Components of working capital

Components of

Working Capital

The main items of WC are:

Cash
Receivables
Inventory

CASH MANAGEMENT
 Cash is the most important component of
current assets
 It is the most liquid current asset
 It includes bank
 Other current assets such as receivables and
inventory are converted into cash in the ordinary
course of business operation
 Cash means, in a narrow sense, currency,
cheques, drafts and demand drafts in banks, but
in broader sense, it includes near-cash assets
such as marketable securities, short term
deposits also.
 Cash management means management of both
cash and non-cash assets

Motives of holding cash:
The cash, though a barren asset, is held by the
firms for the following motives:
 Transaction motive: Transaction motive
refers to the holding of cash to meet routine
cash requirements. The business
transactions result in both inflows and
outflows of cash, which do not perfectly
match. To meet a situation where the
payment exceeds inflows, the firm should
keep cash balance by arranging for cash.

 Precautionary motive: A firm has to keep cash
balance to meet unexpected cash needs at short
notice as a result of flood, strike, increase in cost
of raw material, slow in collection, cancellation of
orders etc. the precautionary motive implies the
need to hold cash to meet unpredictable
situations.
 Speculative motive: A firm keeps cash balance
to take advantage of unexpected opportunities
such as decline in the price of raw materials,
discount in the purchase etc. The speculative
motive helps to take advantage of the
opportunities, which are outside the normal
course of the business.

Objectives of cash management:
 The objective is to keep optimal cash
balance at all times.
 To meet the payment schedule a firm
should keep sufficient cash.
 Keeping adequate cash prevents
insolvency, develops good relation with
lenders and suppliers, help to take
advantage of business opportunities and
enable a firm to meet the contingencies
 At the same time, a higher level of cash
balance means high cost to the firm.

Cash management strategies:
The cash management strategies can be
examined under four heads-
 To keep the minimum level of cash
 Controlling inflow of cash
 Controlling outflow of cash
 Optimal investment of surplus cash

To keep the minimum level of cash:
 To keep the minimum level of cash the
following aspects are to be examined-

1. Preparation of cash budget:
 The prime objective of preparing cash
budget is to know whether there is excess
of cash flow in a period. The following two
elements are to be taken into
consideration for preparing cash budget.
a. The first element is the selection of a
period. The cash flow should be projected
for the given period. Such period should
not be too short or too long.

b. The second element is the selection of
factors for cash flow. Non-cash items
should be carefully excluded.

2. Unpredictable discrepancies:
 A certain portion of cash balance is to be
kept to meet unpredictable discrepancies
such as strikes, riots, floods etc.

3. Short cost:
 The cash budget reveals periods of cash
shortages. In addition, there may be unexpected
short falls. The cost incurred as a result of
shortage of cash is called the short cost . This
includes, brokerage to raise cash, commitment
charges to loan, higher bank charges, penal
rates by banks, etc.
4. Availability of other sources of funds:
 The availability of external sources to obtain
funds on short notice enables a firm to maintain
smaller amount of cash balance. Further, the
level of cash balance is determined by the
relationship of a company with its banks.

To control inflow of cash:
To control the inflow of cash the following points are
worth to be noted:
 Preventing fraudulent diversion of cash receipts
 Speed-up the collection
 Proper internal system to prevent defalcations of cash
 The following techniques may be adopted for speedier
collection of cash:
 Concentration banking – have a number of collection
centres and open bank accounts in each collection
centre and direct the bank to transfer the proceeds to
HO
 Lock box system – hire a post office box and direct the
local bank to collect the cheques and transfer the
proceeds to HO

Control over cash outflows:
 The control over cash inflows aims at maximum
acceleration of collections whereas the control
over cash outflows tries to slow down the
disbursement as much as possible without
affecting the credit standing of the firm. The
combination of these two result in maximum
availability of funds
 Methods:
 Do not make the payments early i.e. before the
due date
 All payments should be made by the HO from a
centralised disbursement

 Float – means the amount of money tied up in
cheques that have been written but not
presented for payment
 Methods of float:
 The firm may issue a cheque away from the
creditor’s bank
 Analyse the time lag in issue and encashment
and arrange fund accordingly
 But, playing float involves high amount of risk

Investing surplus cash:
Surplus cash is the amount in excess of the
firm’s normal cash requirement. This
involves –
 Determination of the amount of surplus cash
and
 Determination of the channels of investment
 Keep the safety level of cash and go for
investment of the balance amount
 While make the investment keep always in
mind the security, liquidity, yield and maturity

Cash management models:
Baumol Model:
 Suggested by William J Baumol, similar to the EOQ in
inventory control.
 According to this model, optimum cash level is that
level of cash where the carrying costs and
transactions costs are minimum.
 Carrying costs – refers to the cost of holding cash –
i.e. the opportunity cost
 Transaction costs – refers to the cost involved in
getting the marketable securities converted into cash
such as clerical, brokerage, registration etc

 There is inverse relationship between
these two cost and the optimum level
means the point where these two costs
are equal

Formula: C= 2U x P
S
Where, C = Optimum cash balance
 U = Annual or monthly cash
disbursements
 P = Fixed cost per transaction and
 S = Opportunity cost of one rupee p.a.

Miller Orr model:
 According to this model, the net cash flow is
completely stochastic or random.
 This model lays down three control limits,
1.An upper limit (h)
2.A lower limit (o) and
3.A return point (z)
 When cash balance reaches the upper limit ‘h’, a transfer of
‘h – z’ is effected to marketable securities and
 When cash balance reaches the lower limit ‘o’, a transfer
equal ‘z-o’ from marketable securities to cash is made.
 When cash balance stays between the upper limit and lower
limit, no transfer is effected
 Both the limits are fixed based on opportunity cost of
holding cash, degree of fluctuation in cash balance
and fixed cost associated with security transactions

H

z
o

 The optimal value of z, the return point for securities
transactions, can be determined by the following
formula:

3b 2
Z= 3 4i
 Where, b = fixed cost associated with a security
transaction
 2 = variance of daily cash flows
 I = interest rate per day on marketable securities

Management of inventories
 Inventories are goods held for eventual sale by a firm.
Inventories are thus one of the major elements, which help
the firm in obtaining the desired level of sales.
Kinds of inventories:
 Raw materials: goods not yet been committed to production
in a manufacturing firm consists of basic raw materials or
finished components.
 Work-in-progress: This includes those materials which have
been committed to production process but not yet been
completed
 Finished goods: These are completely produced products
awaiting for sale. They are the final output of the production
process after inspection in a manufacturing firm and in retail
and wholesale merchandise, it is referred to as merchandise
inventory.
 The level of inventory differ depending upon the nature of
business, time, type of inventory, availability of facilities etc.

Benefits of holding inventories:
 Avoiding losses of sales
 Availing quantity discounts
 Reducing ordering cost
 Achieving efficient production runs,
thereby reducing the set up costs
 Risks and costs associated with
inventories such as
 Pricedecline
 Product deterioration
 Obsolescence

Management of inventory
 Good inventory management is good financial
management
 Inventories constitute a major element of total
WC hence inventory involve costs
Inventory management covers:-
 Fixation of minimum and maximum levels
 Determining the size of inventory to be carried
 Deciding about the issue price policy
 Setting up receipt and inspection procedure
 Determining the EOQ
 Providing proper storage facilities
 Keeping check on obsolescence and setting up
effective information system with regard to
inventories

However, management of inventories from the finance
manager point of view involves two basic problems:
1.Maintaining a sufficient large size of inventory for
efficient and smooth production and sales operation
2.Maintaining a minimum investment in inventories to
minimise the direct/indirect costs associated with
holding inventories to maximise profitability
 High inventory means high interest cost and high
storage costs
 Low inventory means interruption in production
schedule resulting in underutilization of capacity and
lower sales

So, the objective is to hold optimum
inventory to ensure:-
 Continuous sufficient stock of raw
materials in periods of short supply
 Sufficient stock of raw materials in periods
of short supply
 Sufficient stock of finished goods for
smooth sales
 Minimum carrying costs
 Investment in inventories at the optimum
level

Techniques of inventory management
Economic Order quantity
 EOQ refers to the size of the order which gives
maximum economy in purchasing any item of raw
material or finished product after taking into
consideration of the following costs
 Ordering cost – It is the cost of placing an order
and securing supplies. It varies from time to time
depending upon the orders placed and the number
of items ordered. The more frequent the placing of
orders and few the quantity in each order, greater
the ordering cost and v.v.
 Inventory carrying cost – It is the cost of keeping
items in stock, includes interest on investment,
obsolescence losses, store-keeping cost, insurance
premium etc. The larger the volume of inventory,
higher the ICC

 As the ordering cost or the cost of acquiring
decreases while the cost of holding increases
with every increase in the quantity of purchase
lot. A balance is therefore stuck between the two
opposing factors and the economic ordering
quantity is determined at a level for which the
aggregate of two cost is the minimum

2UP
EOQ = CS
Where, U = Quantity(units) purchased in a year or
month
 P = Cost of placing an order
 S = Percentage of storage cost and carrying
cost
 C = Cost per unit of material

 Assumptions:
 The firm knows with certainty the annual usage
or demand of the particular item of inventories
 The rate at which the firm uses the inventories or
makes sales is constant throughout the year
 The orders for replenishment of inventory are
placed exactly when inventories reach at zero
level
 The above assumptions may also be called as
limitations of EOQ model.
 There is every likelihood of a discrepancy between
actual and estimated demand for a particular item of
inventory
 The assumptions as to constant usage or sale of
inventories are also of doubtful validity.

2. Determination of reorder level
 Reorder level is that level of inventory at which the
firm should place an order to replenish the
inventory. In case, the order is placed at this level,
the new goods will arrive before the firm runs out of
goods to sell.
 In order to determine reorder level, information is
required about two things – a. the lead time
and
 b. the usage time
 Lead time: It is the normal time taken in receiving
the delivery of inventory after the order has been
placed
 Usage time: It is the rate at which the consumption
took place, either daily or weekly etc.
 Reorder level = Average usage x Lead time

 3. Safety stock
 The reorder level is computed presuming that there
is no uncertainty regarding the usage as well as
the lead time. However in actual practice, it is
almost impossible to correctly predict both of them.
The actual usage and the lead time may be
different from the normal usage and/or normal lead
time. In order to guard against such a contingency,
the firm maintains a safety stock – the minimum of
buffer stock as a cushion against possible increase
in usage or delay in delivery time.
 The level of safety stock can be worked out with
the following formula:
 Safety stock = Average usage x period of Safety
stock
 If the firm maintains safety stock, then the
 ROL = Lead time x Average usage + Safety stock

Accounts receivable management
 Accounts receivable (also popularly known as
receivables) constitute a significant portion of the
total current assets of the business next after
inventories. They are a direct consequence of ‘trade
credit’ which has become an essential marketing tool
in modern business.
 Receivables created in books when goods or
services are sold on credit.
 Usually, the credit sales are made on open account
which means that no formal acknowledgements of
debt obligations are taken from the buyer except the
PO, shipping documents, despatch statement etc.

 Meaning: Receivables are asset accounts
representing amounts owned to the firm as a result of
sale of goods/services in the ordinary course of
business.
 The objective of such a facility is to allow the customer
a reasonable period of time in which they can pay for
the goods purchased by them.
 Meaning of receivable management
 Receivables as a result of - trade credit – push up
sales – to push up profit.
 Credit sales leads to blocking of funds – therefore
additional funds are required for the operating needs
resulting in additional costs in the form of interest.

 Increase in trade credits results in bad debts.
 Management of accounts receivables, therefore, is
defined as the process of making decisions relating
to the investment of funds in this asset, which will
result in maximising the overall return on the
investment of the firm.
Therefore, the objective of receivable management is
to promote sales and profits until that point is
reached where the return on investment in further
funding of receivables is less than the cost of the
funds raised to finance that additional credit. i.e.
the cost of capital.
 Purpose of receivables:
 Achieving growth in sales
 Increasing profits
 Meeting competition

Cost of maintaining receivables:
 Capital costs – when funds blocked in
receivables means raising of additional funds to
meet other cash out flows, resulting in additional
capital costs
 Administrative costs
 Collection costs – a. additional operating costs
for maintaining records etc and b. credit
information about debtors
 Defaulting costs – bad debts
 Delinquency costs – costs due to non-payment
in time – sending remainders, getting legal
opinion etc

Receivable management policies:
 The receivable management has three
areas:
 Credit policies
 Credit terms
 Collection policies

Credit policies:
The credit policy is based on:
 Credit standards and
 Credit analysis

 Credit standards: Refers to the basic
consideration for the extension of credit facilities
to the customers. If the standards are high,
the sales and receivables are less and v.v.
 The credit standards are fixed by the factors
such as:
 Collection costs such as operating costs such as
maintaining records, staffing, bad debts, legal
charges etc – are semi variable – a portion can be
controlled.
 Average collection period – the time gap between the
availing of credit and repayment – longer period
means idle investment.
 Credit ratings – the integrity of the customers
 Financial ratios such as debt collection period, liquid
and current asset ratios, CA to total assets etc

Credit analysis: The credit analysis is
usually done in two steps:
 Obtaining credit information – from internal
or external sources. Usually the internal
sources are supplemented by the external
sources of information such as financial
statements, bank references, trade
references and specialist credit bureau
reports.
 Analysis of credit information – by using
quantitative and qualitative techniques and
compare with the firm’s credit policies.

 Credit Terms:
 After establishing good credit policy the concern
should design its credit terms. Credit terms mean the
principles listed for extending credit facilities to the
customers. It contains three elements:
 Credit period
 Cash discount
 Cash discount period
 The credit period is highly flexible and vary
depending upon the nature of business, nature of
customers, competition, inventory policy etc. Further,
an earlier period is fixed to avail some concessions
by the customers in the form of cash discounts vary
from 1 – 2.5 %. The cash discount is a loss, but
ensures prompt payments and better turn over of
cash.

 Collection policies:
 The collection policies are the procedure to be
followed in collecting the receivable after the
expiry of collection period. The collection policy
can be liberal or strict based on the cost-benefit
analysis.
 The collection procedure should be fixed, for an
efficient receivable management.
 The receivable can be collected through,
 Sending reminders
 Personal contacts
 Collection agencies
 Legal action as last resort

Components of working capital

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