This document defines key terms related to inventory management, accounts receivable, accounts payable, and cash. It discusses the cash operating cycle and how it reflects a firm's investment in working capital. Key aspects of the operating cycle include raw materials, work in progress, finished goods, and receivables collection periods. Relevant accounting ratios for analyzing financial statements like the current ratio and quick ratio are also defined. Inventory management techniques are mentioned.

1. II Management of inventories, accounts receivable, accounts payable and cash Meaning
Inventories: Inventory refers to all the items, goods and materials held by a business for
selling in the market to earn a profit. Example: If a newspaper vendor uses a vehicle to
deliver newspapers to the customers, only the newspaper will be considered inventory.
Accounts receivable: Accounts receivable (AR) is the balance of money due to a firm for
goods or services delivered or used but not yet paid for by customers. Accounts receivables
are listed on the balance sheet as a current asset. AR is any amount of money owed by
customers for purchases made on credit.
Accounts payable: Accounts payable are amounts due to vendors or suppliers for goods or
services received that have not yet been paid for. The sum of all outstanding amounts owed to
vendors is shown as the accounts payable balance on the company's balance sheet.
Cash: cash indicates the company's current assets that refer to money (currency) that is
readily available for use. It may be kept in physical form, digital form
The cash operating cycle
The cash operating cycle reflects a firm’s investment in working capital as it moves through
the production process towards sales. The investment in working capital gradually increases,
first being only in raw materials, but then in labour and overheads as production progresses.
This investment must be maintained throughout the production process, the holding period
for finished goods and up to the final collection of cash from trade receivables.
(Note: The net investment can be reduced by taking trade credit from suppliers.)

2. The elements of the operating cycle
The cash operating cycle is the length
of time between the company’s outlay
on raw materials, wages and other
expenditures and the inflow of cash
from the sale of goods.
The faster a firm can ‘push’ items
around the cycle the lower its
investment in working capital will be.
Calculation
For a manufacturing business, the cash operating cycle is calculated as
Raw materials holding period X
Less: payables payment period (X)
WIP holding period X
Finished goods holding period X
Receivables collection period X
–––
X
–––
For a wholesale or retail business, there will be no raw materials or WIP holding periods, and
the cycle simplifies to:
Inventory holding period X
Less: payables payment period (X)
Receivables collection period X
–––
X
–––
The cycle may be measured in days, weeks or months and it is advisable, when answering an
exam question, to use the measure used in the question.
Factors affecting the length of the operating cycle
Length of the cycle depends on:
 liquidity versus profitability decisions

3.  terms of trade
 management efficiency
 Industry norms, e.g. retail versus construction.
The optimum level of working capital is the amount that results in no idle cash or unused
inventory, but that does not put a strain on liquid resources.
Role of accounts payable and receivable
The Operating cycle is directly linked with the Accounts payable and Accounts Receivable
services. The business operations of any company are inter-related one activity will always
impact the other. For the operating cycle, the decision made by the inventory management
will impact the account receivable services. Any business activity shall end with the account
receivable hence being the last step of the operations, it requires attention at every stage of
the company’s activity. The service will require an expert’s knowledge and experience to
manage the accounts receivables of the company.
The operating cycle of the company being the average period the company has to manage the
cash flow between the period of work in progress and accounts receivables. Therefore every
company should manage its operating cycle of accounting receivables to regulate the cash
inflow in the business.
Relevant accounting ratios
Accounting ratio: Accounting ratio is the comparison of two or more financial data which are
used for analysing the financial statements of companies. It is an effective tool used by the
shareholders, creditors and all kinds of stakeholders to understand the profitability, strength
and financial status of companies. This is also widely known as financial ratios based on
which business performance can be monitored and important business decisions are made.

4. Liquidity Ratio: Three liquidity ratios are commonly used – the current ratio, quick ratio, and
cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the
denominator of the equation, and the liquid assets amount is placed in the numerator.
Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above
1.0 are sought after, a ratio of 1 means that a company can exactly pay off all its current
liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a
company is not able to satisfy its current liabilities.
A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills.
In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over. A
ratio of 3.0 would mean they could cover their current liabilities three times over, and so
forth.
Sl. No Ratio
Name
Formula Used for Detail
1
Current
Ratio
{(Current
Assets)/(Current
Liabilities)}
1. One of the commonly
used liquidity ratios is the
current ratio which
compares the current assets
to current liabilities held by
the business
Current assets include
cash, inventory,
accounts receivable etc
2. This ratio is used to
check if the company will
be able to pay its debts
which are due in next 12
months
Current liabilities
include accounts
payable, income tax
payable and any other
current liabilities
2
Quick
Ratio
{(Quick
Assets)/(Current
Liabilities)}
1. It is similar to current
ratio except that this uses
only quick assets which are
easy to liquidate.
To calculate the Quick
assets, inventory and
prepaid expenses which
are difficult to liquidate
are to be removed from
the current assets.
2. This is also known as
Acid test

5. Current ratio: The current ratio, also known as the working capital ratio, measures the
capability of a business to meet its short-term obligations that are due within a year. The ratio
considers the weight of total current assets versus total current liabilities. It indicates the
financial health of a company and how it can maximize the liquidity of its current assets to
settle debt and payables. Measures how much of the total current assets are financed by
current liabilities.
Current ratio = Current assets/Current liabilities
A measure of 2:1 means that current liabilities can be paid twice over out of existing current
assets.
Quick (acid test) ratio
The quick or acid test ratio measures how well current liabilities are covered by liquid assets
is particularly useful where inventory holding periods are long and therefore distort the
current ratio.
Quick ratio (acid test) = Current assets – Inventory/Current liabilities
A measure of 1:1 means that the company is able to meet existing liabilities if they all fall
due at once.
Inventory Turnover Ratio
The inventory turnover ratio, also known as the stock turnover ratio, is an efficiency ratio that
measures how efficiently inventory is managed. The inventory turnover ratio formula is equal
to the cost of goods sold divided by total or average inventory to show how many times
inventory is “turned” or sold during a period. The ratio can be used to determine if there are
excessive inventory levels compared to sales.
Inventory Turnover Ratio Formula
The formula for calculating the ratio is as follows:

6. Where:
 Cost of goods sold is the cost attributed to the production of the goods that are sold by
a company over a certain period. The cost of goods sold by a company can found on
the company’s income statement.
 Average inventory is the mean value of inventory throughout a certain period. Note:
an analyst may use either average or end-of-period inventory values.
 It is important to achieve a high ratio, as higher turnover rates reduce storage and
other holding costs. Low turnover implies that a company’s sales are poor; it is
carrying too much inventory, or experiencing poor inventory management.
Average Collection Period: The average collection period amount of time that passes before
a company collects its accounts receivable (AR). In other words, it refers to the time it takes,
on average, for the company to receive payments it is owed from clients or customers. The
average collection period must be monitored to ensure a company has enough cash available
to take care of its near-term financial responsibilities.
Average payment Period: Average payment period means the average period taken by the
company in making payments to its creditors. It is computed by dividing the number of
working days in a year by creditors turnover ratio. Some other formulas for its compu
Average payment Period = Average Account Payable / Total Credit Purchases X Days
in period
Working capital turnover is a ratio: Working capital turnover is a ratio that measures how
efficiently a company is using its working capital to support sales and growth. Also known as
net sales to working capital, working capital turnover measures the relationship between the

7. funds used to finance a company's operations and the revenues a company generates to
continue operations and turn a profit.
The Formula for Working Capital Turnover Is
Working Capital Turnover= Net Annual Sales / Average Working Capital
Where:
 Net annual sales is the sum of a company's gross sales minus its returns, allowances,
and discounts over the course of a year
 Average working capital is average current assets less average current liabilities
Relevant techniques in managing inventory
Inventory Management: Inventory management refers to the process of ordering, storing and
using a company's inventory. This includes the management of raw materials, components
and finished products, as well as warehousing and processing such items.
For companies with complex supply chains and manufacturing processes, balancing the risks
of inventory gluts and shortages is especially difficult. To achieve these balances, firms have
developed two major methods for inventory management EOQ and JIT.
The objectives of inventory management
Inventory is a major investment for many companies. Manufacturing companies can easily be
carrying inventory equivalent to between 50% and 100% of the revenue of the business. It is
therefore essential to reduce the levels of inventory held to the necessary minimum.
The balancing act

8. Costs of high inventory levels
Carrying inventory involves a major working capital investment and therefore levels need to
be very tightly controlled. The cost is not just that of purchasing the goods, but also storing,
insuring, and managing them once they are in inventory.
Purchase costs: once goods are purchased, capital is tied up in them and until sold on (in
their current state or converted into a finished product), the capital earns no return. This lost
return is an opportunity cost of holding the inventory.
Storage and stores administration: in addition, the goods must be stored. The company
must incur the expense of renting out warehouse space, or if using space they own, there is an
opportunity cost associated with the alternative uses the space could be put to. There may
also be additional requirements such as controlled temperature or light, which require extra
funds.
Other risks: once stored, the goods will need to be insured. Specialist equipment may be
needed to transport the inventory to where it is to be used. Staff will be required to manage
the warehouse and protect against theft and if inventory levels are high, significant
investment may be required in sophisticated inventory control systems.
The longer inventory is held, the greater the risk that it will deteriorate or become out of date.
This is true of perishable goods, fashion items and high-technology products, for example.
Keeping inventory levels high is expensive owing to:
Foregone interest from tying up capital in inventory holding costs:
– storage
– stores administration
– risk of theft/damage/obsolescence.
Costs of low inventory levels

9. Stock out: if a business runs out of a particular product used in manufacturing it may cause
interruptions to the production process – causing idle time, stockpiling of work-in-progress
(WIP) or possibly missed orders. Alternatively, running out of goods held for onward sale
can result in dissatisfied customers and perhaps future lost orders if custom is switched to
alternative suppliers. If a stock out looms, the business may attempt to avoid it by acquiring
the goods needed at short notice. This may involve using a more expensive or poorer quality
supplier.
Re-order/setup costs: each time inventory runs out, new supplies must be acquired. If the
goods are bought in, the costs that arise are associated with administration – completion of a
purchase requisition, authorisation of the order, placing the order with the supplier, taking
and checking the delivery and final settlement of the invoice. If the goods are to be
manufactured, the costs of setting up the machinery will be incurred each time a new batch is
produced.
Lost quantity discounts: purchasing items in bulk will often attract a discount from the
supplier. If only small amounts are bought at one time in order to keep inventory levels low,
the quantity discounts will not be available.
If inventory levels are kept too low, the business faces alternative problems:
Stock outs:
 lost contribution
 production stoppages
 emergency orders
 high re-order/setup costs
 lost quantity discounts.
The objective of good inventory management is therefore to determine: the optimum re-
order level – how many items are left in inventory when the next order is placed, and the

10. optimum re-order quantity – how many items should be ordered when the order is placed for
all material inventory items.
In practice, this means striking a balance between holding costs on the one hand and stock
out and re-order costs on the other.
The balancing act between liquidity and profitability, which might also be considered to be a
trade-off between holding costs and stock out/re-order costs, is key to any discussion on
inventory management.
Economic order quantity (EOQ)
The economic order quantity (EOQ) refers to the ideal order quantity a company should
purchase in order to minimize its inventory costs, such as holding costs, shortage costs, and
order costs. EOQ is necessarily used in inventory management, which is the oversight of the
ordering, storing, and use of a company's inventory. Inventory management is tasked with
calculating the number of units a company should add to its inventory with each batch order
to reduce the total costs of its inventory.
The aim of the EOQ model is to minimise the total cost of holding and ordering
inventory.
To minimise the total cost of holding and ordering inventory, it is necessary to balance the
relevant costs. These are:
 the variable costs of holding the inventory
 the fixed costs of placing the order
Holding costs: The model assumes that it costs a certain amount to hold a unit of inventory
for a year (referred to as CH in the formula). Therefore, as the average level of inventory
increases, so too will the total annual holding costs incurred.

11. Because of the assumption that demand per period is known and is constant (see below),
conclusions can be drawn over the average inventory level in relationship to the order
quantity.
When new batches or items of inventory are purchased or made at periodic intervals, the
inventory levels are assumed to exhibit the following pattern over time.
If q is the quantity ordered, the annual holding cost would be calculated as:
Holding cost per unit × Average inventory:
CH × q/2
We therefore see an upward sloping, linear relationship between the reorder quantity and total
annual holding costs.

12. Ordering costs: The model assumes that a fixed cost is incurred every time an order is
placed (referred to as CO in the formula). Therefore, as the order quantity increases, there is a
fall in the number of orders required, which reduces the total ordering cost.
If D is the annual expected sales demand, the annual order cost is calculated as:
Order cost per order × no. of orders per annum.
CO × D/q
However, the fixed nature of the cost results in a downward sloping, curved relationship.
Because you are trying to balance these two costs (one which increases as re-order quantity
increases and one which falls), total costs will always be minimised at the point where the
total holding costs equals the total ordering costs. This point will be the economic order
quantity.
When the re-order quantity chosen minimises the total cost of holding and ordering, it is
known as the EOQ.

13. Assumptions
The following assumptions are made:
 demand and lead-time are constant and known
 purchase price is constant
 no buffer inventory held (not needed).
These assumptions are critical and should be discussed when considering the validity of the
model and its conclusions, e.g. in practice, demand and/or lead-time may vary.
The calculation
The EOQ can be more quickly found using a formula
Where:
CO = cost per order
D = annual demand
CH = cost of holding one unit for one year.
Dealing with quantity discounts
Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the
order size needed for a discount, should the order size be increased above the EOQ?
To work out the answer you should carry out the following steps:
Step 1: Calculate EOQ, ignoring discounts.
Step 2: If the EOQ is below the quantity qualifying for a discount, calculate the total
annual inventory cost (purchase costs + ordering costs + holding costs) arising from
using the EOQ.
Step 3: Recalculate total annual inventory costs using the order size required to just
obtain each discount.

14. Step 4: Compare the cost of Steps 2 and 3 with the saving from the discount, and
select the minimum cost alternative.
Step 5: Repeat for all discount levels.
Just in Time (JIT) systems
JIT is a series of manufacturing and supply chain techniques that aim to minimise inventory
levels and improve customer service by manufacturing not only at the exact time customers
require, but also in the exact quantities they need and at competitive prices.
In JIT systems the balancing act is dispensed with. Inventory is reduced to an absolute
minimum or eliminated altogether.
Aims of JIT are:
 a smooth flow of work through the manufacturing plant
 a flexible production process which is responsive to the customer’s requirements
reduction in capital tied up in inventory.
This involves the elimination of all activities performed that do not add value = waste.
JIT extends much further than a concentration on inventory levels. It centres on the
elimination of waste. Waste is defined as any activity performed within a manufacturing
company which does not add value to the product.
Examples of waste are:
 raw material inventory
 WIP inventory
 finished goods inventory
 materials handling
 Quality problems (rejects and reworks, etc.)
 queues and delays on the shop floor
 long raw material lead times
 long customer lead times
 Unnecessary clerical and accounting procedures.

15. IT attempts to eliminate waste at every stage of the manufacturing process, notably by the
elimination of:
 WIP, by reducing batch sizes (often to one)
 raw materials inventory, by the suppliers delivering direct to the shop floor JIT for use
 scrap and rework, by an emphasis on total quality control of the design, of the
process, and of the materials
 finished goods inventory, by reducing lead times so that all products are made to
order material handling costs, by re-design of the shop floor so that goods move
directly between adjacent work centres.
The combination of these concepts in JIT results in:
 a smooth flow of work through the manufacturing plant
 a flexible production process which is responsive to the customer’s requirements
reduction in capital tied up in inventory.
A JIT manufacturer looks for a single supplier who can provide high quality, frequent and
reliable deliveries, rather than the lowest price. In return, the supplier can expect more
business under long-term purchase orders, thus providing greater certainty in forecasting
activity levels.
 Very often the suppliers will be located close to the company.
 Long-term contracts and single sourcing strengthen buyer-supplier relationships and
tend to result in a higher quality product. Inventory problems are shifted back onto
suppliers, with deliveries being made as required.
 The spread of JIT in the production process inevitably affects those in delivery and
transportation. Smaller, more frequent loads are required at shorter notice. The haulier
is regarded as almost a partner to the manufacturer, but tighter schedules are required
of hauliers, with penalties for non-delivery.

16.  Reduction in inventory levels reduces the time taken to count inventory and the
clerical cost. However with JIT, although inventory holding costs are close to zero,
inventory ordering costs are high.