the decrease in sales. Also, the firm will

be forced to restrict its credit sales. This will further reduce the sales.

(7) Difficulty in the Distribution of Dividends: Because of paucity of cash resources,

firm will not be able to pay the dividend to its shareholders.

(8) Decrease in the Efficiency of Management: It will become increasingly difficult for

the management to pay its creditors on time and pay its day-to-day expenses. It will

also be difficult to pay the wages regularly which will have an adverse effect on the

morale of managers.

Q. Discuss the methods of analysis of working capital?

Ans. Working capital position of an enterprise is analysed by various internal and external

parties. External parties include bankers, creditors, financial institutions etc. The objective of

these parties in analyzing the working capital is to assess the liquidity of the business, i.e. to

know whether the firm will have sufficient current assets and cash to pay their debts when

they fall due. Method to analyse the working capital are:-

1. Schedule of Changes in Working Capital: With the help of this schedule increase or

decrease in various current assets and current liabilities can be ascertained. This

schedule considers only current assets and current liabilities, at the beginning and at

the end of the year. This schedule shows either increase or decrease in working

capital. Following rules are followed while preparing a schedule of changes in working

capital.

ØAn increase in current assets results in increase in working Capital.

ØA decrease in current assets results in decrease in working capital.

ØAn increase in current liabilities results in decrease in working capital.

ØA decrease in current liabilities results in increase in working capital.

(2) Ratio Analysis : A ratio is simply one number expressed in terms of another. It found

by dividing one number into the other. Working capital can be analysed with the help of

various ratios mentioned below:

(A) Liquidity Ratios:-

ØCurrent Ratio:- This ratio explains the relationship between current and current

liabilities of a business. The formula for calculating the ratio is:

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Current Assets Current Ratio = --------------------------------- Current Liabilities

Liquid Ratio:- Liquid ratio explains the relationship between liquid assets and

current liabilities of a business. The formula for calculating the ratio is:

Liquid Assets Liquid Ratio = ----------------------------- Current Liabilities

Cash + Bank + Marketable SecuritiesØAbsolute Liquid Ratio = -------------------------------------------------------

Current Liabilities

(B) Activity Ratios:-

ØInventory Turnover Ratio:

Cost of Goods Sold Inventory Turnover Ratio = -------------------------------------------- Average Stock

ØDebtors Turnover Ratio:- This ratio indicates the relationship between credit sales

and average debtors during the year. The formula for calculating the ratio:

Net Credit SalesDebtors Turnover Ratio = ----------------------------------------- Average Debtors + Average B/R

ØCreditors Turnover Ratio:- This ratio indicates the relationship between credit

purchases and average creditors during the year. The formula for calculating the ratio

is:

Net Credit PurchasesCreditors Turnover Ratio = ----------------------------------------------------- Average Creditors + Average B/P

ØWorking Capital Turnover Ratio:- This ratio indicates the relationship between cost

of goods sold and working capital. The formula for calculating the ratio is :

Cost of Goods SoldWorking Capital Turnover Ratio = ------------------------------------------ Working Capital

(3) Fund Flow Statement:- This statement reveals the sources from which funds were

obtained and the uses to which funds were applied. In other words, this statement

discloses what the main sources of funds were and how these funds were utilized

during the year. With the help of this statement the basic reasons for increase or

decrease in working capital can be analysed. The term 'fund' does not mean 'cash'. It

is generally used to denote the difference between current assets and current

Ø

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liabilities. In other words, the term 'fund' stands for 'net working capital'. Thus, a fund

flow statement indicates the causes of changes in the working capital of a company

during the year.

(4) Cash Flow Statement:- A cash-flow statement is a statement showing and outflows

of cash during a particular period. In other words, it is a summary of sources and

applications of cash during a particular span of time. It analyses the reason for

changes in balance of cash between the two balance sheet dates. The term 'cash'

here stands for cash and cash equivalents. A cash-flow statement can be for the past

or can be projected for a future period.

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UNIT – II

Q. What do you mean by Cash? What are the motives of holding cash?

Ans. Cash:- For the purpose of cash management, the term cash not only includes coins,

currency, notes, cheques, bank drafts, demand deposits with banks but also the 'near-cash

assets' like marketable securities and time deposits with banks because they can be readily

converted into cash. For the purpose of cash management, near-cash assets are also

included under cash because surplus cash is required to be invested in near-cash assets for

the time being.

Motives of Holding Cash: - In every business assets are kept because they generate profit.

But cash is an asset which does not generate any profit itself, yet in every business sufficient

cash balance is maintained. There are four primary motives or causes for maintaining cash

balances:

(1) Transaction Motive: - A number of transactions take place in every business. Some

transactions result in cash outflow such as payment for purchases, wages, operating

expenses, financial charges like interest, taxes, dividends etc. Similarly, some

transactions result in cash inflow such as receipt from sales, receipt from investment,

other incomes etc. But the cash outflows and inflows do not perfectly match with each

other. At times, inflows exceed outflows while, at other times outflows exceed inflows.

To meet the shortage of cash in situation when cash outflows exceed cash inflows, the

business must have an adequate cash balance.

(2) Precautionary Motive: - In every business, some cash balance is kept as a

precautionary measure to meet any unexpected contingency. These contingencies

may contingencies may include the following:

(i) Floods, strikes and failure of important customers.

(ii) Unexpected slow down in collection from debtors.

(iii) Cancellation of orders by customers.

(iv) Sharp increase in cost of Raw-materials.

(v) Increase in operating costs etc.


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(3) Speculative Motive: - In business, some cash is kept in reserve to take advantage of

profitable opportunities which may arise from time to time. These opportunities are:

(i) Opportunity to purchase raw material at low prices on payment of immediate

cash.

(ii) Opportunity to purchase other assets for the business when their prices are low.

(iii) Opportunity to purchase other Assets for the business when their prices are low.

(4) Compensative Motive: - Banks provide a number of services to the business such as

clearance of cheques, supply of credit information about other customers, transfer of

fund and so on. Bank charge commission or fee for some of these services. For other

services, banks do not charge any commission or fee they require indirect

compensation. For this purpose, bank requires the client to maintain a minimum

balance in their accounts in the bank. The clients cannot use this bank balance &

banks compensate the cost of providing free services by using this amount to earn a

return. Therefore, cash is also kept at the bank to compensate for free services by

banks to the business.

Q. Explain how to manage the Cash flows?

Ans. The term cash management also includes prompt collection and efficient

disbursement of cash. If cash is collected promptly and liabilities are paid in time, the

optimum cash balance requirements in the business also reduces. The task of managing the

cash flow is two fold. It includes:

(A) Accelerating cash collections

(B) Slowing disbursements

(A) Accelerating cash collection : The customer should be encouraged to pay as

quickly as possible and their payments should be converted in to cash without any

delay. Customer can be encouraged to pay quickly. If the customer makes the

payment by cheques or draft, the cheques & draft should be encashed promptly.

The main objective of cash management is to reduce these time gaps so far as

possible. There are certain techniques to reduce this time gaps:

(1) Establishment of collection centre or concentration banking: - Under this

technique, large firms which have large number of branches at different places,

select some of these branches for receiving payments from customers. These

branches are called "collection centre". The firms also open its accounts in the

local banks of collection centers. Customers are advised to send their cheques

to their nearest collection centre. The collection centers deposit these cheques

in the firm's local bank a/c. All the collection over a predetermined level is

transferred daily to bank where the head office is situated. Head office can use

these funds for disbursements.

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(2) Lock- box System: - Under this technique also, large firms select some

branches as collection centers for receiving payments from the customers &

open account in local banks of collection centers. Under this technique, firms

also hire a post office lock-box at important collection centers. Customers are

advised to send their cheques or draft to the post office lock- box. The local

banks of the firm are authorized to open the post office lock - box and collect the

cheques received from the customers. The local banks withdraw the cheques

from a lock box several times a day and deposit them in firm's accounts. Local

banks, then, send a deposit slip to the collection center along with list of payment

received from customers, on the basis of which, the collection center makes a

record of all the receipts in its books.

(B) Slowing disbursements:- Payment should be made as late as possible without

damaging the goodwill and credit rating of the firm. It should, however take an

advantages of the cash discount available on prompt payment. There are certain

techniques to slow the disbursement:

1. Avoidance of early payments: - One way to slow disbursements is to avoid

early payments. The firm should not be made before or after due date.

2. Centralized Disbursement: - Another way to slow down disbursements is to

make all the payments by the head office from the centralized account. This

system increase the time gap between remittances are made locally by the

branches, it will take lesser time to reach the creditors by post.

3. Float: - Float is a very important way of slowing down the disbursements. Float

is the amount of money tied up in cheques that have been issued to creditors but

which have not been presented in bank for payment. There is always some gap

between the issue of cheques by firm & presentation it to bank by the creditors

bank for payments due to transit & processing delays by the creditors.

Therefore, a firm can send cheques to its creditors although it does not have

adequate balance at its bank at the time of issuance of the cheques. Meanwhile,

funds can be arranged to make payment when the cheques are presented for

payment after a few days. To make use of the floats, the firm may issue a cheque

on the banks far away from the creditor's bank. In order to take advantage of the

float it is necessary to analyse the time-gap in issue of cheques and their

presentation in the bank for payment.

4. Accruals: - Another way to slow down disbursement is accruals. Certain kind of

expenses such as wages, rent etc. should be paid after the period when actual

services have been rendered.

Q. Explain Investment in Marketable Securities.

Ans. Marketable Securities:- Marketable Securities are those securities which can be

converted into cash in a short period of time., typically a few days. The basic characteristics

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of marketable securities affect the degree of their marketability/liquidity. To be liquid, a

security must have two basic characteristics: a ready market and safety of principal. Only

those securities that can be easily converted into cash without any reduction in the principal

amount qualify for short term investments.

Investment in Marketable Securities:- We describe below briefly the more prominent

marketable securities available for investment. These are :-

(1) Commercial Papers: - These are short-term unsecured securities issued by highly

creditworthy large companies. Commercial papers are regulated by the RBI and the

main features of commercial papers are:-

(i) Only those companies are allowed to issue commercial papers which have a net

worth of Rs. 10 crore or more.

(ii) The minimum size of an issue is Rs. 25 lac and the size of each commercial

paper should not be less than Rs. 5 Lac.

(iii) They can be issued for periods ranging between 15 days and one year.

Advantage:-

(i) It is a cheaper source of short-term finance as compared to bank credit.

(ii) It is a useful source of finance during period of tight bank credit.

Limitations:-

(ii) It can be used only by large and financially sound companies.

(iii) Commercial papers cannot be redeemed before maturity date even if the

issuing firm has surplus funds.

(iv) Maturity fate of commercial papers cannot be extended even is the issuing firm

is facing financial difficulties.

2) Treasury Bills:- There are obligations of the government. They are sold on a discount

basis. The investor does not receive actual interest payment. The return is the

difference between the purchase price and the par value of the bill.

The treasury bills are issued only in bearer form. They are purchased, therefore,

without the investors name upon them. This attributes makes them easily transferable

from one investor to another.

3) Units of Mutual Fund:- The units of mutual funds offer a reasonably convenient

alternative avenue for investing surplus liquidity as

(i) There is a very active secondary market for them.

(ii) The income from u8niots is tax-exempt up to a specified amount.

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4) Bill Discounting:- Surplus funds may be invested to purchase/discount bills. Bills of

exchange are drawn by seller on the buyer for the value of goods delivered to him.

During the pendency of bill, if the seller is in need of funds, he may get it discounted.

On maturity, the bill should be presented to the drawee for payment.

5) Money Market Mutual Funds/Liquid Funds:- These are professionally managed

portfolios of marketable securities. They provide instant liquidity. Due to high liquidity,

competitive yields and low transactions, these funds have achieved significant growth

in size and popularity in recent years.

6) Certificates of Deposit (CDs):- These are marketable receipts for funds that have

been deposited in a bank for a fixed period of time. The deposited funds earn a fixed

rate of interest. The CDs are offered by banks on a basis different from treasury bills,

that is , they are not sold at a discount. Rather , when the certificates mature, the owner

receives the full amount deposited plus the earned interest.

Selection Criteria:- A major decision confronting the financial managers involves the

determination of the mix of cash and marketable securities. These consideration

include evaluation of:

(i) Financial/Default Risk:- It refers to the uncertainty of expected returns from a

security attributable to possible changes in the financial capacity of the security-

issuer to make future payments to the security-owner. If the chance of default on

the terms of the investment is high (low), then the financial risk is said to be high

(low).

(ii) Interest Rate Risk:- The uncertainty that is associated with the expected

returns from a financial instrument attributable to changes in interest rate is

known as interest rate risk.

(iii) Taxability:- Another factor affecting observed difference in market yields is the

difference impact of taxes.

(iv) Liquidity:- With reference to marketable securities portfolio, liquidity refers to

the ability to transform a security into a cash.

Q. Write a short note on Cash System.

Ans. Cash System:- The cash system of a firm is the mechanism that provides the linkage

between cash flows. It includes

(i) Collection System:- The external element of the cash system include a collection

system for getting cash into the firm.

(ii) Disbursement System:- Disbursement systems means for paying the suppliers.ZAD C

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Q. What are the types of collection system?

Ans. Types of Collection System:-

1. Over-the-Counter Collections:- The first specialized collection system that we

describe been over the counter collection system, where the payment is received in a

face-to-face meeting with the customer. Most retail businesses receive at least some

of their payments on an over-the-counter basis. Since payments are not mailed, an

over the counter system does not contain mail float. The cash flow timeline for an over-

the-counter system is shown:-

Customer Deposit Availability

Delivers made at granted

Payment local bank

Processing delay Availability delay

Processing float Availability float

Collection float

Deposit

Bank 1Disbursemen

Bbank 1

Concentration

Bank

Deposit

Bank 2

Disbursement

Bank 2

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Customer

Group 1

Customer

Group 2

Customer

Group 3

Customer

Group 4

Customer

Group 5

Collection

Center A

Collection

Center A

Deposit

Bank X

Deposit

Bank Y

Central Information

System

Components of a collection system for over the counter receipts

2. Mailed Payments Collection System:- For many companies, payments, almost

cheques are mailed by the customer in response to an invoice. A mailed payments

system contains all three components of collection float:

(i) Mail Float

(ii) Processing Float

(iii) Availability Float.

Components of a Mailed Payments Collection System

Customers

Filed Unit

Local Deposit

Bank

Central Information

System

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Q. Explain Baumol Model of Cash Management.

And. Baumol Model:- Baumol model is a device of cash management which is used to

determine optimum cash balance. Optimum cash balance is determined by establishing a

balance between liquidity and profitability. Higher liquidity or higher cash balance means

excessive cash is kept in business which results in loss of interest which can be earned by

investing this excessive cash in marketable securities. On the contrary, lower liquidity or a

very low cash balance means no idle cash and interest is being earned by investing the

excess cash into securities. But in this case also, additional costs are incurred such as

brokerage of converting securities into cash, accounting costs of securities, cost of

registration of securities etc.

Therefore two types of costs are involved in keeping cash balance in a business-

(i) Opportunity Cost

(ii) Transaction Cost

When cash balance increases, opportunity cost increases but transaction cost decreases.

On the other hand, when cash balance is less, opportunity cost decreases but transaction

cost increases.

Optimum cash balance is that level of cash at which the opportunity cost and transaction

cost becomes equal. In other words, total cost of keeping cash balance will be minimum if

both of its component namely opportunity cost and transaction cost are equal.

Assumptions :- The Baumol Model is based on the following assumptions:-

1. The cash needs of the firm are known with certainty

2. The cash disbursements of the firm occurs uniformly over a period of time and is

known with certainty

3. The opportunity cost of holding cash is known and it remains constant.

4. The transaction cost of converting securities into cash is known and remains constant.

Baumol model is in the form of following formula:-

2 U X PC = _____________ = Rs. 10,000

S

Where

C = Optimum Cash Balance

U= Cash disbursement of a year (or month)

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P= Fixed cost per transaction

S= Opportunity cost of one rupee p.a. (per month)

Example:-

Monthly cash requirements according to cash budget Rs. 50,000

Fixed cost per transaction Rs. 10

Interest Rate 12% p.a.

Calculate optimum cash balance

Solution:-

2 X 50,000 X 10C = ________________ = Rs. 10,000

.01

Therefore, optimum cash balance= Rs. 10,000

Q. What are the objectives of Cash Management?

Ans. Cash Management:- Cash management includes maintaining optimum cash

balance and efficient collection and disbursement of cash. Accordingly, the main objectives

of cash management are:-

(i) To maintain optimum Cash Balance:- The main objectives of cash management is

to determine the optimum cash balance required in the business and to maintain the

cash balance at that level.

(ii) To keep the optimum Cash balance Requirement at Minimum level:- The second

main objectives of cash management is to minimize the optimum cash balance

requirement because cash is a non-earning asset.

Q. Explain Miller and Orr Model of Cash Management .

Ans. Introduction:- Baumol's model is based on the basic assumption that the size and

timing if cash flows are known with certainty. This usually does not happen in practice. The

cash flows of a firm are neither uniform nor certain. The Miller and Orr model overcomes the

shortcomings of Baumol model.

The Miller and Orr model provides two control limits:-

1. Upper Control Limit

2. Lower Control Limit along with a Return point.

This model can be explained with the help of the following diagram:-

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When the cash balance touches the upper control limit, marketable securities are

purchased. In the same manner when the cash balance touches lower control limit, the firm

sell the marketable securities. The spread between the upper and lower cash balance limits

(Called R) can be computed using Miller-Orr Model as below:-

1/3

3 Transaction Cost X Variance of Cash FlowsR = ------- X -------------------------------------------------------------- 4 Interest Rate

Upper Control Limit= 3 R + lower control limit

Optimal Return Point = R+L

L= Lower control limit

2

Variance of Cash Flows = (Standard deviation)

Example:- A company has a policy of maintaining a minimum cash balance of Rs. 100000.

The standard deviation in daily cash balance is Rs.50,000. The interest rate on a daily basis

is 0.02 %. The transaction cost for each sale or purchase of securities is Rs. 45. Compute the

upper control limit and the return point as per the Miller -Orr Model.

Spread between the upper and lower cash balance (Z)

Curve represents Cash Balance

Upper Control Limit

Purchase of Marketable Securities

Return Point

Sale of Marketable Securities

Lower Control Limit

O X

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3 Transaction Cost X Variance of Cash FlowsR = ------ X --------------------------------------------------------------

4 Interest Rate2

3 45 X (50000)R = -------- X --------------------------------

4 .0002

R = Rs. 75,000

Upper Control Limits =3 X 75,000 +1,00,000 = 3,25,000

Return Point = 1,00,000 + 75,000. = 175000

Assume that the firm's starting balance was Rs. 1,50,000 and the following cash flows

occur:

Day Net Cash Flow

1 -25,000

2 -75,000

3 + 1,00,000

4 -25,000

5 + 1,25,000

• At the end of day 1, the cash balance would be Rs. 1,25,000 since this is

between the control limits, no action would be taken.

• A the end of day 2, however the cash balance would be reduced to Rs.

50,000 of the firm did nothing since this is below the lower control limit the

would disinvest sufficient securities to get back the return point.

Q. Explain the Stone Model of Cash Management.

Ans. Stone Model of Cash Management:- Like the Miller-Orr model, the Stone model

takes a control-limits approach; when cash balance fall outside the control limits, the firm is

signaled to do something. But in the Stone Model, the signal does not automatically result in

an investment or disinvestment" the recommended action depends on management's

estimates of future cash flows : that is, the model signals an evaluation by management

rather than an action. To do this, the stone model uses two sets of control limits; the inner

control limits (UCL1 and LCL1) and the outer control limits (UCL2 and LCL2).

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Explanation:- The transactions are same as those in Miller Orr Model. Investments are

made sufficient to bring the cash balance back to the return point if the upper control limit is

exceeded: corresponding disinvestment are made if the lower control limit is exceeded.

For Example:- It is assumed that beginning balance was Rs. 1,50,000, the upper control

limit was Rs. 3,25,000, the return point was Rs. 1,75,000, the lower control limit was Rs.

1,00,000. The cash flows doe the first five days were:-

Day Net Cash Flow

1 -25,000

2 -75,000

3 + 1,00,000

4 -25,000

5 +1,25,000

Let us assume that inner control limits are set Rs. 20,000 inside the outer control limits ( at

Rs. 3,05,000 and Rs. 1,20,000) and the firm looks ahead tat the next two days cash flows. At

the end of day 1, the cash balance is 1,25,000 (1,50,000-25,000), but since the outer control

limits have not breached, no evaluation is made. At the end of the day 2, however, the cash

balance has been reduced to Rs. 50,000. At this point, the firms total the next two days cash

flows. Let us assume that forecast is correct; the total obtained is Rs.. 75,000 (1,00,000-

25,000) as the expected future cash flow, Adding this to the current balance of Rs. 50,000

gives an expected balance of Rs. 1,25,000. Since the expected cash balance is within the

inner control limits, no transaction is made. There are no investments or disinvestments over

the five-day period of the example (recall the Miller-Orr model required one investment and

one disinvestment).

UCL2

UCL1

Return PointCash

Balance

LCL1

LCL2

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UNIT – III

Q. Define Inventory Management. What are the objectives of Inventory

Management?

Ans. Inventory Management:- The term inventory refers to stock of goods kept for sale by

the firm. Inventory of finished goods should be maintained at sufficient high level so that the

demand of customers may be fully satisfied. Similarly, inventory of raw-materials should

also be sufficient so that manufacturing process can be run smoothly. In case of inadequate

inventory of raw materials, there is always a risk of being out-of-stock. Therefore, the major

responsibility of inventory management is to determine the sufficient level of inventory

required in the business.

On the other hand, since inventory is a major asset and it involves a lot of funds, inventory

level should not be excessive. Excessive inventory increases costs because extra funds are

involved in it.

Thus, both inadequate and excessive quantity of inventory is undesirable in the business.

Inventory management should maintain the inventory at sufficient level so that it is neither

excessive nor short of requirement. Thus, the term inventory management includes two

conflicting tasks:

(a) To maintain a sufficient large size of inventory to meet the demand of finished goods

and to meet the demand of raw materials by production department.

(b) To keep the investment in inventories at minimum level by efficiently organizing the

purchase and sale operations.

Objectives of Inventory management:

(1) To ensure continuous supply of raw materials so that production should not suffer at

any time.

(2) To maintain sufficient inventory of raw materials in periods of short supply.

(3) To maintain sufficient inventory of finished goods so that the demands of customers

are duly met.


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(4) To minimize the carrying cost of inventory namely cost of godown, insurance

expenses, cost of funds involved in inventory etc.

(5) To control investment in inventory and keep it at an optimum level.

(6) To avoid both over-stocking and under-stocking of inventory.

(7) To minimize losses through wastages and damages.

(8) To facilitates furnishing of data for short-term and long-term planning and control of

inventory.

(9) To ensure right quality goods at reasonable prices. Suitable quality standards will

ensure proper quality of stocks. The price-analysis, the cost-analysis and value-

analysis will ensure payment of proper prices.

(10) An efficient system of inventory management will determine:-

(a) What to purchase

(b) How much to purchase

(c) From where to purchase

(d) Where to store, etc.

Q. Define Inventory. What are the benefits and costs of holding inventory?

Ans. Inventory:- Every enterprise needs inventory for smooth running of its activities. The

term inventory refers to stock of goods kept for sale by the firm.

Kinds of Inventories:-

(A) In Trading Concern.

(B) In Manufacturing Concern.

(A) In Trading Concern:- In case of trading concerns, it includes only finished goods.

(B) Manufacturing Concern:- In case of manufacturing concern, inventory may include:-

(i) Inventory of Raw Materials:- Raw Material form a major input into the

organisation. The inventory of raw materials contains the items which are to be

converted into finished goods through the manufacturing process. The quantity

of raw materials required will be determined by the rate of consumption. The

factors like the availability of raw materials and government regulations, etc. too

affect the stock of raw materials.

(ii) Inventory of Work-in-progress:- The work-in-progress is that stage of stocks

which are in between raw materials and finished goods. The raw materials enter

the process of manufacture but they are yet to attain a final shape of finished

goods.

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(iii) Consumables:- These are the materials which are needed to smoothen the

process of production e.g. fuel oil, coal.

(iv) Inventory of Finished Goods:- These are the goods which are ready for the

consumers. In other words, inventory of finished goods represents completed

items which are available for sale.

(v) Spares:- Spares also form a part of inventory. Spares include those items which

are not converted into finished goods but are needed to run the manufacturing

process smoothly. The costly spare parts like engines, maintenance spares etc.

are not discarded after use, rather they are kept in ready position for further use.

Benefits of Holding Inventories:-

(1) Timing of Demand and Supply:- Need to hold inventory of raw materials arises

because it is not possible for a firm to procure raw materials whenever it is needed. If

the firm is assured of supply of raw material without delay, at the rate it is used in it's

manufacturing process, it need not to hold stock of raw materials. But in actual

practice, a time lag exists between demand of raw materials in manufacturing process

and its supply. Supply of raw material to the firm mat also be delayed because of such

factors as strike, transport problems, short supply etc. Therefore, the firm should

maintain adequate inventory of raw material to run its manufacturing process

regularly. Similarly, need to hold inventory of finished goods arises because the rate

of manufacturing and the rate of sale do not match. A firm cannot manufacture the

goods immediately on demand by customers.

(2) Quantity Discounts:- Raw materials are required as and when production process is

run. But instead of procuring raw materials in small quantities at the time of each

production run, firm may purchase large quantities of raw material in advance to obtain

quantity discounts of bulk purchasing. This results in a significant saving in costs.

(3) Anticipation of Price Rise:- Anticipation of price rise may also necessitate

purchasing and holding of raw material inventories.

(4) Reducing Ordering Cost:- These cost include the cost of preparing purchase orders,

transporting cost, receiving costs, inspecting costs etc. These cost increase in

proportion to number of order placed. Therefore, a firm may purchase raw materials in

excess of its immediate needs by placing one bulk order to reduce the ordering costs.

This also results in accumulation of raw material inventory.

Cost of Holding Inventories:

The holding of inventories involves blocking of a firm's funds. The various risks and

costs in holding inventories are as below:

(1) Capital Costs:- Maintaining of inventories results in blocking of the firm's

financial resources. The firm has, therefore, to arrange additional funds to meet

the cost of inventories. The funds may be arranged from own resources or from

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outsiders. But in both cases, the firm incurs a cost. In the former case, there is an

opportunity cost of investment while in the later case, the firm has to pay interest

to outsiders.

(2) Storage and Handling Costs:- Holding of inventories also involves costs on

storage as well as handling of materials. The storage costs includes:

(i) Rent of the Godown

(ii) Insurance charges etc.

(3) Risk of Price Decline:- There is always a risk of reduction in the prices of

inventories by the suppliers on holding inventories. This may be due to

increased market supplies, competition or general depression in the market.

(4) Risk of Obsolescence:- The inventories may become obsolete due to

improved technology, change in requirements, change in customer's tastes, etc.

(5) Risk Deterioration in Quality:- The quality of the materials may also

deteriorate while the inventories are kept in stores.

Q. What are the methods for Valuation of Inventories?

Ans. Valuation of Inventories:- The value of materials has a direct bearing on the income

of a concern, so it is necessary that a method of pricing materials should be such that it gives

a realistic value of stocks. The traditional method of valuing materials 'Cost price or market

price whichever is less' is no longer the only method.

The following methods for pricing materials issues are generally used:-

(1) First in First Out Method (Known as FIFO Method)

(2) Last in First Out Method (Known as LIFO Method).

(3) Average Price Method.

(4) Base Stock Method.

(5) Standard Price Method.

(6) Market Price Method.

(1) First in First Out (FIFO) Method:- In first in first out method the materials received

first are issue first. The materials are issued in chronological order. The recently

received materials remain in stock. Whenever a requisition for material issue is

presented to the store-keeper he will use the price of the first and then of second and

third lot, etc.

For Example:- A manufacturer has the following record of purchases of a condenser,

which he uses while manufacturing radio sets:

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Date Quantity (Units) Price per unit

Dec. 4 900 5.00

Dec. 10 400 5.50

Dec. 11 300 5.50

Dec. 19 200 6.00

Dec. 28 800 4.75`

Total 2,600

1600 units were issued during the month of December. Find the value of closing stock

assuming FIFO Method.

Solution:-

The closing stock is 1,000 units and would consists of-

800 units received on 28th December; and

200 units received on 19th December as per FIFO

The value of 800 units @ Rs. 4.75 3,800


Total 5,000

(2) Last in First Out (LIFO) Method:- In last in first out method the last received

materials are issued first and ending inventory consists of earlier acquired materials.

This method is also known as replacement cost method because the latest purchased

goods will correspond to the current market prices except that goods were not

purchased much earlier. The inventories will be valued at oldest lot on hand and these

values will be quite different from current invoice prices.

For Example:- A manufacturer has the following record of purchases of a condenser,

which he uses while manufacturing radio sets:

Date Quantity (Units) Price per unit

Dec. 4 900 5.00

Dec. 10 400 5.50

Dec. 11 300 5.50

Dec. 19 200 6.00

Dec. 28 800 4.75`

Total 2,600

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1600 units were issued during the month of December. Find the value of closing stock

by applying LIFO Method.

Solution:-

The closing stock is 1,000 units and would consists of-

100 units received on 10th December; and

900 units received on 4th December as per FIFO

The value of 100 units @ Rs. 5.50 550


Total 5,050

(3) Average Cost Method:- In average cost method of pricing all materials in stock are so

mixed that price based on all lots is formed. Average cost may be of two types:

(a) Simple Average Cost: In this method the prices of all lots in stock are averaged

and the materials are issued on that average price. For example, three lots of

materials are in stock and the prices per unit these lots are Rs.2, Rs.3, Rs.4 of

first, second and third lots respectively; then the average price will be:

2+3+4Average Price= ---------------- = Rs. 3

3

Though this is a simple method of pricing materials but particularly this method does not give

good results. The total cost is not observed in this method. The following example will

explain this point:

10,000 units were purchased @ Rs. 2 per unit



The total cost of materials will be:

10,000 X 2 = 20,000

15,000 X 3 = 45,000

20,000 X 4 = 80,000

Total Cost = 1, 45,000

The simple average price issue in this case is Rs. 3 and total amount will become 1,35,000

(45,000X3). The under absorbed amount in this case will be Rs. 10,000. Because of this

weighted average method is preferred.

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(b) Weighted Average Method:- In this method the total cost of all the materials is

divided by the total number of items in stock. The price calculated in this way will be

used for issue of materials. Taking the earlier example the weighed average price will

be:

10000 X 2 + 15000 X 3 + 20000 X 4Weighted Average Price= ----------------------------------------------------

10000+ 15000+ 20000

1, 45,000= ------------------------ = Rs. 3.22

45,000

(4) Base Stock Method:- In this method some quantity of materials is assumed to be

necessary for keeping the concern going. The quantity is not issued unless otherwise

there is an emergency. This material which is not issued as is kept in stock as a base

stock. This method is not an independent method. It is used alongwith some other

methods such as FIFO, LIFO, Average Price Method, etc. After maintaining the base

quantity in stock, the issues are priced at one of the methods mentioned above.

(5) Standard Price Method:- The issue price of materials is predetermined or estimated

in this method. The standard price is based on market conditions, usage rate, storage

facilities, etc. The materials are priced at standard price irrespective of price paid for

various purchase.

For Example:- The Standard price of raw material is fixed at Rs. 5 per unit. Two lots of

materials of 10000 units and 12,000 units were purchased at Rs. 4.90 and Rs. 5.25 per

unit. Every issue of material will be priced at Rs. 5 per unit, without taking into

consideration the prices at which these were purchased.

(6) Market Price Method:- In this method the price charged to production are not costs

incurred on the materials but latest market prices. It reflects the latest price charged to

production. This method is not generally used because of a number of difficulties. It

becomes difficult to select the market price because price prevails in different markets.

Q. What are the various tools and techniques of Inventory Management?

Ans. Tools and Techniques of Inventory Management:- Effective inventory

management requires an effective control system for inventories. A proper inventory control

not only helps in solving the problems of liquidity but also increases profits and causes

substantial reduction in the working capital of the concern. The following the important tools

and techniques of inventory management and control:

1. Re-order point.

2. Economic Order Quantity (EOQ)

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3. ABC Analysis.

4. Inventory Turnover Ratios.

5. V ED Analysis

6. Aging Schedule of Inventories.

1. Re-order point: - The re-order point is that inventory level at which an order should be

placed. Both the excessive and inadequate level of inventory are not favourable for

business. Therefore, re-order level should not be set up very high or very low. Re-

order point is calculated by the following formula:

Re-order Level/Point = Lead Time X Average Usage

Lead Time: Lead time is the time period between the date of placing order and the

date of receiving delivery. Lead time may also be called procurement of inventory.

Average Usage: Average usage means the quantity of inventory consumed daily.

Therefore, re-order point can be identified as the inventory level which should be

maintained for consumption during the lead time.

For Example:- Lead time in a business is 15 days and average daily usage of

inventory is 2,000 units. Re-order point of the business will be:

Re-Order Point = 15 days X 2000 units = 30000 units.

Safety Stock: in determining re-order point, we have assumed that lead time and

average usage rate have been correctly estimated. But in actual practice, both of

these factors are difficult to predict accurately. Receipt of raw materials may be

delayed beyond the estimated lead time due to strike, floods, transport problems etc.

In such situation, the re-order point will be:

Re-order Point = Lead Time X Average Usage + Safety Stock.

2. Economic Order Quantity (EOQ):- Economic order quantity is that quantity of

material for which each order should be placed. Purchasing large quantities at one

time and keeping the same as stock, increases carrying cost of inventories but

reducing ordering cost of inventories. On the other hand, small orders reduce the

average inventory level thereby reducing the carrying cost of inventories but

increasing the ordering costs because of increased number of purchase orders.

Therefore, determination of economic order quantity is a trade-off between two types

of inventory costs:

(i) Ordering costs:- Ordering costs includes costs of placing orders and cost of

receiving delivery of goods such as clerical expenses in preparing a purchase

order, transportation expenses, receiving expenses, inspection expenses and

recording expenses of goods received.

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(ii) Carrying Cost:- Carrying cost include costs of maintaining or carrying

inventory, such as godown rent, insurance expenses etc. These costs vary with

inventory size.

The sum of ordering costs and carrying costs represents the total costs of inventory.

Economic order quantity is that order quantity at which the total of ordering and

carrying cost is minimum.

Economic order quantity can be explained with the help of following diagram:

EOQ Can be determined by the following formula:

2 x R x OEOQ = ----------------- C

EOQ = Economic Order Quantity

R= Annual purchase Requirements in units

O = Ordering cost per order

C= Carrying cot per unit.

For Example:-

Compute the Economic Order Quantity from the following details:

Annual Inventory Requirements = 4,00,000 units

Cost of placing each order = Rs. 20

Carrying cost for one year = Rs. 4 per unit.

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2 x R x OEOQ = -------------------- C

2 x 4, 00,000 x 20EOQ = -------------------------------

4

= 2,000 units

3. ABC Analysis:- ABC Analysis is a technique of controlling different items of inventory.

Usually a firm has to maintain several different items as inventory. All these items are

not equally important. Therefore, it is not desirable to keep same degree of control on

all these items. The firm should give more attention to those items whose value is

higher in comparison to others.

Under this analysis all the items of inventory are classified into three categories:-

(i) In category 'A' those items are included which are small in number, say, 15

percent of the total items but they are quite valuable, the value being 70 per cent

of the total value of the inventory.

(ii) Category 'B' stands midway and consists of items which are 30 percent in

number and 20 percent of the total value.

(iii) In category 'C' those items are included which are quite large in number, say, 55

percent of the total items but carrying little value, say, 10 percent of the total

value of inventory.

Thereby, all the items can be classified as follows:

Class Number of Items Inventory Value(In terms of their % of (In terms of their % of

total items) total value)

A 15 70

B 30 20

C 55 10

TOTAL 100 100

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4. Inventory Turnover Ratio:- Certain items of inventory are slow moving. It means that

their consumption is quite slow and capital remains locked up in such items for along

period. As a result, carrying costs continue to incur on such items. Slow moving items

can be identified with the help of inventory turnover ratios.

Value of Raw Materials Consumed(i) Raw Material Turnover (in times)= -----------------------------------------------------

Average stock of Raw Materials

Cost of Goods Sold(ii) Finished Goods Turnover ( in times) = --------------------------------------------------

Average Stock of Finished Goods

5. Aging Schedule of Inventory: Another technique of inventory management is aging

schedule. Under this technique, all the items of inventory are classified into several

age groups as on a particular date on the basis of dates of their purchase or

manufacture. A specimen of aging schedule of inventory is as under:-

Age Classification Date of Purchas Amount Percentage of/Manufacturer Total

0-15 March 20 1000 5

16-30 March 7 2000 10

31-45 Feb 25 3000 15

46-60 Feb 10 4000 20

61 and above Jan 13 10000 50

Total 20000 100

It is clear from the above that 50% of total inventory is in stock for more than 60 years.

Q. What do you mean by Receivables Management? What are the motives and cost

of maintaining Receivables? Also explain the objectives of Receivable

Management.

Ans. Receivable Management:- The term receivables refers to debt owed to the firm by

the customers resulting from sale of goods or services in the ordinary course of business.

These are the funds blocked due to credit sales. Receivables are also called as trade

receivables, accounts receivables, book debts, sundry debtors and bills receivables etc.

Management of receivables is also known as management of trade credit.

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Motives of Maintaining Receivables:-

(i) Sales Growth Motives:- The main objectives of credit sales is to increase the total

sales of the business. On being given the facility of credit, customers have shortage of

cash may also purchase the goods. Therefore, the prime motive for investment in

receivables is sales growth.

(ii) Increased profit Motive:- Due to credit sales, the total sales of business increases.

Thus, in turn, results in increase in profits of the business.

(iii) Meeting Competition Motive:- In business, goods are sold on credit to protect the

current sales against emerging competition. If goods are not sold on credit, the

customers may shift to the competitors who allow credit facility to them.

Costs of Investment in Receivables:- When a firm sells goods or services on credit, it has

to bear several types of costs. These costs are as follows:-

(i) Administrative Cost:- To record the credit sale and collections from customers, a

separate credit department with additional staff, accounting records, stationery etc is

needed. Expenses have also to be incurred on acquiring information about the credit

worthiness of the customers.

(ii) Capital Cost:- There is a time lage between sale of goods and its collection from

customers. In that time period, the firm has to pay for purchases, wages, salary and

other expenses. Therefore, the firm needs additional funds which may arrange either

from external sources or from retained earnings. Both of these sources involve cost. If

funds are arranged from external sources, interest has to be paid. On the other hand, if

retained earnings are used for this purpose, the firm has to bear opportunity cost.

Opportunity cost means the income which could have been earned by investing this

amount elsewhere.

(iii) Collection Cost:- These are the expenses incurred by the firm on collection from the

customers after expiry of the credit period.

(iv) Default Cost:- Despite all efforts by the management, the firm may not be able to

recover full amount due from the customers. Such dues are known as bad debts or

default cost.

Objectives of Receivable Management:-

(i) To obtain optimum (not maximum) volume of sales.

(ii) To minimize cost of credit sales.

(iii) To optimize investment in receivables.

Q. Explain briefly the aspects or Scope of receivables management.

Ans. Receivable Management:- The term receivables refers to debt owed to the firm by

the customers resulting from sale of goods or services in the ordinary course of business.

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These are the funds blocked due to credit sales. Receivables are also called as trade

receivables, accounts receivables, book debts, sundry debtors and bills receivables etc.

Management of receivables is also known as management of trade credit.

Scope or Aspects or Receivables Management:- Scope of receivables management is

quite wide. It includes the following aspects:

(1) Formulation of Optimum Credit Policy.

(2) Determination of Credit Terms.

(3) Formulation of Collection Policy.

(4) Evaluation of Credit Policy.

(1) Formulation of Optimum Credit Policy:- A firm needs a clear policy regarding as to

whether the credit should be allowed to a customer and if yes, to what extent. Credit

standards are set for making such decisions. Therefore, a credit policy has two

dimensions:

I. Credit Standards

II. Credit Analysis.

I. Credit Standards:- Credit standards are the basic criteria set for extension of

credit to customers. Decision of credit to customers are taken on the basis of

their credit rating, security provided by them, average collection period of the

firm and financial ratios. Standards are set for all these factors. A firm can control

its credits by setting the credit standards accordingly. If credit standards are

liberal, more credit will be extended. On the other hand, if standards are tight,

less credit will be extended. Factors for which standards are set can be

classified into two broad categories namely:

a) Qualitative Factors:- Qualitative factors such as willingness and ability of

the customers to pay for purchase, public image of the customer and other

social factor are included.

b) Quantitative Factors:- Quantitative factors such as average collection

period and financial ratios.

II. Credit Analysis:- Credit Analysis is made to evaluate the credit worthiness of

the customers before making credit sales. Decision of sale on credit is taken

only on the basis of credit analysis. The firm need not follow the policy of treating

all the customers equal for allowing credit. Each customer may be fully

examined before offering credit terms to hime. Credit evaluation involves two

steps:

A) Obtaining Credit Information:- Credit Information concerning each customer is

gathered from different sources. Gathering credit information involves cost. Cost of

collecting information should be less than the expected profit accruing from it. Credit

information cab be obtained from internal as well as external sources.

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Internal Sources:- As internal sources of credit information, firm can require its

customers to fill up forms giving details about their financial activities. They may

also be asked to furnish trade references with whom the firm can have contact to

obtain the required information.

ØExternal Sources:- Credit information can also be obtained externally from:

(i) Financial Statements: Financial statements, that is , Balance Sheet and

profit & loss a/c are major source of credit information.

(ii) Bank References:- Bank of the customer is also a useful source of credit

information about the customer. Firms obtain credit information from

customer's bank with the help of its own bank. Information such as normal

balance of customer, loan taken by him, any default in repaying such loan

etc. can obtain from the bank of the customer.

(iii) Reports of Credit Rating Agencies:- Credit rating agencies collect

information about the financial and managerial aspects of large number of

business concerns from various sources such as market, newspapers,

private investigation etc.

(iv) Bazaar Reports:- Credit information about the customer can also be

maintained from the business concerns in the same trade or industry.

(v) Other Sources:- Other sources from where credit information can be

obtained are trade directories, journals, government revenue records

such as income tax returns, sales tax returns etc.

B) Analysis of Credit Information:- After obtaining the desired information from various

source, the information is analysed to determine the credit worthiness of the customer.

Analysis of credit information should cover two aspects:

(i) Quantitative Aspects:- Analysis from quantitative aspects is on the basis of

information available from the financial statements, past records of the

customers, and so on.

(ii) Qualitative Statements:- Analysis from qualitative includes judgement

regarding quality of management, willingness to pay the debts, public image of

the customer etc.

(2) Determination of Credit Terms:- The second aspect of receivable management,

after setting the credit standards and assessment of credit worthiness of the

customers, is the determination of the terms on which credit will be given. Credit terms

are the terms which relate to the repayment of the amount of credit sale. There are

three components of credit terms namely:-

(i) Credit Period:- Credit period is the time period for which credit is extended to

the customers and after which they have to make the payment. For example,

credit period of 30 days indicates that customers are required to pay before then

end of 30 days from the date of sale. It will be written as 'Net 30'

Ø

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(ii) Cash Discount:- To encourage the customers for prompt payment, cash

discount may be offered by the firm. Customers can take advantage of cash

discount by paying amount within the period of cash discount.

(iii) Cash Discount Period:- It is the duration within which cash discount is

available. It is written in form of an abbreviation, for example, '2/10 net 30'

indicates that if payment is made within 10 days, 2% cash discount will be paid. If

cash discount is availed, customer has to make the payment before the end of

30 days from the date of sale.

(3) Formulation of Collection Policy:- The third aspect of the receivable management

is to formulate a collection policy. Collection policy is required because all the

customers do not pay in time. Some customers pay after the due date and some do not

pay at all. If collection is delayed, additional funds are needed during the meantime to

pay for purchase, wages etc. Delay in collection also increases risk of bad-debts.

Collection policy pays down the collection procedure followed to collect the amounts

from the customers who do not pay within credit period allowed to them.

After the expiry of credit period, the firm should initiate collection procedures to make

collection from debtors. The efforts should be polite in the beginning but, with the

passage of time, they should be made strict. The efforts usually made by the firm

include:

(i) Reminder Letters

(ii) Telephone Calls

(iii) Personal Visits

(iv) Engaging collection agencies.

(v) Settlement at extended payment period.

(vi) Legal Action.

(4) Evaluation of Credit Policy:- A credit policy if formulated to maintain the investment

in receivables at optimum level. Receivable Turnover Ratio can be used:-

Net Credit SalesReceivable Turnover Ratio= -------------------------------------------------------------------

Average Debtors + Average Bills Receivables

If this ratio comes to 6, it means that the collection from receivables is being made after

12/6= 2 months. Similarly, if the ratio comes to 3, it means that the collection is being made

after 12/3 = 4 months.

Months or days in a periodAverage Collection Period= -----------------------------------------------

Receivables Turnover Ratio

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Q. Define Marginal Analysis Approach to Receivable Management.

Ans. Marginal Analysis:- Marginal analysis involves a systematic comparison between

the marginal returns and the marginal costs from a change in the discount period, the risk

class of the customer, or the collection period. The change should be accepted if the

marginal return from a proposed change in the management of accounts receivable is

greater than the marginal costs on additional investment.

To illustrate the use of marginal analysis, let us assume that the A Ltd. Has annual sales, all

credit, of Rs. 5000000 and a receivables turnover ratio of 6 times per year. The current level

of bad debts losses is Rs. 156250 and the firm's required rate of return on any new

investment in receivables is 14%.Further assume that this firm produces only one product,

the variable costs equaling 80% of the selling price. The company is contemplating a

relaxation of its credit policy and the expected effects of two proposed policies, A and B are

compared below:

Present Policy Policy A Policy B

Annuals Sales 50,00,000 54,68,750 57,81,250(All Credit)

Average CollectionPeriod 2 months 3 months 4 months

Bad Debts Losses 156250 187500 234375

To determine the marginal profitability from relaxing the credit policy first from the present

policy to policy A and then from policy A to policy B and compare the marginal profitability to

the required return on the additional investment in receivable yield, let's apply marginal

analysis approach.

Solution:-

Present Policy Policy A Policy B

Annuals Sales 50, 00,000 54, 68,750 57, 81,250(All Credit)

Average CollectionPeriod 2 months 3 months 4 months

Account Receivable Turnover Ratio 6 Times 4 Times 3 Times(12/ Averagecollection Period)

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Average level of Receivables(Annual Sales/Receivable turnover Rs. 833333 1367187.50 1927083.30Ratio)

Step 1: Determine the Managerial Benefits

Marginal increase in sales

(Above previous policy) Rs. 468750 312500

Profit on Marginal sales (20%) 93750 62500

Marginal increase in bad debts loses 31250 46875

Step 2: Determine the required rate of return on the marginal Investment

Marginal increase in receivables

(Above previous policy) Rs. 533854.50 Rs. 559895.80

Marginal increase investment in

Receivables (Above previous

Policy) Rs. 427083.60 Rs. 447916.60

Required return (14%) on marginal

Increase in investment in receivables Rs. 59791.74 Rs. 62708.33

Step: 3 Compare the Marginal Benefits with the Required Return

Profit on marginal in sales (less marginal increase in bad debts loss)

Less required return (20%) on marginal investment in receivable.

Rs. 270826 Rs. 47083.33

Table -2 shows that the marginal benefits by shifting from the present policy to policy A is Rs.

62500. In addition, the required return on the increase in accounts receivable, which can be

thought of as the marginal cost associated with this change, is Rs. 59791.74. Thus, since the

marginal benefit is Rs. 2708.26 greater than the required return (or marginal cost) a change

in the credit policy should be made from the current policy to policy A.

With respect to the change from policy A to policy B, the associated marginal benefit is Rs.

15625. The required rate of the return on the increase in accounts receivable or marginal

cost associated with this change is Rs. 62708.38. Thus, since the marginal benefit is Rs.

47083.33 less than the required return or marginal cost, the credit policy should not be

changed from policy A to policy B.

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The logic behind this approach to credit policy is to examine the incremental or marginal

benefits, and costs or required return associated with any change in the credit policy. If the

change promises more benefits than costs, the change should be made, if, however, the

incremental costs are greater than the benefits, the proposed change should be dropped.

Q. Explain Credit Analysis and Decision Approach.

Ans. Credit Analysis : - Credit Analysis is made to evaluate the credit worthiness of the

customers before making credit sales. Decision of sale on credit is taken only on the basis of

credit analysis. The firm need not follow the policy of treating all the customers equal for

allowing credit. Each customer may be fully examined before offering credit terms to him.

Credit evaluation involves two steps:

(A) Obtaining Credit Information: - Credit Information concerning each customer is

gathered from different sources. Gathering credit information involves cost. Cost of

collecting information should be less than the expected profit accruing from it. Credit

information can be obtained from internal as well as external sources.

ØInternal Sources: - As internal sources of credit information, firm can require its

customers to fill up forms giving details about their financial activities. They may

also be asked to furnish trade references with which the firm can have contact to

obtain the required information.

ØExternal Sources:- Credit information can also be obtained externally from:

(i) Financial Statements: Financial statements, that is, Balance Sheet and profit

& loss a/c are major source of credit information.

(ii) Bank References: - Bank of the customer is also a useful source of credit

information about the customer. Firms obtain credit information from customer's

bank with the help of its own bank. Information such as normal balance of

customer, loan taken by him, any default in repaying such loan etc. can obtain

from the bank of the customer.

(iii) Reports of Credit Rating Agencies: - Credit rating agencies collect

information about the financial and managerial aspects of large number of

business concerns from various sources such as market, newspapers, private

investigation etc.

(iv) Bazaar Reports: - Credit information about the customer can also be

maintained from the business concerns in the same trade or industry.

(v) Other Sources: - Other sources from where credit information can be obtained

are trade directories, journals, government revenue records such as income tax

returns, sales tax returns etc.

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C) Analysis of Credit Information: - After obtaining the desired information from

various source, the information is analyse to determine the credit worthiness of the

customer. Analysis of credit information should cover two aspects:

(iii) Quantitative Aspects: - Analysis from quantitative aspects is on the basis of

information available from the financial statements, past records of the

customers, and so on.

(iv) Qualitative Statements:- Analysis from qualitative includes judgment

regarding quality of management, willingness to pay the debts, public image of

the customer etc.

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UNIT – IV

Q. What do you mean by management of working capital?

Ans. MANAGEMENT OF WORKING CAPITAL:- The goal of working capital management

is to manage the current assets and current liabilities of a firm in such a way that working

capital is maintained at a satisfactory level. The current assets should be large enough to

pay the current liabilities in time while not keeping too high a level of any one of them. The

interaction between current assets and current liabilities is, therefore, the main objective of

management of working capital. According to Smith, K.V. "Working Capital management is

concerned with the problems that arise in attempting to manage the current assets, current

liabilities and the inter relationship that exists between them". Following are the main

objectives or aspects of working capital management:

(1) To Determine the Adequate or Optimum Quantum of Investment in Working

Capital: - As discussed, a firm should maintain adequate or reasonable investment in

working capital. Investment in working capital should neither be excessive nor

inadequate.

(2) To Determine the Composition or Structure of Current Assets: - The financial

management is required to determine the composition of current assets. It should

decide how much amount should be invested in each individual current asset. For this

purpose, it should fix the average amount invested in stock, debtors, marketable

securities and the level of cash balance.

(3) To Maintain a Proper Balance between Liquidity and Profitability: - While

managing working capital, management will have to reconcile two conflicting aspects.

The conflicting aspects are liquidity and profitability. If the quantum of working capital

is relatively large, it will increase the liquidity but decrease the profitability. The reason

is that a considerable amount of firm's funds will be tied up in current assets, and to the

extent this investment id idle, the firm will have to forego profits. On the other hand, if

the quantum of working capital is relatively small, it will decrease liquidity but will result

in increase in the profitability. This is because the fewer funds are tied up in idle current

assets.


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(4) To Determine the Policy or Means of Finance for Current Assets:- Another

important aspect of working capital management is determining the financing mix i.e.

what will be the sources of financing the current assets. There are mainly two sources

from which funds can be raised for current assets financing:

ØShort-term sources: Such as short-term bank loans and other current

Liabilities such as creditors, bills payable etc.

ØLong-term sources: Such as share capital, long-term borrowings, retained

earnings etc.

It has to be decided as to what proportion of current assets should be financed by

short-term sources and how much from long-term sources. The decision will

determine the financing mix. There are three approaches to determine the financing

mix:

ØMatching Approach or Hedging Approach:- According to this approach, the

expected life of the asset will be matched with the expected life of the source of funds

raised to finance such asset. For example, if stock is to be sold in 30 days, a short-term

loan for 30days may be taken. Using long-term financing for short term assets will be

expensive because funds will not be put to use for the full period. Financing long-term

assets with short-term funds will be risky as well as inconvenient because

arrangement for short-term loans will have to be made on continuous basis and it may

be difficult to borrow during stringent credit periods. When a firm follows matching

approach, (i) fixed portion of current assets is entirely financed with long-term funds,

and (ii) the temporary or variable portion of current assets is financed with short-term

funds. Under matching approach, the liquidity is very low and the risk and profitability

are high.

ØConservative Approach: According to this approach, all the financial needs of a firm

are financed from long-term funds. Short-term funds are used only in emergency

situations. In the periods when the firm has surplus funds, the idle long-term funds are

invested in tradable securities to conserve liquidity. Because of higher liquidity in

conservative approach, the risk is very low but the profitability is also low due to idle

funds.

ØAggressive Approach: This approach strikes a balance between matching and

conservative approach and provides a financing plan that lies between the two

extremes. When a firm follows aggressive approach, amount of long-term funds

remains the same as in matching approach but the amount of short-term funds is

maintained at a higher level than under the matching approach. Thus, this approach

provides more liquidity than the matching approach but less liquidity than the

conservative approach. On the other hand, the risk and profitability are lower than the

matching approach but more than the conservative approach.

Q. What do you mean by Short-term Requirements of funds? Explain short-term

sources of finance.

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Ans. Short-term Requirements: - Working Capital requirements of a firm are met from

short-term funds. These funds are required by a firm for period up to one year. Short-term

sources of finance may be divided into two parts: -

SHORT-TERM SOURCE OF FINANCE

BANK SOURCES NON-BANK SOURCES

(1) Cash Credits (1) Trade Creditors

(2) Overdrafts (2) Commercial Papers

(3) Term Loans (3) Advances from Customers

(4) Discounting Of Bills (4) Accrued Expenses

(5) Miscellaneous Sources.

(A) Bank Sources: - Commercial banks are the most important source of providing short-

term finance. They provide such finance in various forms according to the specific

requirements of a concern. The different forms in which the banks normally provide

short-term finance are as follows:-

1. Cash Credits: A cash credit is an arrangement under which the borrower is allowed to

withdraw money from the bank up to a certain limit, on hypothecation or pledge of

certain security such as stock. Maximum amount of credit limit is determined on the

basis of financial position and credit worthiness of the borrower. In case of

hypothecation, the possession of goods is not given to the bank and the goods remain

at the disposal and in the Godown of the borrower whereas in case of pledge, the

goods are placed in custody of the Bank.

Interest on cash credit account is charged only on the amount actually withdrawn and

not on the full limit of cash credit allowed. The rate of interest charged by the bank on

cash credit is a little higher than that charged on term loans. This is, because the bank

has to keep the entire amount (up to the extent of limit) always ready as the money

may be demanded by the customer at any time.

2. Overdrafts:- It is a temporary arrangement by which a customer operating current

account with the bank is allowed by the bank to overdraw money upto a certain limit.

Like cash credit, in case of overdraft also, interest is charged on the actual amount

withdrawn by the customer and the rate of interest is a little higher as compared to term

loans.

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3. Term Loans: - It is an advance of a fixed amount withdrawn in lump sum and is

sanctioned for a fixed term. Interest is charged on the total amount but the rate of

interest is usually lower as compared to cash credit and overdraft because the bank

has not to keep the amount idle. Most of the businessmen prefer to take cash credit in

comparison to term loan because even though the rate of interest in cash credit is a

little higher, they consider it inconvenient to use the full amount of loan instantly.

4. Discounting of Bills: It is a form of advance by which the bank advances money to

the holder of the bill before its maturity date after deducting the discount. The bank

holds the bill till its maturity and gets its payment from the drawee on the due date.

B) Non-Bank Sources: - These sources may include the following:-

1. Trade Credit: - Trade credit represents the credit automatically allowed by suppliers

to their customers according to the customs of the trade. In other words, when goods

are purchased and the payment is not made immediately, it becomes a short-term

source of finance. Securing of trade credit depends upon the credit-worthiness of a

firm and the confidence of its suppliers.

Advantage of Trade Credit:-

(i) It is relatively easy to obtain.

(ii) It is available on a continuing basis and increases automatically with the

increase in the volume of business of the firm.

(iii) There is no need of mortgaging or pledging any assets any asset for obtaining

trade credit.

Disadvantage of Trade Credit:-

(ii) The biggest disadvantage of trade credit is that the price charged by the supplier

of goods is higher than cash price.

(iii) Buyer has to bear the loss of cash discount which he could have availed on cash

purchases.

2) Commercial Papers: - These are short-term unsecured securities issued by highly

creditworthy large companies. Commercial papers are regulated by the RBI and the

main features of commercial papers are:-

(i) Only those companies are allowed to issue commercial papers which have a net

worth of Rs. 10 crore or more.

(ii) The minimum size of an issue is Rs. 25 lac and the size of each commercial

paper should not be less than Rs. 5 Lac.

(iii) They can be issued for periods ranging between 15 days and one year.

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Advantage:-

(i) It is a cheaper source of short-term finance as compared to bank credit.

(ii) It is a useful source of finance during period of tight bank credit.

Limitations:-

(v) It can be used only by large and financially sound companies.

(vi) Commercial papers cannot be redeemed before maturity date even if the

issuing firm has surplus funds.

(vii) Maturity fate of commercial papers cannot be extended even is the issuing firm

is facing financial difficulties.

3) Advance from Customers: - Manufacturers, whose products are in great demand,

usually demand advance money from their customers and agents at the time of

accepting their orders. Such an advance is a fixed percentage of the value of the order.

Such advances are a part of the price of goods and no interest is paid on them.

4) Accrued Expenses: - These are the expenses which have been incurred but have

not become due for payment. The most common items of accruals are wages,

salaries, interest and taxes. Wages and salaries are usually paid in the month next to

the month in which the services are rendered.

5) Miscellaneous Expense:- Some concerns resort to miscellaneous source of finance

in the times of pressing needs. Such sources may include loan from directors, inter-

corporate deposits etc.

Q. Explain the relationship between working capital and banking policy with

reference to various recommendations.

Ans. Banks in India have been providing finance to industry and trade on the basis of

security. To regulate and control bank finance, the Reserve Bank of India has been issuing

directives and guidelines to the banks from time to time on the recommendations of certain

specially constituted committees entrusted with the task of examining various aspects of

bank finance to industry. We have discussed below the important findings and

recommendations of the following committees:-

(2) Dehejia Committee Report

(3) Tondon Committee Recommendations

(4) Chore Committee Recommendations

(5) Marathe Committee Recommendations.

(6) Chakravarty Committee Report.

(1) Dehejia Committee Report: - National Credit Council constituted a committee under

the chairmanship of Sh. V.T. Dehejia in 1968. The opinions of the committee were:-

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(i) The committee was of the opinion that there was also a tendency to divert short-

term credit for long-term assets.

(ii) The committee was also of the opinion that the banks should finance industry on

the basis of a study of borrower's total operations rather than security basis

alone.

(iii) The committee further recommended that the total credit requirements of the

borrower should be segregated into 'Hard Core' and 'Short-term' component.

The 'Hard Core' component which should represent the minimum level of

inventories which the industry was required to hold for maintaining a given level

of production should be put on a formal term loan basis.

(iv) The committee was also of the opinion that generally a customer should be

required to confine his dealings to one bank only.

(2) Tondon Committee Recommendations: - Reserve Bank of India set up a committee

under the chairmanship of Sh. P.L.Tandon in July 1974. This committee considered

the following questions:

(i) Determination of working capital requirements of industry.

(ii) Supervision of credit for ensuring proper end-use of funds.

(iii) Methodology of sending periodical forecasts by borrowers.

(iv) Norms for build up of current assets and for debt to equity ratio to ensure minimal

dependence on bank finance.

The committee has suggested the level of current assets which each industrial unit is

supposed to hold. These are called "Norms".

RBI has advised in norms in certain cases. Following points are relevant in dealing with

norms.

(i) Norms are maximum levels of current assets that a unit can hold.

(ii) Norms are prescribed separately for each industry.

(iii) Norms have been prescribed separately for individual current assets.

(iv) No norm is fixed for export receivables, imported raw material and other current

assets.

Quantum of Permissible Bank Finance: - The three alternatives have been taken form the

report of the committee:

(i) Method 1---- According to this method, the maximum permissible bank finance

is 0.75 ( CA-CL)

(ii) Method 2---According to this method, the maximum permissible bank finance is

(0.75 CA)-CL.

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(iii) Method 3----- According to this methods, the maximum permissible bank

finance is 0.75 (CA-CCA) -CL.

(3) Chore Committee Recommendation: - RBI constituted a working group in April

1979 under the chairmanship of Sh. K.B. Chore, Chief Officer, and RBI. The

committee was to :

(i) Review the operations of the cash credit system in recent years particularly with

reference to the gap between sanctioned credit limits and the extent of their

utilization.

(ii) Suggest

(iii) Alternative type of credit facilities

Recommendations:-

Major recommendations were as follows:-

(ii) The bank should undertake a periodical review of limits of Rs. 10 Lacs and

above.

(iii) The bank should obtain quarterly statements in the prescribed format form all

borrowers having working capital credit limits of Rs. 50 Lacs and above.

(iv) It was proposed that the bank should sanction separate limit for peak

requirements and non-peak level requirements.

(v) If a borrower does not submit the quarterly returns in time the banks may charge

penal interest of one percent on the total amount outstanding for the period of

default.

(4) Marathe Committee Report: - The Marathe Committee was appointed by the

Reserve Bank of India to suggest measures for giving meaningful directions to the

credit management function of Reserve Bank of India. The two major

recommendations are:-

(i) The committee has declared the third method of lending as suggested

measures by Tondon Committee to be impractical.

(ii) The committee has suggested the introduction of the 'Fast Track Scheme' to

improve the quality of credit appraisal in banks. It recommended that

commercial banks can release without prior approval of the Reserve Bank 50%

of the additional credit required by the borrowers where the following

requirements are fulfilled:-

(a) The estimates/projections in regard to production, sales, current assets,

current liabilities other than Bank borrowings, and net working capital are

reasonable in terms of the past trends and assumptions regarding most

likely trends during the future projected period.

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(b) The projected current ratio is not below 1.33:1.

(c) The borrower has been submitting quarterly information and operating

statements for the past six months within the prescribed time.

(d) The borrower undertakes to submit to the banks his annual account

regularly.

(5) Chakravarty Committee Report: - The Reserve Bank of India appointed another

committee under the chairmanship of Sukhamoy Chakravarty to review the working of

the monetary system of India. The committee submitted its report in April, 1985. The

committee made two major recommendations in regard to the working capital

finance:-

(i) Penal interest for Delayed Payments: - The committee has suggested that the

government must insist that all public sector units, large private sector units and

government departments must include penal interest payment clause in their

contracts for payments delayed beyond a specified period. The penal interest

may be fixed at 2 per cent higher than the minimum lending rate of the supplier's

bank.

(ii) The interest rate should be charged:

• For Cash Credit Portion : Maximum prevailing lending rate of the bank.

• For Bill Finance Portion : 2% below the basic lending rate of the bank.

• For loan Portion: The rate may vary between the minimum and maximum

lending rate of the bank.

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Working capital management (1)

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