Working capital management

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 CurrentAssets".
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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.Anegative 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
CurrentAssets:
ØStock of Raw-Materials:
Average Inventory holding period
Cost of yearly consumption (weeks/months)
Of raw material x ----------------------------------------------- = --------
52 weeks / 12 months
ØWork in Progress:
Average time span of work in process
Cost of yearly consumption (weeks/months)
Of raw material x ----------------------------------------------------------
52 weeks/ 12 months
50 (weeks/months)
+Yearly wages x --------- x --------------------------------------------------------
100 52 weeks/ 12 months
+Yearly manufacturing and administrative overheads (excluding dep.)
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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 -------------------------------------------------- = --------
52 weeks/ 12 months
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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 overheads
Yearly Overheads(other (weeks/ months)
Than Depreciation) x -------------------------------------------------- = ----------
52 weeks/12 months ______
Working Capital (CurrentAssets - 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.Acertain 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 ofAdequate 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 ofAdequate 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.
ØAdecrease in current assets results in decrease in working capital.
ØAn increase in current liabilities results in decrease in working capital.
ØAdecrease 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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CurrentAssets
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:
LiquidAssets
Liquid Ratio = -----------------------------
Current Liabilities
Cash + Bank + Marketable Securities
ØAbsolute 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 Sales
Debtors 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 Purchases
Creditors 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 Sold
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
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.
(FINANCE)
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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 otherAssets 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:- Amajor 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.
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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 1
Disbursemen
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 P
C = _____________ = 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 10
C = ________________ = 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 Flows
R = ------- 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
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3 Transaction Cost X Variance of Cash Flows
R = ------ X --------------------------------------------------------------
4 Interest Rate
2
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 Point
Cash
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.
(FINANCE)
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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) InTrading 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+4
Average 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 4
WeightedAverage 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.Aproper 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. ABCAnalysis.
4. InventoryTurnover Ratios.
5. V EDAnalysis
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 XAverage 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 O
EOQ = -----------------
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 O
EOQ = --------------------
C
2 x 4, 00,000 x 20
EOQ = -------------------------------
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 MaterialTurnover (in times)= -----------------------------------------------------
Average stock of Raw Materials
Cost of Goods Sold
(ii) Finished GoodsTurnover ( 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.Aspecimen 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 CreditTerms.
(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. CreditAnalysis.
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.Afirm 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) LegalAction.
(4) Evaluation of Credit Policy:- A credit policy if formulated to maintain the investment
in receivables at optimum level. ReceivableTurnover Ratio can be used:-
Net Credit Sales
Receivable 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 period
Average Collection Period= -----------------------------------------------
Receivables Turnover Ratio
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Q. Define MarginalAnalysisApproach 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 PolicyA Policy B
Annuals Sales 50,00,000 54,68,750 57,81,250
(All Credit)
Average Collection
Period 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 PolicyA Policy B
Annuals Sales 50, 00,000 54, 68,750 57, 81,250
(All Credit)
Average Collection
Period 2 months 3 months 4 months
Account Receivable
Turnover Ratio 6Times 4Times 3Times
(12/Average
collection Period)
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Average level of
Receivables
(Annual Sales/
Receivable turnover Rs. 833333 1367187.50 1927083.30
Ratio)
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 policyAis 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 policyA.
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 policyAto 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 CreditAnalysis and DecisionApproach.
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.
(FINANCE)
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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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Working capital management

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