Module III

Working capital structure

Working capital management- meaning and components- management of

cash – inventory- marketable securities and receivables

Prepared by MRS. REKHA VENUGOPAL

Working capital management is the process of planning and controlling the level and mix
capital management requires financial managers to decide what quantities of cash, other
liquid assets, account receivables and inventories the firm will hold at any point of time.
In addition financial managers must decide how their current assets are to be financed.
Financing choices include the mix of current as well as long term liabilities.

The high degree of divisibility has two important implications for the management of
working capital. First if the management so chooses working capital can be acquired
piecemeal to meet immediate needs as they arise. The second implication of divisibility,
which follows logically from the first, concerns the appropriate methods for financing
working capital investments.

Importance of working capital management

The management of working capital plays an important role in maintaining the financial
health of the firm during the normal course. The critical role can be portrayed in the
following figure

Used in

Used in Accrued direct labour and

Production process materials
Accrued fixed
Used to purchase interest
Generates working capital cycle

Used to purchase
Cash and marketable
Inventories securities
Via sales generates External financing used to purchase
Collection
process
Return to Fixed asset
capital
Accounts receivable
Suppliers of capital
 The above figure which loosely portrays the flow of resources through the firm. By far
the major flow , in terms of its yearly magnitude is the working capital cycle. This is the
loop which starts at the cash and marketable securities account, goes through the current
accruals accounts as direct labour and materials are purchased and used to produce
inventory which is turn sold and generates accounts receivable which are finally collected
to replenish cash. The major point to notice about this cycle is that the turnover of
resources through this loop is very high relative to the other inflows and outflows of the
cash account.``

According to Genestenberg “ circulating capital means current assets of a company that

are changed in the ordinary course of business from one form to another.”

Concepts of working capital

There are two concepts of working capital viz Gross working capital and net working
capital. In broad terms working capital refers to the gross working capital and represent
the amount of fund invested in working capital . current assets are those assets which in
ordinary course of business can be converted into cash with in a short period of time.
Net working capital on the other hand refers to “net working capital is the excess of
current asset over current liability.
Net working capital = current assets – current liability.
The gross working capital concept is financial or going concern concept while
networking capital is an accounting concept of working capital.
The gross concept is sometimes preferred to the net concept of working capital due to the
following reasons.
1. It enables the enterprise to provide correct amount of working capital at the right
time.
2. Every management is more interested in the total current assets with which it has to
operate than the sources from where it is made available.
3. The gross working capital concept takes into consideration the fact that every increase
in the funds of the enterprise would increase its working capital.
4. The gross concept of working capital is more useful in determining the rate of return
on investments its working capital.
The networking capital however is also important for the following reasons.
1. It is qualitative concept, which indicates the firm’s ability to meet its operating
expenses and short-term liabilities.
2. It indicates the margin of protection available to the short term creditors.
3. It is an indicator of the financial soundness of the enterprise.
4. It suggests the need for financing a part of the working capital requirements out of
permanent sources of funds.
To conclude it may said that both gross and net working capital are important aspects of
the working capital management.

Classification of working capital

Working capital may be classified in two ways.
On the basis of concept and on the basis of time.
On the basis of concept working capital is classified as gross working capital and
networking capital. On the basis of time working capital may be classified as permanent
working capital and temporary working capital.
The following figure shows the classification of working capital
 Kinds of working capital

On the basis of concept on the basis of time.

Gross working capital Net working capital permanent working capital

Variable
Reserve capital Working
Regular working capital capital

Seasonal capital

Special
Capital

1. Permanent working capital

Permanent or fixed working capital is the minimum amount, which is required to ensure
effective utilisation of fixed facilities and for maintaining the circulation of current assets.
There is always a minimum level of current assets, which is continuously required by the
enterprise to carry out its normal business operations. This minimum level is called
permanent or fixed working capital ie blocked in current assets. As the business grows the
requirements of working capital also increases due to the increase in current assets. The
permanent working capital can further be classified as regular working capital and reserve
working capital required to ensure circulation of current assets from cash to inventories from
inventories to receivables and from receivables to cash so on. Reserve working capital is the
excess amount over the requirements for regular working capital which may be provided for
contingencies that may arise at unstated periods such as strikes, rise in prices etc.
2. Temporary working capital
Temporary working capital is the amount of working capital which is required to meet the
seasonal demands and some special exigencies. Variable working capital can be further
classified as seasonal working capital and special working capital. most of the enterprises
have to provide additional working capital to meet the seasonal and special needs. The capital
required to meet the seasonal needs of the enterprise is called seasonal working capital.
special working capital is that part of working capital which is required to meet special
exigencies such as launching of extensive marketing campaigns for conducting research etc.
Temporary working capital differs from permanent working capital in the sense that it is
required for short periods and cannot be permanently employed gainfully in the business. The
following figure will illustrate the difference between permanent working capital and
temporary working capital.
Amount
Amount temporary working
capityal
of temporary working capital of working
working
capital
capital

Permanent working capital permanent

Working capital

Time Time

Here permanent working capital is stable or fixed over time while the temporary or
variable working capital fluctuates. In fig 2 permanent working capital is also increasing
with the passage of time due to expansion of business but even then it does not fluctuate as
variable working capital which sometimes increases and sometimes increases and
sometimes decreases.
Advantages of working capital
Working capital is the lifeblood of business. Just as circulation of blood is essential in the
human body for maintaining life working capital is very essential to maintain the smooth
running of a business. No business can run successfully without an adequate amount of
working capital. The main advantages of maintaining adequate amount of working capital
are as follows.
1. Solvency of the business: Adequate working capital helps in maintaining solvency of the
business by providing uninterrupted flow of production.
2. Goodwill: sufficient working capital enables a business concern to make prompt
payments and hence helps in creating and maintaining goodwill.
3. Cash discounts: Adequate working capital also enables a concern to avail cash discounts
on the purchases and hence it reduces cost.
4. Easy loans: A concern having adequate working capital high solvency and good credit
standing can arrange loans from banks and others on easy and favourable terms.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw
materials and continuous production
6. Regular payment of salaries, wages and other day to day commitments: A company
which has ample working capital can make regular payment of salaries, wages and other
day to day commitment which arises the morale of its employees, increases their
efficiency , reduces wastages and costs and enhances production and profits.
7. Exploitation of favourable market conditions: Only concerns with adequate working
capital can exploit favourable market conditions such as purchasing its requirements in
bulk when the prices are lower and by holding its inventories for higher prices.
8. Ability to face crisis: adequate working capitol enables a concern to face business crisis
in emergencies such as depression because during such periods generally there is much
pressure on working capital.
9. Quick and regular return on investment: Every investor wants a quick and regular return
on his investments. Sufficiently of working capital enables a concern to pay quick and
regular dividends to its investors, as there may not be much pressure to plough back
profits. This gains the confidence of its investors and creates a favourable market to
raise additional funds in the future.
10. High morale: Adequacy of working capital creates an environment of security,
confidence, high morale and creates overall efficiency in a business

Factors determining working capital

Working capital requirement of a concern depend upon a large number of factors such as
nature and size of business, the length of the production cycle etc. It is not possible to rank
them because all such factors are of different importance and the influence of individual
factors changes for a firm over time. However the following are important factors generally
influencing the working capital requirements.
1. Nature or character of business: The working capital requirements of a firm basically
depend upon the nature of its business. Public utility undertaking like electricity, water
supply, railways etc need very limited working capital because they offer cash sales only
and supply services not products and as such no funds are tied up in inventories and
receivables. On the other hand trading and financial services require less investment in
fixed asset but have to invest large amounts in current asset like inventories, receivables
and cash as such they need large amount of working capital. The manufacturing
undertakings also require sizeable working capital along with fixed investment.
Generally speaking it may be said that public utility undertaking require small amount
of working capital trading and financial firms require sizeable working capital between
these two extremes.
2. Size of business or scale of operation: The working capital requirements of a concern
are directly influenced by the size of its business which may be measured in terms of
scale of operations. Greater the size of a business unit generally larger will be the
requirements of working capital. However in some cases even a smaller concern may
need more working capital due to high overhead charges, inefficient use of available
resources and other economic disadvantages of small size.
3. Production policy: In certain industries the demand is subject to wide fluctuations due to
seasonal variation. The requirements of working capital in such cases depend upon the
production policy. The production could be kept either steady by accumulating
inventories during slack period with a view to meet high demand during the peak season
or the production could be curtailed during the slack season and increased during the
peak season. If the policy is to keep production steady by accumulating inventories it
will require higher working capital.
4. Manufacturing process/length of production cycle: In manufacturing business the
requirements of working capital increase in direct proportion to length of manufacturing
process. Longer the process period of manufacture larger is the amount of working
capital required. The longer the manufacturing time the raw materials and other
suppliers have to be carried for a longer period in the process with progressive
increment of labour and service costs before the finished product is finally obtained.
Therefore if there are alternative processes of production the process with the shortest
production period should be chosen.
5. Seasonal variations: In certain industries raw materials is not available throughout the
year. They have to buy raw materials in bulk during the season to ensure an
uninterrupted flow and process them during the year. A huge amount is thus blocked in
the form of material inventories during such season which gives rise to more working
capital requirements. Generally during the busy season a firm requires larger working
capital than in the slack season.
6. Working capital cycle: In a manufacturing concern the working capital cycle starts with
the purchase of raw material and ends with the realisation of cash from the sale of
finished products. This cycle involves purchase of raw material and stores its conversion
into stocks of finished goods through work- in progress with progressive increment of
labour and service costs, conversion of finished stock into sales, debtors and receivables
and ultimately realisation of cash and this cycle continues again from cash to purchase
of raw materials and so on.
7. Rate of stock turn over: There is high degree of inverse co relationship between the
quantum of working capital and the velocity or speed with which then sales are effected.
A firm having a high rate of stock turnover will need lower amount of working capital
as compared to a firm having a low rate of turnover.
8. Credit policy: The credit policy of a concern in its dealings with debtors and creditors
influence considerably the requirements of working capital. A concern that purchases its
requirements on credit and sells its products or services on cash requires lesser amount
of working capital. On the other hand a concern buying its requirements for cash and
allowing credit to its customers shall need larger amount of working capital as very huge
amount of funds are bound to be tied up in debtors or bills receivables.
9. Business cycle: Business cycle refers to alternate expansion and contraction in general
business activity. In a period of boom ie when the business is prosperous there is need
for large amount of working capital due to increase in sales, rise in prices, optimistic
expansion of business etc. on the contrary in the times of depression ie when there is a
down swing of the cycle the business contracts, sales decline, difficulties are faced in
collections from debtors etc may have large amount of working capital lying idle.
10. Rate of growth of business: The working capital requirements of a concern increase
with the growth and expansion of its business activities. Although it is difficult to
determine the relationship between the growth in the volume of business and the growth
in the working capital of a business yet it may be concluded that for normal rate of
expansion in the volume of business we may have retained profits to provide for more
working capital but in fast growing concerns we shall require larger amount of working
capital.
11. Earnings capacity and Dividend policy: some firms have more earnings capacity than
others due to quality of their products monopoly conditions, etc. such firms with high
earnings capacity may generate cash profits from operations and contribute to their
working capital. The dividends policy of a concern also influences the requirements of
its working capital. A firm that maintains a steady high rate of cash dividend
irrespective of its generation of profits needs more working capital than the firm that
retains larger part of its profits and does not pay so high rate of cash dividend.
12. Price level changes: Changes in the price level also affect the working capital
requirements. Generally the rising prices will require the firm to maintain larger amount
of working capital as more funds will be required to maintain the same current assets.
The effect of rising prices may be different for different firms. Some firms may be
affected much while some others may not be affected at all by the rise in prices.
13. Other factors: Certain other factors such as operating efficiency, management ability,
irregularities of supply, import policy, assets structure, importance of labour, banking
facilities etc also influence the requirements of working capital.

Principles of working capital management

The followings are the general principles of a sound working capital management policy:

Principles of working capital management

Principle Principle principles Principle

Of risk of cost of of equity maturity
Variation capital position of payment
1. Principle of risk variation
Risk refers to the inability of a firm to meet its obligations as and when they become due
for payment. Larger investment in current assets with less dependence on short term
borrowings increases liquidity reduces dependence short term borrowings increases
liquidity reduces risk and thereby decreases the opportunity for gain or loss. On the
other hand less investment in current assets with greater dependence on short term
borrowings increases risk , reduces liquidity and increases profitability. In other words,
there is a definite inverse relationship between the degree of risk and profitability. A
conservative management prefers to minimise risk by maintaining a higher level of
current assets or working capital while liberal management assumes greater risk by
reducing working capital. However the goal of the management should be to establish a
suitable trade off between profitability and risk.

Cost
Of
Assets conservative
Policy
Moderate
Policy aggressive policy

Sales

Various working capital policies

2. Principle of Cost of capital
The various sources of rising working capital finance have different cost of capital and
the degree of risk involved. Generally higher the risk lower is the cost and lower the risk
higher is the cost. A sound working capital management should always try to achiever a
proper balance between these two.

3. Principle of Equity position

This principle is concerned with planning the total investment in current assets. According
to this principle the amount of working capital invested in each component should be
adequately justified by a firm’s equity positions. Every rupee invested in the current assets
should contribute to the net worth of the firm. The level of current assets may be measured
with the help of two ratios.1. current assets as a percentage of total asset and 2. current
assets as a percentage of total sales. While deciding about the composition of current assets
the financial manager may consider the relevant industrial averages.
4. Principles pf Maturity of payment
This principle is concerned with planning the sources of finance for working capital.
according to this principle a firm should make every effort to relate maturities of payment
to its flow of internally generated funds. Maturity pattern of various currency obligations is
an important factor in risk assumptions and risk assessments. Generally shorter the
maturity schedule of current liabilities in relation to expected cash inflows the greater the
inability to meet its obligations in time.
 To sum up working capital management should be considered as an integral part of
overall corporate management. in order to plan, measure, control the working capital
requirements the financial manager has to perform the following functions
1. Estimating the working capital requirements
2. Financing of working capital needs.
3. Analysis of and control of working capital.

Determining the working capital finance

There are three basic approaches for determining an appropriate working capital financing
mix

Approaches to financing mix

The Hedging or matching The conservatism Aggressive Approach

Approach Approach

1. The Hedging Approach

The term’ hedging’ usually refers to two off selling transactions of a simultaneous
but opposite nature, which counterbalance the effect of each other. With reference to financing
mix the term hedging refers to ‘a process of matching maturities of debt with the maturities of
financial needs’. According to this approach the maturity of sources of funds should match the
nature of assets to be financed. This approach is therefore also known as ‘ matching approach.
This approach classifies the requirements of total working capital into two categories
1. Permanent or fixed working capital, which is the minimum amount, required to carry out the
normal business operations. It does not vary over time.
2. Temporary or seasonal working capital, which is required to meet special exigencies. It
fluctuates over time.
The hedging approach suggests that the permanent working capital requirements should be
financed with funds from long term sources while the temporary or seasonal working capital
requirements should be financed with short-term funds.

2. The conservative Approach

This approach suggests that the entire estimated investment in current assets should be financed
from the long term sources and the short term sources should be used only for emergency
requirements. The distinct features of this approach are
1. Liquidity is severally greater
2. Risk is minimised
3. The cost of financing is relatively more as interest has to be paid even on seasonal
requirements for the entire period.
Trade off between the Hedging and Conservatism
The hedging approach implies low cost, high profit and high risk while conservatism approach
leads to high cost, low profits, and low risk. Both the approaches are the two extremes and neither
of them serves the purpose of efficient working capital management. A trade off between the two
will then be an acceptable approach. The level of trade off may differ form case to case depending
upon the perception of risk by the persons involved in financial decision-making. However on
way of determining the trade off is by finding the average of maximum and minimum
requirements of current assets or working capital. the average requirements so calculated may be
financed out of long term funds and the excess over the average from the short term funds.
4. The aggressive Approach
 The aggressive approach suggests that the entire estimated requirements of currents assets
should be financed from short term sources even a part of fixed assets investments be
financed form short term sources. This approach makes the finance mix more risky less
costly and more profitable.

New trends in financing working capital by banks

1. Dehejia committee
2. Tandon
3. Chore committee
4. Marathe committee
5. Chakravarty committee
ASSIGNMENT
CASH MANAGEMENT

Management of cash

Cash is one of the current assets of a business. It is needed at all times to keep the
business go on. A business concern should always keep sufficient cash for meeting its obligation.
Any shortage of cash will hamper the operations of a concern and any excess of it will be
unproductive. Cash is the most unproductive of all the assets. While fixed assets like machinery
etc and current assets such as inventory will help the business in increasing its earning capacity
Nature of cash
For some persons, cash means only money in the form of currency. For other person cash means
both cash in hand and cash at bank. Some even include near cash assets in it even they take
marketable securities too as part of cash. Cash itself does not produce goods or services. It is used
as a medium to acquire other assets the other assets which are used in manufacturing goods or
providing services. The idle cash can be deposited in bank to earn interest.
A business has to keep required cash for meeting various needs. The assets acquired by cash help
the business in producing cash. The goods manufactured or services produced are sold to acquire.
A firm will have to maintain a critical level of cash. If at a time it does not have sufficient cash
which will have to borrow from the market for reaching the required level. There remains a gap
between cash inflow and cash out flows. Some times cash receipts are the payments or it may be
vice versa at another time. A financial manager tries to synchronize the cash inflows and cash
outflows but perfect synchronization of receipts and payments of cash is only an ideal situation.

Motives for holding cash

The firm’s needs for cash may be attributed to the following needs: transactions motive,
precautionary motive and speculative motive. Some people are of the view that a business requires
cash only for the first two motives while others feel that speculative motive also remains.
1. Transaction motives.
A firm needs cash for making transactions in the day to day operations. The cash is
needed to make purchases, pay expenses, taxes, dividend etc. the cash needs arise due to the fact
that there is no complete synchronization between cash receipts and payments. Some times cash
receipts exceed cash payments or vice versa. The transactions needs of cash can be anticipated
because the expected payments in near future can be estimated. The receipts in future may also be
anticipated but the things do not happen as desired. If more cash is needed for payments than
receipts it may be raised through bank over draft. On the other hand if there are more cash receipts
than payments it may be spent on marketable securities. The maturity of securities may be
adjusted to the payments in future such as interest payments, dividend payment etc.
 2. Precautionary Motive
A firm is required to keep cash for meeting various contingencies. Though cash inflows and cash
outflows are anticipated but there may be variations in these estimates. For example a debtor who
was to pay after 7 days may inform of his inability to pay; on the other hand a supplier who used
to give credit for 15 days may not have the stock to supply or he may not be in a position to give
credit at present. In these situations cash receipts will be less than expected and cash payments
will be more as purchases may have to be made for cash instead of credit. Such contingencies or it
should be in a position to raise finances at a shorter period. The cash maintained for contingencies
needs is not productive or it remains ideal. However such cash may be invested in short period or
low risk marketable securities which may provide cash as and when necessary.

3. Speculative Motive
The speculative motive relates to holding of cash for investing in profitable opportunities as and
when it arises. Such opportunities cannot be scientifically predicted. But only conjectures can be
made about their occurrences. For example the price of shares and securities may be low at a time
with an expectation that these will go up shortly. The prices of raw materials may fall temporarily
and a firm may like to make purchases at these prices. Such opportunities can be availed if a firm
has cash balance with it. These transactions are speculative because prices may not move in the
direction in which we suppose them to move. The primary motive of a firm is not to indulge in
speculative transactions but such investments may be made at times.

Managing cash flows

After estimating the cash flows efforts should be made to adhere to the estimates of receipts and
payment of cash. Cash management will be successful only if cash collections are accelerated and
can make disbursements, as far as possible are delayed. The following methods of cash
management will help.
Methods of Accelerating cash flows
1. Prompt payment by customers

In order to accelerate cash inflows the collection from customers should be prompt. This will be
possible by prompt billing. The customers should be promptly informed about the amount payable
and the time by which it should be paid. It will be better itself addressed envelope is sent along
with the bill and quick reply is requested. Another method for prompting customer to pay earlier is
to allow them a cash discount. The availability of discounts is good saving for the customer and in
an anxiety to earn it they make quick payments.
2. Quick conversion of payment into cash
Cash inflows can be accelerated by improving the cash collecting process. Once the customer
writes a cheque in favour of the concern the collection can be quickened by its early collection.
There is time gap between the cheque sent by the customer and the amount collected against it.
This is due to many factors 1. mailing time ie time taken by post office for transferring cheque
form customer to the firm referred to as postal float.2. time taken in processing the cheque within
the organisation and sending it to bank for collection it called lethargy and 3. collection time
within the bank ie time taken by the bank in collecting the payment from the customer’ s bank
called bank float. The postal float, lethargy and bank float are collectively referred to as deposit
float. The term deposit float refers to the cheques written by the customers but the amount not yet
usable by the firm. An efficient cash management will be possible only if the time taken in deposit
float is reduced and make the money available for use. This can be done by decentralising
collections.
3. Decentralised collections:
A big firm operating over wide geographical area can accelerate collections by using the
systems of decentralised collections. A number of collecting centres are opened at different
areas instead of collecting receipts at one place. The idea of opening different collecting
centers is to reduce the mailing time from customer’s despatch of cheque and its receipt in the
firm and then reducing the party may have issued the cheque on a local bank, it will not take
 much time in collecting it. The amount so collected will be sent in the central office at the
earliest. Decentralised collection system saves mailing and processing time and thus reduces
the financial requirements.
4. Lock Box System
Lock box system is another technique of reducing mailing, processing and collecting time.
Under this system the firm selects some collecting centres at different centres at different
places. The places are selected on the basis of number of consumers and the remittances to be
received from a particular place. The local bank is authorised to operate the post box. The
bank will collect the post a number of times in a week and start the collection process of
cheques. The amount so collected is credited to the firm’s account. The bank will prepare a
detailed account of cheques received which will be used by the firm for processing purpose.
This system of collecting cheque expedites the collection process and avoids delays due to
mailing and processing time at the accounting department. By transferring clerical function to
the bank the firm may reduce its costs, improve internal control and reduce the possibility of
fraud.

Methods of slowing cash outflows

A company can keep cash by effectively controlling disbursements. The objective of controlling
cash outflows is to slow down the payments as far as possible. Following methods can be used to
delay disbursements:
1. Paying on Last Date: The disbursements can be delayed on making payments on the last due
date only. If the credit is for 10 days then payment should be made on 10th day only. It can help
in using the money in short periods and the firm can make use of cash discount also.
2. Payments through Drafts: A company can delay payments by issuing drafts to the suppliers
instead of paying cheques. When a cheque is issued then the company will have to keep a
balance in its account so the cheque is paid whenever it comes. On the other hand a draft is
payable only on presentation to the buyer. The receiver will give the draft to its bank for
presenting it to the buyer’s bank. It takes a number of days before it is actually paid. The
companies can economies large resources by using this method. The fund so saved can be
invested in highly liquid low risk securities.
3. Adjusting payroll funds: Some economy can be exercised on pay roll funds also. It can be
done by reducing the frequency of payments. If the payments are made weekly then this period
can be extended to next month. Secondly finance manager can plan the issuing of salary cheques
and their disbursements. If the cheques are issued on Saturday then only a few cheques may be
presented for payment, even on Monday all cheques may not be presented. on the basis of his past
experience finance manager can deposit the money in bank because it may be clear to him about
the average time taken by employees in encashing their pay cheques.
4. Centralization of payments: The payments should be centralized and payments should be
made through drafts or cheques. When cheques are issued from the main office then it will take
time for the cheques to be cleared through post. The benefit of cheque collecting time is availed.
5. Inter bank transfer: An efficient use of cash is also possible by inter bank transfers. If the
company has accounts with more than one bank then amounts can be transferred to the bank
where disbursements are to be made. It will help in avoiding excess amount in one bank.
6. Making use of float: Float is a difference between the balance shown in company’s cash book
and balance in pass book of the bank. Whenever a cheque is issued the balance at bank in cash
book is reduced. The party to whom the cheque is issued may not present it for a payment
immediately. If the party is at some other station then cheque will come through post and it may
take a number of days before it is presented. Until the time the cheques are not presented to bank
for payment there will be a balance in the bank. The company can make use of this float if it is
able to estimates it correctly.

Cash Management Models

A number of mathematical models have also been developed to determine the optimal cash balance
such as
a. Operating Cycle Model
 b. Inventory Model
c. Stochastic Model and
d. Probability Model.
However the inventory model as developed by William J Baumol and the Stochastic Model of
MH Miller and Daniel Orr are mainly used to determine the optimum balance of cash. These two
models are

William J.Baumol’s Model

William J Baumol developed a model which is usually used in inventory management but has its
application in determining the optimal cash balance also. Baumol found similarities between
inventory management and cash management. As
Economic Order Quantity (EOQ) in inventory management involves trade off between carrying
costs and ordering cost the optimal cash balance is the trade off between the opportunity cost or
cost of borrowing or holding cash and the transaction cost. The optimal cash balance is reached at
a point where the total cost is the minimum. The figure below shows the optimum cash balance

Cost

Total cost

Opportunity
Or holding
Cost

Transaction cost
Cash balance
Optimum cash balance

The Baumol is based on upon the following assumptions:

The cash needs of the firm are known with certainty.
The cash disbursements of the firm occurs uniformly over a period of time and is known with
The opportunity cost of holding cash is known and it remains constant.
The transaction cost of converting securities into cash is known and remains constant.
The Baumol model can also be represented algebraically:
C= √2AF where
O

C = optimum balance
A = Annual cash disbursement.
O = opportunity cost of holding cash

Miller and Orr Model

Baumol’s model is based on the basic assumption that the size and timing of cash flows are known
with certainty. This usually does not happen in practice. The cash flows of a firm are neither
uniform nor certain. The Miller and Orr model overcomes the shortcomings of Baumol model and
developed stochastic Model for firms with uncertain cash inflows and cash outflows. The miller
and Orr model provides two control limits the upper and lower control limit along with return
point as shown in the figure
Cash

Upper control limit: buy securities

h
Curve representing cash balance purchase of marketable
Securities

Return point

z
Sale of marketable securities

O Time
Lower control limit: sell securities

When the cash balance touches the upper control limit (h) marketable securities are purchased to
the extent of hz to return back to the normal cash balance of z. in the same manner when the cash
balance touches lower control limit (o) the firm
will sell the marketable securities to the extent of oz to again return to the normal cash balance.
The spread between the upper and lower cash balance limit called (z) can
be computed using Miller Orr Model as below;

1/3
Z = [¾ x transaction cost x variance of cash flows /interest rate]

And return point = Lower limit + spread (Z)

2 2
Variances of cash flows = [standard deviation] or (σ)
Receivables Management

A sound managerial control requires proper management of liquid assets and inventory.
These assets are part of working capital of the business. An efficient use of financial
resources is necessary to avoid financial distress. Receivable result from credit sales. A
concern is required to allow credit sales in order to expand its sales volume. It is not always
possible to sell goods on cash basis only. Sometimes other concerns in that line might have
established a practice of selling goods on credit basis. Under these circumstances it is not
possible to avoid credit sales without adversely affecting sales. The increase in sales is also
essential to increase profitability. After a certain level of sales the increase in sales will not
proportionately increase production costs. The increase in sales will bring in more profits.
Thus receivables constitute a significant portion of current assets of a firm. But for
investment in receivables a firm has to incur certain costs.
Receivables represent amounts owed to the firm as a result of sale of goods or service in the
ordinary course of business. These are claims of the firm against its customers and form part
of its current assets. The receivables are also known as accounts receivables, trade
 receivables, accounts receivables etc. The period of credit and extent of receivables depends
upon the credit policy followed by the firm. The purpose of maintaining or investing in
receivables is to meet competition and to increase the sales and profits.

Factors influencing the size of receivables

Besides the sales a number of other factors also influence the size and receivables.
1. Size of credit sales: The volume of credit sales is the first factor which increases or
decreases the size of receivables. If a concern sells only on cash basis as in the case of Bata
shoes etc then there will be no receivables.
2. Credit policies: A firm with conservative credit policy will have a low size of receivable
while a firm with liberal credit policy will be increasing this figure. The vigour with which
the concern collects the receivables also affects its receivables. If collections are prompt
then even if credit is liberally extended the size of receivables will remain under control.
In case receivables remain outstanding for a longer period there is always a possibility of
bad debts.
3. Terms of trade: The size of receivables also depends upon the terms of trade. The period
of credit allowed and rates of discount given are linked with receivables. If credit period
allowed is more then receivables will also be more. Some times trade policies of
competitors have to be followed otherwise it becomes difficult to expand the sales. The
trade terms once followed cannot be changed without adversely affecting sales
opportunities.
4. Expansion plans: When a concern wants to expand its activities it will have to enter new
markets. To attract customers it will give incentives in the form of credit facilities. The
periods of credit can be reduced when the firm is able to get permanent customers. In the
early stages of expansion more credit becomes essential and size of receivables will be
more.
5. Relation with profits: The credit policy is followed with a view to increase sales. When
sales increases beyond a certain level the additional costs incurred are less than the
increase in revenues. It will be beneficial to increase sales beyond a point because it will
bring more profits. The increase in profits will be followed by an increase in the size of
receivables or vice versa.
6. Credit collection effort: The collection of credit should be streamlined. The customers
should be sent periodical reminders if they fail to pay in time. On the other hand if
adequate attention is not paid towards credit collection then the concern can land itself in a
serious financial problems. Efficient credit collection machinery will reduce the size of
receivables. If these efforts are slower then outstanding amounts will be more.
7. Habits of customers: the paying habits of customers also have a bearing on the size of
receivables. The customers may be in the habit of delaying payments even though they are
financially sound. The concern should remain in touch with such customers and should
make them realise the urgency of their needs

Forecasting the receivables

A concern should be clear about its credit policies. This is an important estimation, which will
help the concern in planning its working capital. Though it is not possible to forecast exact
receivables in the future but some estimation is possible on the basis of past experience present
credit policies and policies pursued by other concerns. The following factors will help in
forecasting receivables.
1. Credit period allowed: The ageing of receivables is helpful in forecasting. The longer the
amounts remain due, the higher will be the size of receivables. The increase in receivables
will result in more profits as well as higher costs too. The collection expenses and bad
debts will also be more. If credit period is less then the size of receivables will also be less.
2. Effect of cost of goods sold: Some times an increase in sales results in decrease in cost of
 Goods sold. If this is so then sales should be increased to that extent where costs are low.
The increase in sales will also increase the amount of receivables. The estimates for sales
will enable the estimation of receivables too.
3. Forecasting Expenses: The receivables are associated with number of expenses. Theses
expenses. Theses expenses are administrative expenses on collection of amounts, cost of
funds tied down in receivables, bad debts etc. At the same time increase in receivables will
bring in more profits by increasing sales. If the cost of receivables are more than the
increase in income further credit sales should not be allowed. On the other hand if revenue
earned by the increase in sales is more than the cost of receivables then sales should be
expanded.
4. Forecasting Average collection period and discounts: The credit collection policies will
spell out the time allowed for making payments and the time allowed for availing
discounts. If the average collection period is more then the size of receivable will be more.
Average collection period is calculated as follows
Average collection period = trade debtors x no of working days /net sales

Inventory management

Every enterprise needs inventory for smooth running of its activities. It serves as a link
between production and distribution processes. There is generally a time lag between the
recognition of a need and its fulfilment. The greater the time lag the higher the requirements
for inventory. The unforeseen fluctuations in demand and supply of goods also necessitate
the need for inventory. It also provide a cushion for future price fluctuations
In accounting language inventory means the stock of finished goods. Inventory includes the
following also
Raw material, Work-in-progress, Consumables, Finished goods, and spares

Purpose of holding inventory

Although holding inventories involves blocking of a firm’s funds and the costs of storage and
Handling every business enterprise has to maintain a certain level of inventories to facilitate
uninterrupted production and smooth running of business. In the absence of inventories a
firm will have to make purchases as soon as it receives orders. It will mean loss of time and
delays in execution of orders which some times may cause loss of customers and business. A
firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts
etc. There are three main purpose or motives of holding inventories.
1. Transaction Motive, which facilitates continuous production and timely execution of
sales orders.
2. The precautionary motive which necessitates the holding of inventories for meeting the
unpredictable changes in demand and suppliers of materials.
3. The speculative Motive which induces to keep inventories for taking advantages of price
fluctuations saving in reordering costs and quantity discounts, etc.

Risk and costs of holding inventory

The holding of inventories involves blocking of a firm’s funds and incurrence of capital and
other costs. It also exposes the firm to certain risks. The various costs and risk involved in
holding inventories
1. Capital cost: Maintaining of inventories results in locking of the firm’s financial resources.
The firm has therefore to arrange for additional funds to meet the cost of inventories. The
funds may be arranged from own resources or form outsiders. But in both the cases the firm
incurs a cost. In the former case there is an opportunity cost of investment while in the later
case the firm has to pay interest to the outsiders.
2. Storage and handling costs : Holding of inventories also involves costs on storage as well as
handling of materials. The storage costs include the rental of the godown, insurance charges
etc.
3. Risk of price decline: There is always a risk of reduction in the prices of inventories by the
suppliers in holding inventories. This may be due to increased market supplies, competition
or general depression in the market.
4. Risk of obsolesces : The inventories may become obsolete due to improved technology,
changes in requirements, change in customer’s tastes etc.
5. Risk Deterioration in quality: The quality of the materials may also deteriorate while the
inventories are kept in stores.

Managing inventory
The investment in inventory is very high in most of the undertakings engaged in
manufacturing , whole sale and retail trade. The amount of investment is sometimes more in
inventory than in other assets. in India a study of 29 major industries has revealed that the
average cost of materials is 64 paise and the cost of labour and overhead is 36 paise in rupee. In
industries like sugar the raw materials cost is as high as 68.75 % of the total cost. About 90%
part of working capital is invested in inventories. It is necessary for every management to give
proper attention to inventory management. a proper planning of purchasing, handling, storing
and accounting should form a part of inventory management. an efficient system of inventory
management will determine a. what to purchase b. how much to purchase c. from where to
purchase d. where to store etc.
There are conflicting interests of different departmental heads over issue of inventory. The
finance manager will try to invest less in inventory because for him it is an idle investment
where as production manager will emphasis to acquire more and more inventory as he does not
want any interruption in production due to shortage of inventory. The purpose of inventory
management is to keep the stocks in such a way that neither there is over stocking nor under
stocking . over stocking will mean a reduction of liquidity and starving of other production
processes; under stocking on the other hand will result in stoppage of work. The investment in
inventory should be kept in reasonable limits.

Objects of inventory management

The main objectives of inventory management are operational and financial. The operational
objectives mean that the materials and spares should be available in sufficient quantity so that
work is not disrupted for want of inventory. The financial objectives means that investments in
inventories should not remain idle and minimum working capital should be locked in it. The
following are the objectives of inventory management:
1. To ensure continuous supply of materials spares and finished goods so that production
should not suffer at any time and the customers demand should be met.
2. To avoid both overstocking and stocking of inventory.
3. To maintain investments in inventories at the optimum level as required by the operational
and sales activities.
4. to keep material cost under control so that they contribute in reducing cost of production
and overall costs.
5. To eliminate duplication in ordering or replenishing stocks. This is possible with the help of
centralising purchase.
6. To minimise losses through deterioration, pilferage, wastages and damages.
7. To design proper organisation for inventory management. a clear cut accountability should
be fixed at various levels of the organisation.
8. To ensure perpetual inventory control so that materials shown in stock ledgers should be
actually lying in the stores.
9. To ensure right quality goods at reasonable prices. Suitable quality standards will ensure
proper quality of stocks. The price analysis the cost analysis and value analysis will ensure
payment of proper prices.
10. To facilitate furnishing of data for short term and long term planning and control of
inventory.

TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT

ASSIGNMENT