Working capital management (1)

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Working capital management (1)

  1. 1. WORKING CAPITAL MANAGEMENT (FINANCE) S R UNIT – I TE 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 PU 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. M 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 O 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- C (1) Gross Working Capital Concept (2) Net Working Capital Concept. D (1) Gross working capital: Gross working capital; refers to firms 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 andZA 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".
  2. 2. 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 S 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 R also be considered as symbol of working capital. (ii) Any acquisition of funds increases the working capital. This statement proves true TE 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. PU (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 M are in excess of current assets. Net Working Capital = Current Assets - Current Liabilities O Definitions Favouring Net Working Capital Concept:- According to C.W.Gestenbergh C "It has ordinarily been defined as the excess of current assets over current liabilities". According to Lawrence. J. Gitmen D " The most common definition of net working capital is the difference of firms current assets and current liabilities". Arguments in Favour of Net Working Capital Concept:-ZA (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.
  3. 3. (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 S business. (v) According to this concept a comparison can be made between the financial position of R 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:- TE (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) Negative. PU When current assets are less than current liabilities, then working capital will be 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. M 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. O Q. What is the need of Working Capital? Ans. Meaning of Working Capital:- Working capital management is an important aspect C 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 D determine the optimum amount of working capital required. Generally, management of working capital means management of current assets.ZA 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
  4. 4. 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: S ØConversion of cash into raw material R ØConversion of raw material into work-in-progress ØConversion of work-in-progress into finished goods TE 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 PU 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 M O Debtors and Bills Receivables Raw Materials C D Finished Goods Work-in-ProgressZA 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:-
  5. 5. (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. S The amount involved as permanent working capital has to be met from long-term sources of finance, e.g. R (i) Capital (ii) Debentures TE (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 PU 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:- M SHOWING PERMANENT AND TEMPORARY WORKING CAPITAL: O C DZA Time SHOWING PERMANENT AND TEMPORARY WORKING CAPIRAL IN A GROWING CONCERN:
  6. 6. S R TE Q. PU What is the meaning of Working Capital? Explain the factors affecting the working capital requirements of a business. 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 M 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 O 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 C 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 D 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:ZA (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
  7. 7. 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 S need for working capital. The size of a business may be measured in terms of scale of its business operations. R (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. TE (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) PU 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 M 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 O 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 C 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 D 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.ZA (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,
  8. 8. 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 S capital. (10) Availability of Credit from Banks:- If a firm can get easy bank facility in case of need, R 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. TE (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. PU (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 M 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 O 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. C (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 D 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.ZA (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
  9. 9. 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:- S 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 R 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 TE 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) (i) Gross Working Capital PU On the Basis of Concept: On this basis working capital may be of two types: (ii) Net Working Capital M (2) On the Basis of Need:- On this basis also working capital may be of two types: (i) Permanent Working Capital O (ii) Temporary Working Capital. Q. Define Working Capital. Briefly explain the techniques used in making working capital forecast or Estimating Working Capital Requirements C 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 D 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 ofZA 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
  10. 10. 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. S Following factors should be taken into consideration while forecasting working capital requirement on the basis of operating cycle method: R Øof raw materials, wages and overheads. Cost Ø during which raw material remains in store before it is issued for Period TE production purpose. Ø of Production cycle. Period Ø during which finished goods is stored before sale. Period Ø of credit allowed to debtors and period of credit allowed by suppliers. Period Ø PU Ø lag in payment of wages and overheads. Time Minimum 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. M On the basis of operating cycle, the working capital can be forecasted in the following way: STATEMENT SHOWING WORKING CAPITAL REQUIREMENT Current Assets: O Ø of Raw-Materials: Stock Average Inventory holding period C Cost of yearly consumption (weeks/months) Of raw material x ----------------------------------------------- = -------- 52 weeks / 12 months Ø in Progress: Work D Average time span of work in process Cost of yearly consumption (weeks/months)ZA 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.)
  11. 11. Average time span of work in process 50 (weeks/ months) x -------- x ----------------------------------------------------- = --------- 100 52 weeks/ 12 months S Note: While calculating work in process it will be assumed that full Unit of raw material is R 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. TE Ø of Finished Goods: Stock Cost of goods produced (i.e., yearly cost of raw materials +Wages + manufacturing & administrative overheads(excluding depreciation) ØDebtors: (weeks / months PU Average finished goods holding period x ------------------------------------------------ 52 weeks/ 12 months = ---------- M Working Capital tied up in debtors should be estimated on the basis of cost of sales (excluding depreciation): Average debt collection period O Cost of goods produces (weeks / months) (i.e., raw materials + wages x ----------------------------------- = --------- + manufacturing, administrative 52 weeks/ 12 months & selling overhead) C Ø and Bank Balance: Cash (i.e., minimum cash balance required to be maintained = -------- D Less: Current Liabilities (the working capital are lower to the extent such requirements are met through current liabilities)ZA Ø Creditors: Trade Credit period allowed by creditors Cost of yearly consumption (weeks/ months) Of raw material x -------------------------------------------------- = -------- 52 weeks/ 12 months
  12. 12. ØWages: Average time lag in payment of wages (weeks/ months) Yearly wages x ------------------------------------------------------- = ---------- 52 weeks/ 12 months S 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 days wages are paid on the R 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 TE half a month. ØOverheads: Average time lag in payment of overheads Yearly Overheads(other (weeks/ months) Than Depreciation) x -------------------------------------------------- = ---------- PU 52 weeks/12 months Working Capital (Current Assets - Current Liabilities) Add: Provision for Contingencies ______ ---------- ---------- ________ M Estimated Working Capital Requirement ---------- ________ O (2) Forecasting of Current Assets and Current Liabilities Method:- According to this method, an estimate is made of forthcoming periods current assets and current liabilities on the basis of factors like past experience, credit policy, stock policy and C 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 D 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 ofZA 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 years 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.
  13. 13. (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. S Q. What are the advantage of Adequate working capital? Ans. ADEQUATE WORKING CAPITAL: The firm should maintain a sound working capital R position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from firms point of view. Excessive working capital means holding costs and idle funds which earn no profit for TE the firm. Paucity of working capital not only impairs the firms 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 (2) PU 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. 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 M 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 O date. (4) Increase in Credit Rating :- Paying its short-term obligations in time leads to a strong C 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 D 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 sufficientZA 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.
  14. 14. (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 S 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 R 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 TE 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) PU 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 M 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 O resources at their command. It results in laxity of control on expenses and cash resources. Disadvantage of Inadequate Working Capital: C (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 D discount. (2) Full Utilization of Fixed Assets not Possible: Due to the frequent interruption in theZA 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 firms relations with its bankers and it becomes difficult for the firm to borrow in case of need.
  15. 15. (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 S 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. R (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. TE (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? PU 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:- M 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 O 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. C ØAn increase in current assets results in increase in working Capital. ØA decrease in current assets results in decrease in working capital. D ØAn increase in current liabilities results in decrease in working capital. ØA decrease in current liabilities results in increase in working capital.ZA (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:
  16. 16. Current Assets Current Ratio = --------------------------------- Current Liabilities Ø Ratio:- Liquid ratio explains the relationship between liquid assets and Liquid current liabilities of a business. The formula for calculating the ratio is: S Liquid Assets R Liquid Ratio = ----------------------------- Current Liabilities Cash + Bank + Marketable Securities TE ØAbsolute Liquid Ratio = ------------------------------------------------------- Current Liabilities (B) Activity Ratios:- ØInventory Turnover Ratio: Ø PU Cost of Goods Sold Inventory Turnover Ratio = -------------------------------------------- Average Stock Debtors Turnover Ratio:- This ratio indicates the relationship between credit sales and average debtors during the year. The formula for calculating the ratio: M Net Credit Sales Debtors Turnover Ratio = ----------------------------------------- Average Debtors + Average B/R O ØCreditors Turnover Ratio:- This ratio indicates the relationship between credit purchases and average creditors during the year. The formula for calculating the ratio is: C Net Credit Purchases Creditors Turnover Ratio = ----------------------------------------------------- Average Creditors + Average B/P D 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 SoldZA Working 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
  17. 17. 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 S 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 R 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. TE PU M O C DZA
  18. 18. WORKING CAPITAL MANAGEMENT (FINANCE) S R UNIT – II TE 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 PU 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 M 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 O 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, C 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. D (2) Precautionary Motive: - In every business, some cash balance is kept as a precautionary measure to meet any unexpected contingency. These contingenciesZA 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.
  19. 19. (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. S (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. R (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 TE 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 Q. banks to the business. PU 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 M 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 O (B) Slowing disbursements (A) Accelerating cash collection : The customer should be encouraged to pay as C 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. D 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:ZA (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 firms 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.
  20. 20. (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 S 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 R from a lock box several times a day and deposit them in firms 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 TE 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. 2. PU 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. Centralized Disbursement: - Another way to slow down disbursements is to make all the payments by the head office from the centralized account. This M 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 O 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. C 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 D on the banks far away from the creditors bank. In order to take advantage of the float it is necessary to analyse the time-gap in issue of cheques and theirZA 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
  21. 21. 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. S Investment in Marketable Securities:- We describe below briefly the more prominent marketable securities available for investment. These are :- R (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:- TE (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) Advantage:- (i) PU They can be issued for periods ranging between 15 days and one year. It is a cheaper source of short-term finance as compared to bank credit. M (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. O (iii) Commercial papers cannot be redeemed before maturity date even if the issuing firm has surplus funds. C (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 D 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.ZA 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.
  22. 22. 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. S 5) Money Market Mutual Funds/Liquid Funds:- These are professionally managed portfolios of marketable securities. They provide instant liquidity. Due to high liquidity, R 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 TE 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 (i) PU determination of the mix of cash and marketable securities. These consideration include evaluation of: 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- M 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). O (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. C (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 D the ability to transform a security into a cash. Q. Write a short note on Cash System.ZA 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.
  23. 23. Deposit Disbursemen Bank 1 Bbank 1 S R Concentration Bank TE Deposit Disbursement Bank 2 Bank 2 Q. PU What are the types of collection system? Ans. Types of Collection System:- M 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 O over the counter system does not contain mail float. The cash flow timeline for an over- the-counter system is shown:- C Customer Deposit Availability Delivers made at granted Payment local bank DZA Processing delay Availability delay Processing float Availability float Collection float
  24. 24. Components of a collection system for over the counter receipts Customers S Filed Unit R TE Local Deposit Central Information Bank System 2. Mailed Payments Collection System:- For many companies, payments, almost (i) (ii) Mail Float Processing Float PU cheques are mailed by the customer in response to an invoice. A mailed payments system contains all three components of collection float: M (iii) Availability Float. Components of a Mailed Payments Collection System Customer Customer Customer Customer Customer O Group 1 Group 2 Group 3 Group 4 Group 5 C D Collection Collection Center A Center AZA Deposit Deposit Bank X Bank Y Central Information System
  25. 25. 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 S 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 R 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 TE registration of securities etc. Therefore two types of costs are involved in keeping cash balance in a business- (i) Opportunity Cost (ii) Transaction Cost PU 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 M 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:- O 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 C 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. D Baumol model is in the form of following formula:-ZA 2U X P C = _____________ = Rs. 10,000 S Where C = Optimum Cash Balance U= Cash disbursement of a year (or month)
  26. 26. P= Fixed cost per transaction S= Opportunity cost of one rupee p.a. (per month) Example:- S Monthly cash requirements according to cash budget Rs. 50,000 Fixed cost per transaction Rs. 10 R Interest Rate 12% p.a. Calculate optimum cash balance TE Solution:- 2 X 50,000 X 10 C = ________________ = Rs. 10,000 .01 Q. PU Therefore, optimum cash balance= Rs. 10,000 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 M 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 O cash balance at that level. (ii) To keep the optimum Cash balance Requirement at Minimum level:- The second C 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 . D Ans. Introduction:- Baumols 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 theZA 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:-
  27. 27. Curve represents Cash Balance Upper Control Limit S Purchase of Marketable Securities Return Point R TE Sale of Marketable Securities Lower Control Limit O PU X 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 M 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 O 3 Transaction Cost X Variance of Cash Flows R = ------- X -------------------------------------------------------------- 4 Interest Rate C Upper Control Limit= 3 R + lower control limit D Optimal Return Point = R+L L= Lower control limitZA 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)
  28. 28. 3 Transaction Cost X Variance of Cash Flows R = ------ X -------------------------------------------------------------- 4 Interest Rate 2 S 3 45 X (50000) R R = -------- X -------------------------------- 4 .0002 TE 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 occur: Day PU Assume that the firms starting balance was Rs. 1,50,000 and the following cash flows Net Cash Flow 1 -25,000 M 2 -75,000 3 + 1,00,000 4 -25,000 O 5 + 1,25,000 • At the end of day 1, the cash balance would be Rs. 1,25,000 since this is C 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 D would disinvest sufficient securities to get back the return point. Q. Explain the Stone Model of Cash Management.ZA 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 managements 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).
  29. 29. UCL2 UCL1 S Return Point Cash R Balance TE LCL1 LCL2 PU 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 M 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 O 1 -25,000 2 -75,000 C 3 + 1,00,000 4 -25,000 5 +1,25,000 D 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 controlZA 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).
  30. 30. WORKING CAPITAL MANAGEMENT (FINANCE) S R UNIT – III TE 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 PU 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. M 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. O 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 C 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. D (b) To keep the investment in inventories at minimum level by efficiently organizing the purchase and sale operations.ZA 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.
  31. 31. (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. S (7) To minimize losses through wastages and damages. R (8) To facilitates furnishing of data for short-term and long-term planning and control of inventory. TE (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) (c) (d) How much to purchase From where to purchase Where to store, etc. PU M 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. O Kinds of Inventories:- (A) In Trading Concern. C (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:- D (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 beZA 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.
  32. 32. (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 S items which are available for sale. (v) Spares:- Spares also form a part of inventory. Spares include those items which R 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. TE 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 its manufacturing process, it need not to hold stock of raw materials. But in actual PU 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 M 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 O 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. C (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, D 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.ZA This also results in accumulation of raw material inventory. Cost of Holding Inventories: The holding of inventories involves blocking of a firms funds. The various risks and costs in holding inventories are as below: (1) Capital Costs:- Maintaining of inventories results in blocking of the firms 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
  33. 33. 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 S storage as well as handling of materials. The storage costs includes: (i) Rent of the Godown R (ii) Insurance charges etc. (3) Risk of Price Decline:- There is always a risk of reduction in the prices of TE 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 customers tastes, etc. Q. (5) PU Risk Deterioration in Quality:- The quality of the materials may also deteriorate while the inventories are kept in stores. What are the methods for Valuation of Inventories? Ans. Valuation of Inventories:- The value of materials has a direct bearing on the income M 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:- O (1) First in First Out Method (Known as FIFO Method) (2) Last in First Out Method (Known as LIFO Method). C (3) Average Price Method. (4) Base Stock Method. D (5) Standard Price Method. (6) Market Price Method.ZA (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:
  34. 34. Date Quantity (Units) Price per unit Dec. 4 900 5.00 Dec. 10 400 5.50 S Dec. 11 300 5.50 R Dec. 19 200 6.00 Dec. 28 800 4.75` TE Total 2,600 1600 units were issued during the month of December. Find the value of closing stock assuming FIFO Method. Solution:- PU 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 M The value of 200 units @ Rs. 6.00 1,200 Total 5,000 (2) Last in First Out (LIFO) Method:- In last in first out method the last received O 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 C 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, D which he uses while manufacturing radio sets: Date Quantity (Units) Price per unitZA 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
  35. 35. 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- S 100 units received on 10th December; and R 900 units received on 4th December as per FIFO The value of 100 units @ Rs. 5.50 550 TE The value of 900 units @ Rs. 5.00 4,500 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) PU 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: M 2+3+4 Average Price= ---------------- = Rs. 3 3 Though this is a simple method of pricing materials but particularly this method does not give O good results. The total cost is not observed in this method. The following example will explain this point: C 10,000 units were purchased @ Rs. 2 per unit 15,000 units were purchased @ Rs. 3 per unit 20,000 units were purchased @ Rs. 4 per unit D The total cost of materials will be: 10,000 X 2 = 20,000ZA 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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