FM

FINANCIAL MANAGEMENT / UNIT-4
UNIT
4
1
INTRODUCTION TO WORKING CAPITAL
4. Introduction to working capital: Concepts and characteristics of working capital,

Factors determining the working capital. Estimation of working capital requirements.
Current Assets Management: Management of current assets Cash, Receivables and
Inventory. Cash budget, Credit terms Financing current assets.
4.1. Introduction to working capital.....................................................................116
4.1.1.
Meaning of working capital.................................................................116
4.1.2.
Definitions ...........................................................................................116
4.1.3.
Concepts of Working Capital...............................................................117
4.1.4.
Classification of Working Capital........................................................118
4.1.5.
Types of Working Capital.....................................................................119
4.1.6.
Needs of Working Capital....................................................................120
4.1.7.
Working Capital Position/ Balanced Working Capital Position...........121
4.1.8.
Factors determining working capital requirements..............................121
4.1.9.
Computation or estimation of working capital.....................................122
4.1.10. Working capital management policy....................................................124

4.1.11. Nature of Working Capital...................................................................125
4.1.12. Characteristics of working capital........................................................125
4.1.13. Estimation of working capital..............................................................126
4.1.14. ADEQUATE WORKING CAPITAL...................................................131
4.1.15. Importance/Need/Advantage of Adequate Working Capital................132
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4.1.16. EXCESSIVE AND INADEQUATE WORKING CAPITAL..............133

4.1.17. Disadvantage of Excessive Working Capital.......................................133
4.1.18. Disadvantage of Inadequate Working Capital......................................133
4.1.19. DETERMINANTS OF WORKING CAPITAL...................................134
4.1.20. Estimation of Working capital requirements........................................137
4.2. Sources of working capital..............................................................................144
4.3. Current assets management...........................................................................146
4.3.1.
Cash Management................................................................................146
4.3.2.
Meaning and definition of cash............................................................146
4.3.3.
The Concept of Cash Management......................................................146
4.3.4.
Motives for Holding Cash....................................................................147
4.3.3.
Cash Management Techniques.............................................................147
4.3.5.
Objectives of cash management...........................................................147
4.3.6.
Cash Management Models...................................................................149
4.3.7.
Significance of Cash Management.......................................................149
4.3.8.
Objectives of cash management...........................................................150
4.3.9.
Principles of Cash Management...........................................................151
4.3.10. Cash Management Models...................................................................152

4.4. Inventory Management...................................................................................158
4.4.1.
Meaning and Definition of Inventory..................................................158
4.4.2.
Types/Classification of Inventory........................................................158
4.4.3.
Meaning of Inventory management.....................................................159
4.4.4.
Motives of Inventory Management......................................................159
4.4.5.
Techniques of Inventory Management.................................................160
4.4.6.
BENEFITS OR ADVANTAGES OF HOLDING

INVENTORY.......................................................................................165
4.4.7.
DISADVANTAGES OF HOLDING INVENTORY...........................166
4.5. Introduction to Receivables ...........................................................................168
115
4.5.1.
Meaning of Receivables.......................................................................168
4.5.2.
RECEIVABLE MANAGEMENT.......................................................168
4.5.3.
Factors Considering the Receivable Size.............................................169
4.5.4.
Significance and Purpose of Receivable Management........................170
4.5.5.
Characteristics of Receivables.............................................................170
4.5.6.
Objectives of Receivables....................................................................171
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4.1. INTRODUCTION TO WORKING CAPITAL

Working capital management is also one of the important parts of the financial
management. It is concerned with short-term finance of the business concern which is a
closely related trade between profitability and liquidity. Efficient working capital
management leads to improve the operating performance of the business concern and it helps
to meet the short-term liquidity. Hence, study of working capital management is not only an
important part of financial management but also is overall management of the business
concern.
Working capital is described as the capital which is not fixed but the more common
uses of the working capital is to consider it as the difference between the book value of
current assets and current liabilities.
4.1.1. MEANING OF WORKING CAPITAL
Capital of the concern may be divided into two major headings.
Capital
Fixed Capital
Working Capital
Capital of the Business

Fixed capital means that capital, which is used for long-term investment of the
business concern. For example, purchase of permanent assets. Normally it consists of nonrecurring in nature.
Working Capital is another part of the capital which is needed for meeting day to day
requirement of the business concern. For example, payment to creditors, salary paid to
workers, purchase of raw materials etc., normally it consists of recurring in nature. It can be
easily converted into cash. Hence, it is also known as short-term capital.
Working Capital is the amount of Capital that a Business has available to meet the
day-to-day cash requirements of its operations.
Working Capital is the difference between resources in cash or readily convertible into
cash (Current Assets) and organizational commitments for which cash will soon be required
(Current Liabilities) .It refers to the amount of Current Assets that exceeds Current
Liabilities (i.e. CA - CL) Working Capital refers to that part of the firms Capital, which is
required for Financing Short-Term or Current Assets such as Cash, Marketable Securities,
Debtors and Inventories.
4.1.2. Definitions
According to the definition of Mead, Baker and Malott, Working Capital means
Current Assets.
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According to the definition of J.S.Mill, The sum of the current asset is the working
capital of a business.
According to the definition of Weston and Brigham, Working Capital refers to a
firms investment in short-term assets, cash, short-term securities, accounts receivables and
inventories.
According to the definition of Bonneville, Any acquisition of funds which increases
the current assets, increase working capital also for they are one and the same.
According to the definition of Shubin, Working Capital is the amount of funds
necessary to cover the cost of operating the enterprises.
According to the definition of Gerestenberg, Circulating capital means current
assets of a company that are changed in the ordinary course of business from one form to
another, for example, from cash to inventories, inventories to receivables, receivables to
cash.
Working Capital is also known as Revolving or Circulating Capital or Short-Term Capital.
4.1.3. CONCEPT OF WORKING CAPITAL
Working capital can be classified or understood with the help of the following two
important concepts.
Gross
working
Capital
Net
working
Capital
1. Gross Working Capital

Gross Working Capital is the general concept which determines the working capital
concept. Thus, the gross working capital is the capital invested in total current assets of the
business concern.
Gross Working Capital is simply called as the total current assets of the concern.
Gross Working Capital = Total Current Assets
2. Net Working Capital

Net Working Capital is the specific concept, which, considers both current assets and
current liability of the concern.
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Net Working Capital is the excess of current assets over the current liability of the
concern during a particular period.
If the current assets exceed the current liabilities it is said to be positive working
capital; it is reverse, it is said to be Negative working capital.
Net Working Capital = Current Assets - Current Liabilities
Definitions Favoring 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".
4.1.4. Classification of Working Capital
(1) On the Basis of Concept: (i) Gross Working Capital
(ii) Net Working Capital
(2) On the Basis of time or Need:(i) Permanent Working Capital
(ii) Temporary Working Capital
II. On the basis of time or need
(1) Permanent or Fixed 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 goods 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 meet from longterm sources of finance, e.g.
(i) Capital
(ii) Debentures
(iii) Long-term loans.
(2) Temporary or Variable or Fluctuating Working Capital:Depending upon the changes in production and sales, the need for working capital,
over and above the permanent level of working capital is called temporary, fluctuating or
variable working capital. It may be two types:-(a)Seasonal-Due to seasonal changes, level of
business activities is higher than normal during some months of year and therefore additional
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working capital will be required along with the permanent working capital. It is so because
during peak season, demand rises and more stock is to be maintained to meet the demand.
(b) Special- Additional doses of working capital may be required to face cut throat
competition in the market or other contingencies like strikes, lock outs, theft etc.
4.1.5. TYPES OF WORKING CAPITAL
Working Capital may be classified into three important types on the basis of time.
Working Capital
Permanent
Temporary
Seasonal Working
Capital
Working Capital
Semi Variable
Special Working
Capital
Working Capital
Working Capital
Types of Working Capital

1. Permanent Working Capital
It is also known as Fixed Working Capital. It is the capital; the business concern must
maintain certain amount of capital at minimum level at all times. The level of Permanent
Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not
change irrespective of time or volume of sales.
Permanent Working Capital
Amount of
Working Capital
Time
Permanent Working Capital
2. Temporary Working Capital
It is also known as variable working capital. It is the amount of capital which is
required to meet the Seasonal demands and some special purposes. It can be further classified
into Seasonal Working Capital and Special Working Capital.
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The capital required to meet the seasonal needs of the business concern is called as
Seasonal Working Capital. The capital required to meet the special exigencies such as
launching of extensive marketing campaigns for conducting research, etc.
Seasonal Working Capital:
Seasonal working capital is that temporary increase in working capital which is caused
due to some relevant season for the business. It is applicable to businesses having impact of
seasons for example, manufacturer of sweaters for whom relevant season is the winters.
Normally, their working capital requirement would increase in that season due to higher sales
in that period and then go down as collection from debtors is more than sales.
Special Working Capital:
Special working capital is that rise in temporary working capital which occurs due to a
special event which otherwise normally does not take place. It has no basis to forecast and
has rare occurrence normally. For example, country where Olympic Games are held, all the
business require extra working capital due to sudden rise in business activity.
3. Semi Variable Working Capital
Certain amount of Working Capital is in the field level up to a certain stage and after
that it will increase depending upon the change of sales or time.
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Semi Variable Working Capital

Amount of
Working Capital
Time semi variable working capital

4.1.6. NEEDS OF WORKING CAPITAL
Working Capital is an essential part of the business concern. Every business concern
must maintain certain amount of Working Capital for their day-to-day requirements and meet
the short-term obligations.
Working Capital is needed for the following purposes.
1. Purchase of raw materials and spares: The basic part of manufacturing process is, raw
materials. It should purchase frequently according to the needs of the business concern.
Hence, every business concern maintains certain amount as Working Capital to purchase
raw materials, components, spares, etc.
2. Payment of wages and salary: The next part of Working Capital is payment of wages
and salaries to labour and employees. Periodical payment facilities make employees
perfect in their work. So a business concern maintains adequate the amount of working
capital to make the payment of wages and salaries.
3. Day-to-day expenses: A business concern has to meet various expenditures regarding the
operations at daily basis like fuel, power, office expenses, etc.
4. Provide credit obligations: A business concern responsible to provide credit facilities to
the customer and meet the short-term obligation. So the concern must provide adequate
Working Capital.
4.1.7. Working Capital Position/ Balanced Working Capital Position.
A business concern must maintain a sound Working Capital position to improve the
efficiency of business operation and efficient management of finance. Both excessive and
inadequate Working Capital lead to some problems in the business concern.
A. Causes and effects of excessive working capital.
(i) Excessive Working Capital leads to unnecessary accumulation of raw materials,
components and spares.
(ii) Excessive Working Capital results in locking up of excess Working Capital.
(iii)
It creates bad debts, reduces collection periods, etc.
(iv)It leads to reduce the profits.

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B. Causes and effects of inadequate working capital

(i) Inadequate working capital cannot buy its requirements in bulk order.
(ii) It becomes difficult to implement operating plans and activate the firms profit target.
(iii)
It becomes impossible to utilize efficiently the fixed assets.
(iv)The rate of return on investments also falls with the shortage of Working Capital.
(v) It reduces the overall operation of the business.
4.1.8. FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS
Working Capital requirements depends upon various factors. There are no set of rules
or formula to determine the Working Capital needs of the business concern. The following are
the major factors which are determining the Working Capital requirements.
1. Nature of business: Working Capital of the business concerns largely depend upon the
nature of the business. If the business concerns follow rigid credit policy and sell goods
only for cash, they can maintain lesser amount of Working Capital. A transport company
maintains lesser amount of Working Capital while a construction company maintains
larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the length of the production
cycle. If the production cycle length is small, they need to maintain lesser amount of
Working Capital. If it is not, they have to maintain large amount of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the
business condition and it will affect the requirements of the Working Capital. In the
booming conditions, the Working Capital requirement is larger and in the depression
condition, requirement of Working Capital will reduce. Better business results lead to
increase the Working Capital requirements.
4. Production policy: It is also one of the factors which affects the Working Capital
requirement of the business concern. If the company maintains the continues production
policy, there is a need of regular Working Capital. If the production policy of the company
depends upon the situation or conditions, Working Capital requirement will depend upon
the conditions laid down by the company.
5. Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit policy to
collect the payments from its customers, they have to maintain more Working Capital. If
the company pays the dues on the last date it will create the cash maintenance in hand and
bank.
6. Growth and expansion: During the growth and expansion of the business concern,
Working Capital requirements are higher, because it needs some additional Working
Capital and incurs some extra expenses at the initial stages.
7. Availability of raw materials: Major parts of the Working Capital requirements are
largely depend on the availability of raw materials. Raw materials are the basic
components of the production process. If the raw material is not readily available, it leads
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to production stoppage. So, the concern must maintain adequate raw material; for that
purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning capacity, they
can generate more Working Capital, with the help of cash from operation. Earning
capacity is also one of the factors which determines the Working Capital requirements of
the business concern.
4.1.9. COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL
Working Capital requirement depends upon number of factors, which are already
discussed in the previous parts. Now the discussion is on how to calculate the Working
Capital needs of the business concern. It may also depend upon various factors but some of
the common methods are used to estimate the Working Capital.
A. Estimation of components of working capital method

Working capital consists of various current assets and current liabilities. Hence, we have
to estimate how much current assets as inventories required and how much cash required
to meet the short term obligations.
Finance Manager first estimates the assets and required Working Capital for a particular
period.
B. Percent of sales method
Based on the past experience between Sales and Working Capital requirements, a ratio
can be determined for estimating the Working Capital requirement in future. It is the simple
and tradition method to estimate the Working Capital requirements. Under this method, first
we have to find out the sales to Working Capital ratio and based on that we have to estimate
Working Capital requirements. This method also expresses the relationship between the Sales
and Working Capital.
C. Operating cycle
Working Capital requirements depend upon the operating cycle of the business. The
operating cycle begins with the acquisition of raw material and ends with the collection of
receivables.
Operating cycle consists of the following important stages:
1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)
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F
Working Capital Cycle
Each component of the operating cycle can be calculated by the following formula:
R=
Average Stock of Raw Material

Average Raw Material Consumption
per Day
Average Work in Process Inventory

Average Cost of Production Per Day
Average Finished Stock Inventory

Average Cost of Goods Sold per Day
D
Average Book Debts

Average Credit Sales per Day
Average Trade Creditors

Average Credit Purchase per Day
4.1.10. WORKING CAPITAL MANAGEMENT POLICY

Working Capital Management formulates policies to manage and handle efficiently;
for that purpose, the management established three policies based on the relationship between
Sales and Working Capital.
1. Conservative Working Capital Policy.
2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.
1. Conservative working capital policy: Conservative Working Capital Policy refers to
minimize risk by maintaining a higher level of Working Capital. This type of Working
Capital Policy is suitable to meet the seasonal fluctuation of the manufacturing operation.
2. Moderate working capital policy: Moderate Working Capital Policy refers to the
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moderate level of Working Capital maintenance according to moderate level of sales. It

means one percent of change in Working Capital that is Working Capital is equal to sales.
3. Aggressive working capital policy: Aggressive Working Capital Policy is one of the
high risky and profitability policies which maintain low level of Aggressive Working
Capital against the high level of sales, in the business concern during a particular period.
Working Capital Policies

4.1.11. Nature of Working Capital:
The nature of working capital is as discussed below:
i. It is used for purchase of raw materials, payment of wages and expenses.
ii. It changes form constantly to keep the wheels of business moving.
iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the
enterprise.
iv. It generates the elements of cost namely: Materials, wages and expenses.
v. It enables the enterprise to avail the cash discount facilities offered by its suppliers.
vi. It helps improve the morale of business executives and their efficiency reaches at the
highest climax.
vii. It facilitates expansion programmes of the enterprise and helps in maintaining
operational efficiency of fixed assets.
4.1.12. Characteristics of working capital
The following are the important characteristics of working capital;
1. Short Life: Current assets have very short life so it is difficult to manage. The
components of working capital change their shape quickly which requires efficient
management and timely decisions. The life may extend from one hour to one year.
Management has to spend a lot of its time on working capital because these assets often
change and require continuous control and supervision.
2. Nearness to Cash: All the components of working capital are more liquid and near to
cash, marketable securities may be sold and converted into cash at any time. Receivable
almost takes a time from one month to two months to convert into cash. Inventory may
convert into cash from one day to nearly one year. Cash is already the most liquid assets.
The liquidity of working capital needs much time and supervision.
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3.
4.
5.
6.
7.
8.
Lack of Synchronization: In other important characteristic of working capital is the lack

of synchronization among its components. All the parts of working capital do not occur at
the same time. So there is a lack of synchronization.
High rate of Change: The shape of working capital components change more quickly
which requires timely and quick decision from the management. It may be profitable for
the firm to purchase securities at the time of low price and sell them when the price arises.
Financing from all Sources: Working capital requires financing from all sources. More
fluctuating working capital may be financial with short-term sources, while the permanent
working may be financed with intermediate and long term sources. Both variable and
permanent types of working capital are also financed with internal sources.
Risk and return Trade off: Another characteristic of working capital is that it has a
direct impact on the profitability and risk of the firm. If many funds are invested in
working capital to avoid technical insolvency and to meet the material shortages, the
return on investment will be low. On the other hand if adequate liquidity is not maintained
the firm is likely to face but the return will be maximum.
Interchange of Current Assets: All the components of working capital interchange
during the life time of the firm. Sometimes, they change into permanent nature and some
time transferred into liquid nature frequent interchange needs proper attention of the
management to maintain a balance between the permanent and fluctuating working
capital.
Seasonal and Cyclical Influence: The activity of the firm does not remain the same for
the whole period. It fluctuates due to face great demand in spring and autumn, while low
demand in other seasons. The changing economy also influences the operations. These
changes affect only the current assets and have little or no effect on other assets. The
changes must be faced and dealt carefully.
4.1.13. ESTIMATION OF WORKING CAPITAL

The approach to estimate a working capital is based on an operation cycle. Operation
cycle comprises of two important components of working capital (see figure 11.3) Current
assets and Current liabilities
Components of working capital

Estimation of working capital is based on the assumption that production and sales
occur on a continuous basis and all costs occur accordingly.
Estimation of Current Assets
Current assets are estimated based on the following assumptions:
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Average investment in raw material is estimated
Average investment in work-in-progress inventory is estimated
Average investment in finished goods inventory is estimated
Average investment in receivables (both in debtors and bills receivables) is estimated

based on credit policy that the firm wishes to pursue
Based on the firms attitude towards risk, past experience and nature of business, firms
decide on the policy of maintaining the minimum cash balances
Estimation of Current Liabilities

Current liabilities are estimated based on the following factors Trade creditors,
Direct wages and Overheads.
Estimation of current liabilities

Trade creditors: The average amount of financing available to the firm is estimated based on
the production budget, raw material consumption and the credit period enjoyed from
suppliers.
Direct wages: Estimation is made on total wages, to be paid on average basis, based on
production budget, direct labour cost per unit and average time-lag in payment of wages.
Overheads: Estimation on an average basis of the outstanding amount to be paid to the
creditors for overhead is estimated based on production budget, overhead cost per unit and
average time-lag in payment of overhead
Solved Problem
A pro-forma cost sheet of a company provides the following details as shown in table 11.2.
Pro-forma sheet
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Raw material
52.00
Direct labour
19.50
Overheads
39.00
Total cost
110.50
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Profit
19.50
Selling price
130.00
The following additional information is also available:
Average raw material in stock: One month
Average materials in process: Half a month
Credit allowed by Suppliers: One month
Credit allowed to debtors: Two months
Time lag in payment of wages: one and a half weeks
Time lag in payment of overheads: one month
One-fourth of sales on cash basis
Cash balance expected to be maintained is Rs.1,20,000
You are required to prepare a statement showing the working capital required to
finance a level of activity of 70,000 units of output. You may assume that production is
carried on evenly through-out the year and wages and overheads occur similarly. Assume 360
days in a year.
Solution
Estimation of Working Capital
a.
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Investment in inventory
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f. Total Current Liabilities = 568750.00
Net working Capital (D F) = 1788958.33

Solved Problem
The following annual figures are regarding the sales and production of the company XYZ ltd.
Annual figures of XYZ ltd
Sales (at two months credit)
Rs. 36,00,000
Materials consumed (suppliers extend two months

credit)
Rs. 9,00,000
Wages paid (monthly in arrears)
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Rs. 7,20,000
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Manufacturing expenses outstanding at the end of

the
Rs. 80,000
year(cash expenses are paid one month in arrears)
Total administrative expenses paid, as above
Rs. 2,40,000
Sales promotion expenses, paid quarterly in advance
Rs.1,20,000
The company sells its products on gross profit of 25% counting depreciation as part of
the cost stock each of raw materials and finished goods, and a cash balance of Rs.100 000.
Assume a 20 percent safety margin. Calculate the working capital requirements of the
company on cash cost basis.
Solution
The computation of manufacturing expenses is as shown below
Computation of manufacturing expenses
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Sales
Rs.36,00,000
Less: gross profit at 25%
Rs.9,00,000
Total manufacturing cost
Rs.27,00,000
Less: materials
Rs.9,00,000
Less: wages
Rs.7,20,000
Manufacturing expenses
Rs.10,80,000
Cash manufacturing expenses
Rs.9,60,000
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Depreciation
Total manufacturing expenses Cash manufacturing expenses
10,80,000 9,60,000 = Rs.1,20,000
The total cash cost is determined and shown in the following table
Total cash cost
Total manufacturing cost
Rs.27,00,000
Less: depreciation
Rs.1,20,000
Cash manufacturing cost
Rs.25,80,000
Total manufacturing expenses
Rs.2,40,000
Sales promotion expenses
Rs.1,20,000
Total cash cost
Rs.29,40,000
Statement of working capital required:

Current assets:
Raw Materials stock
Material Cost
9000 1
1
75000
12
12
Finished goods stock
Cash manufacturing cost
1
12
2580 000 x = 215000

Debtors
Total cash cost of sales x 2 /12 = 2940000 x 2 / 12 = 490000
Sales promotion expenses = 120000 x 1/4= 30,000
Cash required = 100000
Total Assets = 910000
Current Liabilities
Sundry Creditors
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Material cost
90000 2
2
150000
12
12
1
Wages outstanding = 720000 60000
12
Wages outstanding = 720000 x 1/12 = 60000
Manufacturing expenses outstanding = 80000
Total administrative expenses:
Outstanding = 240000 / 12 =20000
Total current Liabilities = 310000
Working Capital (A B) = 600000
Add 20% safety margin = 120000
Working Capital required = 720000
4.1.14. 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
4.1.15. Importance/Need/Advantage of Adequate Working Capital:
(1) Availability of Raw Materials Regularly:Adequacy of working capital makes it possible for a firm to pay the suppliers
of raw materials on time. As a result it will continue to receive regular supplies of raw
materials and thus there will be no disruption in production process.
(2) Full Utilization of Fixed Assets:Adequacy of working capital makes it possible for a firm to utilize its fixed assets
fully and continuously. For example, if there is inadequate stock of raw material, the
machines will not be utilized in full and their productivity will be reduced.
(3) Cash Discount:A firm having the adequate working capital can avail the cash discount by
purchasing the goods for cash or by making the payment before the due date.
(4) Increase in Credit Rating:Paying its short-term obligations in time leads to a strong credit rating which enables
the firm to purchase goods on credit on favorable terms and to maintain its line of credit with
banks etc. it facilities the taking of loan in case of need.
5) Exploitation of Favorable Market conditions:132
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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 favorable 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.
(8) Ability to face crisis:Adequate working capital enables a concern to face business crisis in emergencies
such as depression. Generally in these periods there is much pressure on working capital.
(9) Solvency of the business:Adequate working capital helps in maintaining solvency of the business by providing
uninterrupted flow of production.
(10) Good will
Sufficient working capital enables a business concern to male prompt payments and
hence helps in creating and maintaining good will.
4.1.16. 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.
4.1.17. 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:133
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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.
results in laxity of control on expenses and cash resources.
It
4.1.18. 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 favorable 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.
(5) Non Utilization of Favorable 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:
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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.
4.1.19. 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 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
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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 up to 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, 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:-
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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 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 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.
4.1.20. Estimation of Working capital requirements:
In estimating working capital needs, different people adopt different approaches.
Some experts suggest that the working capital should be greater than the minimum
requirements of the firm. The management should feel safety. It would be able to meet its
obligations even in adverse circumstances. However, the excessive capital may lead to waste
and inefficiency. There are various methods which have been applied in practice for the
estimation of working capital requirements of a firm. Lets discuss some of them in brief.
1. 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
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of each month and then monthly requirements are converted into yearly requirement of
current assets. The estimated amount of current liabilities is deducted from this amount in
order to estimate the requirement of working capital. A certain percentage for
contingencies may also be added to this amount.
2. 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.
3. 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.
4. 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.
5. Operating Cycle Approach - Estimation of Working Capital Requirements
Efficient working capital management is one which ensures continuous flow without any
interruptions/holdups at any of the stages referred to above and involves as for as possible
a rapid completion of the revolutions. In other words, when raw materials remain in store
pending issue for production for a less duration, when raw materials get converted into
WIP in short duration, when WIP is converted into finished goods in short duration, when
finished goods remain in dept pending sales for a short while only, and when cash
realizations out of sales are made quickly and finally when payment to creditors is made
slowly, the operating cycle would be smaller and consequently the working capital will
also be reasonable.
There should be neither too little nor too much investment in working capital. Efficient
handling of the operating cycle would make possible the above. Note, what is suggested is
optimization, and not minimization of current assets and maximization of current liabilities.
That will affect your liquidity and your profitability. Too little means more illiquid, but more
profitability, but not more absolute profits. We want both high profitability and high profits.
Too much current liability means illiquid but more profitability as it is assumed short-term
funds are less expensive for they can be redeemed the moment you dont need thus saving
interest. The reverse is true with too little current liability. Actually the business has to tradeoff between risk and return. If it wants less risk it has to carry more current assets and less
current liability. This will lead to lower profits. Low risk means low profits. If the business
takes more risk, ie., it carries less working capital, it might make more profits. There is no
guarantee however that higher level of risk yields higher profits.
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In terms of operating cycle concept, too long an operating cycle gives more liquidity but
only low returns and vice versa. The optimum operating cycle has to be worked out taking
into account the costs and benefits and levels of risk and levels of return for varying lengths
of operating cycle.
As a first step, we have to compute the operating cycle as follows:
i) Inventory period: Number of days consumption in stock = I M/36
Where I Average inventory during the year
M = Materials consumed during the year
ii) Work-in-process: Number of days of work-in-process = W K/365 Where W = Average
work-in-process during the year
K = Cost of work-in-process i.e., Material + Labour + Factory overheads.
iii) Finished products inventory period = G F/365
Where G = Average finished products inventory during the year F= Cost of finished goods
sold during the year
iv) Average collection period of Debtors = D S/365
Where D = Average Debtors balances during the year S = Credit sales during the year
v) Credit period allowed by Suppliers = C P/365
Where C = Average creditors balances during the year
P = credit purchases during the year
vi) Minimum cash balance to be kept daily.
Formula: O.C. = M + W + F + D C
Note : It is also known as working capital cycle. Operating cycle is the total time gap
between the purchase of raw material and the receipt from Debtors.
The calculation of net working capital may also be shown as follows ;
Working Capital = Current Assets Current Liabilities =(Raw Materials Stock +
Work-in-progress Stock + Finished Goods Stock + Debtors + Cash Balance) (Creditors
+Outstanding Wages + Outstanding Overheads).
Where,
Raw Materials = Cost (Average) of Materials in Stock
Work-in-progress Stock = Cost of Materials + Wages +Overhead of Work-in-progress.
Finished Goods Stock = Cost of Materials + Wages +Overhead of Finished Goods. Creditors
for Material = Cost of Average Outstanding Creditors.
Creditors for Wages = Averages Wages Outstanding. Creditors for Overhead = Average
Overheads Outstanding. Thus,
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Working Capital = Cost of Materials in Stores, in Work-in-progress, in Finished Goods

and in Debtors.
Less : Creditors for Materials
Plus : Wages in Work-in-progress, in Finished Goods and in Debtors.
Less :Creditors for Wages
Plus : Overheads in Work-in-progress, in Finished Goods and in Debtors.
Less : Creditors for Overheads.
The work sheet for estimation of working capital requirements under the operating cycle
method may be presented as follows:
ESTIMATION OF WORKING CAPITAL REQUIREMENTS
I Current Assets:
Amount
Minimum Cash Balance
Amount Amount
****
Inventories :
Raw Materials
****
Work-in-progress
****
Finished Goods
****
****
Receivables :
Debtors
****
Bills
****
Gross Working Capital (CA)
***
****
****
II Current Liabilities :
Creditors for Purchases
Creditors for Wages
****
****
Creditors for Overheads
****
****
Total Current Liabilities (CL)
****
****
Excess of CA over CL
****
+ Safety Margin
****
Net Working Capital
****
The following points are also worth noting while estimating the working capital requirement:
1. Depreciation: An important point worth noting while estimating the working capital
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requirement is the depreciation on fixed assets. The depreciation on the fixed assets,
which are used in the production process or other activities, is not considered in working
capital estimation. The depreciation is a non-cash expense and there is no funds locked up
in depreciation as such and therefore, it is ignored. Depreciation is neither included in
valuation of work-in-progress nor in Finished goods. The working capital calculated by
ignoring depreciation is known as cash basis working capital. In case, depreciation is
included in working capital calculations, such estimate is known as total basis Working
capital.
2. Safety Margin: Sometimes, a firm may also like to have a safety margin of working
capital in order to meet any contingency. The safety margin may be expressed as a % of
total current assets or total current liabilities or net working capital. The safety margin, if
required, is incorporated in the working capital estimates to find out the net working
capital required for the firm. There is no hard and fast rule about the quantum of safety
margin and depends upon the nature and characteristics of the firm as well as of its
current assets and current liabilities
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating Cycle /
365 Days) + Bank and Cash Balance.
If the cost of goods sold (estimated) is $35 million and operating cycle is of 75 days
and bank balance required is 1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 =
$8.44 Million.
In this method, each component can also be calculated. It means bifurcation of $8.44
million can be done in inventory, cash, accounts receivable, accounts payable etc.
Example.1
Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods sold is as
follows:
Rs. (Per Unit)
Raw material
100
Manufacturing expenses
30
Selling, administration and financial expenses
20
Selling price
200
The duration at various stages of the operating cycle is expected to be as follows :

Raw material stage
2 months
Work-in-progress stage
1 month
Finished stage
1/2 month
Debtors stage
1 month
Assuming the monthly sales level of 2,500 units, estimate the gross working capital
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requirement. Desired cash balance is 5% of the gross working capital requirement, and
working- progress in 25% complete with respect to manufacturing expenses.
Solution:
Statement of Working Capital Requirement
1. Current Assets:
Amt. (Rs.
Stock of Raw Material (2,5002100)
Amt. (Rs.)
5,00,000
Work-in-progress:
Raw Materials (2,500100)
2,50,000
Manufacturing Expenses 25% of (2,50030)
18,750
2,68,750
Finished Goods:
1,25,000
Manufacturing Expenses (2,50030)
37,500
Debtors (2,500150)
1,62,500
3,75,000
13,06,250
Cash Balance (13,06,2505/95)
68,750
Working Capital Requirement
13,75,000
Note: Selling, administration and
financial expenses have not been included in

valuation of closing
stock.
Example.2
Calculate the amount of working capital requirement for SRCC Lt d. from the following
information:
. (Per Unit)
Raw materials
160
Direct labour
60
Overheads
120
Total cost
34 0
Profit
Selling price
60
400
Raw materials are held in stock on an average for one month. Materials are in process
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on an average for half-a-month. Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two months. Time
lag in payment of wages is 1 weeks. Time lag in payment of overhead expenses is one
month. One fourth of the sales are made on cash basis.
Cash in hand and at the bank is expected to be Rs. 50,000; and expected level of
production Cash in hand and at the bank is expected to be Rs. 50,000; and expected level of
production amounts to 1,04,000 units for a year of 52 weeks.
You may assume that production is carried on evenly throughout the year and a time
period of four weeks is equivalent to a month.
Solution :
1. Current Assets :
Amt. (Rs.)
Amt. (Rs.)
Cash Balance
50,000
Stock of Raw Materials (2,0001604)
12,80,000
Work-in-progress :
6,40,000
Labour and Overheads (2,0001802)50%
3,60,000
10,00,000
Finished Goods (2,0003404)
27,20,000
Debtors (2,00075%3408)
40,80,000
Total Current Assets
91,30,000
2. Current Liabilities :
Creditors (2,000Rs. 1604)
12,80,000
Creditors for Wages (2,000Rs. 601)
1,80,000
Creditors for Overheads (2,000Rs. 1204)
9,60,000
Total Current Liabilities
24,20,000
Net Working Capital (CACL)
67,10,000
Example.3
JBC Ltd. sells goods on a gross profit of 25%. Depreciation is considered as a part of
cost of production. The following are the annual figures given to you :
Sales (2 months credit)
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Rs. 18,00,000
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Materials consumed (1 months credit)
4,50,000
Wages paid (1 month lag in payment)
3,60,000
Cash manufacturing expenses (1 month lag in payment) 4,80,000

Administrative expenses (1 month lag in payment)
1,20,000
Sales promotion expenses (paid quarterly in advance)
60,000
The company keeps one months stock each of raw materials and finished goods. It
also keeps Rs. 1,00,000 in cash. You are required to estimate the working capital
requirements of the company on cash cost basis, assuming 15% safety margin.
Solution:
1. Current Assets :
Amt. (Rs.)
Cash-in-hand
1,00,000
Debtors (cost of sales i.e. 14,70,0002/12)
2,45,000
Prepaid Sales Promotion expenses
15,000
Inventories :
Raw Materials (4,50,000/12)
37,500
Finished goods (12,90,000/12)
1,07,500
Total current assets
5,05,000
2. Current Liabilities :
Sundry creditors (4,50,000/12)
37,500
Outstanding Manufacturing exp. (4,80,000/12)
40,000
Outstanding Administrative exp. (1,20,000/12)
10,000
Outstanding Wages (3,60,000/12)
30,000
Total current liabilities
1,17,500
Excess of CA and CL
3,87,500
+ 15% for contingencies
58,125
Working capital required
4,45,625
Working Notes :
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1. Cost Structure
Rs.
Sales
18,00,000
VS Publishers
Gross profit 25% on sales
4,50,000
Cost of production
13,50,000
Cost of materials
Rs. 4,50,000
Wages
3,60,000
8,10,000
Manufacturing expenses (Total)
5,40,000
Cash Manufacturing expenses
4,80,000
Therefore, Depreciation
60,000
2. Total cash cost :

Cost of production
13,50,000
Depreciation
60,000
+ Administrative expenses
1,20,000
+ Sales promotion expenses
60,000
Total Cash Cost
14,70,000
4.2. SOURCES OF WORKING CAPITAL

Working Capital requirement can be normalized from short-term and long-term
sources. Each source will have both merits and limitations up to certain extract. Uses of
Working Capital may be differing from stage to stage.
WORKING CAPITAL AND BANKING COMMITTEE

Banking finance to working capital requirements is a very important part of the
business concern. Banks provide finance to business concerns to meet the requirements. To
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regulate and control bank finance, RBI constitutes committees. These committees submit
reports with findings and recommendations to formulate the finance policy of the banks. The
major committee and the recommendations are as follows:
Committee
Year
Major Recommendations
DEHEJIA
1969
Appraisal of credit applications received by banks

for granting loan.
TANDON
1975
Banks must carry out the realize appraisal for

granting loan Fixation
of norms for bank lending to industry.
CHORE
1980
No bifurcation of cash credit accounts separate

limits for peak
level and non peak level requirements.
MARATHE
1984
Second method of lending

introduction of fast track
to
industry,
concept.
KANNAN
1997
Regular conduct with the borrowers, periodical

monitoring the credit
disposition.
4.3. Current assets management

Current asset management is the handling of the current assets of a company. Any
assets that a company or business has that is the equivalent of cash or can be liquidated into
cash in the period of a year is considered a current asset. Typically, current assets are the
inventory a company has, as well as the accounts receivables and any short-term investments
it has in place.
The main principle in current asset management is to keep the proper flow of income
and liability in balance. Managing current assets also takes into account the long-term
investments of a company, but short-term assets, another name for current assets, is important
in determining the liquidity of a company. The measure of liquidity is really the measure of
how well and how fast a company can pay off its debts.
Calculating the current ratio is key in figuring out the proper balance for current asset
management. The current ratio is the companys current assets divided by its current
liabilities. Current liabilities are defined as what a business needs to pay off in a specific cycle
of time, either a financial year or a cycle of time particular to a business, whichever is longer.
4.3.1. CASH MANAGEMENT
Business concern needs cash to make payments for acquisition of resources and
services for the normal conduct of business. Cash is one of the important and key parts of the
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current assets.
Cash is the money which a business concern can disburse immediately without any
restriction. The term cash includes coins, currency, cheques held by the business concern and
balance in its bank accounts. Management of cash consists of cash inflow and outflows, cash
flow within the concern and cash balance held by the concern etc.
4.3.2. Meaning and definition of cash:
1. Cash may be in any form of currency, like banknotes and coins, which have a legal
acceptance and recognition in the market.
2. The acceptance of cash by its user indicates that it has a trading value when tendered for
purchase of goods and services.
3. Cash is one of the current assets in a business. It is needed all times to keep the business
on going. A business concern to keep the sufficient fund to meet its obligations.
"Cash is money in form of banknotes and coins that are issued by the government of
a country under the administration and control of its finance ministry or department of
finance."
4.3.3. The Concept of Cash Management
Cash, like the blood stream in the human body, gives vitality and strength to business
enterprises.
Though, cash holds the smallest portion of total current assets. However, cash is both
the beginning and end of working capital cycle cash, inventories, receivables and cash. It is
the cash, which keeps the business going. Hence, every enterprise has to hold necessary cash
for its existence. Moreover, steady and healthy circulation of cash throughout the entire
business operations is the basis of business solvency.
In the words of R.R. Bari, Maintenance of surplus cash by a company unless there are
special reasons for doing so, is regarded as a bad sigh of cash management.
Cash may be interpreted under two concepts. In narrow sense, cash is very important
business asset, but although coin and paper currency can be inspected and handled, the major
part of the cash of most enterprises is in the form of bank checking accounts, which represent
claims to money rather than tangible property. While in broader sense, cash consists of legal
tender, cheques, bank drafts, money orders and demand deposits in banks. In general, nothing
should be considered unrestricted cash unless it is available to the management for
disbursement of any nature. Thus, from the above quotations we may conclude that in narrow
sense cash means cash in hand and at bank but in wider sense, it is the deposit in banks,
currency, cheques, bank draft etc. in addition to cash in hand and at bank.
4.3.4. Motives for Holding Cash
1. Transaction motive
It is a motive for holding cash or near cash to meet routine cash requirements to finance
transaction in the normal course of business. Cash is needed to make purchases of raw
materials, pay expenses, taxes, dividends etc.
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2. Precautionary motive
It is the motive for holding cash or near cash as a cushion to meet unexpected
contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc.
3. Speculative motive
It is the motive for holding cash to quickly take advantage of opportunities typically
outside the normal course of business. Certain amount of cash is needed to meet an
opportunity to purchase raw materials at a reduced price or make purchase at favorable
prices.
4. Compensating motive
It is a motive for holding cash to compensate banks for providing certain services or
loans. Banks provide variety of services to the business concern, such as clearance of
cheque, transfer of funds etc.
4.3.5. Cash Management Techniques
Managing cash flow constitutes two important parts:
A. Speedy Cash Collections.
B. Slowing Disbursements.
A. Speedy Cash Collections
Business concern must concentrate in the field of Speedy Cash Collections from
customers. For that, the concern prepares systematic plan and refined techniques. These
techniques aim at, the customer who should be encouraged to pay as quickly as possible and
the payment from customer without delay. Speedy Cash Collection business concern applies
some of the important techniques as follows:
1. Prompt Payment by Customers
Business concern should encourage the customer to pay promptly with the help of
offering discounts, special offer etc. It helps to reduce the delaying payment of customers and
the firm can avoid delays from the customers. The firms may use some of the techniques for
prompt payments like billing devices, self address cover with stamp etc.
2. Early Conversion of Payments into Cash
Business concern should take careful action regarding the quick conversion of the
payment into cash. For this purpose, the firms may use some of the techniques like postal
float, processing float, bank float and deposit float.
3. Concentration Banking
It is a collection procedure in which payments are made to regionally dispersed
collection centers, and deposited in local banks for quick clearing. It is a system of
decentralized billing and multiple collection points.
4.Lock Box System
It is a collection procedure in which payers send their payment or cheques to a nearby post
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box that is cleared by the firms bank. Several times that the bank deposit the cheque in the
firms account. Under the lock box system, business concerns hire a post office lock box at
important collection centers where the customers remit payments. The local banks are
authorized to open the box and pick up the remittances received from the customers. As a
result, there is some extra savings in mailing time compared to concentration bank.
B. Slowing Disbursement
An effective cash management is not only in the part of speedy collection of its cash
and receivables but also it should concentrate to slowing their disbursement of cash to the
customers or suppliers. Slowing disbursement of cash is not the meaning of delaying the
payment or avoiding the payment. Slowing disbursement of cash is possible with the help of
the following methods:
1. Avoiding the early payment of cash
The firm should pay its payable only on the last day of the payment. If the firm avoids
early payment of cash, the firm can retain the cash with it and that can be used for other
purpose.
2. Centralised disbursement system
Decentralized collection system will provide the speedy cash collections. Hence centralized
disbursement of cash system takes time for collection from our accounts as well as we can
pay on the date.
4.3.6. Cash Management
The term cash management refers to the management of cash resource in such a way
that generally accepted business objectives could be achieved. In this context, the objectives
of a firm can be unified as bringing about consistency between maximum possible
profitability and liquidity of a firm.
Cash management may be defined as the ability of a management in recognizing the
problems related with cash which may come across in future course of action, finding
appropriate solution to curb such problems if they arise, and finally delegating these solutions
to the competent authority for carrying them out. The choice between liquidity and
profitability creates a state of confusion. It is cash management that can provide solution to
this dilemma. Cash management may be regarded as an art that assists in establishing
equilibrium between liquidity and profitability to ensure undisturbed functioning of a firm
towards attaining its business objectives.
Cash itself is not capable of generating any sort of income on its own. It rather is the
prime requirement of income generating sources and functions. Thus, a firm should go for
minimum possible balance of cash, yet maintaining its adequacy for the obvious reason of
firms solvency. Cash management deals with maintaining sufficient quantity of cash in such
a way that the quantity denotes the lowest adequate cash figure to meet business obligations.
Cash management involves managing cash flows (into and out of the firm), within the firm
and the cash balances held by a concern at a point of time. The words, managing cash and
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the cash balances as specified above does not mean optimization of cash and near cash items
but also point towards providing a protective shield to the business obligations. Cash
management is concerned with minimizing unproductive cash balances, investing temporarily
excess cash advantageously and to make the best possible arrangement for meeting planned
and unexpected demands on the firms cash.
4.3.7. Significance of Cash Management
Cash is one of the most important components of current assets. Every firm should
have adequate cash, neither more nor less. Inadequate cash will lead to production
interruptions, while excessive cash remains idle and will impair profitability. Hence, the firm
need for cash management. The cash management assumes significance for the following
reasons.
1. Cash planning: Cash is the most important as well as the least unproductive of all
current assets. Though, it is necessary to meet the firms obligations, yet idle cash earns
nothing. Therefore, it is essential to have sound cash planning neither excess nor
inadequate.
2. Management of cash flows: This is another important aspect of cash management.
Synchronization between cash inflows and cash outflows rarely happens. Sometimes, the
cash inflows will be more than outflows because of receipts from debtors, and cash sales
in huge amounts. At other times, cash outflows exceed inflows due to payment of taxes,
interest and dividends etc. Hence, the cash flows should be managed for better cash
management.
3. Maintaining optimum cash balance: Every firm should maintain optimum cash balance.
The management should also consider the factors determining and influencing the cash
balances at various point of time. The cost of excess cash and danger of inadequate cash
should be matched to determine the optimum level of cash balances.
4. Investment of excess cash: The firm has to invest the excess or idle funds in short term
securities or investments to earn profits as idle funds earn nothing. This is one of the
important aspects of management of cash. Thus, the aim of cash management is to
maintain adequate cash balances at one hand and to use excess cash in some profitable
way on the other hand.
:4.3.8. Objectives of cash management
(1) To make Payment According to Payment Schedule:- Firm needs cash to meet its
routine expenses including wages, salary, taxes etc.Following are main advantages of
adequate cash:a) To prevent firm from being insolvent.
b) The relation of firm with bank does not deteriorate.
c) Contingencies can be met easily.
d) It helps firm to maintain good relations with suppliers.
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(2) To minimise Cash Balance:- The second objective of cash management is to minimise
cash balance. Excessive amount of cash balance helps in quicker payments, but excessive
cash may remain unused & reduces profitability of business. Contrarily, when cash
available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum
level of cash should be maintained.
1. Meeting cash disbursements: The first basic objective of cash management is to meet
the payments Schedule. In other words, the firm should have sufficient cash to meet the
various requirements of the firm at different periods of times. The business has to make
payment for purchase of raw materials, wages, taxes, purchases of plant, etc. The business
activity may come to a grinding halt if the payment schedule is not maintained. Cash has,
therefore, been aptly described as the oil to lubricate the ever-turning wheels of the
business, without it the process grinds to a stop.
2. Minimizing funds locked up as cash balances: The second basic objective of cash
management is to minimize the amount locked up as cash balances. In the process of
minimizing the cash balances, the finance manager is confronted with two conflicting
aspects. A higher cash balance ensures proper payment with all its advantages. But this
will result in a large balance of cash remaining idle. Low level of cash balance may result
in failure of the firm to meet the payment schedule.
The finance manager should, therefore, try to have an optimum amount of cash balance
keeping the above facts in view.
4.3.9. Principles of Cash Management

Harry Gross has suggested certain general principles of cash management that,
essentially add efficiency to cash management. These principles reflecting cause and effect
relationship having universal applications give a scientific outlook to the subject of cash
management. While, the application of these principles in accordance with the changing
conditions and business environment requiring high degree of skill and tact which places cash
management in the category of art. Thus, we can say that cash management like any other
subject of management is both science and art for it has well-established principles capable of
being skill fully modified as per the requirements. The principles of management are follows
as;
1. Determinable Variations of Cash Needs: A reasonable portion of funds, in the form of
cash is required to be kept aside to overcome the period anticipated as the period of cash
deficit. This period may either be short and temporary or last for a longer duration of
time. Normal and regular payment of cash leads to small reductions in the cash balance at
periodic intervals. Making this payment to different employees on different days of a
week can equalize these reductions. Another technique for balancing the level of cash is
to schedule cash disbursements to creditors during that period when accounts receivables
collected amounts to a large sum but without putting the goodwill at stake.
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2. Contingency Cash Requirement: There may arise certain instances, which fall beyond
the forecast of the management. These constitute unforeseen calamities, which are too
difficult to be provided for in the normal course of the business. Such contingencies
always demand for special cash requirements that was not estimated and provided for in
the cash budget. Rejections of wholesale product, large amount of bad debts, strikes,
lockouts etc. are a few among these contingencies. Only a prior experience and
investigation of other similar companies prove helpful as a customary practice. A practical
procedure is to protect the business from such calamities like bad-debt losses, fire etc. by
way of insurance coverage.
3. Availability of External Cash: Another factor that is of great importance to the cash
management is the availability of funds from outside sources. There resources aid in
providing credit facility to the firm, which materialized the firms objectives of holding
minimum cash balance. As such if a firm succeeds in acquiring sufficient funds from
external sources like banks or private financiers, shareholders, government agencies etc.,
the need for maintaining cash reserves diminishes.
4. Maximizing Cash Receipts: Every financial manager has aims at making the best
possible use of cash receipts. Again, cash receipts if tackled prudently results in
minimizing cash requirements of a concern. For this purpose, the comparative cost of
granting cash discount to customer and the policy of charging interest expense for
borrowing must be evaluated on continuous basis to determine the futility of either of the
alternative or both of them during that particular period for maximizing cash receipts. Yet,
the under mentioned techniques proved helpful in this context:
a) Concentration Banking: Under this system, a company establishes banking centers for
collection of cash in different areas. Thereby, the company instructs its customers of
adjoining areas to send their payments to those centers. The collection amount is then
deposited with the local bank by these centers as early as possible. Whereby, the collected
funds are transferred to the companys central bank accounts operated by the head office.
b) Local Box System: Under this system, a company rents out the local post offices boxes
of different cities and the customers are asked to\forward their remittances to it. These
remittances are picked by the authorized lock bank from these boxes to be transferred to
the companys central bank operated by the head office.
c)
Reviewing Credit Procedures: It aids in determining the impact of slow payers and
debtors on cash. The accounts of slow paying customers should be reviewed to determine
the volume of cash tied up. Besides this, evaluation of credit policy must also be
conducted for introducing essential amendments. As a matter of fact, too strict a credit
policy involves rejections of sales. Thus, curtailing the cash inflow. On the other hand, too
lenient, a credit policy would increase the number of slow payments and bad debts again
decreasing the cash inflows.
d)
Minimizing Credit Period: Shortening the terms allowed to the customers would
definitely accelerate the cash inflow side-by-side revising the discount offered would
prevent the customers from using the credit for financing their own operations profitably.
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e)
Others: Introducing various procedures for special handling of large to very large
remittances or foreign remittances such as, persona! pick up of large sum of cash using
airmail, special delivery and similar techniques to accelerate such collections.
5. Minimizing Cash Disbursements: The motive of minimizing cash payments is the

ultimate benefit derived from maximizing cash receipts. Cash disbursement can be
brought under control by preventing fraudulent practices, serving time draft to creditors of
large sum, making staggered payments to creditors and for payrolls etc.
6. Maximizing Cash Utilization: Although a surplus of cash is a luxury, yet money is
costly. Moreover, proper and optimum utilization of cash always makes way for
achievement of the motive of maximizing cash receipts and minimizing cash payments.
At times, a concern finds itself with funds in excess of its requirement, which lay idle
without bringing any return to it. At the same time, the concern finds it unwise to dispose
it, as the concern shall soon need it. In such conditions, efforts should be made in
investing these funds in some interest bearing securities.
4.3.10. Cash Management Models
Cash management models analyse methods which provide certain framework as to
how the cash management is conducted in the firm. Cash management models are the
development of the theoretical concepts into analytical approaches with the mathematical
applications. There are three cash management models which are very popular in the field of
finance.
1. Baumol model
The basic objective of the Baumol model is to determine the minimum cost amount of
cash conversion and the lost opportunity cost.
It is a model that provides for cost efficient transactional balances and assumes that
the demand for cash can be predicated with certainty and determines the optimal conversion
size.
Total conversion cost per period can be calculated with the help of the following formula:
t
Tb
C
where,
T = Total transaction cash needs for the period
b = Cost per conversion
C = Value of marketable securities
Opportunity cost can be calculated with the help of the following formula;
I=C/2
where,
i = interest rate earned
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C/2 = Average cash balance

Optimal cash conversion can be calculated with the help of the following formula;
C
2Bt
I
where,
C = Optimal conversion amount
b = Cost of conversion into cash per lot or transaction
T = Projected cash requirement
i = interest rate earned
2. Miller-Orr model
This model was suggested by Miller Orr. This model is to determine the optimum cash
balance level which minimizes the cost of management of cash. Miller-Orr Model can be
calculated with the help of the following formula;
C
bE N
iE M
t
where,
C = Total cost of cash management b = fixed cost per conversion
E(M) = expected average daily cash balance E (N) = expected number of conversion
t = Number of days in the period
i = lost opportunity cost
3. Orglers model
Orglers model provides for integration of cash management with production and
other aspects of the business concern. Multiple linear programming is used to determine the
optimal cash management.
Orglers model is formulated, based on the set of objectives of the firm and specifying
the set of constrains of the firm.
Illustration on Cash Management
1. XYZ Company wishes to arrange overdraft facilities with its bankers during the period
April to June of a particular year, when it will be manufacturing mostly for stock. Prepare
a cash budget for the above period from the following data, indicating the extent of the
bank facilities the company will require at the end of the each month.
Month
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Sales (RS)
Production (RS)
Wages (RS)
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February 1,80,000
1,24,000
12,000
March
1,92,000
1,44,000
14,000
April
1,08,000
2,43,000
11,000
May
1,74,000
2,46,000
10,000
June
1,26,000
2,68,000
15,000
50% of the credit sales realized in the month following the sales realized in the month
following; creditors are paid in the following month of purchase.
Cash at Bank on 1st April (estimated) is Rs. 25,000.
Solution:
Cash budget for the period 01.04---- to 30.06------Particulars
April
May
June
Opening balance
25,000
56,000,
(47,000)
Collection from debtors
1,86,000
1,50,000
1,41,000
Total receipts
2,22,000
2,06,000
94,000
1,44,000
2,43,000
2,46,000
Receipts:
Payments:
Creditors (purchases)
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Wages
11,000
10,000
15,000
Total payment(B)
1,55,000
2,53,000
2,61,000
Closing balance(A-B)
56,000
(47,000)
1,67,000
Workings:
1. Calculation of collection from Debtors:
Collection
Total
Month Previous months credit Prior to previous Total

sales
months credit sales
April
50%*1,92,000=96,000
50%*1,80,000=90,000 1,86,000
May
50%*1,08,000=54,000
50%*1,92,000=96,000 1,50,000
June
50%*1,74,000=87,000
50%*1,08,000=54,000 1,41,000
2. M/S Smart tech Limited has instructed you to prepare cash budget for October to
December from the following particulars:
1. Cash and Bank balance as on 1st October-Rs.20, 000.
2. Actual and budgeted sales; purchases, wages and other expenses:-
Months
Sales
Purchases
Wages
Expenses
(RS)
June
60,000(actual)
36,000(actual)
July
65,000(actual)
40,000(actual)
August
70,000(actual)
48,000(actual)
15,000(actual)
5,000(actual)
September 75,000(actual)
45,000(actual)
15,000(actual)
6,000(actual)
October
48,000
budgeted
18,000
budgeted
6,000
budgeted
40,000
18,000
8,000
80,000
budgeted
November 82,000
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December
budgeted
budgeted
budgeted
budgeted
89,000
budgeted
50,000
budgeted
20,000
budgeted
8,000
budgeted
3. Special points
i. Advance income tax Rs. 5000 on November.
ii. Plant Rs.8, 000 in October.
4. Rs.3000 Rent payable in advance.
5. 10% of purchases and sales are on cash terms.
Trade creditors are paid in the following month after purchases while collections from
debtors are made two months after from, the date of sales.
Solution:
Cash budget for the period 01.10-----to 31.12------Particulars
October
November
December
Opening balance
20,000
13,400
10,600
Cash sales
8,000
8,200
8,900
Collection from debtors
63,000
67,500
72,000
Total receipts(A)
91,000
89,100
91,500
Cash purchases
4,800
4,000
5,000
Creditors(purchases)
40,500
43,200
36,000
Wages
18,000
18,000
20,000
Expenses
6,000
8,000
8,000
Rent payble in advances
300
300
300
Advance income tax
5,000
Plant
8,000
Receipts:
Payments:
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Total payment(B)
77,600
78500
69,300
Closing balance(A-B)
13,400
10,600
22,200
Workings:
1.
Calculation of cash and credit sales
Particulars
July
Aug
Total sales
65,000
70,000 75,000 80,000 82,000 89,000
Less cash
month sales)
sales(of 65,000
Credit sales
1.
58,500
7,000
Sep
7,500
Oct
8,000
Nov
8,200
Dec
8,900
63,000 67,500 72,500 73,800 8,000
Calculation of collection from debtors:

Month
Collection made two months after from the plate Total

sales
Oct
Sales of the month aug(working 1)
36,000
Nov
67,500
Dec
72,000
4.4. Inventory Management:

Inventory or stock refers to the goods and materials include that a business holds for
the ultimate purpose of resale.
Inventory can be defined in many ways with respect to different perspectives.
Following selected statements will help you to get a broad understanding of its concept.
In general, the simple definition of inventory can be stated as follows.
Inventory means the stock of goods available or held for sale in the ordinary course
of business.
In a business sense, the inventory can be defined as under.
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Inventory includes raw-materials stored in a warehouse, work-in-progress in

production, and finished goods available for sale.
Inventory is that stock of goods, which have a demand and supply in the market and
can be easily realized in cash.
4.4.1. Meaning and Definition of Inventory:
An inventory is a stock of goods maintained for the purpose of future production or
sales. In broad sense, the term inventory refers to all materials, parts, supplies, tools, inprocess or finished products recorded in the books by an organisation and kept in its stocks,
warehouse or plant for some period of time. It is a list or schedule of materials held on behalf
of an enterprise. The quantity and value of every item is also mentioned in such list.
According to R.L. Ackoff and M.W. Sasieni, Inventory consists of usable but idle
resources. The resources may be of any type; for example, men, materials, machines or
money. When the resources involved are materials or goods in any stage of completion,
inventory is referred to as stock.
In a nutshell, the term inventory may be defined as the stock of goods, commodities
or other economic resources that are stored or reserved at any given period for future
production or for meeting future demand.
4.4.2. Types/Classification of Inventory:
The term inventory may be classified into two types namely:
1. Direct Inventories:
Direct inventories are those inventories that play a major role in the production and
constitute a vital part of finished goods. These inventories can be easily assigned to specific
physical units. Direct inventories may be categorised into four groups.
(i) Raw materials:
Raw materials are the physical resources to be used in the manufacture of finished
products. They include materials that are in their natural or raw form. For example, cotton in
the case of textile mill, sugarcane in the case of sugar factory, oil seeds in the case of an oil
mill etc. The chief objective of keeping raw material is to ensure uninterrupted production in
the event of delays in delivery and also to enjoy the economies of large scale buying.
(ii) Semi-finished Goods:
Semi-finished goods are those materials which are not cent per cent (100%) complete
in all respects i.e., some processing still remains to be done before the product can be sold.
For example, a person who is engaged in the manufacture of furniture, may purchase
unpolished furniture from market and sell it after polishing the same.
(iii) Finished Goods:
Finished goods are complete products that are ready for sale or distribution. For
instance, in case of a hosiery factory, sweaters, shawls etc. are finished products.
(iv) Spare Parts:
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Spare parts means duplicate parts of a machine. Usually, almost all the industrial
concerns maintain spare parts of various machines which they use for manufacture. This will
enable them to ensure smooth running of machines which in turn provide for uninterrupted
production.
2. Indirect Inventories:
Indirect inventories include those items which are necessary for manufacturing but do
not become component of the finished goods. They normally include petrol, maintenance
materials, office materials, grease, oil lubricants etc. These inventories are used for ancillary
purposes to the business and cannot be assigned to specific, physical units. These inventories
may be used in the factory, the office or the selling and distribution divisions.
Inventory management:
4.4.3. Meaning of Inventory management
Inventory management is a very important function that determines the health of the
supply chain as well as the impacts the financial health of the balance sheet. Every
organization constantly strives to maintain optimum inventory to be able to meet its
requirements and avoid over or under inventory that can impact the financial figures.
Inventory is always dynamic. Inventory management requires constant and careful evaluation
of external and internal factors and control through planning and review. Most of the
organizations have a separate department or job function called inventory planners who
continuously monitor, control and review inventory and interface with production,
procurement and finance departments.
Inventory management is the supervision of non-capitalized assets (inventory) and
stock items.
4.4.4. Motives of Inventory Management
Managing inventories involves lack of funds and inventory holding costs.
Maintenance of inventories is expensive, then why should firms hold inventories. There are
three general motives:
i. The transaction motive:
The company may be required to hold the inventories in order to facilitate the smooth and
uninterrupted production and sales operations. It may not be possible for the company to
procure raw material whenever necessary. There may be a time lag between the demand
for the material and its supply. Hence it is needed to hold the raw material inventory.
Similarly, it may not be possible to produce the goods immediately after they are
demanded by the customers. Hence, it is needed to hold the finished goods inventory. The
need to hold work-in-progress may arise due to production cycle.
ii. The precautionary motive:
In addition to the requirement to hold the inventories for routine transactions, the
company may like to hold them to guard against the risk of unpredictable changes in
demand and supply forces. E.g. the supply of raw material may get delayed due to the
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factors like strike, transport disruption, short supply, lengthy processes involved in import
of the raw materials etc.
iii. The speculative motive:
The company may like to purchase and stock the inventory in the quantity which is more
than needed for production and sales purposes. This may be with intention to get the
advantages in terms of quantity discounts connected with bulk purchasing or anticipated
price rise.
4.4.5. Techniques of Inventory Management:
Some of the most important techniques of inventory control system are:
1. Setting up of various stock levels
2. Preparations of inventory budgets
3. Maintaining perpetual inventory system
4. Establishing proper purchase procedures
5. Inventory turnover ratios and
6. ABC analysis.
1. Setting up of various stock levels:
To avoid over-stocking and under stocking of materials, the management has to decide
about the maximum level, minimum level, re-order level, danger level and average level of
materials to be kept in the store.
These terms are explained below:
(a) Re-ordering level:
It is also known as ordering level or ordering point or ordering limit. It is a point
at which order for supply of material should be made.
This level is fixed somewhere between the maximum level and the minimum level in
such a way that the quantity of materials represented by the difference between the reordering level and the minimum level will be sufficient to meet the demands of production till
such time as the materials are replenished. Reorder level depends mainly on the maximum
rate of consumption and order lead time. When this level is reached, the store keeper will
initiate the purchase requisition.
Reordering level is calculated with the following formula:
Re-order level =Maximum Rate of consumption x maximum lead time
(b) Maximum Level:
Maximum level is the level above which stock should never reach. It is also known as
maximum limit or maximum stock. The function of maximum level is essential to avoid
unnecessary blocking up of capital in inventories, losses on account of deterioration and
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obsolescence of materials, extra overheads and temptation to thefts etc. This level can be
determined with the following formula.
Maximum Stock level = Reordering level + Reordering quantity (Minimum
Consumption x Minimum re-ordering period)
(c) Minimum Level:
It represents the lowest quantity of a particular material below which stock should not
be allowed to fall. This level must be maintained at every time so that production is not held
up due to shortage of any material.
It is that level of inventories of which a fresh order must be placed to replenish the
stock. This level is usually determined through the following formula:
Minimum Level = Re-ordering level (Normal rate of consumption x Normal delivery
period)
(d) Average Stock Level:
Average stock level is determined by averaging the minimum and maximum level of stock.
The formula for determination of the level is as follows:
Average level =1/2 (Minimum stock level + Maximum stock level)
This may also be expressed by minimum level + 1/2 of Re-ordering Quantity.
(e) Danger Level:
Danger level is that level below which the stock should under no circumstances be
allowed to fall. Danger level is slightly below the minimum level and therefore the purchases
manager should make special efforts to acquire required materials and stores.
This level can be calculated with the help of following formula:
Danger Level =Average rate of consumption x Emergency supply time.
(f) Economic Order Quantity (E.O.Q.):
One of the most important problems faced by the purchasing department is how much
to order at a time. Purchasing in large quantities involve lesser purchasing cost. But cost of
carrying them tends to be higher. Likewise if purchases are made in smaller quantities,
holding costs are lower while purchasing costs tend to be higher.
Hence, the most economic buying quantity or the optimum quantity should be
determined by the purchase department by considering the factors such as cost of ordering,
holding or carrying.
This can be calculated by the following formula:
Q = 2AS/I
where Q stands for quantity per order ;
A stands for annual requirements of an item in terms of rupees;
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S stands for cost of placement of an order in rupees; and

I stand for inventory carrying cost per unit per year in rupees.
Meaning of EOQ:
EOQ refers to that level of inventory at which the total cost of inventory is minimum.
The total inventory cost comprising ordering and carrying costs. Storage costs are excluded in
adding total cost of inventory due to the difficulty in computation of storage cost. EOQ is also
known as Economic Lot Size (ELS).
Assumptions of EOQ Model:
i.
Demand for the product is constant and uniform throughout the period.
ii.
Lead time (time from ordering to receipt) is constant.
iii.
Price per unit of product is constant.
iv.
Inventory holding cost is based on average inventory.
v.
Ordering costs are constant.
vi.
All demand for the product will be satisfied (no back orders are allowed).
EOQ= 2AO/I
Where,
A = Annual Consumption
O = Ordering cost per order C = Carrying cost per unit
EOQ is applicable both to single items and to any group of stock items with similar
holding and ordering costs. Its use causes the sum of the two costs to be lower than under any
other system of replenishment.
Limitation of EOQ:
I. Constant usage:
This may not be possible to predict, it usage varies unpredictably, as it often does, no
formula will work well.
II. Faulty basic information:
Ordering and carrying cost is the base for EQA calculation. It assumes that ordering cost
is constant per order is fixed, but actually varies from commodity to commodity. Carrying
cost also can vary with the companys opportunity cost of capital.
III. Costly calculations:
In many cases, the cost of estimation cost of possession and acquisition and calculating
EQA exceeds the savings made by buying that quantity
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2. Preparation of Inventory Budgets:

Organisations having huge material requirement normally prepare purchase budgets.
The purchase budget should be prepared well in advance. The budget for production and
consumable material and for capital and maintenance material should be separately prepared.
Sales budget generally provide the basis for preparation of production plans.
Therefore, the first step in the preparation of a purchase budget is the establishment of sales
budget.
As per the production plan, material schedule is prepared depending upon the amount
and return contained in the plan. To determine the net quantities to be procured, necessary
adjustments for the stock already held is to be made.
They are valued as standard rate or current market. In this way, material procurement
budget is prepared. The budget so prepared should be communicated to all departments
concerned so that the actual purchase commitments can be regulated as per budgets.
At periodical intervals actual are compared with the budgeted figures and reported to
management which provide a suitable basis for controlling the purchase of materials,
3. Maintaining Perpetual Inventory System:
This is another technique to exercise control over inventory. It is also known as
automatic inventory system. The basic objective of this system is to make available details
about the quantity and value of stock of each item at all times. Thus, this system provides a
rigid control over stock of materials as physical stock can be regularly verified with the stock
records kept in the stores and the cost office.
4. Establishing Proper Purchase Procedures:
A proper purchase procedure has to be established and adopted to ensure necessary
inventory control. The following steps are involved.
(a) Purchase Requisition:
It is the requisition made by the various departmental heads or storekeeper for their
various material requirements. The initiation of purchase begins with the receipts of a
purchase requisition by the purchase department.
(b) Inviting Quotations:
The purchase department will invite quotations for supply of goods on the receipt of
purchase requisition.
(c) Schedule of Quotations:
The schedule of quotations will be prepared by the purchase department on the basis
of quotations received.
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(d) Approving the supplier:

The schedule of quotations is put before the purchase committee who selects the
supplier by considering factors like price, quality of materials, terms of payment, delivery
schedule etc.
(e) Purchase Order:
It is the last step and the purchase order is prepared by the purchase department. It is a
written authorisation to the supplier to supply a specified quality and quantity of material at
the specified time and place mentioned at the stipulated terms.
5. Inventory Turnover Ratio:
These are calculated to minimise the inventory by the use of the following formula:
Inventory Turnover Ratio = Cost of goods consumed/sold during the period/Average
inventory held during the period
The ratio indicates how quickly the inventory is used for production. Higher the ratio,
shorter will be the duration of inventory at the factory. It is the index of efficiency of material
management.
The comparison of various inventory turnover ratios at different items with those of
previous years may reveal the following four types of inventories:
(a) Slow moving Inventories:
These inventories have a very low turnover ratio. Management should take all
possible steps to keep such inventories at the lowest levels.
(b) Dormant Inventories:
These inventories have no demand. The finance manager has to take a decision
whether such inventories should be retained or scrapped based upon the current market price,
conditions etc.
(c) Obsolete Inventories:
These inventories are no longer in demand due to their becoming out of demand. Such
inventories should be immediately scrapped.
(d) Fast moving inventories:
These inventories are in hot demand. Proper and special care should be taken in
respect of these inventories so that the manufacturing process does not suffer due to shortage
of such inventories.
Perpetual inventory control system:
In a large b essential to have information about continuous availability of different
types of materials and stores purchased, issued and their balance in hand. The perpetual
inventory control system enables the manufacturer to know about the availability of these
materials and stores without undergoing the cumbersome process of physical stock taking.
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Under this method, proper information relating to receipt, issue and materials in hand
is kept. The main objective of this system is to have accurate information about the stock
level of every item at any time.
Perpetual inventory control system cannot-be successful unless and until it is
accompanied by a system of continuous stock taking i.e., checking the total stock of the
concern 3/4 times a year by picking 10/15 items daily (as against physical stock taking which
takes place once a year).
The items are taken in rotation. In order to have more effective control, the process of
continuous stock taking is usually undertaken by a person other than the storekeeper. This
will check the functioning of storekeeper also. The items may be selected at random to have a
surprise check. The success of the system of perpetual inventory control depends upon the
proper implementation of the system of continuous stock taking.
6. ABC analysis:
In order to exercise effective control over materials, A.B.C. (Always Better Control)
method is of immense use. Under this method materials are classified into three categories in
accordance with their respective values. Group A constitutes costly items which may be
only 10 to 20% of the total items but account for about 50% of the total value of the stores.
A greater degree of control is exercised to preserve these items. Group B consists of
items which constitutes 20 to 30% of the store items and represent about 30% of the total
value of stores.
A reasonable degree of care may be taken in order to control these items. In the last
category i.e. group Q about 70 to 80% of the items is covered costing about 20% of the total
value. This can be referred to as residuary category. A routine type of care may be taken in the
case of third category.
This method is also known as stock control according to value method, selective
value approach and proportional parts value approach.
If this method is applied with care, it ensures considerable reduction in the storage
expenses and it is also greatly helpful in preserving costly items.
4.4.6. BENEFITS OR ADVANTAGES OF HOLDING INVENTORY:
Optimum level of inventory is that level where the total cost of inventory is less. The major
benefits of inventory are the basic functions of inventory. Proper management of inventory
will result in the following benefits to a firm:
i. Inventory management ensures an adequate supply of materials and stores minimize stock
outs and shortages and avoid costly interruption in operations.
ii. It keeps down investment in inventories; inventory carrying costs, and obsolescence
losses to the minimum.
iii. It facilitates purchasing economies throughout the measurement of requirements on the
basis of recorded experience.
iv. It eliminates duplication in ordering stock by centralizing the source from which purchase
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requisition emanate.
v. It permits better utilization of available stock by facilitating inter-department transfers
within a firm.
vi. It provides a check against the loss of materials through carelessness or pilferage.
Perpetual inventory values provide a consistent and reliable basis for preparing financial
statements a better utilization.
4.4.7. DISADVANTAGES OF HOLDING INVENTORY
Holding of inventories involves the different costs, they also exposes the firm to take
some risks. Risk in inventory management refers to the chance that inventories cannot be
turned over into cash through normal sales without loss. Risks associated with inventory
management are as follows:
i. Price decline:
Price decline is the result of more supply and less demand. In other words, it may be
the result due to introduction of competitive product. Generally, prices are not controllable in
the short run by the individual firm. Controlling inventory is the only way that a firm can
counter act with these risks. On the demand side, a decrease in the general market demand
when supply remains the same may also cause price to increase. This is also a long run
management problem, because decrease demand may be due to change in customer buying
habits, tastes and incomes.
ii. Product deterioration:
Holding of finished goods for a long period or shortage under improper conditions for
light, heat, humidity and pressures lead to product deterioration. For example:
Cadburys chocolate. Recently, there were some live worms in chocolate; it was due
to improper storage. Deterioration usually prevents selling the product through normal
channels.
iii. Product obsolescence:
Product may become obsolete due to improved products, changes in customer tastes,
particularly in high style merchandise, changes in requirements etc. This risk may prove very
costly for the firms whose resources are limited and tied up in slow moving inventories.
Obsolescence cost risk is least controllable except by reduction in inventory management.
Illustration on Inventory Management
Problem 1:
ABC Analysis
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Stock Number
Annual $ Volume
Percent of Annual $ Volume
J24
12,500
46.2
R26
9,000
33.3
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L02
3,200
11.8
M12
1,550
5.8
P33
620
2.3
T72
65
0.2
S67
53
0.2
Q47
32
0.1
V20
30
0.1
= 100.0
What are the appropriate ABC groups of inventory items?

Solution
ABC Groups
Class
Items
Annual Volume
Percent of $ Volume
J24, R26
21,500
79.5
L02, M12
4,750
17.6
P33, T72, S67, Q47, V20
800
2.9
= 100.0
Item P33 is a judgment call. It might be considered a B item by some organizations.

However, the modern tendency is to move items to as low a level as possible thereby
reducing inventory management costs.
Problem 2:
A firm has 1,000 A items (which it counts every week, i.e., 5 days), 4,000 B items
(counted every 40 days), and 8,000 C items (counted every 100 days). How many items
should be counted per day?
Solution
168
Item Class
Quantity
Policy
Number of Items to Count Per

Day
1,000
Every 5 days
1000/5 = 200/day
4,000
Every 40 days
4000/40=100/day
8,000
Every 100 days
8000/100=80/day
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Total items to count: 380/day

4.5.Introduction to Receivable Management
The management of accounts receivables management deals with viable credit and
collection policies. A very liberal credit policy will increase sales and also bad debt losses. On
the other hand a conservative credit policy will reduce bad debt losses but also reduce sales. A
good credit policy should seek to strike a reasonable balance between sales and bad debt
losses.
The objective of receivables management is to promote sales and profits until that
point is reached where the returns that the firm gels from funding of receivables is less than
the cost that the firm has to incur in order to fund these receivables. This, the purpose of
receivables is directly connected with the firms objective of making credit sales.
4.5.1. Meaning of Receivables Management:
Receivables, also termed as trade credit or debtors are component of current assets.
When a firm sells its product in credit, account receivables are created. Account receivables
are the money receivable in some future date for the credit sale of goods and services at
present. These days, most business transactions are in credit. Most companies, when they face
competition, use credit sales as an important tool for sales promotion. As a sales promotion
tool, credit sale enhances firm's sales revenue and ultimately pushes up the profitability. But
after the credit sale has been made, the actual collection of cash may be delayed for months.
As these late payments stretch out over time, they may cause substantial drop in a company's
profit margin. Since the extension of credit involves both cost and benefits, the firm's
manager must be able to measure them to determine the ultimate effect of credits sales. In this
prospective, we define the receivable management as the aspect of a firm's current assets
management, which is concerned with determining optimum credit policy associated to a
firm, such that the benefit from extension of credit is greater than the cost of maintaining
investment in accounts receivables.
4.5.2. RECEIVABLE MANAGEMENT
The term receivable is defined as debt owed to the concern by customers arising from
sale of goods or services in the ordinary course of business. Receivables are also one of the
major parts of the current assets of the business concerns. It arises only due to credit sales to
customers, hence, it is also known as Account Receivables or Bills Receivables.
Management of account receivable is defined as the process of making decision resulting to
the investment of funds in these assets which will result in maximizing the overall return on
the investment of the firm.
The objective of receivable management is to promote sales and profit until that point
is reached where the return on investment in further funding receivables is less than the cost
of funds raised to finance that additional credit.
The costs associated with the extension of credit and accounts receivables are
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identified as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.
1. Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit
sales have been made.
2. Capital Cost
This is the cost on the use of additional capital to support credit sales which
alternatively could have been employed elsewhere.
3. Administrative Cost
This is an additional administrative cost for maintaining account receivable in the
form of salaries to the staff kept for maintaining accounting records relating to customers,
cost of investigation etc.
4. Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be
able to recover the over dues because of the inability of the customers.
4.5.3. Factors Considering the Receivable Size
Receivables size of the business concern depends upon various factors. Some of the
important factors are as follows:
1. Sales Level
Sales level is one of the important factors which determine the size of receivable of
the firm. If the firm wants to increase the sales level, they have to liberalise their credit policy
and terms and conditions. When the firms maintain more sales, there will be a possibility of
large size of receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from
firm to firm or even some times product to product in the same industry. Liberal credit policy
leads to increase the sales volume and also increases the size of receivable. Stringent credit
policy reduces the size of the receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon
the credit terms, size of the receivables may increase or decrease. Hence, credit term is one of
the factors which affect the size of receivable.
4. Credit Period
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It is the time for which trade credit is extended to customer in the case of credit sales.
Normally it is expressed in terms of Net days.
5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date.
A special discount will be provided to the customer for his payment before the due date.
6. Management of Receivable
It is also one of the factors which affect the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce the size of
receivable.
4.5.4. Significance and Purpose of Receivable Management
The basic purpose of firm's receivable management is to determine effective credit
policy that increases the efficiency of firm's credit and collection department and contributes
to the maximization of value of the firm. The specific purposes of receivable management are
as follows:
1.
2.
3.
4.
To evaluate the creditworthiness of customers before granting or extending the credit.

To minimize the cost of investment in receivables.
To minimize the possible bad debt losses.
To formulate the credit terms in such a way that results into maximization of sales
revenue and still maintaining minimum investment in receivables.
5. To minimize the cost of running credit and collection department.
6. To maintain a tradeoff between costs and benefits associated to credit policy.
4.5.5. Characteristics of Receivables
1. Risk involvement:
Receivables involve risk; since payment takes place in future and future is uncertain, so
they should be carefully analyzed.
2. Based on economic value:
Accounts receivables are based on economic value. The economic value in goods or
services passes to the buyer currently in return the seller expects an equivalent value from
the buyer latter
3. Implies futurity:
Buyer will make cash payment of the goods or services received by him or her in a future
period i.e. generally after a credit period.
4.5.6. Objectives of Receivables
1. Maximizing the value of the firm:
The basic objective of debtors management is to maximize the value of the firm by
achieving a trade-off between liquidity (risk) and return. The main purpose of receivables
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management is to minimize the risk of bad debts and maximization of order. Efficient
management of receivables expands sales by retaining old customers and attracting new
customers.
2. Optimum investment in sundry debtors:
Credit sales expand, but they involve block of funds, that have an opportunity cost,
which can be reduced by optimum investment in receivables. Providing liberal credit
increases sales consequently, profits will increase, but increasing investment in receivables
result in increased costs.
3. Control and the cost of credit:
When there are no credit sales, there will not be any trade credit. But credit sale
increases profits. It is possible only when the firm is able to keep the costs at minimum.
Illustration on Receivables Management
1. A trader whose current sales are in the region of Rs.6 lakhs per annum and an average
collection period of 30 days want to purpose a more liberal policy to improve sales. A
study made a management consultant reveals the following information.
Credit
policy
Increase in collection
period
Increase in
sales
Payment
default
anticipated
10 DAYS
RS.30,000
1.5%
20DAYS
RS.48,000
2%
30 DAYS
RS.75,000
3%
45 DAYS
RS.90,000
4%
The selling price per unit is RS.3 lakhs average cost per unit is Rs.2025 and variable
per unit are RS.2The current bad debt loss is 1% required return on additional investment is
20%asume a 360 days years which of the above policies would you recommend for adoption?
Solution:
Statement showing evaluation of allotment option in comparison to existing policy
SN
172
PARTICUL
ARS
CALCULAT
ION
EXISTI
NG
POLICY
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CREDIT
PERIOD
30 DAYS
40DAYS
50DAYS
60DAYS
75DAYS
Sales
Given
6,00,000
6,30,000
6,48,000
6,75,000
6,90,000
Variable cost
A 2/3
4,00,00
4,20,00
4,32,000
4,50,000
4,60,000
Contribution
A-B
2,00,000
2,10,000
2,16,000
2,25,000
2,30,000
Fixed cost
Working 1
50,000
50,000
50,000
50,000
50.000
Bad debit
percent
Given
1%
105%
2%
3%
4%
Amount of
bad debt
A*E
6,000
9,450
12,960
20,250
27,600
Cost of debit
(B+D)*credit
37,500
52,222
66,944
83,333
1,06,250
Interest cost
of debt
G*20%
7,500
10,444
13,389
16,667
21,250
Surplus
C-D-F-H
1,36,500
1,40,106
1,39,651
1,38,083
1,31,150
Conclusion: credit policy (A) of 40 days is better

Working: calculation of fixed cost
Sales
6,00,000
Total cost(2.25/3)*6,00,000
4,50,000
Variable cost (2/3)*6,00,000
4,00,000
Fixed cost(4,50,000-4,00,000)
50,000
2. A companys present credit sales amount to Rs.50 lakhs Its variable cost ratio is 60% of
sales and fixed costs amount to Rs.10 lakhs per annum. The company purpose to relax its
present credit policy of 1 month to either 2 months or 3 months /as the case may be. The
following information are also available:
Present
policy
Policy 1
Policy 2
Average age of 1 months

debtors
2 months
3 months
Increase in class
20%
30%
2.5
5.0
Percentage
bad debts
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3. If the company requires are turn investment of 20% before tax, evaluate the proposals.
Particulars
Calculation
Existing
policy
Policy 1
1 month
2 months
Policy 2
S.NO
Credit
period
Sales
Given
50,00,000
60,00,000 65,00,000
Variable
cost
A*60%
30,00,000
36,00,000 39,00,000
Contribution
A-B
20,00,000
24,00,000 26,00,000
Fixed cost
Given
10,00,000
10,00,000 10,00,000
Given
1%
2.5%
A*E
50,000
1,50,000
3,25,000
3,33,333
7,66,667
12,25,000
1,53,333
2,45,000
Bad debt in
Percentage
Amount of
bed debts
Cost of debt
Interest cost
of debtors
G*20%
66,667
Surplus
C-D-F-H
8,83,333
(B+D)*credit
Period 12
3 months
10,96,667 10,30,000
Conclusion: credit policy of 1 month is better.

Exercise
The board of directors of Aravind mills limited request you to prepare a statement
showing the working capital requirements for a level of activity of 30,000 units of output for
the year. The cost structure for the companys product for the above mentioned activity level
is given below.
Cost per Unit (Rs.)
174
Raw materials
20
Direct labour
Overheads
15
Total
40
Profit
10
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Selling price
50
(a) Past experience indicates that raw materials are held in stock, on an average for 2 months.
(b) Work in progress (100% complete in regard to materials and 50% for labour and
overheads) will be half a months production.
(c) Finished goods are in stock on an average for 1 month.
(d) Credit allowed to suppliers: 1 month.
(e) Credit allowed to debtors: 2 months.
(f) A minimum cash balance of Rs 25,000 is expected to be maintained.
Prepare a statement of working capital requirements.
Solution
Output per annum = 30,000 units
Output per annum = 12% of 30,000 =2,500 units
Raw materials p. m. Rs. 202500 =
50,000
Labour p. m. Rs. 52,500 =
12,500
Overheads p. m. Rs. 152,500 =
37,500
1,00,000
Statement of Working Capital Requirements

Particulars
Rs.
Rs.
Current assets
Stock of raw materials (2 months) 50,000 x 2
1,00,000
Work-in-progress (1/2 months)

Raw materials = 50,000 x
25,000
Labour = 12,500 x x 50/100
3,125
Overheads = 37,500 x x 50/100
9,375
Stock of finished goods (1 month) 1, 00,000 x 1
1,00,000
Debtors (2 month) 1,00,000 x 2
2,00,000
Cash balance required
25,000
Less: current liability
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37,500
4,62,500
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Creditors (1 month) 50,000 x 1
50,000
(Working capital required)
4,12,500
Exercise
Prepare an estimate of working capital requirement from the following information of a
trading concern.
Projected annual sales
10,000 units
Selling price
Rs. 10 per unit

Percentage of net profit on sales
20%
Average credit period allowed to customers
8 Weeks
Average credit period allowed by suppliers
4 Weeks
Average stock holding in terms of sales requirements
12 Weeks
Allow 10% for contingencies

Solution
Current Assets
Debtors (8 weeks)
Rs.
80, 000 8
52
12,307
80, 000 12
52
18,462
(at cost)
Stock (12 weeks)
30,770
Less: Current
Liability
Credits (4 weeks)
80, 000 4
52
6,154
24,616
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Add 10% for contingencies
2,462
Working Capital Required
27,078
Working Notes
Sales = 1000010 = Rs. 1,00,000 Profit 20% of Rs. 1,00,000 = Rs. 20,000
Cost of Sales=Rs.1,00,000 20,000 = Rs. 80,000
As it is a trading concern, cost of sales is assumed to be the purchases.
Exercise
Prepare an estimate of working capital requirement from the following informations of a
trading concern.
Projected annual sales
Rs. 6,50,000
Percentage of net profit on sales
25%
Average credit period allowed to debtors
10 Weeks
Average credit period allowed by creditors
4 Weeks
Average stock holding in terms of sales requirements
8 Weeks
Allow 20% for contingencies

Solution
Current Assets
Rs.
Debtors (10 weeks) (at cost)
Stock (8 weeks)
5, 20, 000 8
52
5, 20, 000 10
52
1,00,000
80,000
1,80,000
Less: Current Liability
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Credits ( 4 weeks)
5, 20, 000 4
52
40,000
1,40,000
Add 20% for contingencies
28,000
(Working Capital Required)
1,68,000
Working Notes
Sales=Rs. 6,50,000
Profit 25/125 of Rs. 6,50,000= Rs. 1,30,000
Cost of Sales=Rs. 6,50,000 1,30,000=Rs. 5,20,000
As it is a trading concern, cost of sales is assumed to be the purchases.
Exercise
A Performa cost sheet of a company provides the following particulars:
Elements of cost
Material
35%
Direct Labours
25%
Overheads
20%
Further particulars available are:

(i) It is proposed to maintain a level of activity of 2,50,000 units.
(ii) Selling price is Rs. 10/- per unit
(iii)
Raw materials are to remain in stores for an average period of one month.
(iv)Finished foods are required to be in stock for an average period of one month.
(v) Credit allowed to debtors is 3 months.
(vi)Credit allowed by suppliers is 2 months.

You are required to prepare a statement of working capital requirements, a forecast profit
and loss account and balance sheet of the company assuring that
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Share Capital
Rs.
12,00,000
10% Debentures
Rs.
3,00,000
Fixed Assets
Rs. 11,00,000
Solution
Statement of Working Capital
Particulars
Rs.
Rs.
Current Assets
Stock of Raw Materials (1 Month)
(5,00,000 x 35% x 1/12)
72,917
Work in process (1/2 months)

Materials (25,00,000 x 35% x 1/24)
36,458
Labour (25,00,000 x 25% x 1/24)
26,041
Overheads (25,00,000 x 20% x 1/24)
20,833
83,332
Stock of finished goods (one

month)
Materials (25,00,000 x 35% x 1/12)
72,917
Labour (25,00,000 x 25% x 1/12)
52,083
Overheads (25,00,000 x 20% x 1/12)
41,667
1,66,667
Debtors (2 months) At cost

Materials (25,00,000 x 35% x 3/12)
2,18,750
Labour (25,00,000 x 25% x 3/12)
1,56,250
Overheads (5,00,000 x 20% x 3/12)
1,25,000
Less: Current
5,00,000
8,22,916
liability
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Credits (2 Months) for raw materials

25,00,000 x 35% x 2/12
1,45,833
Net working capital required
6,77,083
Forecast Profit and Loss Account

Dr.
Cr.
To Materials
(25,00,000 x 35%)
By cost of goods sold
20,00,000
8,75,000
To Wages
(25,00,000 x 25%)
6,25,000
To Overheads
(25,00,000 x 20%)
5,00,000
20,00,000
To Cost of goods sold 20,00,000

To Gross profit
20,00,000
By Sales
25,00,000
5,00,000
25,00,000
25,00,000
To Interest on
debentures
30,000
To Net profit
4,70,000
By Gross profit
5,00,000
5,00,000
5,00,000
Forecast Balance Sheet

Liabilities
180
Rs.
Assets
Rs.
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Share capital
12,00,000
Fixed Assets
11,00,000
Net profit
4,70,000
Stock
10% debentures
3,00,000
Raw material
72,917
Credits
1,45,833
Work-in-process
38,458
Finished goods
1,66,667
Debtors
5,00,000
Cash and Bank Balance 2,37,791

21,15,833
21,15,833
Exercise
Selva and Co. desires to purchase a business and has consulted you and one point on
which you are to advise them is the average amount of working capital which will be required
in the first years working.
You have given the following estimates and instructed to add 10% to youre computed
figure to allow for contingencies.
(i)
(ii)
(iii)
Amount blocked up for stocks:
Figures for the year
Stocks of finished product
3,000
Stocks of stores, materials, etc.,
5,000
Average credit given:

Inland sales 4 weeks credit
26,000
1
Export sales- 1 weeks credit
2
65,000
Lag in payment of wages and other outputs

1
Wages- 1 weeks
2
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2,40,000
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Stocks of materials, etc.- 1
1
2
month
Rent, Royalties, etc.- 4 months
Clerical staff - 1
Manager - 1
1
2
1
2
8,000
month
60,000
month
4,000
Miscellaneous expenses - 1
(iv)
36,000
1
2
month
36,000
Payment in advance
(v)
Sundry Expenses (paid quarterly in advance)
6,000
Undrawn profit on the average throughout the year
9,000
State your calculations for the average amount of working capital required.
Solution
Particulars
Rs.
Current Assets
Stock of finished products
3,000
Stock of stores material, etc.
5,000
Sundry debtors
(a) Inland (4 weeks) 2,60,000 4/52
1
15
(b) Export Sales ( 1 weeks) 65,000
2
12
20,000
1,875
21,875
Payments in advance 6,000

182
1,500
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31,375
Less: Lag in payment of wages ( 1
1
weeks)
2
24,000
15
12
6,923
1
6
Stock,Materials etc.( 1 months)8000
2
12
4,500
01
12
4,000
Rent,Royalties, etc. (6 months) 8000
1
15
Clerical staff ( 1 month) 60,000
2
12
7,500
1
.5
Manager ( 1 month) 4000
2
12
167
1
Miscellaneous Expenses ( 1 months)36,000
2
1.5
12 1.5
4,500
27,590
Net Working Capital
3,785
Add: 10% Margin for Contingencies

Net working capital required
379
4,164
Exercise
A performa cost sheet of a company provides the following particulars:
183
Elements of Cost
Amt. Per Unit (Rs.)
Raw Materials
140
VS Publishers
Direct Labours
60
Overheads
70
Total Cost
270
Profit
30
Selling Price
300
Further particulars available are:

Raw materials are in stock on an average for one month. Materials are in process on
an average for half a month. Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month credit allowed to customers is two months.
Lag in payment of wages is 1 21 weeks. Lag in payment of overhead expenses is one month.
One fourth of the output is sold against cash. Cash in hand and at bank is expected to be Rs.
50,000.
You are required to prepare a statement showing the working capital needed to
finance, a level of activity of 2,40,000 units of production. You may assume that production is
carried on evenly throughout the year; wages and overhead accrue similarly and a time period
of 4 weeks is equivalent to a month.
Note: Year = 412 = 48 weeks
Solution
Particulars
Rs.
Rs.
Current Assets
(i) Stock of raw materials (4 weeks) 2,40,000
140
48
28,00,000
= 7,00,000 4
(ii) Work in process (2 weeks)
Raw materials 7,00,000 2
184
14,00,000
VS Publishers
60
, 3,00,000 2
48
Direct labour 2,40,000
Overheads 2,40,000
70
48
6,00,000
7,00,000
350000 2
27,00,000
(iii) Stock of finished goods (4 weeks)

Raw Materials 7,00,000 4
28,00,000
Direct Labour 30,000 4
1,20,000
Overheads 3,50,000 4
14,00,000
54,00,000
(iv) Sundry Debtors (8 weeks)
Raw Materials 7,00,000 8
Direct Labour 3,00,000 8
Overheads 3,50,000 8
3
4
3
4
3
4
42,00,000
18,00,000
21,00,000
Cash in hand and at Bank
81,00,000
50,000
1,90,50,000
() Current Liabilities
(i)
(ii)
Sundry creditors (4 weeks) 7,00,000 4
Wages Outstanding ( 1
1
3
Weeks) 3,00,000
2
2
(iii) Lag in payment of overhead(4 weeks)3,50,000 4
185
28,00,000
4,50,000
14,00,000
46,50,000
VS Publishers
Net Working Capital required
1,44,00,000
Exercise
Mr. Siva wishes to commerce a new trading business and gives the following informations.
(i) The total estimated sales in a year will be Rs. 20, 00,000.
(ii) His expenses are estimated fixed Expenses of Rs. 3,000 per month plus variable expenses
equal to 10% of his turnover.
(iii)
He expects to fix a sales price for each product which will be 33 13% in excess of his
cost of purchase.
(iv)He expects to turnover his stock six times in a year.

(v) The sales and purchases will be evenly spread throughout the year. All sales will be for
cash but he expects one months credit for purchases.
Calculate
(i) His estimated profit for the year.
(ii) His average working capital requirements.
Solution
(i) Estimated profit of Mr. Siva for the year
Sales
20,00,000
() Gross Profit ( 20,00,000 33
1
1
, 133
3
3
Cost of goods sold
5,00,000
15,00,000
Gross Profit
5,00,000
() Expenses
Fixed (3,00012)
36,000
Variable 20,00,00010/100
2,00,000
2,36,000
Net Profit
Particulars
186
2,64,000
Rs.
VS Publishers
Current Assets
Stock
Turnover of stock is 6 times
Cost of goods sold
Stock turnover =
Average stock at cost
15,00,000
6=
Average stock at cost
6 Average stock at cost = 15,00,000

15, 00, 000
2,50, 000
Average stock at cost =
6
Cost
To meet fixed expenses = 3,000
To meet variable expenses
10 1
20, 00, 000
16, 667
100 12
Debtors
(as all sales are for cash only)
Less: Current Liabilities :
Creditors (1 months)
1
15, 00, 000
12
Working capital required
2,50,000
19, 667
-2,69,667
1, 25, 000
1,44,667
Exercise
From the informations given below, you are required to prepare a projected balance
sheet, profit and loss account and then an estimate of working capital requirements.
(a) Issued share capital
5,00,000
6% debentures
2,50,000
Fixed Assets at cost
2,50,000
(b) The expected ratios to selling price are
(c)
(d)
187
Raw materials
45%
Labour
20%
Overheads
15%
Profit
20%
Raw materials are kept in store for an average of 1
1
2
Months.
Finished goods remain in stock for an average period of 2 months.

VS Publishers
(e)
Production during the previous year was 2, 40,000 units and it is planned to maintain
the rate in the current year also.
(f)
Each unit of production is expected to lag in process for half a month.
(g)
Credit allowed to customers is two months and given by suppliers is one month.
(h)
Selling price is Rs. 6 per unit.
(i)
There is a regular production and sales cycle.
(j)
Calculation of debtors may be made at selling price.
Solution
Rs.
(i)
Calculation of sales
Total Sales =
2, 40,000614,40,000
(ii)
Calculation of Amount blocked in inventories.
(a)
Stock of Raw Material

1, 44, 000
(b)
81,000
Stock of finished goods at cost (Material + Labour + Overheads)

1, 44, 000.
(c)
45 1.5
100 12
80 2
.
100 12
1,92,000
Work-in progress at cost

(Material + Labour + Overheads)
(at selling price, as given)
144000
80 5
.
100 12
48,000
(iii) Calculation of Amount locked up in Debtors

Total sales 14,40,000
Debors = 14,40,000
2
12
2,40,000
(iv) Calculations of creditors (For Raw Materials)

Total Purchases = 14, 40, 000
Creditors = 6, 48, 000
1
12
45
100
6,48,000
54,000
Projected balance sheet

188
VS Publishers
Liability
Rs.
Assets
Rs.
Rs.
Share Capital
5,00,000
Fixed Assets (at

cost)
6% Debentures
2,50,000
Current Assets
Profit and Loss

A/c
2,73,000
Stock
81,000
Work in Process
48,000
Finished Goods
1,92,000
Debtors
2,40,000
Creditors
54,000
2,50,000
5,61,000
Cash and Bank (Balance for)
2,66
,000
10,77,00
0
10,77,00
0
Exercise
V.S.M. Ltd. is engaged in large scale retail business. From the following informations
you are required to forecast their working capital requirements. Projected Annual Sales Rs.
130 lakhs Percentage of net profit on cost of sales 25% Average credit period allowed to
debtors 8 weeks. Average credit period allowed by creditors 4 weeks. Average stock carrying
8 weeks (in terms of sales requirements). Add: 10% to computed figures to allow for
contingencies.
Solution
Sales
1,30,00,000
Gross profit 25% of sales
32,50,000
Cost of goods sold
97,50,000
Statement showing working capital
Particulars
Rs.
Current Assets
(i)
(ii)
189
Debtors (97,50,000
8
)
52
15,00,000
15,00,000
VS Publishers
Stock ( 97,50, 000
8
)
52
Total current assets
30,00,000
() Current Liabilities
Creditors (97,50,000
4
52
7,50,000
22,50,000
Net working capital
2,25,000
Add: Contingencies 10%
24,75,000
Net working Capital Required

Net working capital
Add:
10%
22,50,000
Contingencies
2,25,000
Net Working Capital Required
24,75,000
Exercise
Prepare an estimate of working capital requirements.
(i)
Projected annual sales80,000 units.
(ii)
Selling price Rs. 8 per unit.
(iii) Percentage of profit 20%.

(iv) Credit allowed to debtors10 weeks.
(v)
Credit allowed to suppliers8 weeks.
(vi) Average stock holding (in terms of sales)10 weeks.

(vii) Allow 20% for contingencies.
Solution
Sales
Less
: Current Liabilities 80,000 Units
Selling Price
Rs. 88
Creditors (5,12,000 )
Total sales in
Rs.52
6,40,000
Sales New working Capital
Rs. 6,40,000
Profit
20% of sales20% 1,28,000
Add:
Contingencies
Cost of
Sold Capital
5,12,000
NetGoods
Working
Required
78,769
1,18,155
23,631
1,41,786

Particulars
190
Rs.
i. Debtors (5,12,000
ii. Stock (5,12,000
10
)
52
10
)
52
Total Current Assets
98,462
98,462
1,96,924
VS Publishers
Cash Management
Exercise
A Company expects to have Rs. 37500 cash in hand on 1st April, and requires you to
prepare an estimate of cash position during the three months.
April, May and June the following information is supplied to you:
Month
Sales
Purchases
Wages
Factory
Office
Selling
Rs.
Rs.
Rs.
Expenses
Expenses
Expenses
Rs.
Rs.
Rs.
Feb
75,000
45,000
9,000
7,500
6,000
4,500
March
84,000
48,000
9,750
8,250
6,000
4,500
April
90,000
52,500
10,500
9,000
6,000
5,250
May
1,20,000
60,000
13,500
11,250
6,000
6,570
June
1,35,000
60,000
14,250
14,000
7,000
7,000
Other Information:
(i) Period of credit allowed suppliers 2 months.
(ii) 20% of sales for cash and period of credit allowed to customers for credit is one month.
(iii)
Delay in payment of all expenses: 1 month.
(iv)Income tax of Rs. 57,500 is due to be paid on June 15th.

(v) The company is to pay dividend to shareholders and bonus to workers of Rs. 15,000 and
Rs. 22,500 respectively in the month of April.
(vi)A plant has been ordered to be received and paid in May. It will cost Rs. 1,20,000.
Cash Budgets of April, May, June
191
Particulars
April
May
Opening Balance b/d
37,500
10,950
Sales (i) Cash 20%
18,000
24,000
June
27,000
VS Publishers
(ii) Credit sales
67,200
72,000
96,000
1,22,700
1,06,950
1,23,000
Purchase
45,000
48,000
52,500
Wages
10,500
13,500
14,250
Factory Expenses
8,250
9,000
11,250
Office Expenses
6,000
6,000
6,000
Selling Expenses
4,500
5,250
6,570
Income Tax
57,500
Dividend to Shareholders
15,000
Bonus to workers
22,500
Plant Cost
1,20,000
Total Payments (B)
1,11,750
2,01,750
1,48,070
Balance c/d (A-B)
10,950
()94,800
()25,070
Bank Overdraft
(+)94,800
(+)25,070
(One month)
Total Receipts (A)
Payments :
Assumed that the company has arranged overdraft facility.

Receivable Management
Exercise
192
VS Publishers
A Companys collection period pattern is as follows:
10% of sales in the same month
20% of sales in the second month
40% of sales in the third month
30% of sales in the fourth month
The sales of the company for the first three quarters of the year are as follows:
Month
Quarter I
Quarter II
Quarter III
First
15,000
7,00
22,500
Second
15,000
15,000
15,000
Third
15,000
22,500
7,500
45,000
45,000
45,000
Working Days
90
90
90
You are required to calculate the average age of receivables and comment upon the results.
Solution
The collection period of the companys policy indicates that the outstanding
receivables at the end of each month will consist of 90% of the months sales, 70% of the
previous months sales and 30% of the sales made two months earlier.
Statement of Accounts receivable and their age.
Sales
I Quarter
II Quarter
III Quarter
30% 1st Month
4,500
2,250
6,750
70% 2nd Month
10,500
10,500
10,500
90% 3rd Month
13,500
20,250
6,700
28,500
33,000
24,000
Accounts receivable (Debtors)

Average of receivable is =
193
No. of working days

VS Publishers
Sales
28,500
=
=
33,000
45,000 90 45,000
57 Days
66 Days
24,000
90
45,000 90
48 Days
The average age of receivable is affected because of sales is fluctuation.
194
VS Publishers

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FINANCIAL MANAGEMENT / UNIT-4

INTRODUCTION TO WORKING CAPITAL

4. Introduction to working capital: Concepts and characteristics of working capital,

Meaning of working capital.................................................................116

Concepts of Working Capital...............................................................117

Classification of Working Capital........................................................118

Types of Working Capital.....................................................................119

Needs of Working Capital....................................................................120

Working Capital Position/ Balanced Working Capital Position...........121

Factors determining working capital requirements..............................121

Computation or estimation of working capital.....................................122

4.1.10. Working capital management policy....................................................124

FINANCIAL MANAGEMENT / UNIT-4

4.1.16. EXCESSIVE AND INADEQUATE WORKING CAPITAL..............133

Meaning and definition of cash............................................................146

The Concept of Cash Management......................................................146

Motives for Holding Cash....................................................................147

Cash Management Techniques.............................................................147

Objectives of cash management...........................................................147

Cash Management Models...................................................................149

Significance of Cash Management.......................................................149

Objectives of cash management...........................................................150

Principles of Cash Management...........................................................151

4.3.10. Cash Management Models...................................................................152

Meaning and Definition of Inventory..................................................158

Meaning of Inventory management.....................................................159

Motives of Inventory Management......................................................159

Techniques of Inventory Management.................................................160

BENEFITS OR ADVANTAGES OF HOLDING

DISADVANTAGES OF HOLDING INVENTORY...........................166

4.5. Introduction to Receivables ...........................................................................168

Factors Considering the Receivable Size.............................................169

Significance and Purpose of Receivable Management........................170

FINANCIAL MANAGEMENT / UNIT-4

4.1. INTRODUCTION TO WORKING CAPITAL

Capital of the Business

FINANCIAL MANAGEMENT / UNIT-4

1. Gross Working Capital

2. Net Working Capital

FINANCIAL MANAGEMENT / UNIT-4

FINANCIAL MANAGEMENT / UNIT-4

Types of Working Capital

FINANCIAL MANAGEMENT / UNIT-4

Seasonal Working Capital:

Special Working Capital:

FINANCIAL MANAGEMENT / UNIT-4

Semi Variable Working Capital

Time semi variable working capital

It creates bad debts, reduces collection periods, etc.

(iv)It leads to reduce the profits.

FINANCIAL MANAGEMENT / UNIT-4

B. Causes and effects of inadequate working capital

It becomes impossible to utilize efficiently the fixed assets.

FINANCIAL MANAGEMENT / UNIT-4

A. Estimation of components of working capital method

FINANCIAL MANAGEMENT / UNIT-4

Average Stock of Raw Material

Average Work in Process Inventory

Average Finished Stock Inventory

Average Book Debts

Average Trade Creditors

4.1.10. WORKING CAPITAL MANAGEMENT POLICY

FINANCIAL MANAGEMENT / UNIT-4