Working Capital Management PDF

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WORKING CAPITAL MANAGEMENT

Unit-I WORKING CAPITAL COMPUTATION:
Objectives: The objective of this lesson is to understand the meaning concepts, objectives
the methods of estimating the working capital and working capital mix.
Structure:
1 Meaning of working Capital
2 Concepts of Workings d Capital
3 Classification or kinds of Working Capital
4 The Need or objectives of working Capital
5 Factors determining the Working Capital Requirements
6 Estimate of Working Capital Requirement
7 Determining the Working Capital mix
8 Summary
9 Practice problems
10 Review Exercises.
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WORKING CAPITAL
3.2.1 MEANING OF WORKING CAPITAL

Capital required for a business can be classified under two main categories viz,
(i) Fixed Capital, and
(ii) Working Capital
Every business needs funds for two purposes – for its establishment and to
carry out its day-to-day operations. Long-term funds are required to create
production facilities through purchase of fixed assets such as plant and machinery,
land, building, furniture etc. Investments in these assets represent that part of firm’s
capital which is blocked on a permanent or fixed basis and is called fixed capital.
Funds are also needed for short-term purposes for the purchase of raw materials,
payment of wages and other day-to-day expenses, etc. These funds are known as
working capital.
In simple words, working capital refers to that part of the firm’s capital which is
required for financing short term or current assets such as cash, marketable
securities, debtors and inventories. Funds, thus, invested in current assets keep
revolving fast and are being constantly converted into cash and these cash flows out
again in exchange for other current assets. Hence, it is also known as revolving or
circulating capital or short-term capital.
In the words of Shubin, “Working Capital is the amount of funds necessary to
cover the cost of operating the enterprises.”
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, as for example, from cash to inventories, inventories to receivables,
receivables to cash.”
3.2.2 CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital :
(i) Gross Working Capital
(ii) Net working capital
The gross working capital is the capital invested in total current
assets of the enterprise.
Current assets are those assets which in the ordinary course of business can
be converted into cash within a short period of time normally one accounting year.
Examples of current assets are:
CONSTITUENTS OF CURRENT ASSETS

1. Cash in hand and bank balances.
2. Bills Receivables.
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances
5. Inventories of stocks, as :
a) Raw materials
b) Work-in-progress
c) Stores and spares
d) Finished goods
6. Temporary Investments of surplus funds
7. Prepaid Expenses.
8. Accrued Incomes
In a narrow sense, the term working capital refers to the net working capital. Net
working capital is the excess of Current assets over current liabilities, or say :
Net Working Capital = Current Assets – Current liabilities
Net Working Capital may be positive or negative. When the current assets exceed the
current liabilities the working capital is positive and the negative working capital results
when the current liabilities are more than the current assets.
Current liabilities are those liabilities which are intended to be paid in the ordinary
course of business within a short period of time, normally one accounting year out of the
current assets or the income of the business.
Examples of current liabilities are :
CONSTITUENTS OF CURRENT LIABILITIES
1. Bills Payable
2. Sundry Creditors or Accounts Payable
3. Accrued or Outstanding Expenses
4. Short-term loans, advances and deposits
5. Dividends Payable
6. Bank overdraft
7. Provision for taxation,
The following example explains both the concepts of working capital.
Balance Sheet of Pearl India Ltd. as on 31.03.2003

Liabilities Rs. Assets Rs.
Equity Shares 2,00,000 Goodwill 20,000

8% debentures 1,00,000 Land and Building 1,50,000
Reserve & Surplus 50,000 Plant and Machinery 1,00,000
Sundry Creditors 1,50,000 Inventories :
Bills Payable 30,000 Finished Goods 60,000
Outstanding Expenses 20,000 Work-in-progress 40,000
Bank Overdraft 50,000 Prepaid Expenses 20,000
Provision for Taxation 20,000 Marketable Securities 60,000
Proposed Dividend 30,000 Sundry Debtors 90,000
Bills Receivables 20,000
Cash & Bank Balance 90,000
6,50,000 6,50,000
(i) Gross Working Capital = Total of Current Assets

=0,000+40,000+20,000+60,000+90,000+20,000+90,000=Rs.3,80,000
(ii) Net Working Capital = Current Assets – Current Liabilities
Total of Current Assets = Rs.3,80,000
Total of Current Liabilities = 1,50,000+30,000+20,000+50,000+20,000+30,000 =
Rs.3,00,000
W.C (Net) = Rs.3,80,000 – 3,00,000 = Rs.80,000
3.2.3 CLASSIFICATION OR KINDS OF WORKING CAPITAL
Working Capital may be classified in two ways :
(a) On the basis of concept.
(b) On the basis of time.
On the basis of concept, working capital is classified as gross working capital and net
working capital as discussed earlier. This classification is important from the point of
view of the financial manager. On the basis of time, working capital may be
classified as :
1. Preliminary or fixed working capital
2. Temporary or variable working capital.
KINDS OF WORKING CAPITAL
ON THE BASIS OF CONCEPT ON THE BASIS OF TIME
PERMANENT OR TEMPORARY OR
GROSS WORKING NET WORKING FIXED WORKING VARIABLE
CAPITAL WORKING
CAPITAL CAPITAL CAPITAL
REGULAR RESERVE SEASONAL SPECIAL

WORKING CAPITAL WORKING CAPITAL WORKING CAPITAL WORKING CAPITAL
1. Permanent or Fixed Working Capital : Permanent or fixed working capital is the

minimum amount which is required to ensure effective utilization 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. For example, every firm has to maintain a minimum level of taw material, work-in-
process, finished goods and cash balance. This minimum level of current assets is called
permanent or fixed working capital as this part of capital is permanently ‘locked in current
assets. As the business grows, the requirements of permanent working capital also increase
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 and so on. Reserve
working capital is the excess amount over the requirement for regular working capital which
may be provided for contingencies that may arise at unstated periods such as strikes, rise in
prices, depression, etc.
2. Temporary or Variable Working Capital : Temporary or variable 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.
Figures given below illustrate the difference between permanent and temporary working
capital.
Permanent working capital is stable or fixed over time while the temporary or variable
working capital fluctuates. 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 decreases.
Gross working capital vs Net working capital
The gross working capital concept is financial or going concern concept whereas net
working capital is an accounting concept of working capital. These two concepts of working
capital are not exclusive, rather both have their over merits.
The gross working capital concept is sometimes preferred to the net concept of
working capital for 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 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 in working capital.
The net working capital concept, however, is also important for the following
reasons :
1. It is a 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 tot eh short-
term creditors, i.e the excess of current assets over current
liabilities.
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 be said that, both, gross and net, concepts of working capital
are important aspects of the working capital management. The net concept of working
capital may be suitable only for proprietary form of organizations such as sole-trader or
partnership firms. But the gross concept is very suitable to the company form of
organization where there is a divorce between ownership, management and control.
However, it may be made clear that as per the general practice, net working capital
is referred to simply as working capital.
IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL
Working capital is the lifeblood and nerve center of a business. Just as circumstance
blood is essential in the human body for maintaining life, working capital is very essential to
maintain 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. Easy loans: A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and others on easy and favorable
terms.
4. Cash discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular

supply of raw materials and continuous production.
6. Regular payments 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 commitments which raises 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 capital 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 investments: Every Investor wants quick and
regular dividends to its investors and creates as there may be much pressure to
plough back of 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.
3.2.5 EXCESS OR INADEQUATE WORKING CAPITAL
Every business concern should have adequate working capital to run its business
operations. It should have neither redundant or excess working capital nor inadequate nor
shortage of working capital. Both excess as well as short working capital positions are bad
for any business. However, out of the two, it is the inadequacy of working capital which is
more dangerous from the point of view of the firm.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for the business and
hence the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy
which may cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investment, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.
Disadvantages of Dangers of Inadequate Working Capital
1. A concern which has inadequate working capital cannot pay its short-term
liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit
facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts etc.
3. It becomes difficult for the firm to exploit favourable market conditions and
undertake profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and it creates
inefficiencies, increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability

of liquid funds.
6. The rate of return on investments also falls with the shortage of working capital.
3.2.6 THE NEED OR OBJECTS OF WORKING CAPITAL
The need for working capital cannot be over emphasized. Every business needs
some amount of working capital. The need for working capital arises due to the time gap
between production and realization of cash from sales. There is an operating cycle involved
in the sales and realization of cash. There are time gaps in purchase of raw materials and
production; production and sales; and sales and realization of cash. Thus, working capital is
needed for the following purposes:
1. For the purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel, power and
office expenses, etc.
4. to meet the selling costs as packing, advertising etc.
5. To provide credit facilities to the customers.
6. To maintain the inventories of raw material, work-in-progress, stores and

spares and finished stock.
For studying the need of working capital in a business, one has to study the business
under varying circumstances such as a new concern, as a growing concern and as one
which has attained maturity. A new concern requires a lot of liquid funds to meet initial
expenses like promotion, formation, etc. These expenses are called preliminary expenses
and are capitalized. The amount needed as working capital in a new concern depends
primarily upon its size and the ambitions of its promoters. Greater the size of the business
unit, generally, larger will be the requirements of working capital. The amount of working
capital needed goes on increasing with the growth and expansion of business till it attains
maturity. At maturity the amount of working capital needed is called normal working capital.
There are many other factors which influence the need of working capital in a business and
these ae discussed in the next pages.
3.2.7 FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS
The working capital requirements of a concern depend upon a large number of

factors such as nature and size of business, the character of their operations, the
length of production cycles, the rate of stock turnover and the state of economic
situation. 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 he nature of its business. Public utility undertakings like
Electricity, Water supply and Railways 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
firms require less investment in fixed assets but have to invest large amounts in
current assets like inventories, receivables and cash; as such they need large
amount of working capital. The manufacturing undertakings also require sizeable
working capital alongwith fixed investments. Generally speaking it may be said that
public utility undertakings require small amount of working capital, trading and
financial firms require relatively very large amount, whereas manufacturing
undertakings require sizeable working capital between these two extremes.
2. Size of Business/Scale of Operations: 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 variations. 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 periods 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 supplies 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 process of production, the process
with the shortest production period should be chosen.
5. Seasonal Variation: In certain industries raw material 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 entire year. A huge
amount is, thus, blocked in the form of material inventories during such season,
which
2. Principle of Cost of Capital: The various sources of raising 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 achieve a proper balance between
the 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
position. 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: (I) current assets as a percentage of total assets and (ii) 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. Principle of 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 internally generated
funds. Maturity pattern of various current 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 the words of Louis Brand, “We need to
know when to look for working capital funds, how to use them and how to measure,
plan and control them”. To achieve the above mentioned objectives of working
capital management, the financial manager has to perform the following basic
functions:
1. Estimating the working capital requirements.
2. Financing of working capital needs.
3. Analysis and control of working capital.
3.2.8 FORECAST/ESTIMATE OF WORKING CAPITAL REQUIREMENTS
“Working capital is the life-blood and controlling nerve centre of a business.” No

business can be successfully run without an adequate amount of working capital. To
avoid the shortage of working capital at once, an estimate of working capital
requirements should be made in advance so that arrangements can be made to
procure adequate working capital. But estimation of working capital requirements is
not an easy task and a large number of factors have to be considered before starting
this exercise. For a manufacturing organization, the following factors have to be
taken into consideration while making an estimate of working capital requirements:
Factors Requiring Consideration While Estimating Working Capital
1. Total costs incurred on material, wages and overheads.
2. The length of time for which raw materials are to remain in stores before they
are issued for production.
3. The length of the production cycle or work-in-progress, i.e., the time taken for
conversion of raw material into finished goods.
4. The length of sales cycle during which finished goods are to be kept waiting for
sales.
5. The average period of credit allowed to customers.
6. The amount of cash required to pay day-to-day expenses of the business
7 The average amount of cash required to make advance payments, if any.
8. The average credit period expected to be allowed by suppliers.
9. Time-lag in the payment of wages and other expenses.
From the total amount blocked in current assets estimated on the basis of the first
seven items given above, the total of the current liabilities, i.e., the last two items, is
deducted to find out the requirements of working capital.
In case of purely trading concerns, points 1, 2 and 3 would not arise but all other
factors from points 4 to 9 are to be taken into consideration.
In order to provide for contingencies, some extra amount generally calculated as a

fixed percentage of the working capital may be added as a margin of safety.
Suggested Proformas for estimation of working capital requirements are given on the
following pages:
1. For a Trading Concern: Proforma

Statement of working capital Requirements Amount (Rs.)
Current Assets:
(i) Cash _
(ii) Debtors or Receivables (For….. month’s sales) _
(iii) Stocks (for….. month’s sales)

_
(iv) Advance payments, if any

_
(v) Others
_
Less: Current Liabilities:
_
(i) Creditors (For…… month’s purchases)
(ii) Lag in payment of expenses
(Outstanding expenses, if any)
Working Capital (C.A. – C.L.)
Add: Provision/Margin for Contingencies
Net working capital required

---------------
Notes: (I) Profits should be ignored while calculating working capital requirements as funds
provided by profits may or may not be used as working capital.
(ii) Stock and debtors should be taken at cost unless otherwise required in a given
question.
2. For a Manufacturing Concern
Statements of Working Capital Requirements
Amount (Rs.)
Current Assets:
(i) Stock of Raw material (for …. Month’s consumption)
(ii) Work-in-progress (for…. Months)
(a) Raw materials
(b) Direct labour
(c) Overheads
(iii) Stock of Finished Goods (for …. Month’s sales):
(a) Raw materials
(b) Labour
(c) Overheads
(iv) Sundry Debtors or Receivables (for ….. month’s sales);
(a) Raw materials
(b) Labour
(c) Overheads
(v) Payments in Advance (if any)
(vi) Balance of Cash (Required to meet day-to-day expenses)
(vii) Any other (if any)
(i) Creditors (for ….. month’s purchases of raw materials)
(ii) Lag in payment of expenses (Outstanding expenses… months)
(iii) Others (if any)

Working Capital (C.A. – C.I.)
Add: Provision/Margin for Contingencies
Net Working Capital Required -----
Notes: (I) Profits should be ignored while calculating working capital requirements for the
following reasons:
(a) Profits may or may not be used as working capital.
(b) Even if profits are to be used for working capital it has to be reduced by the
amount of income tax, drawings, dividend paid etc.
(ii) Calculation of work-in-process depends upon its degree of completion as regards

material, labour and overheads: However, if nothing is given in a question as
regards the degree of completion, we suggest the students to take 100% cost of
material, labour as well as overheads. Because, in such a case the average period of
work-in-process must have been calculated as equivalent period of completed units.
The same approach has been followed by various famous authors on this project.
But some authors have assumed in such a case 100% consumption of raw material
and 50% (one half on an average) in case of labour and overheads.
(iii) Calculation for Stocks of finished goods and debtors should be made at cost
unless otherwise asked in the question.
Illustration 2: Prepare an estimate of working capital requirement from the following

information of a trading concern:
(a) Project annual sales 1,00,000 units
(b) Selling price Rs. 8 per unit
(c) %age of net profit allowed to customers 25%
(d) average credit period allowed by suppliers 8 weeks

(e) average credit allowed to customers 4 weeks
(f) average stock holding in terms of sales requirement

12 weeks
(g) allow 10% for contingencies
Solution:
Statement of working capital requirements
Rs.
Current Assets: 92,308

Debtors (8 weeks): 6,00,000 x 8/52 1,38,462
(At cost) 2,30,770
Stock (12 weeks): 6,00,000 x 12/52 46,154
Creditors (4 weeks): 6,00,000 x 4/52 1,84,616
Net working capital 18,462
Add 10% for contingencies
Working capital Required 2,03,078
Working Notes:
(a) Sales = 1,00,000 x 8 = Rs. 8,00,000
Profit = 25% of Rs. 8,00,000 = Rs. 2,00,000
Cost of sales = Rs. 6,00,000
(b) As, it is a trading concern, cost of sales are assumed to be the purchases.
(c) Profits have been ignored as funds provided by profits may or may not be used as
working capital.
Illustration 3: A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Material 40%
Direct labour 20%

Overheads 20%
The following further particulars are available
(a) It is proposed to maintain a level of activity of 2,00,000 units.
(b) Selling price is Rs. 12/- per unit,
(c) Raw materials are expected to remain in stores for an average period of one month.
(d) Materials will be in process, on average half a month.
(e) Finished goods are required to be in stock for an average period of one month.
(f) Credit allowed to debtors is two months.
(g) Credit allowed by suppliers is one month.
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements, a forecast

Profit and Loss Account and Balance Sheet of the company assuming that:
Rs.
Share Capital 15,00,000
8% Debentures 2,00,000
Fixed Assets 13,00,000
Solution:
Statement of Working Capital

Current Assets: Rs. Rs.
Stock of Raw materials (1 month) 24,00,000 x 40/ 100 80,000
x 12
Work-in-process (1/2 month):
40,000
Materials (24,00,000 x 40)/100 x 12 x( ½)
20,000
Labour (24,00,000 x 20)/100 x 12 x (1/2)
20,000
Overheads (24,00,000 x 20)/100 x 12 x (1/2)
80,000
Stock of Finished Goods (1 month)
80,000
Materials (24,00,000 x 40)/100 x 12
Labour (24,00,000 x 20)/100 x 12 40,000

Overheads (24,00,000 x 20)/100 x 12 40,000
Debtors (2 months) at cost 1,60,000
Material 1,60,000
Labour 80,000
Overheads 80,000 3,20,000
Less: Current Liabilities: 6,40,000
Creditors (1 month) for raw materials
24,00,000 x 40/100 x 12
Net working Capital Required: 80,000
5,60,000
Note: Sales = 2,00,000 x 12 = Rs. 24,00,000)
Forecast Profit and Loss Account

For the year ended….
Rs. Rs.
To Materials 9,60,000 By Cost of goods sold 19,20,000
To wages 4,80,000
To overheads 4,80,000 19,20,000
19,20,000 By Sales 24,00,000
To cost of goods sold 19,20,000
To gross profit c/d 4,80,000 24,00,000
24,00,000 By Gross Profit b/d 4,80,000
To Interest on Debentures 16,000
To Net Profit 4,64,000
4,80,000 4,80,000
Forecast Balance Sheet
As at…..
Share capital 15,00,000 Fixed Assets 13,00,000
8% Debentures 2,00,000 Stocks:
Net Profit 4,64,000 Raw materials 80,000
Creditors 80,000 Work-in-process 80,000
Finished goods 1,60,000
Debtors 4,00,000
Cash & bank balance

(balancing figure) 2,24,000
22,44,000 22,,44,000
Working Notes:
(a) Profits have been ignored while preparing working capital requirements for the following
reasons:
(i) Profits may or may not be used for working capital.
(ii) Even if profits have to be used for working capital, they have to be reduced by the
amount of income tax, dividends, etc.
(b) Interest on debentures has been assumed to have been paid.
Illustration 4: X & Co. is desirous to purchase a business and has consulted you and one
point on which you are asked to advise them is the average amount of working capital
which will be required in the first year’s working.
You are given the following estimates and are instructed to add 10% to your
computed figure to allow for contingencies:
Figures for the year
(Rs.)
(i) Amount blocked up for stocks:
stocks of finished product 5,000
stocks of stores, materials, etc. 8,000
(ii) Average credit given:
Inland Sales – 6 weeks credit 3,12,000
Export Sales 1 ½ weeks credit, 78,000
(iii) Lag in payment of wages and other outgoings:

Wages – 1 ½ weeks 2,60,000
Stocks of materials, etc – 1 ½ months 48,000
Rent, Royalties, etc. – 6 months 10,000
Clerical staff = ½ month 62,400
Manager ½ month 4,800
Miscellaneous Expenses – 1 ½ months 48,000
(iv) Payment in Advance:
Sundry Expenses (paid Quarterly in advance) 8,000
(v) Undrawn profit on the average throughout the eyar 11,000
Set up you calculations for the average amount of working capital required:
Solution:
Statement showing the Calculation of Average Working Capital Required

Rs.
Current Assets: Rs.
(i) Stock of finished products

(ii) Stocks of stores materials, etc. 5,000
(iii) Sundry Debtors 8,000
(a) Inland (6 weeks) 3,12,000 x 6/52 36,000
(b) Export Sales (1 ½ weeks) 78,000 x /52 x ½ 2,250 38,250
(iv) Payments in Advance 8,000 x 1/4 2,000
Less: Current Liabilities: 53,250
Lag in payment of:
Wages (1 ½ weeks) 2,60,000 x 3/52 x ½ 7,500
Stocks, materials, etc. (1 ½ months) 48,000/12 x 3/2 6,000
Rent, Royalties, etc. (6 months) 10,000 x 6/12 5,000
Clerical staff (1/2 month) 62,400/12 x ½ 2,600
Manager (1/2 month) 4,800/12 x ½ 200
Miscellaneous Expenses (1 ½ months) 4,800/12 x 3/2 6,000 27,300
Net Working Capital 25,950

Add 10% Margin for Contingencies 2,595
28,545
Notes:
Undrawn Profits have been ignored for the following reasons:
(i) Profits may or may not be used as working capital.
(ii) Even if it is to be used for working capital, it should be reduced by the amount of
income-tax, drawings, dividends paid etc.
Illustration 5: A proforma cost sheet of a company provides the following particulars:
Elements of Cost Amount per unit
(Rs.)
Raw material 80
Direct labour 30
Overheads 60
Total cost 170
Profit 30
Selling price 200
The following further particulars are available:
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 ½ 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 Rs. 25,000.
You are required to prepare a statement showing the working capital needed to
finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year, wages
and overheads accrue similarly and a time period of 4 weeks is equivalent to am month.
Solution:
Statement Showing the Working Capital Needed
Rs. Rs.
Current Assets:
(i) Stock of raw materials (4 weeks) 1,60,000 x 4 6,40,000
(ii) Work-in-process (2 weeks):
Raw materials 1,60,000 x 2 3,20,000
Direct labour 60,000 x 2 1,20,000
Overheads 1,20,000 x 2 2,40,000 6,80,000
(iii) Stock of Finished goods (4 weeks):
Raw materials 1,60,000 x 4 6,40,000
Direct labour 60,000 x 4 2,40,000
Overheads 1,20,000 x 4 4,80,000 13,60,000
(iv) Sundry Debtors (8 weeks)
Raw materials 1,60,000 x ¾ x 8 9,60,000
Direct labour 60,000 x ¾ x 8 3,60,000
Overheads 1,20,000 x ¾ x 8 7,20,000 12,10,000
(v) Cash in hand and at bank (given)
(i) Sundry Creditors (4 weeks) 1,60,000 x 4 6,40,000
(ii) Wages outstanding (1 – ½ weeks): 60,000 x 3/2 90,000
(iii) Lag in payment of overheads (4 weeks) 1,20,000 x
4
4,80,000
Net working capital needed
35,35,000
Working Notes:
(i) It has been assumed that a time period of 4 weeks is equivalent to one month.
(ii) It has been assumed that direct labour and overheads are in process, on
average, half a month.
(iii) Profit has been ignored and debtors have been taken at cost.
(i) Weekly calculations have been made as follows:
(taking 52 weeks in a year)
(a) Weekly average of raw materials 1,04,000 x 80/52 = 1,60,000
(b) Weekly labour cost = 1,04,000 x 30/52 = 60,000
(c) Weekly overheads = 1,04,000 x 60/52 = 1,20,000
Illustration 6: From the following information you are required to estimate the net
working capital:
Cost per unit
Rs.)
Raw materials 400
Direct labour 150
Overheads (excluding depreciation) 300
850
Total cost Rs. 1,000 per unit
Additional Information: 52,000 units per

annum
Selling price
average 4 weeks
Output
average 2 weeks
Raw material in stock
Work-in-process average 4 weeks
(assume 50% completion stage with full material consumption)
finished goods in stock average 4 weeks
credit allowed by suppliers average 8 weeks
credit allowed to debtors Rs. 50,000
cash at bank is expected to be
Assume that production is sustained at an even pace during the 52 weeks of the year. All
sales are on credit basis. State any other assumption that you might have made while
computing.
Solution:
Statement showing Net Working Capital Requirements

Current Assets:
Stock of raw material (4 weeks) 52,000 x 400 x 4/52 16,00,000
Stock of work-in-process (2 weeks)
Raw material 52,000 x 400 x 2/52 8,00,000
Direct labour (50% completion) 52,000 x 150 x 2/52
x 50/100
1,50,000
Stock of finished goods (4 weeks) 52,000 x 850 x
4/52
3,00,000 12,50,000
Amount blocked in Debtors at cost (8 weeks) 52,000
x 850 x 8/52
Cash at Bank 34,00,000
Total current assets 68,00,000
Less: Current Liabilities: 50,000
Creditors for raw materials (4 weeks) 52,000 x 400 x 1,31,00,000
4/52 16,00,000
Net Working Capital Required 1,15,00,000
Working Notes:
(i) Profit has been ignored and debtors have been taken at cost. The profit has been
ignored because this may or may not be used as a source of working capital.
(ii) It has been assumed that raw material is introduced at the beginning of the process.
DETERMINING THE WORKING CAPITAL FINANCING MIX
Broadly speaking, there are two sources of financing working capital requirements:
(I) Long-term sources such as share capital, debentures, public deposits, ploughing back of
profits, loans from financial institutions, and (ii) short-term sources such as commercial
banks, indigenous bankers, trade credits, installment credit, advances, accounts receivables
and so on. Therefore, a question arises as to what portion of working capital (current assets)
should be financed by long-term sources and how much by short-term sources?
There are three basic approaches for determining an appropriate working capital financing
mix.
Approaches to Financing Mix
The hedging or The Conservative The aggressive

Matching Approach Approach
approach The
Hedging or matching 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 the approach, the maturity of sources of funds should match
the nature of assets to be financed. The approach therefore, also known as matching
approach’. The approach classifies the requirements of total working capital into two
categories:
(i) Permanent or fixed working capital which is the minimum amount required to
carry out the normal business operations. It does not vary over time.
(ii) 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. The following example
explains this approach.
Estimated total Investment in Current assets of company X for the Year 2000
Month Investments in Permanent or Temporary or

Current assets Fixed investments Seasonal Invest.
(Rs.) (Rs.) (Rs.)
January 50,400 45,000 5,400
February 50,000 45,000 5,000
March 48,700 45,000 3,700
April 48,000 45,000 3,000
May 46,000 45,000 1,000
June 45,000 45,000 --
July 47,500 45,000 2,500
August 48,000 45,000 3,000
September 49,500 45,000 4,500
October 50,700 45,000 4,700
November 52,000 45,000 3,500
December 48,500 45,000 3,500
Total 44,300
According to hedging approach the permanent portion of current assets required (Rs. 45,000)
should be financed with long-term sources and temporary or seasonal requirements in
different months (Rs. 5,400 ; Rs. 5,000 and so on) should be financed from short-term
sources.
The Conservative Approach
This approach suggests that the entire estimated investments in current assets should
be financed from long-term sources and the short-term sources should be used only for
emergency requirements. According to this approach, the entire estimated requirements of
Rs. 52,000 in the month of November (in the above given example) will be financed from
long-term sources. The short-term funds will be used only to meet emergencies. The distinct
features of this approach are:
(i) Liquidity is severally greater;
(ii) Risk is minimized; and
(iii) 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 Conservative approaches
The hedging approach implies low cost, high profit and high risk while the
conservative 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 from case to case depending upon the perception of risk, by the persons
involved in financial decision-making. However, one way of determining the trade off is by
finding the average of maximum and the 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. Thus, in the above given example the
average requirements of Rs. 48,500 i.e. 45,000+52,00 may be financed from long-term while
2
the excess capital required during various months from short-term sources.
1 The Aggressive Approach
The aggressive approach suggests that the entire estimated requirements of currents
asset should be financed from short-term souces and even a part of fixed assets investments
be financed from short-term sources. This approach makes the finance mix more risky, less
costly and more profitable.
Illustration 7 Excel Industries Ltd. Is considering its current assets policy. Fixed
assets are estimated at Rs. 40,00,000 and the firm plans to maintain a 50 per cent debt to
asset ratio. The interest rate is 14 per cent on all debt. Three alternative current asset policies
are under consideration: 40,50 and 60 percent of projected sales. The company expects to
earn 20 percent before interest and tax on sales of Rs. 2,00,00,000. the corporate tax rate is
35 percent. Calculate the expected return on equity under each alternative.
Solution:
Alternative Balance Sheets of Excel industries Ltd.
Current assets Policies
Conservative Moderate Aggressive
(40% of Sales) (50% of Sales) (60% of Sales)
Rs. In lacs Rs. In lacs Rs. In lacs
Current Assets 80.00 100.00 120.00
Fixed Assets 40.00 40.00 40.00
Total Assets 120.00 140.00 160.00
Debt (50% of Total Assets) 60.00 70.00 80.00
Equity 60.00 70.00 80.00
Total Liabilities and Equity 120.00 140.00 160.00
Alternative income Statements : Effects of alternative current assets Policies

Current Assets Policies
Conservative Moderate Aggressive
(40%) (50%) (60%)
Rs. In lacs Rs. In lacs Rs. In lacs
Sales 200.00 200.00 200.00

Earnings Before Interest and Tax (20%) 40.00 40.00 40.00
Interest on Debt (14%) 8.40 9.80 11.20
Earning Before Tax (EBT) 31.60 30.20 28.80
Tax (35%) 11.00 10.57 10.08
Earnings After Tax (EAT) 20.54 19.63 18.72
Return on Equity (EAT/Equity) 34.23% 28.04% 23.40%
Illustration 8. The following are the summarized balance sheets of X Ltd and Y Ltd as on 31st
March 2003
X Ltd Y Ltd
Current Assets 100.00 60.00
Fixed Assets 100.00 140.00
Total Assets 200.00 200.00
Current Liabilities 20.00 80.00
Long-term Debt 80.00 20.00
Equity Share Capital 70.00 30.00
Retained Earnings 30.00 20.00
200.00 200.00
Earnings before interest and tax for both the companies are Rs. 50 lacs each. The corporate
atax rate is 35 percent.
(a) What is the return on equity (ROE) for each company if the interest rate on current
liabilities is 10 percent and 12 percent on long-term debt?
(b) Assuming that the rate of interest on current liabilities rises to 15 percent, while it
remains unchanged for long-term debt, what would be its effect on return on equity
for each company?
Solution:
Calculation of Return on Equity
(Rs. In lacs)
X Ltd Y Ltd
(a) (b) (a) (b)
Earning Before Interest and Tem 50.00 50.00 50.00 50.00
Interest on current and long-term Debt 11.60 12.60 10.40 14.40
Earning Before Tax (EBT) 38.40 37.40 39.60 35.60
Tax (35%) 13.44 13.09 13.86 12.46
Earnings after Tax (EAT) 24.96 24.31 25.74 23.14
Equity (Eq share capital + Retained 100.00 100.00 100.00 100.00
earning)
Return on Eqity (EAT/Equity) 24.96% 24.31% 25.74?% 23.14%
Example 9: Gaurav Motors Ltd. forecast its working capital requirement as per the
details given below:
Month Rotal funds required (Amount in Rs.)
Jan 5,000
Feb 7,000
March 9,000
April 4,000
May 5,000
June 10,000
Cost of long term source of funds 10%
Cost of short term source of funds 6%
Find the cost of financing working capital for the entire period, according to (a) Hedging
approach (b) Conservative approach (c) Intermediate approach.
Solution.
(a) Financing technique according to Hedging Approach
Month Total funds required Rs Permanent requirementRs Seasonal requirementRs
Jan 5,000 4,000 1,000
Feb 7,000 4,000 3,000
March 9,000 4,000 5,000
April 4,000 4,000 0
May 5,000 4,000 1,000
June 10,000 4,000 6,000
Total funds 24,000 16,000
The permanent requirement shall be financed through long term and the seasonal requirement
shall be financed through short term source of funds
Cost of financing Rs24,000 X 10% +Rs 16,000 X 6% = Rs3360
(b) Financing technique according to Conservative approach

Month Total funds requiredRs Permanent requirementRS
Jan 5,000 10,000
Feb 7,000 10,000
March 9,000 10,000
April 4,000 10,000
May 5,000 10,000
June 10,000 10,000
Total funds 60,000
Cost of financing Rs 60,000 X 10% = Rs 6000

(c) Financing technique according to Intermediate Approach

Month Total funds Permanent requirement (average of Temporary
required maximum and minimum requirement) requirement
Jan 5,000 7,000 0
Feb 7,000 7,000 0
March 9,000 7,000 2,000
April 4,000 7,000 0
May 5,000 7,000 0
June 10,000 7,000 3,000
Total funds 42,000 5,000
10,000 + 4,000
Average requirement = 2 = 7,000
Cost of financing Rs 42,000 X 10% +Rs 5,000 X 6% = Rs 4500
A firm, that follows this policy / approach will be under less risk since, it relies an
long finance but the returns are also less.
11 Aggressive Approach: A firm is said to be aggressive, when it uses more short-term for
than warranted by the hedging approach or matching approach. In other words, a firm
finances are a part of its regular or permanent current assets with short-term source funds.
A firm, which follows this approach, is under more risk, but it will prove to have more
returns. Figure as per the aggressive approach.
Short term
financing
Temporary Current Assets
Permanent Current Assets
Fixed assets
Time
SUMMARY
 Working capital management is concerned with the problems that arise in attempting
to manage the current assets, current liabilities and their inter relationship that exists
between them.
 Working capital management goal is maintain a satisfactory level of working capital.
 There are two concepts of working capital: Gross working Capital (Quantitative
Concept) and Net Working Capital (Qualitative Concept). Gross Working Capital,
refers to the total current assets. Net Working Capital refers to the excess of current
assets over current liabilities or it is that portion of firm’s current assets, which
financed with ling term funds.
 Gross Working Capital concept focuses attention on the two aspects of current assets
management, they are: Optimum investment in current assets, and financing of
current assets.
 Net working capital concept focuses attention on the two aspects of current assets
management, they are: maintaining liquidity position, and to decide upon the extent
of long term capital in financing current assets.
 Working capital has conveniently classified the working capital into two: regular or
permanent and temporary or variable working capital. Permanent working capital
refers to the minimum level of current assets maintained in a firm. Temporary
working capital refers to additional current assets temporarily over and above
permanent working capital to satisfy cyclical demands.
 The main components of working capital: Current assets (each, marketable securities,
inventories, sundry debtors, one year fixed deposits with banks, prepaid expenses)
and current liabilities (sundry creditors, loans and advances, bank over-draft, short-
term borrowings, taxes and proposed dividend).
 The importance of working capital management is reflected in the fact that financial
managers spend most of their time in managing current assets and current liabilities.
The working capital management is concerned with determination of relevant levels
of current assets and their efficient use as well as the choice of the financing mix.
 Management of working capital involves the following four aspects, viz,

determination the level of current assets, decide the proportion of long-term and
short-term capital to finance current assets, to evolve suitable policies, procedures and
reporting systems for controlling the individual components of current assets, and to
determine the various sources of working capital.
 The objectives of working capital management could be stated as, to ensure optimum
investment in current assets, to strike a balance between the twin objectives of
liquidity and profitability in the use of funds, to ensure adequate flow of funds for
current operations, and to speed up the flow of funds or to minimize the stagnation of
funds.
 The operating cycle concept penetrates to the heart of working capital management in
a more dynamic form. The time that elapses to convert raw materials into cash is
known as operating cycle. Operating Cycle (OC)=AAI + ARP, Cash Conversion
Cycle (CCC) is the time length between the payment for suppliers of raw materials
and the collection of cash for sales, CCC=OC-APP.
 There is a need to maintain a balance working capital for maximization profits or

minimization of working capital cost or to maintain balance between liquidity and
profitability.
 The dangerous excessive working capital are unnecessary accumulation of

inventories indication of defective credit policy and stack collection period,
degeneration in to managerial inefficiency, and speculative profits grow.
 The dangers of inadequate wo4rking capital are stagnates growth, difficult to

implement operating plans, difficult even to meet day-to-day commitments,
inefficient utilization of fixed assets, unable to avail attractive credit opportunities,
firm loses its reputation.
 Working capital requirement is determined by a wide variety of factors, they are:

Nature of Business, Size of Business, Production Cycle Process, Production Policy,
Credit Policy or terms of Purchase and Sales, Business Cycle, Growth and Expansion,
Scarce Availability of Raw Materials, Profit Level, Level of Taxes, dividend Policy,
Depreciation Policy, Price Level Changes, Operating Efficiency, Availability of
Credit, close co-ordination between production and distribution policies, an absence
of specialization in the distribution of products, the means of transportation and
communication, the hazards and contingencies inherent in a particular type of
business, credit policy of RBI and so on.
 Working capital is equal to the current assets minus current liabilities.

Determination/estimation of working capital, involve four steps: (1) Estimation of
cash cost of the various current assets required by the firm, (2) Estimation of
spontaneous current liabilities of the firm, (3) Compute net working capital by
subtracting the estimate current liabilities (step 2) from current assets (step 1), and (4)
Add some percentage (given in the problem) of net working capital, if there is any
contingency or safety working capital required, to get the required working capital.
(costs and profits are calculated excluding depreciation).
 There are three financing policies vis- a-vis’, to finance current assets: (1) short-term
financing, generally current assets should be financed by only short-term financial
sources. The sources of short-term finance are loans from banks, public deposits,
commercial papers, factoring of receivables, bills discounting, retention of profits etc,
a firm, which required short-term finance can go for any one of these sources. (2)
Long-term financing, net current assets or permanent current assets or working capital
are supposed to be financed by long-term sources of finance. Long-term finance
sources include, ordinary share capital, preference share capital, debentures, long-
term loans from bankers, and surpluses (includes retained earning) (3) spontaneous
financing, it refers to the automatic sources of short-term funds arising in the normal
course of a business. The source includes trade credit (suppliers) and outstanding
expenses.
 They are three approaches available for a company, that are matching, conservative
and aggressive approach (1) matching or Hedging approach, is that approach in
which, the expected life of an assets is matched with the source of finance period with
which the asset is financed (2) conservative Approach, according to this approach a
firm depends more on long-ter5m funds for financing needs. In this plan, the firm
finances its regular or permanent current assets and a part of temporary or variable
current assets with long term source of funds. In the year, when the firm has no need
for temporary current assets, the idle funds (long-term) can be invested in the
marketable securities so that the firm conserves liquidity. (3) aggressive approach, a
firm is said to be aggressive, when it uses more short-term funds then warranted by
the hedging approach or matching approach.
PRACTICE PROBLEMS
Illustration 1:
X and Y who want to buy a business seek your advice about the average working capital
requirements in the first year’s trading. The following estimates are available and you are
asked add 5% to allow for contingencies.
a) Average amount locked Stocks: Rs.

Stock of finished goods and WIP 10,000
Stock of stores, materials etc 8,000
b) Average Credit given:

Local sales 3 week’s credit 90,000
Outside the states-5 week’s credit 1,10,000
c) Time available for payment:

For purchases-5 weeks 1,10,000
For wages-3 weeks 2,90,000
Solution:
Current Assets:
Inventories:
Stock of finished goods & WIP 10,000
Stock of stores, materials etc 8,000 18,000
Accounts Receivable:
Local sales 90,000 X 3/52= 5,192
Outside the sate 3,20,000 X 5/52= 30,769 35,961
Total Current assets 53,961

Less: Current Liabilities
Accounts, payable 1,10,000 X 5/52= 10,577
Outstanding wages 2,90,000 X 5/52= 16,731 27,308
Add 5% for contingencies (266653 X 5%) 26,653
1,333
Working capital required 27,986
CASE FOR CLASS DISCUSSION – 1

Creative Promotion Company
Mr. Bhatt is a young man of bright ideas. Although he is employed as an engineer in
one of the large engineering concerns in Lahore (Pakistan), he spends all his spare time
developing new products in his private laboratory at home. Currently, he has commercially
provided a domestic appliance called Lavex, which would be a great convenience kitchen to
help housewives. He is not interest in manufacturing and selling his new products: his only
interest in developing new products is to make money by way of selling patent rights to some
established concerns. However, he releases that till he succeeds in selling the patent rights at
the price he expects, he has to manufacture and sell the new products on ad hoc basis so as to
demonstrate the commercial superiority of his products and thereby, to induce the parties to
buy the patents from him. With this objective, he currently thinking of manufacturing and
selling Lavex. He will not give up his full-time job: he will supervise and guide Lavex’
production and sales during his spare time.
Bhatt has already spent Rs. 30,000 in developing the product. He proposes to buy
the component from other parties and keep the production activity to a minimum. The
minimum equipment required would cost Rs. 11,000. he would need to rent a small place for
Rs. 1,200 per month for production. He proposes to use his residence as office for sales
activity. Bhatt proposes to introduce the product in Chennai city only. His sales projections
are as follows:
January 60
February 40
March 110
April 140
May 220
June 180
He is not interested in pushing sales beyond 220 units per month as he cannot cope with the
production. He has budgeted Rs. 20,000 for sales promotion, which will be spent mostly for
demonstration in leading department stores in the city. The promotion budget is scheduled as
follows.
Rs.
January 7,000
February 7,000
March 3,000
April 3,000
The selling price per units will be Rs. 280 and the dealers will be given 15 percent trade
discount. He calculates that about 50 unit will be needed for demonstration and display in the
leading sores at his cost. Although the sales to dealers will be made on one month’s credit he
knows that the actual collections will be realized in about 4 weeks time. He rules out cash
sales.
Assembling is one of the activity in the production process. Components and materials,
which will be purchased from outside parties strictly on 30 days credit will cost Rs. 160 per
unit. Wages per month will be Rs. 6000. the production capacity per month will be 220 units.
Wages will be paid weekly. Overhead expenses are estimated at Rs. 2800 per month
Materials and components need to be ordered at least one month in advance. There will be
inventory of finished goods or goods in process as the production will be strictly against firm
orders. Bhatt proposes to employ a full-time production sales supervisor for Rs. 880 per
month.
Mr. Bhatt wants to know how much finance will be needed for his first six months of
operation and when, so that he may plan accordingly.
Assignments
1. Discuss the nature of the financial problem involved.
2. Prepare the monthly cash budget for the first six months period of the proposed
venture.
3. How can the above mentioned problem be sorted out?
CASE-2
Mysore Lamps Limited
Mysore Lamps Limited is a company specializing in the production of fluorescent
lamps. The company has been maintaining the Quality of its products and due to the efforts
of its marketing manager, the company has been able to capture a sizeable share of the
product market in the recent past. The company is planning to expand in the same product
line. Me. Mysore, the Managing director of the company is confronted with the problem of
increasing working capital due to the expansion plans of the company.
Mysore Lamps limited was set up in 1991 with an authorized capital of Rs. 110 crore
and faced heavy competition in the initial years of commencement of business. During 2006,
the company could make a dent in the fluorescent lamps market and its position as on
December 31, 2006, was as shown in Exhibit I.
xhibit-I
Balance Sheet
Capital 1500 Fixed assets 1000
Reserves 762 Current assets 1862
Long-term loan 400 Raw materials 200
Current liabilities 200 Work-in-progress 287
Finished goods 450 Accounts receivables 675
Bank overdraft 962 cash 250
Total 4274 Total 4274
During the year 2006, the company was able to sell 50 lakh pieces of fluorescent
lamps a Rs. 60 with a profit margin of 10 per cent. The raw material comprised about 50 per
cent of the selling price: while wages and overheads accounted for 12 and 18 per cent,
respectively.
As a policy, the company keeps raw material stock for two months of its
requirements. In order to make prompt supply to customers on orders received, finished
goods stock for two months requirements is maintained and sales credit of 3 months is given
to customers. Due to the standing of the company in the market, the company is able to enjoy
2 months from its suppliers. The production process is of 30 days duration.
Mr. Mysore is seriously considering the proposal for expansion by installing an
automatic plant costing Rs. 30 pcrores. The expansion will bring in an additional capacity of
100 lakh units per annum. Mr. Mysore is not worried about the financing of this plant as the
same would be done for the retained earnings supplemented by finances from Mr. Mysore;s
personal sources. He expects that the company would be able to increase its sale from 50
lakh pieces after the expansion scheme.
Assignments
1. As a manager, what steps would you take to effectively manage the working
capital in an inflationary situation?
2. What additional informations are required while evaluating the additional

working capital requirement and expansion plans?
3. What steps must be taken to manage the working capital effectively under
inflationary situation? What would be the effect of expansion plan on working
capital requirement?
Unit-II
WORKING CAPITAL FINANCE
Objectives: The objective of this lesson is to discuss how the working capital of a business
organization is financed from various sources.
Structure:
2.1 Financing of Working Capital-An introduction.
2.2 Sources of Working Capital Finance.
2.3 Financing of permanent/Fixed/or Long-Term working Capital.
2.4 Financing of Short-Term working Capital.
(by Trade Credit, Factoring and Commercial paper).
2.5 Trade Credit
2.6 Working Capital Finance by Commercial banks or bank Credit.
2.7 RBI Frame Work for Regulation of Bank Credit.
2.8 Working Capital analysis or Measuring the working Capital.
2.9 Summary.
2.10 Review exercises.
UNIT-II
WORKING CAPITAL FINANCE

1.1 FINANCING OF WORKING CAPITAL
The working capital requirements of a concern can be classified as:
(a) Permanent or Fixed working capital requirements.
(b) Temporary or Variable working capital requirements.
In any concern, a part of the working capital investments are as permanent

investments in fixed assets. This is so because there is always a minimum level of current
assets which are continuously required by the enterprise to carry out its day-to-day business
operations and this minimum cannot be expected to reduce at any time. This minimum level
of current assets gives rise to permanent or fixed working capital as this part of working
capital is permanently blocked in current assets.
Similarly, some amount of working capital may be required to meet the seasonal
demands and some special exigencies such as rise in prices, strikes, etc. this proportion of
working capital gives rise to temporary or variable working capital which cannot be
permanently employed gainfully in business.
The fixed proportion of working capital should be generally financed from the fixed
capital sources while the temporary or variable working capital requirements of a concern
may be met from the short term sources of capital.
The various sources for the financing of working capital are as follows:
1.2 SOURCES OF WORKING CAPITAL FINANCE:
sources of Working Capital
Permanent or Fixed Temporary or Variable
1. Shares 1 Commercial Banks

2. Debentures 2 Indigenous bankers
3. Public deposits 3 Trade Creditors
4. Ploughing back of profits 4 Installment Credit
5. Loans from Financial Institutions 5 Advances
6. Accounts Receivable-
Credit/Factoring
7. Accured Expenses
8. Commercial Paper
1.3 FINANCING OF PERMANENT/FIXED OR LONG-TERM WORKING

CAPITAL:
Permanent working capital should be financed in such a manner that the enterprise
may have its uninterrupted use for a sufficiently long period. There are five important
sources of permanent or long-term working capital.
1. Shares. Issue of shares is the most important source for raising the permanent or
long-term capital. A company can issue various types of shares as equity shares,
preference shares and differed shares, preference shares and differed shares.
According to the Companies Act, 1956, however, a public company cannot issue
differed shares. Preference shares carry preferential rights in respect of dividend
at a fixed-rate and in regard to the repayment of capital at the time of winding up
the company. Equity shares do not have any fixed commitment charge and the
dividend on these shares is to be paid subject to the availability of sufficient
profits. As far as possible, a company should raise the maximum amount of
permanent capital by the issue of shares.
2. Debentures: A debenture is an instrument issued by the company acknowledging
its debt to its holder. It is also an important method of raising long-term or
permanent working capital. The debenture-holders are the creditors of the
company. A fixed rate of interest is paid on debentures. The interest on
debentures is a charge against profit and loss account. The debentures are
generally given floating charge on the assets of the company. When the
debentures are secured they are paid on priority to other creditors. The debentures
may be of various kinds such as simple, naked or unsecured debentures, secured
or mortgaged debentures, redeemable debentures, irredeemable debentures,
convertible debentures and non-convertible debentures. The debentures as a
source of finance have a number of advantages both to the investors and the
company. Since interest on debentures have to be paid on certain predetermined
intervals at a fixed rate and also debentures get priority on repayment at the time
of liquidation, they are very well suited to cautious investors. The firm issuing
debentures also enjoys a number of benefits such as trading on equity, retention of
control, tax benefits, etc.
3. Public Deposits: Public deposits are the fixed deposits accepted by a business
enterprise directly from the public. This source of raising short term and medium-
term finance was very popular in the absence of banking facilities. In the past,
generally, public deposits were accepted by textile industries in Ahmedabad and
Bombay for periods of 6 months to 1 year. But now-a-day seven long-term

deposits for 5 to 7 years are accepted by the business houses. Public deposits as a
source of finance have a large number of advantages such as very simple and
convenient source of finance, taxation benefits, trading on equity, no need of
securities and an inexpensive source of finance. But it is not free from certain
dangers such as, it is uncertain, unreliable, unsound and inelastic source of
finance. The Reserve Bank of India has also laid down certain limits on public
deposits. Non-banking concerns cannot borrow by way of public deposits more
than 25% of its paid-up capital and free reserves.
4. Ploughing Back of Profits: Ploughing back of profits means the reinvestments

by concern of its surplus earnings in its business. It is an internal source of finance
and is mot suitable for an 3established firm for its expansion, modernization and
replacement etc. This method of finance has a number of advantages as it is the
cheapest rather cost-free source of finance; there is no need to keep securities;
there is no dilution of control it ensures stable dividend policy and gains
confidence of the public. But excessive resort to ploughing back of profits may
lead to monopolies, misuse of funds, over capitalization and speculation etc.
5. Loans from Financial Institutions: financial institutions such as Commercial

Bank. Life Insurance Corporation, Industrial Finance Corporation of India, State
Financial Corporation, State Industrial Development Corporations, Industrial
Development Bank of India etc. also provide short term medium-term and long-
term loans. This source of finance is more suitable to meet the medium-term
demands of working capital. Interest is charged on such loans at a fixed rate and
the amount of the loan is to be repaid by way of installments in a number of years.
1.4 FINANCING OF TEMPORARY, VARIABLE OR SHORT-TERM WORKING
CAPITAL:
The main source of short-term working capital are as follows:

1. Indigenous Bankers
2. Trade Credit
3. Installment Credit
4. Advances
5. Accounts Receivable Credit or Factoring

6. Accrued Expenses
7. Deferred income
8. Commercial paper
1. Indigenous Bankers
Private money-lenders and other country bankers-used to be the onbly source of
finance prior to the establishment of commercial banks. They used to charge very high
rates of interest and exploited the customers to the largest extent possible. Now-a-days
with the development of commercial banks they have lost their monopoly. But even
today some business houses have to depend upon indigenous bankers for obtaining loans
to meet their working capital requirements.
2. Trade Credit
Trade credit refers to the credit extended by the supploi8ers of goods in the
normal course of business. As present day commerce is built upon credit, the trade credit
arrangement of a firm with its suppliers is an important source of short-term finance. The
credit-worthiness of a firm and the confidence of its suppliers are the main basis of
securing trade credit. It is mostly granted on an open account basis whereby supplier
sends goods to the buyer for the payment to be received in future as per terms of the sales
invoice. It may also take the form of bills payable whereby the buyer signs a bill of
exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the terms of sales
invoice, it is called stretching accounts payable. A firm may generate additional short-
term finances by stretching accounts payable, but it may have to pay penal interest
charges as well as to forgo cash discount. If a firm delays the payment frequently, it
adversely affects the credit worthiness of the firm and it may not be allowed such credit
facilities in future.
The main advantages of trade credit as a source of short-term finance include.
(i) It is an easy and convenient method of finance
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However the biggest disadvantage of this method of finance is charging of higher
prices by the suppliers and loss of cash discount.
1.5 Trade Credit:

Trade Credit is one of the major sources of short-term of financing to
business houses. In most of the developing countries, trade credit helps business
houses to increase their activities substantially. Here, the seller of the goods offers a
definite period for payments. The prices of such goods and commodities are not
collected immediately after delivery. Hence, it helps the buyer to avail such benefits
to meet working capital requirements. Therefore, trade credit offered by a seller to the
buyer will become B/R or debtors in his books. The same amount would appear in the
buyer’s book under the head of B/P or creditors.
There are three categories of trade credit: viz, (a) Open Account, (b) Notes
Payable and (c) Trade Acceptances:
Trade Credit
Open Account Credit
Notes payable
Trade Acceptances
Open Account Credit
Under this method, a seller will offer the credit period to the buyer on open
account. There will not be a specific agreement to a avail this facility to the buyer.
However, as and when the credit period gets over, it is the obligation of the buyer to
clear his commitments. This account will be operated continuously as per the invoices
raised by the seller. Open account credit system is a more popular means of financing
to small business houses. (SSIs and small traders). It is the duty of the seller to select
the buyer to offer open account credit. The success of this mainly depends on the
paying habit of the buyer.
Notes Payable
Under this arrangement, the buyer has to acknowledge the debt commitment to
the seller. The acknowledgement will be established between them by a promissory
note. The seller draws the promissory note on the buyer mentioning therein the
amount, period of credit and mode payment. The buyer has to accept this document to
avail credit facility. Acceptances will normally be made by obtaining the buyer’s
signature on the promissory note.
Trade Acceptance
Under this arrangement of trade credit, goods will be delivered by the seller
only after obtaining the acceptance from the buyer. The seller normally draws the
draft. The draft is an order of payment at some date in future. The buyer designates
the banker to make the payment on his own behalf. Trade acceptance is a more
popular and marketable arrangement of credit.
Terms of Credit
There are two aspect of trade credit namely:
(a) The Cash Discount; and
(b) The Payment Period.
The Cash Discount: A Cash Discount is a reduction in the sale price of commodity
allowed by a seller for receiving the payments on due date. It is a concession offered
by the seller to accelerate the speed of credit collection. The percentage of redacting
varies according to the time span taken for payment. Lower percentage of discounts
are allowed to a buyer who takes more credit period and vice versa.
COD cash on delivery

Models of
CBD cash before delivery
Payment
Period Net period without cash discount
Net period with cash discount
(a) COD Cash on Delivery: Under this method, the payments of the invoices or
bills will be made against the delivery of goods. The only risk associated with
cash on delivery is, that the buyer may refuse to take the delivery of the goods
for his own reasons. On such circumstances, the seller has a bear the risk of
transportation or cost of shipping.
(b) CBD Cash before Delivery: Under this method, the seller doesn’t offer credit
to buyer. The buyer has to make the payments prior to the shipment of goods.
This arrangement is popular and the parched only in the event of an unknown
buyer or a product should have such a value. Hence the it eliminates the
collection of the seller.
(c) Net Period without Cash Discount: Under this arrangement a seller
specifically instructs the buyer to make payments on the date without offering
cash discount. If he mentions not 30 as the choice, it indicates the payment must
be made within 30 days of the invoice date.
(d) Net Period with Cash Discount: Under Net Period with Cash discount, the
seller not only offers the credit period but also offers cash discount. The seller
clearly spells out the concession as the invoice example if the payments are
made within 15 days, a discount of 3% is allowed to the buyer. Otherwise, the
buyer has to make full payments without any cash discount.
TRADE CREDIT AS A MEANS OF SHORT-TERM FINANCING
Trade Credit has been considered as one of the main sources of short term financing.
Trade Credit is a direct bearing on production cycle. The benefit of trade credit can be
conveniently availed by making proper purchase and financial plans. The facilities that are
associated with trade credit are cheap and easy sources of funds. The seller will not undertake
series of efforts to evaluate the creditworthiness of the buyer and buyer need not have to
make arrangement of funds to buy materials, and can avail finance without straining his
financial costs. However, he has to evaluate the benefit of:
(a) Cash purchase with discounts.
(b) Credit purchase without down payment.
Trade Credit is a powerful tool of finance during the boom period. A manufacturer
who anticipates and sales in the coming month can aptly purchase the material under trade
credit and can exploit the business opportunity. It is also used as a booster to sales specially
with small traders. They mainly depend on trade credit for all types of purchases. The main
reason behind here is, for smaller people, it is difficult to obtain bank loans. They cannot
afford to follow the formalities of the banker. Trade Credit substitutes such problems to small
industries and business horses with its liberal attitudes.
The cost associated with trade credit may be borne either by the seller or the buyer or
both. It the buyer refuses to accept the higher price with trade credit, it becomes the
responsibility of assuming trade credit cost by the seller. If the buyer prefers to have more
price and lengthy credit period, he assumes the cost of trade credit. Many at times, the cost of
trade credit will be shared both by seller and the buyer.
Conclusion:
With the above discussion, we can arrive at a conclusion that trade credit is a easy
means of financing, it is a continuous financing and more flexible to the buyer. It increases
the over all businesses of both seller and the buyer. The seller can attract more customers
through trade credit and can increase his production and sales. In the long run, it helps to
achieve his goals. The buyer can also increase his business and production plans. He can
exploit more business opportunities to increase his profit. The most efficient system of trade
credit mainly depends on the honesty, integrity and sincerity of the buyer. If he clears his
commitments on the due dates it becomes the most powerful tool which accelerates the speed
of industrial as a well as trading activities.
tallment Credit
This is another method by which the assets are purchased and the possession of
goods is taken immediately but the payment is made in instalments over a pre-determined
period of time. Generally, interest is charged on the unpaid price or it may be adjusted in the
price. But, in any case, it provides funds for sometime and is used as a source of short-term
working capital by many business houses which have difficult fund position.
Advances
Some business houses get advances from their customers and agents against orders and this
source is a short-term source of finance for them. It is a cheap source of finance and in order
to minimize their investment in working capital, some firms having long production cycle,
specially the firms manufacturing industrial products prefer to take advances from their
customers.
Factoring or Accounts Receivable Credit:
Another method of raising short-term finance is through accounts receivable credit
offered by commercial banks and factors. A commercial bank may provide finance by
discounting the bills or invoices of its customers. Thus, a firm gets immediate payment for
sales made on credit. A factor is a financial institution which offers services relating to
management and financing of debts arising out of credit sales. Factoring is becoming popular
all over the world on account of various services offered by the institutions engaged in it.
Factors render services varying from bill discounting facilities offered by commercial banks
to a total take over of administration of credit sales including maintenance of sales ledger,
collection of accounts receivables, credit control and protection from bad debts, provision of
finance and rendering of advisory services to their clients. Factoring may be on a recourse
basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the
risk of credit is borne by the factor.
At present, factoring in India is rendered by only a few financial institutions on a
recourse basis however the Report of the Working Croup on Money market (Vaghul
Committee) constituted by the Reserve Bank of India has recommended that banks should be
encouraged to set up factoring divisions to provide speedy finance to the corporate entities.
Inspite of many services offered by factoring, it suffers from certain limitations. The
most critical fall outs of factoring include (i) the high cost of factoring as compared to other
sources of short-term finance (ii) the perception of financial weakness about the firm availing
factoring services, and (iii) adverse impact of tough stance taken by factor, against a
defaulting buyer upon the borrower resulting into reduced future sales.
Accrued Expenses
Accrued expenses are the expenses which have been incurred but not yet due and
hence not yet paid also. These simply represent a liability that a firm has to pay for the
services already received by it. The most important items of accruals are wages and salaries,
interest, and taxes. Wages and salaries are usually paid on monthly, fortnightly or weekly
basis for the services already rendered by employees. The longer the payment-period, the
greater is the amount of liability towards employees or the funds provided by them. In the
same manner, accrued interest and taxes also constitute a short-term source of finance. Taxes
are paid after collection and in the intervening period serve as a good source of finance. Even
income-tax is paid periodically much after the profits have been earned. Like taxes, interest is
also paid periodically while the funds are used continuously by a firm. Thus, all accrued
expenses can be used as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm.
When the activity level expands, accruals also increase and hence they provide a spontaneous
source of finance. Further, as no interest is payable on accrued expenses, they represent a free
source of financing. However, it must be noted that it may not be desirable or even possible
to postpone these expenses for a long period. The payment period of wages and salaries is
determined by provisions of law and practice in industry. Similarly, the payment dates of
taxes are governed by law and delays may attract penalties. Thus, we may conclude that
frequency and magnitude of accruals is beyond the control of managements. Even then, they
serve as a spontaneous, interest free, limited source of short-term financing.
Deferred Incomes
Deferred incomes are incomes received in advance before supplying foods of
services. They represent funds received by a firm for which it has to supply goods or services
in future. These funds increase the liquidity of firm and constitute an important source of
short-term finance. However, firms having great demand for its products and services, and
those having good reputation in the market can demand deferred incomes.
Commercial Paper
Commercial paper represents unsecured promissory notes issued by firms to raise
short-term funds. It is an important money market instrument in advanced countries like
U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian money
market on the recommendations of the Working Group on Money Market (Vaghul
Committee). But only large companies enjoying high credit rating and sound financial health
can issue commercial paper to raise short-term funds. The Reserve Bank of Indian has laid
down a number of conditions to determine eligibility of a company for the issue of
commercial paper. Only a company which is listed on the stock exchange, has a net worth of
at least Rs. 10 crores and a maximum permissible bank finance of Rs. 25 crores can issue
commercial paper not exceeding 30 per cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180
days. It is sold at a discount from its face value and redeemed at face value on its maturity.
Hence, the cost of raising funds, through this source, is a function of the amount of discount
and the period of maturity and no interest rate is provided by the Reserve Bank of India for
this purpose. Commercial paper is usually bought by investors including banks, insurance
companies unit trusts and firms to invest surplus funds for a short-period. A credit rating
agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the
bank credit and proves to be effective even during period of night bank credit. However, it
can be used as a source of finance only by large companies enjoying high credit rating and
sound financial health. Another disadvantage of commercial paper is that it cannot be
redeemed before the maturity date even if the issuing firm has surplus funds to pay back.
1.6 Working Capital Finance By Commercial Banks
Commercial banks are the most important source of short-term capital. The major
portion of working capital loans are provided by commercial bank, they provided a wise
verity of loans tailored to meet the specific requirement of a concern. The different forms in
which the banks normally provide loans and advances are as follows:
(a) Loans
(b) Cash Credits
(c) Overdrafts
(d) Purchasing and Discounting of bills
(a) Loans. When a bank makes and advance in lump-sum against some security it is called
a loan. In case of a loan, a specified amount is sanctioned by the bank to the customer.
The entire loan amount is paid to the borrower wither in cash or by credit to his
account. The borrower is required to pay interest on the entire amount of the loan from
the date of the sanction. A loan may be repayable in lump sum or installments. Interest
on loans is calculated at quarterly rests and where repayments are stipulated in
instalments, the interest is calculated at quarterly rests on the reduced balances.
Commercial banks generally provide short-term loans up to one year for meeting
working capital requirements. But now-a-days term loans exceeding one year are also
provided by banks. The term loans may be either medium-term or long-term loans.
(b) Cash Credits. A cash credit is an arrangement by which a bank allows his customer to
borrow money upto a certain limit against some tangible securities or guarantees. The
customer can withdraw from his cash credit limit according to his needs and he can also
deposit any surplus amount with him. The interest in case of cash credit is charged on
the daily balance and not on the entire amount of the account. For these reasons, it is
the most favourite mode of borrowing by industrial and commercial concerns. The
Reserve Bank of India issued a directive to all scheduled commercial banks on 28th
March 1970, prescribing a commitment charge which banks should levy on the
unutilized portion of the credit limits.
(c) Overdrafts. Overdraft means an agreement with a bank by which a current account-
holder is allowed to withdraw more than the balance to his credit upto a certain limit.
There are no restrictions for operation of overdraft limits. The interest is charged on
daily overdrawn balances. The main difference between cash credit and overdraft is that
overdraft is allowed for a short period and is a temporary accommodation whereas the
cash credit is allowed for a longer period. Overdraft accounts can either be clean
overdrafts, partly secured or fully secured.
(d) Purchasing and Discounting of Bills. Purchasing and discounting of bills is the most
important form in which a bank lends without any collateral security. Present day
commence is built upon credit. The seller draws a bill of exchange on the buyer of
goods on credit. Such a bill may be either a clean bill or a documentary bill which is
accompanied by documents of title to goods such as a railway receipt. The bank
purchases the bills payable on demand and credits the customer’s account with the
amount of bill less discount. At the maturity of the bills, bank presents the bill to its
acceptor for payment. In case the bill discounted is dishonoured by non-payment, the
bank recovers the full amount of the bill from the customer along with expenses in that
connection.
In addition to the above mentioned forms of direct finance, commercial banks
help their customers in obtaining credit from their suppliers through the letter of credit
arrangemenyt.
Letter of Credit
A letter of credit popularly known as L/C is an undertaking by a bank to honour the
obligations of its customer upto a specified amount, should the customer fail to do so. It helps
its customers to obtain credit from suppliers because it ensures that there is no risk of non-
payment. L/C is simply a guarantee by the bank to the suppliers that their bills upto a
specified amount would be honoured. In case the customer fails to pay the amount, on the
due date, to its suppliers, the bank assumes the liability of its customer for the purchases
made under the letter of credit arrangement.
A letter of credit may be of many types, such as:
(i) Clean Letter of Credit- It is a guarantee for the acceptance and payment of bills without
any conditions.
(ii) Documentary Letter of Credit- it requires that the exporter’s bill, the exchange be
accompanied by certain documents evidencing title to the goods.
(iii) Revocable Letter of Credit- It is one which can be withdrawn by the issuing bank
without the prior consent of the exporter.
(iv) Irrevocable Letter of Credit- It cannot be withdrawn without the consent of the
beneficiary.
(v) Revolving Letter of Credit- In such type of letter of credit the amount of credit it
automatically reversed to the original amount after such an amount has once been paid
as per defined conditions of the business transaction. There is no deed for further
application for another letter of credit to be issued provided the conditions specified in
the first credit are fulfilled.
(vi) Fixed Letter of Credit-It fixes the amount of financial obligation of the issuing bank
either in one bill or in several bills put together.
Security Required in Bank Finance: Banks usually do not provide working capital finance
without obtaining adequate security. The following are the most important modes of security
required by a bank.
1 Hypothecation. Under this arrangement, bank provided working capital finance
against the security of movable property, usually inventories. The borrower does not give
possession of the property to the bank. It remains with the borrower and hypothecation is
merely a charge against property for the amount of debt. If the borrower fails to pay his dues
to the bank, the banker may file a case to realize his dues by sale of the goods/property
hypothecated.
2 Pledge. Under this arrangement, the borrower is required to transfer the physical
possession of the property or goods to the bank as security. The bank will have the right of
lien and can retain the possession of goods unless the claim of the bank is met. In case of
default, the bank can even sell the goods after giving due notice.
3 Mortgage: In addition to the hypothecation or pledge, banks usually ask for
mortgages as collateral or addition security Mortgage is the transfer of a legal or equitable
interest in specific immovable property for the payment of a debt. Although, the possession
of the property remains with the borrower the full legal title is transferred to the lender. In
case of default, the bank can obtain decree from the court to sell the immovable property
mortgaged so as to realize its dues.
Solution:
Calculation of Return on Equity
(Rs. In lacs)
X Ltd Y Ltd
(a) (b) (a) (b)
Earnings Before interest and Tax 50.00 50.00 50.00 50.00
Interest on Current and Long-term Debt 11.60 12.60 10.40 14.40
Earnings Before Tax (BBT) 38.40 37040 39.60 35.60
Tax (35%) 13.44 13.09 13.86 12.46
Earnings After Tax (EAT) 24.96 24.31 25.74 23.14

Equity (Eq. Share Capital retained 100.00 100.00 100.00 100.00
Earnings)
Return on Equity (EAT/Equity) 24.96% 24.31% 25.74% 23.14%-
1.7 NEW TRENDS IN FINANCING WORKING CAPITAL BY BANKS OR RBI

FRAMEWORK FOR REGULATION OF BANK CREDIT:
Banks in India have been providing finance to industry and trade on the basis of
security. To ensure its equitable distribution in the right channels bank credit has been a
subject matter of regulation and control by the Government. Since November 1965, a Credit
Authorization Scheme has been in operation as part of the Reserve Bank of India’s credit
policy. (As was adopted by the RBI to regulate the end use of bank credit) Under this
scheme, all scheduled commercial banks age required to obtain prior authorization of the
Reserve Bank before sanctioning any fresh credit limits of Rs. One crore or more to any
single party or any limit that would enable the party avail Rs. One crore or more from the
entire banking system on secured or unsecured basis. The limit of Rs. One crore was
subsequently raised to Rs. Five crores.
To regulate and control bank finance, the Reserve bank of India has been issuing
directives and guidelines to the banks from time to time on the recommendations of certain
specially constituted committees entrusted with the task of examining various aspects of bank
finance to industry. We have discussed below the important findings and recommendations
of the following committees.
2 Dehejia Committee
3 Tandon Committee
4 Chore Committee
5 Marathe Committee
6 Chakravarty Committee
7 Kannan Committee Report.
Dehejia Committee Report:
National credit council constituted a committee under the chairmanship of Shri
V.T.Dehejia in 1968 to determine the extent to which credit needs of industry and trade are
likely to be inflated and how such trends could be checked and to go into establishing some
norms for lending operations by commercial banks. The committee was of the opinion that
there was also a tendency to divert short-term credit for long-term assets. Although
committee was of the opinion that it was difficult to evolve norms for lending to industrial
concerns, the committee recommended that the banks should finance industry on the basis of
a study of borrower’s total operations rather than security basis alone. The Committee further
recommended that the total credit requirements of the borrower should be segregated into
‘Hard Core’ and ‘Short-term’ component. The ‘Hard Core’ component which should
represent the minimum level of inventories which the industry was required to hold for
maintaining a given level of production should be put on a formal term loan basis and subject
to repayment schedule. The committee was also of the opinion that generally a customer
should be required to confine his dealing to one bank only.
Tandon Committee Report
Reserve Bank of India set up a committee under the chairmanship of Shri P.L.
Tandon in July 1974. The terms of reference of the Committee were:
(1) To suggest guidelines for commercial banks to follow up and supervise credit
from the point of view of ensuring proper end use of funds and keeping a watch
on the safety of advances;
(2) To suggest the type of operational data and other information that may be
obtained by banks periodically from the borrowers and by the Reserve Bank of
India from the leading banks;
(3) To make suggestions for prescribing inventory norms for the different industries,
both in the private and public sectors and indicate the broad criteria for deviating
from these norms.
(4) To make recommendations regarding resources for financing the minimum
working capital requirements;
(5) To suggest criteria regarding satisfactory capital structure and sound financial
basis in relation to borrowings;
(6) To make recommendations as to whether the existing pattern of financial working
capital requiremnt6s by cash credit/overdraft system etc. requires to be modified,
if so, to suggest suitable modifications.
The committee was of the opinion that: (i) Bank credit is extended on the amount of
security available and not according to the level of operations of the customer, (ii) Bank
credit instead of being taken as a supplementary to other sources of finance is treated as the
first source of finance. Although the Committee recommended the continuation of the
existing cash credit system, it suggested certain modifications so as to control the bank
finance. The banks should get the information regarding the operational plans of the
customer in advance so as to carry a realistic appraisal of such plans and the banks should
also know the end use of bank credit so that the finances are used only for purposes for which
they are lent.
The recommendations of the committee regarding lending norms have been suggested
under three alternatives. According to the first method, the borrower will have to contribute a
minimum of 25% of the working capital gap from long-term funds i.e. owned funds and term
borrowing; this will give a minimum current ratio 1.17 :1 Under the second method the
borrower will have to provide a minimum of 25% of the total current assets from long-term
funds: this will give a minimum current ratio of 1.33:1. In the third method, the borrower’s
contribution from long-term funds will be to the extent of the entire core current assets and a
minimum of 25% of the balance current assets, thus strengthening the current ratio further.
Example
Rs.
Total current assets required 40,000
Current liabilities other than bank borrowings 10,000
Core current assets 5,000
1st Method
Total current assets required 40,000
Less Current Liabilities 10,000
Working Capital Gap 30,000
Less 25% from Long-term sources 7,500
Maximum permissible bank borrowings 22,500
2nd Method
Current assets required 40,000
Less 25% to be provided from long-term funds 10,000
30,000
Less current Liabilities 10,000
3rd Methods
Current assets 40,000
Less Core Current assets 5,000
35,000
Less 25% to be provided from long-term funds 8,750
26,250
Less Current Liabilities 10,000
Chore Committee report

The Reserve Bank of India in March, 1979 appointed another committee under the
chairmanship of Shri K.B.Chore to review the working of cash credit system in recent years
with particular reference to the gap between sanctional limits and the extent of their
utilization and also to suggest alternative type of credit facilities which should ensure greater
credit discipline.
(i) The banks should obtain quarterly statements in the prescribed format from all
borrowers having working capital credit limits of Rs. 50 lacs and above.
(ii) The banks should undertake a periodical review of limits of Rs. 10 lacs and
above.
(iii) The banks should not bifurcate cash credit accounts into demand loan and cash
credit components.
(iv) If a borrower does not submit the quarterly returns in time the banks may charge
penal interest of one per cent on the total amount outstanding for the period of
default.
(v) Banks should discourage sanction of temporary limits by changing additional one
per cent interest over the normal rate on these limits.
(vi) The banks should fix separate credit limits for peak level and non-peak level
wherever possible.
(vii) Banks should take steps to convert cash credit limits into bill limits for financing
sales.
Marathe Committee Report

The Reserve Bank of India in 1982 appointed a committee under the chairmanship of
Marathe to review the working of Credit authorization Scheme (CAS) and suggest measures
for giving meaningful directions to the credit management function of the Reserve Bank. The
recommendations of the committee have been accepted by the Reserve Bank of India with
minor modifications.
The principal recommendations of the Marathe Committee include:
(i) The committee has declared the Third Method of Lending as suggested by the
Tandon Committee to be dropped. Hence, in future, the banks would provide
credit for working capital according to the Second Method of Lending.
(ii) The committee has suggested the introduction of the ‘Fast Track Scheme’ to
improve the quality of credit appraisal in banks. It recommended that commercial
banks can release without prior approval of the Reserve bank 50% of the
additional credit required by the borrowers (75% in case of export oriented

manufacturing units) where the following requirements are fulfilled:
(a) The estimates/projections in regard to production, sales, chargeable current
assets, other current assets, current liabilities other than bank borrowings,
and net working capital are reasonable in terms of the past trends and
assumptions regarding most likely trends during the future projected period.
(b) The classification of assets and liabilities as ‘current’ and ‘non-current’ is in
conformity with the guidelines issued by the Reserve bank of India.
(c) The projected current ratio is not below 1.33:1.
The borrower has been submitting quarterly information and operating
statements 9Form I,II and III) for the past six months within the prescribed time and
undertakes to do the same in future also.
(d) The borrower undertakes to submit to the bank his annual account regularly
and promptly, further, the bank is required to review the borrower’s
facilities at least once in a year even if the borrower does not need
enhancement in credit facilities.
Chakravarty Committee Report
The Reserve bank of India appointed another committee under the chairmanship of
Sukhamoy chakravarty to review the working of the monetary system of India. The
committee submitted its report in April, 1985. the committee made two major
recommendations in regard to the working capital finance:
Penal Interest for Delayed Payments
The committee has suggested that the government must insist that all public sector
units, large private sector units and government departments must include penal interest
payment clause in their contracts for payments delayed beyond a specified period. The
penal interest may be fixed at 2 per cent higher than the minimum lending rate of the
supplier’s bank.
(i) Classification of Credit Limit Under Three Different Heads:
The committee further suggested that the total credit limit to be sanctioned to a
borrower should be considered under three different heads: (1) Cash Credit to include
supplies to government, (2) Cash Credit II to cover special circumstances, and (3)
Normal Working Capital Limit to cover the balance credit facilities. The interest rates
proposed for the three heads are also different. Basic lending rate of the bank should
be charged to Cash Credit II, and the Normal Working Capital Limit be charged as
below:
(a) For Cash Credit Portion : maximum prevailing lending rate of the bank
(b) For Bill Finance Portion : 2% below the basic lending rate of the bank.
(c) For Loan Portion : The rate may vary between the minimum and
maximum lending rate of the bank.
Kannan Committee Report
In view of the ongoing liberalistion in the financial section the Indian banks
association (IBA) constituted a committee headed by Shri K.Kannan, Chairman and
Managing director of Bank of Baroda to examine all the aspects of working capital finance
including assessment of maximum permissible bank finance (MPBF). The committee
submitted its report on 25th February, 1997. it recommended that the arithmetical rigidities
imposed by Tandon Committee (and reinforced by Chore Committee) in the form of MPBF
computation so far been in practice, should be scrapped. The Committee further
recommended that freedom to each bank be given in regard to evolving its own system of
working capital finance for a faster credit delivery so as to serve various borrowers more
effectively. It also suggested that line of credit system (LCS), as prevalent in many advanced
countries, should replace the existing system of assessment/fixation of sub-limits within total
working capital requirements. The committee proposed to shift emphasis from the Liquidity
Level Lending (Security Based Lending) to the Cash Deficit Lending called Desirable bank
Finance (DBF). Some of the recommendations of the committee have already been accepted
by the Reserve bank of India with suitable modifications. The important measures adopted by
RBI in this respect are given below:
(i) Assessment of working capital finance based on the concept of MPBF, as
recommended by Tandon Committee, has been withdrawn. The banks have been
given full freedom to evolve an appropriate system for assessing working capital
needs of the borrowers within the guidelines and norms already prescribed by
Reserve bank of India.
(ii) The turnover method may continue to be used as a tool to assess the requirements of
small borrowers. For small scale and tiny industries, this method of assessment has
been extended upto total credit limits of Rs. 2 crore as against existing limit of
crore.
(iii) Banks may now adopt Cash Budgeting System for assessing the working capital
finance in respect of large borrowers.
(iv) The banks have also been allowed to retain the present method of MPBF with
necessary modification or any other system as they deem fit.
(v) Banks should lay down transparent policy and guidelines for credit dispensation in
respect of each broad category of economic activity.
(vi) The RBI’s instructions relating to directed credit, quantitative limits on lending and
prohibitions of credit shall continue to be in force. The present reporting system to
RBI under the Credit Monitoring Arrangement (CMA) shall also continue in force.
2.8 WORKING CAPITAL ANALYSIS OR MEASURING THE WORKING CAPITAL
We have already studied in this chapter that working capital is the life blood and nerve centre
of a 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. However, it must also
be noted that working capital is a means to run the business smoothly and profitably, and not
an end. Thus concept of working capital has its own importance in a going concern. A going
concern, usually, has a positive balance of working capital, i.e. the excess of current assets
over current liabilities, but sometimes the uses of working capital may be more than the
sources resulting into a negative value of working capital. This negative balance is generally
offset soon by gains in the following periods. A study of changes in the uses and source of
working capital is necessary to evaluate the efficiency with which the working capital is
employed in a business. This involves the need of working capital analysis.
The analysis of working capital can be conducted through a number of devices, such as:
1 Ratio analysis
2 Funds Flow analysis
3 Budgeting
1. Ratio analysis. A ratio is a simple arithmetical expression of the relationship of one
number to another. The technique of ratio analysis can be employed for measuring short-term
liquidity or working capital position of a firm. The following ratios may be calculated for this
purpose.
(a) Current Ratio
(b) Acid test Ratio
(c) Absolute Liquid Ratio of Cash Position Ratio
(d) Inventory Turnover Ratio

(e) Receivables Turnover Ratio
(f) Payables Turnover Ratio
(g) Working Capital Turnover Ratio
(h) Working Capital Leverage
(i) Ratio of Current Liabilities to Tangible Net worth
All the above mentioned ratios have been discussed in detail in the ‘Chapter relating
to Ratio Analysis’
2. Funds Flow Analysis. Funds flow analysis is a technical device designated to study
the sources from which additional funds were derived and the use to which these sources
were put. It is an effective management tool to study changes in the financial position
(working capital) of a business enterprise between beginning and ending financial statements
dates. The funds flow analysis consists of : (i) preparing schedule of changes in working
capital and (ii) statement of sources and application of funds
3. Working Capital Budget. A budget is a financial and/or quantitative expression of
business plans and policies to be pursued in the future period of time. Working capital
budget, as a part of total budgeting process of a business, is prepared estimating future long-
term and short-term working capital needs and the sources to finance them, and then
comparing the budgeted figures with the actual performance.
SUMMARY
 Estimation of working capital required is completed, then the next step is
financing of working capital. Statement of working capital gives clear picture
about the components, (raw materials, work-in-process, finished goods and
receivables) and required investment in these components of working capital.
Financing of current assets is the responsibility of finance manager who may
require spending lot of time for raising finance.
 Working capital should be financed by suitable and optimal mix of short-term
source of funds and long-term source of funds.
 Sources of short-term financing funds are: trade credit, accruals, differed incomes,
commercial papers (CPs) public deposits (PDs), inter corporate deposits (ICDs),
and commercial banks.
 Trade credit refers to the credit extended by the supplier of goods or services to
his customer in the normal course of business. Trade credit is a spontaneous
source of finance that it arises in the normal business transactions of the firm
without specific negotiations (automatic source of finance).
 Acfrued expenses are those expenses which the company owes to the other
persons or organistions, but not yet due to pay the amount.
 Deferred Incomes are income received in advance by the firm for supply of goods
or services in future period.
 Commercial papers (CPs) represents a short-term unsecured promissory notes
issued by firm’s that have a fairly high credit (standing) rating. CP is an
alternative source of finance and proves to be helpful during the period of tight
bank credit, it is a cheaper source of short-term finance when compared to the
bank credit. But CP is a available only for large and financially sound companies,
and it cannot be redeemed before the maturity date.
 Public Deposits or term deposits are in the nature of unsecured deposits, have
been solicited by the firms (both large and small) from general public primarily
for the purpose of financing their working capital requirements. But fixed deposits
accepted by companies are governed by the Companies (Acceptance of Deposits)
Amendment Rules of 1978. benefits of public deposits are simple procedures
involved in issuing public deposits, no restrictive covenants are involved, no
security is offered against public deposits, and its cheaper (post-tax cost is fairly
reasonable). But it has some disadvantages they are: limited amount of funds can
be raised, and funds available only for a short period.
 Inter-Corporate Deposits (ICDs): A deposit made by one firm with another firm is
known as Inter-Corporate Deposits (ICDs). Generally, these deposits are usually
made for a period up to six months. Such deposits may be of three types: call
deposits, (its repayment is demanded on just one days notice), three months
deposits, and six-months deposits. These types of deposits are usually given to
‘A’ category borrowers only and they carry an interest rate of around 16% per
annum.
 Commercial banks are the major source of working capital finance to industries
and commerce
 . The loaning of funds to business is one of their primary functions. Forms of
bank Finance are: Loans, (2) overdrafts, (3) Cash credits, (4) purchase or
discounting of bills and (5) Letter of Credit.
Bank finance is available on providing adequate security. The modes of security

required by a bank are (a) hypothecation, (b) pledge, and (c) mortgage.
 ctoring service may be offered to the client in two ways: (a) with recourse to the
drawer(s) and (b) without recourse to the drawer(s) advantages relating to the
facility factors which ensure certain pattern of cash in flows from credit sales, and
elimination of debt collection department, if it continuously goes in for factoring.
Apart from the services observed by factor, the arrangement suffers from some
limitations they are: services would be provided on selective accounts basis and
not for all accounts (debts). The cost of factoring is higher and compared to other
sources of short-term working capital finance. Factoring of debt may be perceived
as an indication of financial weakness, and reduces future sales due to strict
collection policy of factor.
 Net working capital should be financed by long-tem sources of finance. The
sources of long-term working capital are: retained earnings issue of shares
(ordinary or equity shares and preference shares), debentures, public deposits,
loan from financial institutions, life insurance corporation of India (LICI).
General Insurance Corporation (GIC), Unit Trust of India (UTI), State Financial
Corporation (SFCs), Industrial Development Bank of India (IDBI), etc.
TEST QUESTIONS
Objective Type Questions
1. Fill in the blanks with approapriate word(s)
(a) ______________ and ______________ working capital the two types of
working capital.
(b) Trade credit is a _________________ source of short-term finance.
(c) ___________ income is income received in advance by the firm for supply of
goods in future.
(d) CPs are sold at _____________ and redeemed at ____________.
(e) A firm cannot issue public deposits for more than________ of its share capital
and free reserves.
(f) _______________ interest rate ceiling on public deposits.
(g) There are no commitment charge for _________________.
(h) ______________ lettr of credit is one that can be withdrawn by the issuing
banker any time after it is issued.
(i) _________________ means borrower is provided money against the security of

movable property.
(j) ____________________ is a financial institution, which render services relating
to the management of and finacing of sundry debtors that arises from credit sale.
(Answers: (a) permanent, variable; (b) Spontaneous; (c) Differed (d) Discount, face
value; (e) 25% (f) 15%; (g) Cash credit account; (h) Revocable; (i) Hypothecation;
(j) Factor)
2. State whether each of the following statement is true of false
(a) Minimum size of CP is Rs. 6 lakhs.
(b) Public deposits are governed by the companies (Acceptance of deposits)
Amendment rules 1978.
(c) There are three types of inter-corporate deposits.
(d) In India, the factoring services are providing by four financial institutions.
(e) Factor charges a commission ranging between 1% and 2%.
[Answers: (a) False; (b) True; (c)True; (d) True; (e) True]
REVIEW QUESTIONS
Section-A
1. Name the sources of short-term working capital
(1) What is factoring?
(2) What is CP?
(3) What do you mean by L/C?
(4) Distinguish between pledge and hypothecation.
(5) How do you compute cost of trade credits?
(6) List out the important forms of working capital advance given by banks.
(7) Distinguish between ordinary share and preference share.
Unit-III
CASH MANAGEMENT
Objective: To discuss what is cash and how to manage the cash in the business as a major
part of the Working Capital of a business.
Structure:
Introduction
Nature of Cash
Motives for holding Cash
Cash Management
Objectives of Cash Management
Factors determining Cash needs
Preparation of cash budget
Basic strategies for cash management
Determining optimum cash balance
Cash Management Techniques
Management of Surplus funds
Practical problems
Summary
Case studies
Review Exercises.
UNIT-III
CASH MANAGEMENT
Introduction
Cash is one of the current assets of a business. It is needed at all times to keep the
business going. A business concern should always keep sufficient cash for meeting its
obligations. 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, plant, etc. and current aswets, such as inventory will help the
business in increasing its earning capacity, cash in hand will not add anything to the
concern. It is in this context that cash management has assumed much importance.
Nature of Cash:
For some persons, cash means only money in the form of currency (cash in hand).
For other persons, cash means both cash in hand and cash at bank. Some even include
near cash assets in it. They take marketable securities too as part of cash. These are the
securities which can easily be convereted into cash. These viewpoints reflect the degree
of freedom of the persons using the csh. Whether a persons wants to use it immediately
or can wait for a time to use it depends upon the needs of the concerned person.
Cash itself does not produce goods or services. It is used as a medium to acquire
other assets. It is the othr 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 again help the business in producing cash. The goods manufactured of
services produced are sold to acquire cash. A firm will have to maintain a critical level of
cash. If at a time it does not have sufficient cash with it, it will have to borrow from the
market for reaching the required level.
There remains a gap between cash inflows and cash outflows. Sometimes cash
receipts are more than the payments or it may be vice-versa at another time. A financial
manager tries to synchronise the cash inflows and cash outflows. But this situation is
seldom found in the real world. Perfect synchronisation of receipts any payments of cash
is only an ideal situation.
Motives for Holding Cash:
There are certain motives for which cash is held by a firm which are given below:
(a) Transaction Motive- One of the main reasons of holding cash is transaction
motive i.e. when a firm enters into a variety of transactions involving cash, the
transactions are completed after payment of cash to the counter party. Further,
it also helps in meeting routine expenditures which cannot be postponed. For
example, if a firm has sold goods on credit for Rs. 5,000 and the payment for
the same is likely to be received after two months but the payment to the
worker involved in the manufacturing of goods is to be made on monthly
basis, in order to meet expenditure in such a scenario, the firm is required to
keep cash.
(b) Precautionary Motive- It is an effort of a firm to plan its expenditure in such a
way that it either very closely succeed or precede the inflows of cash in the
form of revenues. For example, a company is likely to receive Rs. 10,000 in
the end of June, then it will engage itself in purchase of new machinery or any
other item somewhere close to that date so that the funds to be received by the
company can be utilized for the purpose of payment. However, sometimes
such synchronization does not exist in the actual practice and the company is
required to maintain enough reserves of cash to meet such unforeseen non-
synchronisation of funds. Cash balance kept for such unforeseen cases in
known as precautionary balance.
Speculative Motive- Sometimes a firm may come across situations which may
provide firm with unexpected huge profits. For example, availability of raw material at a very
reasonable.
Cash Management
Cash management has assumed importanced because it is the most significant of all
the current assets. It is required to meet business obligations and it is unproductive when
not used.
Cash management deals with the following:
(j) Cash inflow and outflows
(ii) Cash flows within the firm
(ii) Cash balances held by the firm at a point of time
Cash management needs strategies to deal with various facets of cash. Following are
some of its facets:
(a) Cash Planning

Cash planning is a technique to plan and control the use of cash. A projected cash
flow statement may be prepared, based on the present business operations and anticipated
future activities. The cash inflows from various sources may be anticipated and cash
outflows will determine the possible use of cash.
(b) Cash forecasts and Budgeting
A cash budget is the most important device for the control of receipts and payments
of cash. A cash budget is an estimate of cash receipts and disbursements during a future
period of time. It is an analysis of flow of cash in a business over a future, short or long
period of time. It is a forecast of expected cash intake and outlay.
The short-term forecasts can be made with the help of cash flow projections. The
finance management will make estimates of likely receipts in the near future and the
expected disbursements in that period. Though it is not possible to make exact forecasts even
then estimates of cash flows will enable the planners to make arrangement for cash needs. It
may so happen that expected cash receipts may fall short or payments may exceed estimates.
A financial manager should keep in mind the sources from where in will meet short-term
needs. He should also plan for productive use of surplus cash for short periods.
The short-term and long-term cash forecasts are also essential for proper cash
planning. These estimates may be for three, four, five or more years. Long-term forecasts
indicate company’s future financial needs for working capital, capital projects, etc.
Both short-term and long-term cash forecasts may be made with the help of following
methods:
(i) Receipts and disbursements method
(ii) Adjusted net income method.
(i) Receipts and Disbursements Method-In this method the receipts and payments of
cash are estimated. The cash receipts may be from cash sales, collections from
debtors, sale of fixed assets, receipts of dividend or other incomes of all the items; it
is difficult to forecast sales. The sales may be on cash as well as credit basis. Cash
sales will bring receipts at the time of sale while credit sales will bring cash later on.
The collections from debtors (credit sales) will depend upon the credit policy of the
firm. Any fluctuation in sales will disturb the receipts of cash. Payments may be
made for cash purchases, to creditors for goods, purchase of fixed assets, for
meeting operating expenses such as wage bill, rent, rates, taxes or other usual
expenses, dividend to shareholders etc.
The receipts and disbursements are to be equaled over a short as well as long
periods. Any shortfall in receipts will have to be met from banks or other sources.
Similarly, surplus cash may be invested in risk free marketable securities. It may be easy
to make estimates for payments but cash receipts may not be accurately made. The
payments are to be made by outsiders, so there may be some problem in finding out the
exact receipts are a particular period. Because of uncertainty, the reliability of this
method may be reduced.
(ii) Adjusted Net Income Method- The method may also be known as sources and
uses approach. It generally has three sections: sources of cash, uses of cash and
adjusted cash balance. The adjusted net income method helps in projecting the
company’s need for cash at some future date and to see whether the company will
be able to generate sufficient cash. If not, then it will have to decide about
borrowing or issuing shares, etc. in preparing its statement the items like net
income, depreciation, dividends, taxes, etc can easily be determined from
company’s annual operating budget. The estimation of working capital movement
becomes difficult because items like receivables and inventories are influenced by
factors such as fluctuations in raw material costs, changing demand for company’s
products and likely delays in collections. This method helps in keeping a control on
working capital and anticipating financial requirements.
Managing Cash Flows:
After estimating the cash flows, efforts should be made to adhere to the estimates of
receipts and payments of cash. Cash management will be successful only if cash
collections are accelerated and cash disbursements, as far as possible, are delayed. The
following methods of cash management will help:
1. Prompt Payment by Customers- In order to accelerate cash inflows, the
collections 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 if self addressed envelope is
sent along with the bill and quick reply is requested. Another method for prompting
customers to pay earlier is to allow them a cash discount. The availability of
discount is a 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 a
time gap between the cheque sent by the customer and the amount collected against
it. This is due to many factors (i) mailing time, i.e time taken by post office for
transferring cheque from customer to the firm, referred to as postal float; (ii) time
taken in processing the cheque within the organistion and sending it to bank for
collection, it is called lethargy and (iii) collection time within the bank i.e 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 buy decentralizing collections.
3. Decentralised Collections- A big firm operating over wide geographical area can
accelerate collections by using the system of decentralized collections. A number of
collecting centres are opened in different areas instead of collecting receipts at one
place. The idea of opening different collecting centres is to reduce the mailing time
from customer’s dispatch of cheque and its receipt in the firm and then reducing the
time in collecting these cheques. On the receipt of the cheque it is immediately sent
for collection. Since 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. Decentralized 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 places. The places are selected on the basis of number of
consumers and the remittances to be received from a particular place. The firm hires
a Post Box in a post office and the parties are asked to send the cheques on that post
box number. A local bank is authorized to operate the post box. The bank will
collect the post a number of times in a day and start the collection process of
cheques. The amount so collected is credited to the firm’s account. The bank will
prepare a defiled account of cheques received which will be used by the firm for
processing purpose. This system of collecting cheques 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 s 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 for 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 giving cheques. When a cheque is issued then the company will
have to keep a balance in its account so that the cheques paid whenever it comes. On
the other hand a draft is payable only on presentation to the issuer. 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 company can ceconomise large resources by using this
method. The funds so saved can be invested in highly liquid low risk securities to earn
income thereon.
3. Adjusting Payroll Funds- Some economy can be exercised on payroll 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 a 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 price, to
invest funds at very high interest cost, etc. a firm can take advantage of such situations
only if it is in possession of abundant amount of cash which is ready available to encash
upon such situation. Thus, a firm may keep reserves of cash for such speculative motive
as well.
(d) Compensatory Motive- The compensatory motive of the cash can be
explained from the example of a bank. A bank provides loan to a customer at a specified rate
for specified period. During this period, the lending rates may vary. If the lending rates
increase above the rates at which the funds have already been lent to the customers, the bank
stands to lose. In order to compensate for such losses, the bank makes a condition for a client
that he would always maintain certain minimum balance with the bank till the loan is repaid.
The minimum balance kept with the bank is used for investment by the bank to earn return
which compensate the loss to the bank due to hike in lending rates. Besides this, the return on
minimum balance maintained with the bank is also used for compensating the charges for
various services provided by the bank to the customer for which no charges are taken by the
bank from the customer.
Objectives of Cash Management:

A financial manager who looks after the job of cash management is required to
achieve the following objectives:
(a) Meeting payment at the scheduled dates.
(b) Minimizing idle cash balance with the company
Both the objective have been dealt in detail here under
Meeting payment at the scheduled Dates:
The financial manager shall plan the expenditure and income of the company in such a
way that the firm shall be in possession of cash as and when there is requirement for it. For
example if the debentures are to be redeemed in the month of December, the firm would
require cash for the redemption process in the month of December. In order to have smooth
process of redemption, the firm shall arrange enough cash for the same. Therefore, the firm
shall minimize its other avoidable expenditure in the month of December and also request its
debtor to make payment to the firm before the redemption process commences. Likewise, if
the firm is likely to receive funds by issuing shares of debenture in any particular period, the
firm shall postpone its capital expenditure till that time. Sometime, a firm has an opportunity
to avail cash discount by making early payment for the goods purchased by it. Therefore, the
firm shall plan its receipt of funds in such a manner so that it can avail the cash discount. The
firm is benefited in following respect by making timely payment.
(a) avoidance of loss of reputation of the firm
(b) It prevent solvency of the firm.
(c) Maintaining good relationship with the creditors and suppliers to the firm.
(d) Avail the opportunities of trade discount and cash discount.
Minimizing Idle Cash Balance with the Firm:

It is not in the interest of the firm to keep large cash balance with it beyond its daily
requirement. As already mentioned, if a firm keeps more funds than its requirement, though
it is able to maintain its liquidity but it forgoes its profitability. The excess funds, if had been
lent by the firm, would have yielded some return to the firm. Likewise, it is also not
advisable that a firm should lend its cash without caring for its daily requirement as in this
process though the firm is able to achieve the goal of profitability but it loses its liquidity.
Factors determining Cash Needs
(a) Matching of Receipts and payment: This is also known as synchronization of
cash flows. If the receipts and payments are coinciding with each other then there is no
need for maintaining cash balance but if there is a time lag between receipt of funds and
payment of funds, there is need to have cash balance which is utilized during the time lag
between the payment and receipt of funds
(b) Short cost: It refers to the situation when the firm foregoes opportunities due
to non availability of funds. Short cost normally includes following kinds of cost:
(i) Transaction Cost: Sometimes in order to meet immediate requirement of
funds, a firm may have to convert its other near cash assets such as
marketable securities into cash by selling them in the open market and
realizing cash out of such. In such a process the firm has to incur a
brokerage cost for converting such asset into cash such cost known as
transaction cost.
--Borrowing cost: A firm may resort to borrowing of funds in certain situations
when there is ___________ requirement ------------------------------------ borrowing
cost.
(ii) A firm may also lose opportunity of availing trade discount because of non-
availability of funds.
(iii) If a firm becomes habitual in delaying payment to its creditors or suppliers,
the firm lose reputation as well as its rating in the market. The banks or
financial institution extending credit facility to such firms may ask for
higher interest cost.
Surplus Cash: A firm having excess reserve of cash balance may lose
interest on funds lying in excess and idle with the firm. If the same funds would have been
lent in the market, that would have yielded some return to the firm.
Preparation of Cash Budget:

The importance related with appropriate cash balance has already been explained in
the previous section of this chapter. However, the mute question is how to determine or
how to forecast the requirement of cash in the forthcoming period so that the financial
manager can take appropriate action timely. If a financial manager make schedule of the
funds which he is likely to be received in the forthcoming months and the funds which is
likely to be used in the same period, he can easily determine the periods in which he will
be having surplus funds and the periods in which he will be short of funds. Whenever, he
will foresee that he will be having surplus funds, he will make necessary arrangement for
investment of funds and when he will find that he will find that he shortage of funds may
occur, he will make necessary arrangement of funds to cover the shortfall. The device
which is used by a financial manager to achieve the above objective is known as cash
budget. Cash budget may be defined as the statement of estimated cash in flows and cash
outflows showing the surplus and deficit position of cash in various periods.
Determining Period for which Cash Budget is to be Prepared
The first task in the preparation of cash budget is to decide the period for which
cash budget is to be prepared. It is advisable to take neither very long nor very short period.
In case the period chosen is very long, it is likely to affect the accuracy of the cash budget.
This is due to the fact that the elements of cash budget are basically estimated figures and
estimation is likely to get affected with time. For example, one can make fairly precise
estimate of the events likely to happen in the next three months but one can’t make good
estimates of the events which are to happen after one year. Therefore, the size of the period
shall not be very long. On the other hand, if the period is very small, again it is likely to
affect the accuracy of the net cash position at the end of various sub periods of the cash
budget. For example, if the goods are sold on credit basis for which 50% of the payment is to
be received in the third month from the month of sale and the period of cash budget is taken
for two months only, the receipt of the funds would not be reflected and thus it would present
inaccurate picture of the cash budget.
Elements of Cash Budgets:
The elements which form part of the cash budget are cash items only and the non
cash items such as depreciation shall be excluded. The cash receipt and payments cash be
divided into two categories revenue and capital nature.
Receipts Payments
Capital Receipts Capital payments
Cash received from issue of securities such Redemption of preference shares or payment
as shares, debentures, etc of loans
Cash received from sale of fixed assets. Cash spent in purchase of fixed assets.
Revenue Receipts Revenue Payments

Amount received on sale of goods and Payment for material purchased
services on cash basis
Amount due to be received from customers Payment of wages and overheads
Receipt of brokerage, commission etc. Payment of interest on loans, dividends etc
Rent received, Refund of tax, receipt of Income tax or other tax payments.
dividend and interest
The concept of cash management would become more clear from the following examples:
Example 1: A company has experienced that 15% of its sales are made in cash and
remainder 85% on 30 days term. The company has observed from its past available data that
there are no bad debts. It has also observed that
60% of credit sales are collected in the month following sales
30% in the second month
10% in the following month
Sales in the preceding 3 months have been as follows:
Months Amount (Rs.)
January 125,000
February 130,000
March 155,000
Sales for the next 3 months are estimated as follows:
Months Amount (Rs.)
April 150,000
May 135,000
June 140,000
You are required to prepare a schedule of the expected cash collections during the months of
April. May and June for presentation to the finance manager.
What will be the cash receipts, if the credit policy is enforced strictly so that there are no
overdue accounts and bad debts?
Solution, Schedule of cash receipts
Jan Feb March April May June
Total sales 1,25,000 1,30,000 1,55,000 1,50,000 1,35,000 1,40,000
Cash sales 15% 18,750 19,500 23,250 22,500 20,250 21,000
Credit sales 85% 1,06,250 1,10,500 1,31,750 1,27,500 1,14,250 1,19,000
Required information
Cash sales 22,500 20,250 21,000
Collection from Credit sales
1st month following sales 60% 79,050 76,500 68,850
11nd month following sales 30% 33,150 39,525 38,250
111rd month following sales 10% 10,625 11,050 13,175
Total estimated cash receipts 1,45,325 1,47,325 1,41,275
Example-2 : X Ltd. Has experienced that 20% of in sales are made on cash down basis and
the remainder 80% on 30 days term. It has further experience remaining from its credit
policy.
Bad debts 2% of credit sales
Collection 40% of credit sales are collected in the month following
35% in the second month
23% in the following month
Month Amt. (Rs)
January 60,000
February 90,000
March 95,000
Month Amt (Rs)
April 90,000
May 95,000
June 1,05,000
You are requested to prepare a schedule of the expected cash collections during the months
of April, May and June for presentation to the finance manager.
Solution. Schedule of cash receipts
Jan. Feb. March April May June
Total sales 60,000 90,000 95,000 90,000 95,000 1,05,000
Cash sales 20% 12,000 18,000 19,000 18,000 19,000 21,000
Credit sales 80% 48,000 72,000 76,000 72,000 76,000 84,000
Cash sales 18,000 19,000 21,000
Total estimated Cash receipts 84,640 90,960 94,080
Cash Management: Basic Strategies

After a financial manager is able to forecast cash position of his firm in the
forthcoming months, his next job is to apply cash management strategies to make
optimum utilization of the funds of the firm. The basic objective of any cash management
strategy used by the financial manager is to increase cash turnover of the firm which is
given as
Cash Turnover=360/Cash cycle
As can be observed from the above equation, the cash turnover can be increased
only by decreasing cash cycle since numerator is a constant figure.
Cash cycle refers to the process by which cash is used to purchase materials from
which are produced goods which are sold and cash is realized. The cash so received from
the customers to whom goods were sold is used again to purchase raw material and like
this the process goes on. The cash cycle is given as
Cash cycle=Account Receivable + Production cycle-Accounts Payable
The concept would become clear from the following example.
Example-1: A firm purchase raw material on credit for manufacturing certain goods. The
credit period allowed to the firm by its suppliers is 45 days. The credit period allowed by
the firm to its customer is 60 days. However the firm’s experience has been that on the
average, it takes 50 days pay its account payable and 70 days to collect its account
receivable. It has also been observed that 100 days elapses between the date of purchase
of inventory and sale of finished goods. In other words, average age of inventory is 100
days calculate the firm’s cash cycle and also estimate the cash turnover.
Solution Cash cycle = Average age of average age of average age of
+
Inventory account receivable account
payable
=100 + 70-50=120 days
360 360
Cash turnover = = =3
Cash cycle 120
From the above equation, one can easily infer that in order to reduce cash cycle, the
following steps shall be taken
(a) Decrease account receivable
(b) Decrease Production cycle
(c) Increase Accounts payable
(d) Apply all the strategies simultaneously
Methods of Decreasing account Receivable
In order to decrease account receivable, the firm shall adopt the following practice
Speed up cash collections
(a) The firm shall sell its product on cash basis and where it is sold on credit basis, the
firm shall try to recover the money from its customers at the earliest either by
offering them incentives like trade discount, cash discount or by making proper
follow up for recovery of the amount.
(b) The firm shall try to encash the cheque received from the customer at the earliest.
The cheque received from the customer shall not get delayed in payment because of
lengthy procedure of recording in the firm. In other words, we shall say that the
firm shall overcome the problem of float. The term float means the time span
involved in the payment by a customer to a firm in form of cheque and its
encashment by the firm. There are different types of floats which arise due to
different stages involved in the process. For example, when a customer draws a
cheque in favour of a firm and mail it to the firm through post, some of the time
gets wasted in this process as the post office would take some time in sorting of dak
and finally delivering it to the firm. This delay is known as postal float.
When a cheque is delivered to the firm, the firm gets it processed at its office which
means recording of the fact that payment has been received and it is full amount and
finally get it deposited in its bank account. This process also involves some time
and causes delay in the encashment of cheque. This is known as lethargy. Finally,
the firm a account. The delay caused in this process is known as bank float.
The postal float, lethargy and bank float collectively are called as deposit float.
The firm can overcome the problem of float by decentralizing its collection centres
which can be done by adopting the practice of
(a) Concentration Banking, and/or
(b) Lock Box System
Concentration Banking:
Under the scheme of concentration banking, the firm which has customers located at
various places chooses some of the place as key collection centre and open up their small
collection centres at such place. This helps the customers in visiting the collection centre
located near to their residence and making payment instead of visiting at the head office of
the firm which is situated at a distant place from the customer. The collection centres of the
firm collect the payments from the customer located in their prescribed region and deposit
the cheque in account of our maintained in the local bank. The funds from the local bank
beyond a prescribed minimum level are transferred in the account of the head office of the
firm. The account maintained at the head office of the firm is known as concentration bank.
The advantages and disadvantages of the scheme of concentration banking are given
below.
Advantages of Concentration Banking
(a) It overcomes the problem of postal float as it helps in wastage of time which
generally occurs in transfer of cheque from the customer to the firm.
(b) It helps in speeding up collection process
(c) In this case, the collection system is decentralized as a result of which the work load
on collection division is less therefore the cheque received can be processed easily
and in less time. Thus, it also helps in overcoming the problem of lethargy.
(d) It also helps in proper supervision and follow up of payment from the customers.
Disadvantages of Concentration Banking

(a) It does not overcome the problem of bank float i.e the time involved in the process
of deposit of cheque by the firm and the transfer of funds to the firm’s account from
the customer account.
(b) Though it overcomes the problem of lethargy to a very large extent but it does
eliminate it completely as even at the collection centre some time gets wasted in the
receipt of the cheques from the customer and their deposit in the local bank after
processing them.
The cost-benefit analysis of concentration banking can be understood from the
following example.
Example 2. A company has daily receipt of Rs. 5,00,000. It is expected that the
system of concentration banking would reduce the receivable by 4 days and the
system would cost Rs. 25,000. is it acceptable if the firm can earn 10% p.a. on its
investment?
Solution: Reduction in investment due to concentration banking
` = 5,00,000 X 4 = 20,00,000
[ .‘. Average daily receipt X reduction in number of days]
Savings = 2,00,000 (10% of reduction in investment)

Cost = 25,000 (Given)
Benefit = (savings – Cost) = 2,00,000 – 25,000 = 1,75,000
.‘. System of concentration banking is acceptable.
Lock Box System:
In order to overcome the limitations of the concentration banking, a new system was
developed which is known as lock Box system. Under the scheme of Lock Box system, the
firm hires a box at post offices located in the regions where the firm has large customer base.
The customers are directed to deposit the cheque in the lock box at their respective post
office. The firm authorized bankers of that logion to open up the box and collect the cheque
and directly remit the funds in the account of the firm. Thus it save the time a mailing of
cheque from the customer to the firm and thereafter from the firm to the banker i.e postal
float and lethargy. It also reduces the problem of bank float also to a very large extent. The
payment collected by the bank of behalf of the firm from the lock box is recorded and
intimated to the firm by way of deposit slip. The firm is required to spent some charges to
avail this facility. Thus, lock box system is superior to the concentration banking as it
removes the problem of collection of cheque by the firm and their deposit with the firm.
Advantages of Lock Box System
(a) It avoids delay involved in processing of cheques by the firm and their deposit with
the firm’s banker.
(b) It provides easy access to the customer for making their payment.
(c) It reduces firm’s cost of keeping staff for the purpose of processing the cheque and
ensuring their timely deposit with the bank as this function in this case is
handled by the bank.
Disadvantages of Lock Box System:
(a) Under this system, the firm is required to pay certain charges to the bank for
availing its facilities. If only few customers deposit their chequew them it may not
be beneficial for the same as the cost involved in the system may turn out to be
higher than the benefits associated with the system.
(b) The firm has to adopt a restrictive approach in opening up such boxes as large
number of boxes in same region may increased cost of availing this facility by the
firm. The cost benefit analysis of the system can be understood from the following
example .
Example. 3 Master Ltd. has average daily of Rs. 1,00,000. it is expected that the lock box
system would reduce the receivable by 4 days. The system would cost Rs. 30,000. is it
acceptable if the firm can earn 10% on its investment?
Solution: Reduction in investment due to lock box system
= 1,00,000 X 4 = 4,00,000
Savings = 10% of 4,00,000 = 40,000
Benefit = Savings – Cost
= 40,000 – 30,000 = 10,000
The system is acceptable.

Methods of Increasing in account payable:
The firm shall try to delay its account payable by adopting the following practices:
(a) The firm shall avoid early payment and it should try to avail the maximum credit
period. For example, if the firm has purchased goods on the credit period of 30 days
then it is required to make payment within 30 days. The firm shall make payment
on the 30th day of the credit period to avail maximum benefit of the credit period.
(b) The firm shall try to delay payment by the mechanism of float. Instead of directly
handing over cheque to the counter party, the firm shall mail the cheque to the
counter party so that some time gets elapsed betwee4n the time when the cheque is
drawn and when it is encashed. The firm is able to enjoy credit period during this
period. This firm is benefited due to postal float.
(c) The firm shall centralize all its payments so that payment to the concerned party
become firm consuming process as it would involve number of channel to be
cleared before the payment is actually made to the concern party.
(d) The firm shall make payment to the creditor from the cheque of a bank which is at a
distant place from the place of the creditor so that clearing and processing of cheque
gets delayed.
Determining Optimum cash Balance:
A firm has to main in a minimum amount of cash for setting the dues in time. The
cash is needed to purchase raw materials, pa. creditors, day to day expenses, dividend,
etc. the test of liquidity of the firm is that it is able to meet various obligations in time.
Some cash will be needed for transaction needs and amount may be kept as a safety
stock. An appropriate amount of cash balance to be maintained should be determined on
the basis of past experience and future expectations. If a firm maintains less cash balance
then its liquidity position will be weak. If higher cash balance is maintained then an
opportunity to earn is lost. Thus, a firm should maintain an optimum cash balance,
neither a small nor a large cash balance. For this purpose the transaction costs and risk of
too small a balance should be matched with the opportunity costs of top large a balance.
There are basically two approaches to determine an optimal balance namely (i)
minimizing Cost Models and (ii) Preparing Cash Budget. Cash budget is the most
important tool in cash management Cash Budget.
A cash budget is an estimate of cash receipts and disbursements of cash during a
future period of time. In the words of soloman Ezra, a cash budget is “an analysis of flow
of cash in a business over a future, short or long period of time. It is a forecast of
expected cash intake and outlay.” It is device to plan and control the use of cash. The
cash budget pin points the period when there is likely to be excess or shortage of cash.
Thus, a firm by preparifng a cash budget can plan the use of excess cash and make
arrangements for the necessary cash as and when required.
The cash receipts from various sources are anticipated. The estimated cash
collections for sales, debts, bills receivables, interests, dividends and other incomes and
sale of investments and other assets will be taken into account. The amounts to be spent
on purchase of materials, payment to creditors and meeting various other revenue and
capital expenditure needs should be considered. Cash forecasts will include all possible
sources from which cash will be received and the channels in which payments are to be
make to that a consolidated cash position is determined.
The cash budget should be co-ordinated with other activities of the business. The
functional budgets may be adjusted according to the cash budget. The available funds
should be fruitfuily used and the concern should not suffer for want of funds.
Illustration 1: From the following forecast of income and expenditure, prepare a cash for
the months January to April, 2003.
Sales Purchases Wages Manufacturing Administrative Selling
(Credit) (Credit) expenses expenses expenses
Months Rs. Rs. Rs. Rs. Rs. Rs.
2002 Nov. 30,000 15,000 3,000 1,150 1,060 500
Dec. 35,000 20,000 3,200 1,225 1,040 550
2003 Jan. 25,000 15,000 2,500 990 1,100 600
Feb. 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:

1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April
.
3. The creditors are allowing a credit of 2 months.

4. Wages are paid on the 1st of the next month.
5. Lag in payment of other expenses is one month
6. Balance of cash in hand on 1st January, 2003 is Rs. 15,000
Capital expenditure to be incurred: plant purchased on 15th January for Rs. 5,000; a
Building has been purchased on 1st March and the payments are to be made in monthly
instalments of Rs. 2,000 each
Solution:
Cash Budget
Details January February March April
Rs. Rs. Rs. Rs.
Receipts
Opening Balance of Cash 15,000 18,985 28,795 30,975
Cash realized from Debtors 30,000 35,000 25,000 30,000
Cash available 45,000 53,985 53,795 60,975
Payments
Payments to Customers (for purchase) 15,000 20,000 15,000 20,000
Wages 3,200 2,500 3,000 2,400
Manufacturing Expenses 1,225 990 1,050 1,100
Administrative Expenses 1,040 1,100 1,150 1,220
Selling Expenses 550 600 620 570
Payment of Dividend 10,000
Purchase of Plant 500
Instalments of Building Loan 2,000 2,000
Total Payments 6,015 25,190 22,820 37,290
Closing Balance 18,985 28,795 30,975 23,685
Illustration 2: ABC Co. wishes to arrange overdraft facilities with its Bankers during the
period April to June, 2003 when it well 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 each month;
(a) 2003 Sales Purchases Wages
Rs. Rs. Rs.
February 1,80,000 1,24,800 12,000
February 1,92,000 1,44,000 14,000
March 1,08,000 2,43,000 11,000
April 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000
(c) 10 per cent of credit sales are realized in the month following the sales and
remaining 50 per cent in the second month following. Creditors are paid in the
month following the month of purchase.
(d) Cash at Bank on 1.4.2003 (estimated) Rs. 25,000
Solution:
Cash Budget for Three Months from April to June, 2003
April May June
Rs. Rs. Rs.
(a) Receipts:
Opening Balance 25,000 53,000 (-) 51,000
Sales 90,000 96,000 54,000
Amount received from Sales 96,000 54,000 87,000
Total Receipts 2,11,000 2,03,000 90,000
(b) Payments: 2,43,000 2,46,000
Purchase 1,44,000
Wages 14,000 11,000 10,000
Total Payments 1,58,000 2,54,000 2,56,000
Closing balance (a-b) 53,000 (-) 51,000 (-)
1,66,000
Note: Workers are paidon 1st of the following month.

Cash management techniques:
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 M.H. Miller and Daniel Orr are mainly used to determine the
optimum balance of cash. These two models are discussed as below.
William J.Baumol’s Model
William J.Baumol developed a model (The Transactions Demand for Cash:
An Inventory Theoretic Approach) 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. At 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 opportunity cost or cost of borrowing or
holding cash and the transaction cast (i.e the cost of converting marketable securities into
cash etc. the optimal cash balance is reached at a point where the total cost is the minimum.
The figure below shows the optimum cash balance.
Costs
Total Costs
Opportunity/Holding Cost
Transaction Cost
Optimum Cash balance Cash balance

(Banmol Model: Trade off Between Holding Cost and Transaction Cost)
The Baumol model is based upon the following assumptions:

(a) The cash needs of the firm are known with certainty
(b) The cash disbursements (usage) of the firm occurs uniformly over a period of time
and is known with certainty.
(c) The opportunity cost of holding cash is known and it remains constant
(d) The transaction cost of converting securities into cash is known and remains
constant. The Baumol model can also be represented algebraically.
C= 2A X F
0
Where C = Optimum balance
A = Annual (or monthly) cash disbursements
F =Fixed cost pr transaction
O = Opportunity cost of holding cash.
Illustration 3. The annual cash requirement of A Ltd. is Rs. 10 lakhs. The company has
marketable securities in lot sizes of Rs. 50,000, Rs. 1,00,000, Rs. 2,00,000 and Rs. 5,00,000.
Cost of conversion of marketable securities per lot is Rs. 1,000. the company can earn 5%
annual yield on its securities.
You are required to prepare a table indicating which lot size will have to be sold by the
company. Also show that the economic lot size can be obtained by the Baumol Model.
Solution:
Table indicating Lot Size
(a) Annual requirement of cash (Rs.) 10,00,000 10,00,000 10,00,000 10,00,000 10,00,000
(b) Lot size securities (Rs.) 50,000 1,00,000 2,00,000 2,50,000 5,00,000
(c) Number of lot size [a+b] 20 10 5 4 2
(d) Average holding of cash (Rs) [b-2] 25,000 50,000 1,00,000 1,25,000 2,50,000
(e) Opportunity holding cost of cash (Rs) [d x 5/100] 1,250 2,500 5,000 6,250 12,500
(f) Fixed conversion cost per transaction (Rs) 1,000 1,000 1,000 1,000 1,000
(g) Total conversion cost (Rs) [e x f] 20,000 10,000 5,000 4,000 2,000
(h) Total cost (Rs) [e + g] 21,250 12,500 10,000 10,250 14,500
The above table clearly indicates that the total cost is minimum at Rs. 10,000 when the
lot size of securities is Rs. 2,00,000 and thus it is economic lot size of selling securities.
Calculation of Economic Lot size (Baumol Medel)
C= 2A X F
0
Where C = Optimum cash balance or lot size
A = Annual requirements of cash (Rs. 10,00,000)
F =Fixed conversion cost per transaction (Rs. 1,000)
O = Opportunity cost of holding cash (5% or 0.05)
C= 2 X 10,00,000 X 1,000 = Rs. 2,00,000

0.05
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. M.H Miller and Daniel Orr (A model of the Demand for Money) expanded
on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows
and cash outflows. The Miller and Orr (MO) model provides two control limits the upper
control limit and the lower control limit along with a return point as shown in the figure
below.
Cash
When the cash balance touches the upper control limit (h) markable 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 limits (called z) can be computed using Miller-Orr model as below:
Z = ¾ X Transaction Cost X Variance of Cash flows ½

Interest Rate
and Return Point = Lower Limit + Spread (Z)

3
Variance of Cash Flows = (Standard deviation) 2 of (c)2
Illustration 4: A company has a policy of maintaining a minimum cash balance of Rs.
1,00,000. the standard deviation daily cash balance is Rs. 10,000. the interest rate on a daily
basis is 0.01%. the transaction cost for each sale or purchase of securities is Rs. 50. compute
the upper control limit and the return point as per the miller-Orr model.
Solution:
Spread between the upper and lower cash balance ( Z )
Z = ¾ X Transaction Cost X Variance of Cash flows ½

Interest Rate
=3 ¾ X 50 X (10,000)2 1
/3
.0001
= Rs. 1,00,415
Thus, the upper control limit of cash balance is
= Rs. 1,00,000 + Rs. 1,00,415 = Rs. 2,00,415
And, the return point is

Lower Limit + Spread
3
= Rs. 1,00,000 + 1,00,415/3
= Rs. 1,33,471
Illustration 5 : A firm having an annual opportunity cost of 15 per cent is contemplating

installation of a lock box system at an annual cost of Rs. 3,00,000. the system is expected to
reduce mailing time by 4 days and reduce cheque clearing time by 3 days. If the firm collects
Rs. 4,00,000 per day, would you recommend the system?
Solution:
Reduction in time if lock box system is installed

Mailing time = 4 days
Cheque clearing time = 3 days
Total reduction in time = 7 days
Calculation of reduction in float

Rs. 4,00,000 per day for 7 days = Rs. 28,00,000
Annual savings on account of reduction in float

Gross savings = 28,00,000 X 15/100 = Rs. 4,20,000
Annual cost of lock box system = Rs. 3,00,000
Net annual savings if the proposed lock box system is installed = Rs. 1,20,000
Thus, it is recommended that the proposed lock box system should be installed
Illustration 6: Beta Ltd. his an annual turnover of Rs. 84 crores and the same is spread
evenly over each of the 50 weeks of the working year. However, the pattern within each
week is that the daily rate of receipts on Mondays and Tuesdays is twice that experienced on
the other three days of the week. The cost of banking per day is estimated at Rs. 2,500. it is
suggested that banking should be done daily or twice a week Tuesdays and Fridays as
compared to the current practice of banking only on Fridays. Beta Ltd. away operates on
bank overdraft and the current rate of interest is 15% per annum. This interest charge is
applied by the bank on a simple daily basis. Ignoring taxation, advise Beta Ltd, the best
course of banking. For your exercise, use 360 days a year for computational purposes.
Solution:
Calculation of daily sales
Annual Sales = Rs. 8,400 lacs
Weekly sales = 8400/50 = Rs. 168 lacs
Daily Sales Proportion Rs. In lacs
Monday 2 168 X 2/7 =Rs. 48 lacs
Tuesday 2 168 X 2/7 =Rs. 48 lacs
Wednesday 1 168 X 1/7 =Rs. 24 lacs
Thursday 1 168 X 1/7 =Rs. 24 lacs
Friday 1 168 X 1/7 =Rs. 24 lacs
Total 7 Rs. 168 lacs
Computation of cost if banking is done daily Rs.
Cost of banking (Rs. 2500 per day for 5 days) 12,000
Add: Interest cost on account of delayed banking ______
Total Cost 12,500
Computation of cost of banking done twice a week, i.e. on Tuesdays

and
Fridays 5,000
Cost of banking (Rs. 2500 per day for 2 days)
Add: interest cost on account of delayed banking: 2,000
Mondays (48,00,000 X 1/300 X 15/100) 2,000
Wednesdays (24,00,000 X 2/360 X 15/100) 1,000
Thursdays (24,00,000 X 1/360 X 15/100)
10,000
Total Cost
Rs.
Computation of cost if banking is done on Friday only 2,500
Cost of banking (Rs. 2500 per day for 1 day)
Add: interest cost on account of delayed banking 8,00,000

Mondays (48,00,000 X 4/360 X 15/100) 6,00,000
Tuesday (48,00,000 X 3/360 X 15/100) 2,000
Monday (24,00,000 X 2/360 X 15/100) 1,000
Tuesday (24,00,000 X 1/360 X 15/100)
19,500
Total Cost
Advise. Beta Lit. is advised to do banking twice a week on Tuesdays and Fridays as it has sthe least
cost of Rs. 10,000
Investment of surplus funds:

There are sometime, surplus funds with the companies which are required after
sometime. These funds can be employed in liquid and risk free securities to earn some
income. There are a number of avenues where these funds can be invested. The selection of
securities or method of investment is very important. Some of these methods are discussed
herewith:
1. Treasury Bills: The treasury bills are issued by RBI on behalf of the Central
Government. Barlier they were issued on the basis of tenders floated regularly but
now are available on tap system, i.e. on rates announced by RBI every week. These
bills are issued only in bearer form. Name of the purchaser is not mentioned on the
bills, rather they are easily transferable from one investor to another. No interest is
paid on the bills but the return is the difference between the purchase price and face
(par) value of the bill. Since there is a backing of the Central Government, these are
risk free securities. A very active secondary market exists for these bills to it has
made them highly liquid. Thesauri bills are one of the popular marketable securities
even though the yield on them may be low.
2. Negotiable Certificates of Deposit (CD’s). The money is deposited in a bank for a
fixed period of time and marketable receipt is issued. The receipt may be registered
or bearer, the latter facilities transactions in the secondary market. The

denominations and maturity periods are decided as per the needs of the investor. On
maturity the amount deposited and interest are paid. The CD’s are different from
the treasury bills which are issued on discount. The short-term surplus funds can be
used to earn interest in this method. The investment is secure unless the bank fails,
the chances of which are remote.
3. Unit 1964 Scheme: The unit Trust of India’s unit 1964 scheme is very populr for
making short-term investments. It is an open ended scheme which allows investors
to withdraw their funds on a continuing basis. The units have a face value of Rs. 10.
the purchase and sale value of units is not based on net assets value but it is
determined administratively in such a manner that they rise gradually over time.
The unit scheme offers a good avenue for investing short-term funds and has the following
advantages:
(i) The dividend income from unit received by companies is treated as inter-
corporate dividend., it qualifies for tax exemption upto 80 per cent under Sec.
80M of the Income Tax Act. Many companies purchase cum=dividend units in
May, collect dividend in July and then sell the units.
(ii) The yield can be increased by a careful synchronizing of the purchase and sale
of units because the capital loss on sale of units would quality for a tax set-off,
of which 80 per cent of the dividend income would be tax free.
(iii) There is an active secondary market for units, there will be no liquidity problem.
4. Ready Forwards: A commercial bank or some other organization may enter into a
ready forward deal with a company willing to invest funds for a short period of
time. Under this system the bank sells and repurchases the same security (that
means that company purchases and sells securities in turn) at pre-determined prices.
The difference between the purchase and sale price is the income of the company.
Ready forwards are generally done in units, public sector bonds or government
securities. Ready forward deals are linked with the position of the money market.
The investor can hope to earn more if money market is tight during busy season and
at elosing of the year.
5. Badla Financing : Badla financing is used in stock exchange transactions when a
broker wants to carry forward his transactions from one settlement period to another
Badla financing is done though operators in stock exchange. It is the financing of
transactions of a broker who wants to carry forward this deal to the other settlement
period. The Badla rates are decided on the day of settlement. Badla transaction is
financed on the security of shares purchased whose settlement is to be carried
forward. Sometime this financing facility may be extended for a particular share
only. For example, a company may provide Badla finance to a broker Rs. 10 crores
for purchasing ACC shares in forward market. Badla rates vary with demand and
supply position of funds.
Badla financing offers attractive interest rates. However, it becomes risky
if the broker defaults in his commitment. Even the wide fluctuation in prices of
shares may also affect the value of security. An investor in this type of financing
should be careful about following things:
(i) The selection of a broker should be on the basis of reputation
(ii) The shares with a sound intrinsic value should be selected
(iii) The margin should be adequate
(iv) The possession of securities should be taken
6. Inter-Corporate Deposits: These are short term deposits with other companies
which attract a good rate of return. Inter-corporate deposits are of three types:
(i) Call Deposits: It is a deposit which a lender can withdraw on one day’s
notice. In practice it takes three days to get this money. The rare of interest
at present is 14 per cent on these deposits.
(ii) Three Months Deposits: These deposits are popular and are used by
borrowers to tide over short-term inadequacy of funds. The interest rate on
such deposits in influenced by bank overdraft interest rate and at present the
borrowing rate is 22 per cent per annum.
(iii) Six-month Deposits: The lenders may not have surplus funds for a very
long period. Six-month period is normally the maximum which lenders may
prefer. The current interest rate on these deposits is 24 per cent per annum.
Since inter-corporate deposits are unsecured loans, the credit worthiness of the borrower
should be ascertained. Section 370 of the Company’s act has placed certain restriction on
inter-company deposits, so these provisions should be adhered to these provisions are:
(a) A company cannot lend more than 10 per cent of its net worth (equity plus free
reserves) to any single company.
(b) The total lending of a company cannot exceed 30 per cent of its net worth without
the prior approval of the central government and a special resolution should permit
such a lending.
7. Bill Discounting: A bill arises out of credit sales. The buyer will accept a bill drawn
on him by the seller. In order to raise funds the seller may get the bill discounted
with his bank. The bank will charge discount and release the balance amount to the
drawer. These bills normally donot exceed 90 days.
A company may also discount the bills as a bank does thus using its surplus funds.
The bill discounting is considered superior to inter-corporate deposits. The company
should ensure that the discounted bills are (a) trade bills (resulting from a trade
transaction) and not accommodation bills (helping each other) (b) the bills backed buy
the letter of credit of a bank will be most secure as these are guaranteed by the drawer’s
bank.
8. Investment in Marketable Securities: A firm has to maintain a reasonable balance of
cash. This is necessary because there is no perfect balancing of inflows and
outflows of cash. Sometimes more cash is received than required for quick
payments. Instead of keeping the surplus cash s idle, the firm tries to invest it in
marketable securities. It will bring some income to the business. The cash surpluses
will be available during slack seasons and will be required when demand picks up
again. The investment of this cash in securities needs a prudent and cautious
approach. The selection of securities for investment should be carefully made so
that the amount is raised quickly on demand.
In choosing among alternative securities, the firm should examine three basic
features of a security safety, maturity and marketability. The security element deals
with the absence of any type of risk. The securities with risk may give higher
returns but these should be avoided. There should not be any default in payment
when the securities are redeemed. The maturity periods will give higher returns.
The short-period securities will carry lower rates of interest but these should be
preferred. The surplus cash can be invested only for smaller periods because the
amount may be required for meeting operating cash needs in the short periods. The
securities should have a ready market. These investments can be made only in near
cash securities. If the securities selected are such which require some time for
realization then there may be payment problems. So the securities should have a
ready market and may be realizable in a very short period.
Money Market Mutual Funds (MMMF): Money market mutual fund means a
scheme of a mutual fund which has been set up with the objective of investing
exclusively in money market instruments. These instruments include treasury bills, dated
Government securities with an expired maturity of upto one year, call and notice money,
commercial paper, commercial bills accepted by banks and certificates of deposits. Till
recently, only commercial banks and public financial institutions were allowed to set up
MMMFs. But in November 1995, the Government has permitted private sector mutual
funds also to set up money market mutual fund. MMMFs are wholesale markets for low
risk, high liquidity and short-term securities. The main feature of this fund is the access to
persons of small savings.
Practical Problems
Problem 1. ABC Ltd has observed that in the normal course it has 15% of its sales
in cash and remainder 85% of its sales on 30 days’ term. It is estimated that 1% of credit
sales are bad debts. Further it has been observed that 60% of credit sales are collected in
the month following sales, 25% in the second month and 14% in the following months.
Sales in the preceding 3 months have bee, as follows:
January 80,000
February 1,00,000
March 140,000
April 150,000
May 110,000
June 1,00,000
Prepare a schedule of the expected cash collections during the months of April, May and
June for presentation to the finance manager.
Solution: Schedule of Cash Receipts.

Jan. Feb. Mar. April May June
Total sales 80,000 1,00,000 1,40,000 150,000 110,000 1,00,000
Cash sales 15% 12,000 15,000 21,000 22,500 16,500 15,000
Credit sales 85% 60,000 85,000 119,000 127,000 93,500 80,000

Cash sales 22,500 16,500 15,000
IIIrd month following sales 14% 9,520 11,900 16,660
Total estimated cash receipts 1,24,670 1,34,650 1,19,635
Problem 2 : XYZ Ltd. has observed that in the normal course it has 30% of its sales in
cash and remainder 70% of its sales on 30 days term. It is estimated that 3% of credit
sales are bad debts. Further it has been observed that 50% of credit sales are collected in
the month following sales, 25% in the second month and 22% in the following month:
Sales in the preceding three months have been as follows:
January 75,000
February 80,000
March 85,000
April 80,000
May 90,000
June 70,000
Prepare a schedule of the expected cash collections during the months of April, May and
June for presentation to the finance manager.
Jan Feb Mar April May June
Total sales 75,000 80,000 85,000 80,000 90,000 70,000
Cash sales 30% 22,500 24,000 25,500 24,000 27,000 21,000
Credit sales 70% 52,500 56,000 59,500 56,000 63,000 49,000
Cash sales 24,000 27,000 21,000
Collection from credit sales

Total estimated cash receipts 79,300 82,195 79,590
Problem 3: ABC Ltd. started its operation from July 1, 2,000 and initially deposits 5,000
in the bank. This sum will be insufficient to finance its operations over a period of 6
months.
It is further given that:
(a) Sales to be made to one distributor at 3% discount ______________ are received in
the first day of the month following due date.
(b) Plant purchases totaling Rs. 4,800 to be made in July
Budgeted figures:
July August Sept Oct Nov Dec.
Purchase 6,000 5,000 3,000 4,000 4,000 5,000
Wages 3,000 4,000 4,000 4,000 5,000 4,000
Cash exp 350 500 400 400 500 400
Sales 8,000 7,000 8,000 8,000 9,000 12,000
All purchases are made on net 30 days credit and cheques are posted to creditors on the last
day of the due month.
Prepare cash budget from July to December to determine monthly overdraft limits to seek
from the company’s bankers.
Solution: Cash Budget
(a) Cash Inflows
Discount 3% 3% 3% 3% 3% 3%
Sales of previous month 3,000 8,000 7,000 8,000 8,000 9,000
Receipt from distributor 0 7,760 7,760 7,760 7,760 8,730
(R) (at 3% discount)
(b) Cash Outflows:
Payment to creditor (one 0 6,000 5,000 3,000 4,000 4,000
month time lag)
Wages (paid in the same 3,000 4,000 4,000 4,000 5,000 4,000
month)
Cash expenses 350 500 400 400 500 400
Plant purchases 4800
Total cash payments (P) 8,150 10,500 9,400 7,400 9,500 8,400
Net cash receipts (R-P) -8,150 -2,740 -2,610 360 -1,740 330
Balance overdraft at the 5,000 -3,150 -5,890 -8,500 -8,140 -9,880
start
(Deficit)/Surplus (3,150) (5,890) (8,500) (8,140) (9,880) (9,550)
Problem 4: Shivani Ltd. commences its business on July 1 and deposited Rs. 15,000 in the
bank. This sum will be insufficient to finance its operations over a period of 6 months.
Prepare cash budget from July to December to determine monthly overdraft limits to
seek from the company bankers.
The following additional information is available:
(a) sales to be made to one distributor at 4% discount and cheques are received on the
first day of the month following due date.
(b) Plant purchases totaling Rs. 5,000 to be month in July
Budgeted figures:
Purchase 5,000 4,000 3,000 4,000 4,000 5,000
Wages 4,000 5,000 4,000 4,000 5,000 4,000
Cash exp 400 500 400 400 500 400
Sales 6,000 7,000 8,000 8,000 9,000 12,000
All purchases are made on net 30 days terms and cheques are posted to creditors on the last
day of the due month.
Solution: Cash Budget
(a) Cash Inflows:

Discount 4% 4% 4% 4% 4% 4%
Sales of previous month 6,000 7,000 8,000 8,000 9,000

Receipt from distributor 0 5,760 6,720 7,680 7,680 8,640
(R) (at 4% discount)
(c) Cash Outflows:

Payment to creditor (one 0 5,000 4,000 3,000 4,000 4,000
month time lag)
Wages (paid in the same 4,000 5,000 4,000 4,000 5,000 4,000
month)
Cash expenses 400 500 400 400 500 400
Plant purchases 5,000
Total cash payment (P) 9,400 10,500 8,400 7,400 9,500 8,400
Net cash receipts (R-P) -9,400 -4,740 -1,680 280 -1,820 240
Balance overdraft at the 15,000 5,600 860 -820 -540 -2,360
start of the month
Surplus/(Deficit) +5,600 +860 (820) (540) (2360) (2120)
Summary:
Cash is one of the components of current assets and it is a medium of exchange for
purpose of goods and services and for discharging liabilities.
Cash management is one of the key areas of working capital management as cash
is both beginning and the end of working capital cycle-cash, inventories, receivables and
cash. It is the most liquid asset and the basic input required to keep the business running
on a continuous basis.
Efficient management of cash involves an effort to minimize investment in cash
without impairing to liquidity of the firm. It imphes a proper balancing between the two
conflicting objectives of the liquidity and profitability.
In cash management, the term cash has used in two senses: narrow sense and Broad
some in narrow sense, cash cover currency and generally accepted equivalents of cash,
viz. cheques, demand drafts and banks demand deposits. Broad sense, cash includes not
only the above stated but also near cash assets. There are bank’s time deposits and
marketable securities. The marketable security can easily sold and converted into cash.
Here cash management is in broader sense.
John Maynard Keynes, put forth that there are three possible motives for holding
cash:
(1) The Transaction Motive

(2) Precautionary motive, and
(3) Speculative motive.
Objectives of cash management are to meet cash payment needs; and to maintain
minimum cash balance.
Aspects of cash management can be examined under three heads: cash inflows and
outflows, cash flow within the firm and cash balances held at the point of time.
Facets of cash management strategies:
(1) Cash Planning,
(2) Determination of Optimum Cash Balance, and
(3) Investment of Surplus.
The required cash balance is estimated after taking into consideration of the factors: (1)
Synchronizations of Cash Flows, (2) Short Costs, (3) Surplus Cash Balance Costs, and (4)
management Costs.
Cash planning is a technique to plan and control the use of cash. A projected cash flow
statement prepared based on expected cash receipts and payments, anticipation the financial
condition of the firm. Cash planning may be prepared on daily, weekly, monthly or quarterly
basis.
Cash budget is statement showing the estimated cash inflows and cash outflows over a
planning period. It pinpoints the surplus or deficit cash of a firm as it moves from one period
to another period. Cash budget is prepared for the purpose of estimating cash requirements.
Planning short-term finance planning, Scheduling payments, in respect of acquiring capital
goods, Planning and phasing the purchase of raw materials; Evolving and implementing
credit policies, Checking and verifying the accuracy of long-term cash forecasting.
Preparation of cash budget involves two steps: (1) selection of period of time (planning
horizon). Planning horizon is that period for which cash budget is prepared, (2) selection of
factor that has bearing on cash flows.
There are two types of cash forecasts: (1) Short-term cash forecast and (2) Long-term
cash forecast. Short-term cash forecast is that forecast, which covers less than one year’s
period. The most commonly used methods of short-term cash forecasting are: The receipt and
disbursements method, and the adjusted income method. Long-term forecast may be
prepared for a period of more than one year. Long-term forecasts may be done for a period of
2 to 5 years and it provides a broader picture of the firm a cash position (excess or
inadequate). In simple works, it highlights the firm a ingestible surplus and financing needs
in future. This type od forecast is useful for planning capital investments and long-term
financing.
For efficient cash management firm has (A) to collect accounts receivables as early as
possible and (B) it has to delay the accounts payables without affecting credit standing.
Accelerating cash collections can conserve cash and reduce its requirements for cash
balances of a firm. Cash inflow process can be accelerated through systematic planning that
includes the methods of accelerating cash collections (Prompt payment of Customers, Early
Conversion of payments into Cash, Concentration banking, and Lock-Box System). Slowing
down Cash payments, involves, paying on Last Date, Centralized payments.
A firm has to maintain optimal cash balance is that cash balance where the firm’s
opportunity cost equals to transaction cost and the total cost are minimum. They are: (1)
baumol Model (Inventory Model)- This model is suitable only when the cost flows are
predictable (under certainty). It considers optimum cash balance similar to the economic
order quantity, since it is based on EOQ concept, and determines the cash conversion size
and (2) Miller-Orr Model (Statistical Model), is in fact an attempt to make Baumol model
more elastic as regards to the pattern of periodic changes in cash balances.
A firm can invest surplus funds in any types of short-term marketable securities, but it
has to take into considerations the prime criterion in security, liquidity and interest. Thus in
selecting an investment avenue among available alternatives the firm has to examine four
basis features of a secutity safety, marketability, yield and maturity.
Money market refers to the market for short-term securities. The most prominent short-
term securities available for investment of surplus cash are: Units of unit 1964 Scheme,
Ready Forward (RPs or repos), Treasury Bills, Commercial papers (CPs), Certificate of
Deposit (CDs), Banker’s Acceptance, Inter-Corporate Deposits (ICDs), Badla Financing and
Bills discounting,
CASE FOR CLASS DISCUSSION-2

Bajaj Electronics Case: Cash Forecasting
This case tests the reader’s ability to develop a basis cash forecast for a firm and
prepare a recommendation for backup financing over a period of 12 months.
A leading product of telecommunications components and a major contender in

shorter antennas is Bajaj Electronics Company. Bajan’s business has grown tremendously in
recent years despite increased competition. The primary reasons for increased growth are
technological advancement that have expanded production capacity, an aggressive marketing
effort, and a reputation for quality products and excellent service.
Loofer the financial analyst for the company has been assigned the task of preparing
quarterly cash forecast for the next fiscal year. After checking with marketing he was given a
monthly breakdown of actual sales for last month and the current month and the current
month and a forecast for the next 12 months. These are given in Table 11.3 and reflect the
somewhat seasonal nature of the firm’s marketing activities.
Table 11.3 : Actual and Forecast Sales from marketing
Month Actual Credit Sales Forecast Sales
November $4,338,000
December 5,204,000
January $4,600,000
February 4,500,000
March 4,500,000
April 52,00,000
May 5,000,000
June 4,700,000
July 6,000,000
August 6,000,000
September 5,800,000
October 4,500,000
November 4,600,000
December 4,600,000
From the accounting department. Loofer obtained information on the historical mix
of sales and collection information. During the first half of the year, credit sales generally
mad up about 80 per cent of all sales. In the second half, this dropped to 75 per cent. With
respect to the credit sales. Collection patterns varied seasonally. This information is
contained in Table 11.4. once again, the collection pattern is also seasonal Note, however that
the collections do not total to 100 per cent of credit sales. This is the case because the firm
allows a margin for bad debts and unexpected collection costs.
The firm follows a unique and highly controlled system for its trade payables. Each
month during the first half of the year, the accounts payable section pays suppliers cash could
to 50 per cent of the monthly sales. During the second half of the year, this rises to 55 per
cent. Over a full year, this pattern of payment seems to be adequate to pay all bills. At times,
suppliers are pressing for more payments and some maneuvering is needed. Still, this policy
assists the firm’s cash management during the busy third quarter and will be followed next
year.
Cash operating expenses are paid as they occur. During the first and fourth quarters,
they are estimated at 50 per cent of sales. During the second and third quarter they rise to 55
per cent of sales.
Loofer knows that the firm includes the impact of interest and taxes in its operating
cash flow forecasts. The levels of such debt, along with the forecasted average interest rate
for each month, are given in Table 11.5. interest will be calculated to reflect change in debt
levels.
The firm pays estimated tax payments monthly at a 35 per cent rate. It uses a cost of
goods sold estimate at 50 per cent of sales, not including depreciation. Loofer assumes that
monthly depreciation for the next year will be $ 185,000.
Table 11.4: Collection pattern of Receivables
Percent of Credit Sales
Months Collected in Collected Collected
Same Month one Month Later Two Months later
November 0.20
December .0.60 0.15
January 0.20 0.60 0.15
February 0.30 0.60 0.50
March 0.26 0.60 0.10
April 0.26 0.60 0.10
May 0.16 0.60 0.20
June 0.20 0.60 0.15
July 0.10 0.60 0.25
August 0.20 0.60 0.15

September 0.15 0.60 0.20
October 0.20 0.60 0.15
November 0.15 0.60
December 0.10 0.60
Table 11.5: Debt Forecast, Last Day of Each month and average monthly interest Rates
Months Interest Bearing Debt Interest Rate
(.000s)
December 1600
January 1800 0.120
February 1500 0.100
March 1600 0.110
April 1500 0.100
May 1600 0.110
June 1500 0.100
July 1500 0.090
August 1400 0.080
September 1300 0.090
October 1400 0.080
November 1200 0.095
December 1600 0.095
The final information for the forecast involves establishing a safety level. The firm reouires
cash or equivalents equal to 20 per cent of the monthly cash operating expenses. The firm
began the year with $6,10,000 in the form of cash and equivalents.
Question
Prepare a statement showing cash forecast for the next 12 months, and in case where firm
needs additional cash, draw the recommendation with the tune of credit that must be arranged
from bank.
REVIEW EXERCISES
Objective Type Questions
State which of the following statement is True or False.
(i) Capital expenditures does not form part of cash budget.
(ii) Operating cycle and cash cycle are synonym terms
(iii) Lock Box system is an improvement over concentration banking system.
(iv) Float helps in making early payments.
(v) The postal float, lethargy and bank float collectively are called as deposit
float.
(vi) Concentration Banking and Lock Box system aims at speedy collection of
account receivable.
(vii) The increase in cash cycle would result in increase in cash turnover.
(viii) Cash cycle can be decreased by reducing account receivable and production
cycle.
(ix) Cash cycle can be decreased by decreasing account payable.
(x) Cash management aims at minimizing idle cash balance.
Answer
(i) True (ii) False (iii) True (iv) False (v) True (vi) True (vii) False (viii) True (ix) False (x)
True
Theoretical Questions
1. What are the motives of holding cash?
2. what are the objectives of Cash management?
3. Explain the method of preparation of cash budget
4. Write notes on the following
(a) Cash Cycle (b) Cash turnover (c) Float
(d) lethargy (e) Lock box System (f) Concentration Banking55
5 as a financial manager, what steps you would take to increase account payable
and decrease account receivable.
Numerical Questions
1. Sundaram Ltd has observed that in the normal course it has 20% of its sales in cash
and remainder 80% of its sales on 30 days’ term. It is estimated that 2% of credit
sales are bad debts. Further it has been observed that 50% of credit sales are
collected in the month following sales, 30% in the second month and 18% in the
following month.
January 90,000
February 95,000
March 125,000
April 140,000
May 125,000
June 90,000
Prepare a schedule of the expected cash collections during the months of
april, may and June for presentation to the finance manager.
2. Amit Spinners Ltd. has observed that in the normal course it has 30% of its
sales in cash and remainder 70% of its sales on 30 days term. It is estimated that
there are no bad debts. Further it has been observed that 70% of credit sales are
collected in the month following sales, 20% in the second month and 10% in the
flowing month.
Sales in the preceding 3 months has been as follows:
January 120,000
February 130,000
March 140,000
April 150,000
May 120,000
June 130,000
Prepare a schedule of the expected cash collections during the moths of April,
may and June for presentation to the finance manager.
3. J.K Ltd. commences its business on July 1 and deposited Rs. 40,000 in the bank.
This sum will be insufficient to finance its operations of a period of 6 months.
The following additional information available:
(a) Sales to be made to one distributor at 5% discount and cheques are
received on the first day of the month following due date.
(b) Plant purchases totaling Rs. 10,000 to be made in July.

(c)
Budgeted figures July August August August August August
Purchase 8,000 9,000 6,000 7,000 5,000 6,000
Wages 2,000 4,000 3,000 2,500 4,500 3.500
Chash exp 600 700 800 300 500 700
Sales 15,000 17,000 18,000 20,000 90,000 10,000
All purchase are made on next 30 days terms and cheques are posted to creditors on
the last day of the due month.
Prepare cash budget from July to Dec. to determine monthly overdraft limits to seek
from the company bankers.
4. Achin Tools Ltd. has forecasted the following sales turnover for the next five
months
January 60,000
February 45,000
March 55,000
April 65,000
May 60,000
Other data:
Debtors’ balance at the beginning of the year 26,000
Creditors’ balance at the beginning of the year 14,000
Cash balance 12,000
Stock 7,000
Accrued sales commission 3300
Further, it has been observed that 50% of sales on cash basis. Credit sales are
collected in the month following the sales.
Cost of sales is 55% of sales
Variable cost 5% commission to sales agents
Sales commission is paid in the month after it is earned
Inventory is 2.5 months of budgeted sales.
Trade creditors are paid in the moth following the purchases.
Fixed cost are Rs. 6,500 per month including depreciation of Rs. 3,500
You are requested to prepare a cash budget for first 3 months of the coming year
5 US Ltd. has average daily receipt of Rs. 50,000. it is expected that the lock box
system would reduce the receivable buy 3 days. Lock Box system would cost 25,000
annually. It is expected that the firm can earn 8% on its investment
Advise whether the system be installed [ Ans. Yes, it will result in profit of Rs. 16,000]
6 in problem 7, what would be your answer the cost or instailation is Rs. 10,000
[ Ans, Yes, it will result in profit of Rs. 2,000]
7 C Ltd. hs average daily receipt of 4,00,000. it is expected that the system of
concentration Banking would reduce the receivable by 2 days and the system
would cost Rs. 75,000 annually7. it is expected that the firm can earn 8% on its
investment.
Advise whether the system be installed [Ans, No, the system would result in loss of
Rs. 11,000]
8 Z. Ltd, has average daily receipt of 65,000. it is expected that the system of
concentration banking would reduce the receivable by 3 days and the system would
cost Rs. 42,000 annually. It is expected that the firm can earn 10% in its investment.
Advise whether the system be installed [Ans. No, the system would esult in loss of Rs.
22,500]
9 Y. Ltd has average daily receipt of 60,000. it is expected that the system of
conc4entration banking would reduce the receivable by 4 days and the system
would cost Rs. 23,000 annually. It is expected that the firm can earn 10% on its
investment
Advise whether the system be installed [ans. Yes the system would result in profit of
Rs. 1,000]
UNIT-IV
Lesson-I : RECEIVABLE MANAGEMENT

Objective: The objective of this lesson is to give an idea regarding the techniques of
Receivable management being a component of the Working Capital
Management
Structure:
4.1.1 Introduction
4.1.2 Meaning and objective of the receivable management
4.1.3 Costs and benefits associated with receivable management
4.1.4 Factors influencing the size of receivables
4.1.5 Forecasting the Receivables
4.1.6 Credit Standards
4.1.7 Credit terms
4.1.8 Dimensions of Receivable Management
4.1.9 Evaluation of credit policies
4.1.10 Monitoring Accounts Receivable
4.1.11 Practical problems & solutions
4.1.12 Summary
4.1.13 Review exercises
4.1.14 Case studies.
UNIT-IV
LESSON-I
RECEIVABLE MANAGEMENT
4.1.1 Introduction
The term “receivable” means debt owed to the company. It normally happens that a
company selling its product on credit basis is likely to attract more buyers as compared to
the company selling its goods on cash basis. In other words, we may say that a company
adopting liberal credit policy will have higher sales turnover relative to the company
having strict credit policy. At times, a company may face decision pertaining to relaxing
or contracting its credit policy. Besides having impact on the profitability of the
company, there are costs which are also affected in the process. Further, while extending
credit facilities to the customers, their credit-worthiness shall also be kept under
consideration and be evaluated. These issues have been discussed in this chapter.
4.1.2 Meaning and Objectives of the Receivable Management
Receivable is defined as the debt owed to the firm by the customers arising as a
result of sale of goods or services in the ordinary course of business. Receivables arises
when goods or services are said by a firm on credit basis. The basic objectives of making
credit sales of creating receivables are:
(a) To increase sales. It is but natural that a firm selling its goods on a credit are likely to
attract more customer that the other firms which are selling the same goods on cash
basis provided there is no significant difference in the selling price of the goods. This
practice would be more prominent in case where buyers could find alternative source
of funds where they can generate more return in comparison to the additional amount
which they are required to pay besides the actual selling price to the company. For
example, if a company comes out with a scheme that either its customer can pay Rs.
100 on cash basis for its product or Rs. 102 after availing credit of one month. There
may be certain customers who can generate Rs. 3 on Rs. 100 in one month, such
customers would prefer to avail credit facility of the company.
There may also be situation where a customer has limited funds and having its
operating cycle smaller than the credit period given by the company. In such
situation, the customer would always by tempted to avail credit facility. For example,
Mr. X purchases raw material from A Ltd. on a credit period of 30 days and promises
to pay the due amount on the 30th day. In this case, if Mr. X is able to convert the raw
material purchased from A Ltd. into finished goods, sell it off and realize cash also
within 30 days, Mr. X would be tempted to avail credit facilities offered by A Ltd.
(b) To increase Profitability of a company. The credit sales made by a firm provides
higher profit margin to a firm in comparison to its cash sales. Thus, the cash rich firm
can work out the cost benefit analysis of its credit policy and accordingly increase
their profitability.
(c) To increase market share of a product being manufactured by a firm. Sometimes
a firm may resort to provide credit facility in a bid to increase the market share of its
product. A company may design its credit facility in such a way that it can score over
its competitors by offering more liberal credit facility to the customers of the same
product.
(d) To induce new customers. A company always attempts to increase its customer base
so to have constant growth in its sales and also to stabilize its existence. Therefore a
company keeps on looking for customers who can be offered credit facility as per
their own requirement. For example, as already discussed above, Customers like Mr.
X who has shorter operating cycle that the credit period offered by the suppliers of
the raw material will always be attracted towards companies like A Ltd. Keeping in
view this fact, a company may design its credit policy to induce customers having
shorter operating cycle.
4.1.3 Costs and Benefits Associated with Receivable management
The financial manager who has to design credit policy of a company shall
have thorough knowledge of the costs and benefits associated with the credit policy
of any company. A liberal credit policy though helps in increasing sales but at the
same time result in increase of various costs discussed below. If the net increase in
profit due to increase in sales on account of liberal credit policy is more than increase
in costs, such credit policy shall be accepted. But, if the net increase in profit due to
increase in sales on account of liberal credit policy is less that increase in costs, such
credit policy shall be rejected. Likewise, if the credit policy is tightened, it will result
in decrease of sales and consew2uently profits along with various costs associated
with receivable management. If the net decrease in profit due to decrease in sales on
account of tight credit policy is more than decrees in costs, such credit policy shall be
rejected.
The major categories of costs associated with the receivable management are
discussed as under:
(a) Administrative cost
(b) Capital Cost
(c) Delinquency cost
(d) Default cost
Administrative Cost
This cost basically comprises of collection cost, shall cost etc. When the sales turnover
increases due to liberal credit policy, a company is required to make more investment on the
staff which will keep record of account receivable and timely follow up with the customers to
recover the dues. It also includes cost incurred in the credit appraisal of the clients which
require procurement and analysis of past tract of the clients in meeting their dues in other
organition. The cost incurred in the arrangement of such system constitutes administrative
cost. These are also known as Collection cost.
Capital Cost
When a company allows credit facility to its customers, the company has to make
arrangement of funds from outside sources to maintain its operations during the intermediary
period when its own funds are tied up in form of receivables. The company may be required
to pay certain interest on such funds. The interest paid on such funds is known as capital cost.
Delinquency Cost
A company offers credit facility to its customer for a specified period depending upon
the credit period. The customer is required to make payment on the specified date. However,
if the customer instead of paying the dues on the due date makes the payment after few days
i.e. delays the payment by few days, the company loses interest on the payment due from the
customer for the delayed period. The loss of interest to the company for the delayed period
from the due date constitute delinquency cost of the company.
Default cost
When a company fails to recover the amount due from its customer, the company
treats it as bad debts and finally they are written off. Such costs are known as default cost.
Benefits
A relaxation or contraction in credit policy have direct impact on the sales turnover of
the company and therefore the profitability of the company. As already mentioned above,
while discussing the objective of receivable management, a relaxation or provision of credit

facility helps in adding customer base ad enable a company to face its competitors.
Trade off on Receivables
In the preceding section, various costs and benefits associated with the change in
credit policy has been discussed. A liberal credit policy helps in increasing sales along with
profit but reduces the liquidity of the firm as the firm’s fund/working capital gets tied up in
receivable. In contrast to it. A stringent credit policy reduces the profitability but helps in
increasing the liquidity of the firm. The financial manager shall, therefore, design such a
credit policy which ensures profitability to the firm without impairing its liquidity. Such
credit policy is known as optimum credit policy. It is shown below in the figure.
Cost & Benefits profitability
Liquidity
String cut Optimum Credit Liberal

Credit
Policy Policy Policy
Credit Policy
The concept of designing credit policy would become more clear from the following
examples.
Example 1: X Ltd. is planning to tighten its present credit policy. The company has current
annual sales of Rs. 25,000 and it is expected that implementation of the proposed credit
policy would decrease the annual sales to Rs. 20,000. the average age of account receivable
would decrease from 30 days to 20 days. The sale price of a product is Rs. 20 and the
variable cost involved in manufacturing of a product is Rs. 12. on the volume of 1250 units,
the average cost is Rs. 15. assume a year comprises of 360 days. Advice whether the
proposed credit policy shall be implemented if firm’s required rate of return is 20% .
Solution:
First of all, find the fixed cost using the formula given below
Fixed Cost = (Avg. cost per unit – Var. cost per unit) X Total no. of units
Fixed cost = (15 – 12) X 1,250

Fixed Cost = =3 X 1,250 = 3,750
Reduction in cost
Present Proposed
Total no. of units 1,250 1,000
Fixed cost 3,750 3,750
VC 15,000 12,000
Total cost of sales 18,750 15,750
Debtors’ turnover 12 18
[Average Investment in A/C receivable = Total cost of sales / Debtors’ turnover]

Avg. Invst. In A/C Rec 1562.5 875
Reduction of invest. In A/C receivable 687.5
Savings (.’ . 20% of 687.5) 137.5
Reduction in profits
Present Proposed
No. of units 1,250 1,000
Sp/unit 20 20
Sales 25,000 20,000
Total cost 18,750 15,750
Profit 6,250 4,250
Reduction in profits 2,000
Since reduction in profits is more than reduction in savings, the firm shall reject the proposal.
Example 2: XY Ltd. is considering of liberalizing its present credit policy. The company
current annual sales of Rs. 2,00,000 and it is expected that implementation of the proposed
credit policy would increase the annual sales to Rs. 3,00,000. the average age of account
receivable would increase from 15 days to 30 days. The sale price of a disc is Rs. 20 and the
variable cost involved in manufacture of a disc is Rs. 5. on the volume of 10,000 units, the
average cost is Rs. 8. assume a year comprises 360 days. Advice whether the proposed credit
policy shall be implemented if firm’s required rate of return 18%.
Solution. Fist of all find the average investment in account receivable

Total number of units currently being manufactured = 2,00,000 / 20 = Rs. 10,000
Fixed cost = (Avg. cost per – Var. cost per unit) X total no. of units
Fixed cost = Rs. (8-5) X 10,000 = Rs. 30,000
Receivable Management
Present Proposed
Total no.. of units 10,000 15,000
Fixed cost 30,000 30,000
Variable cost 50,000 75,000
Total cost of sales 80,000 1,05,000
Debtors’ turnover 24 12
(. ‘ . 360/Avg. collection period
[Average Investment in A/C receivable = Total cost of sales / Debtors’ turnover]

Avg. Invst. In A/C 3,333,33 8750
Increase of invest. In A/C receivable 5416.67
Additional Expense (5,416.67 X 0.18) 975
Reduction in profits
Present Proposed
No. of units 10,000 15,000
Sp/unit 20 20
Sales 2,00,000 3,00,000
Total cost 80,000 1,05,000
Profit 1,20,000 1,95,000
Increase in profits 75,000
Since increase in profits is more than increase in investment in account receivable, the
firm shall reject the proposal.
Thus, the credit policies of the firm are designed keeping in view the cost and benefits
associated with the same. Apart from cost and benefit analysis, other important issues related
to the receivable management are
(i) Credit standards
(ii) Credit Terms

(iii) Collection Procedure
4.1.4 Factors influencing the size of Receivables
Besides sales, a number of other factors also influence the size of receivables. The
following factors directly and indirectly affect the size of 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 Shoe Company, then there will be no receivables. The higher the part
of credit sales out of total sales, figures of receivables will also be more or vice
versa.
(2) Credit Policies. A firm with conservative credit policy will have a low size of
receivables 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. It 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 than receivables will also be more.
Sometimes 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 increase 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 receivable or vice-versa.
(6) Credit Collection Efforts. 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 problem. An efficient credit
collection machinery will reduce the size of receivables. If these efforts are slower
then outstand9ing 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 realize the urgency of their needs.
4.1.5 Forecasting the Receivables:
A concern should be clear about its credit policies. How much will be the size of
receivables on the basis of present policies? This is an important estimation which will
help the concern in planning is 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 receivable will also be less.
(2) Effect of Cost of Goods Sold. Sometimes 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
estimate for sales will enable the estimation of receivables too. This can be explained
with the help of an example; supposing cost of sales is 60 per cent of the total sales
when sales are Rs. 20 lakhs. If sales are increased to Rs. 25 lakhs the cost of sales
goes down to 55 per cent of sales. The concern should raise its sales to Rs. 25 lakhs
so that it may be able to earn more profits. The increase in sales may increase the cost
of sale to the same old percentage. Under these circumstances it will not be wise to
increase sales beyond Rs. 25 lakhs. The receivables will be forecasted when sales
figures are estimated.
(3) Forecasting Expenses. The receivables are associated with a number of expenses.
These expenses are administrative expenses on collection of amounts, cost of funds
tied down in receivables, bad debts, etc. At the same time the increase in receivables
will bring in more profits by increasing sales. If the costs 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 costs 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
receivables will be more. Average collection period is calculated as follows:
Average collection period= Trade debtors X No of working days
Net sales
(5) Average size of receivables. The determination of average size of receivables will
also be helpful in forecasting receivables. Average size of receivables is calculated as:
Average size of Receivables = Estimated annual sales X Average collection period.
4.1.6 Credit standards
The term credit standard basically refers to the criteria for the extension of credit
to customers. If a firm is adopting liberal credit standard, the level of sales and
receivables are likely to be very high whereas if it is strict, the level of sales and
receivables are likely to be low. The credit standard determines the extent of the credit
which can be extended to the customer. It depends upon the qualitative and quantitative
parameters of the customers. It is not necessary that a firm extend credit to all the
customers. It may extend credit to only certain selected customers who satisfy the norms
given by the firm.
While setting credit standards, the firm shall give consideration to the following
quantitative and qualitative parameters of the customers:
Qualitative Parameters
(a) Management Ability and Promoter Track record
(b) Nature of Business of the customers
(c) Production cycle of the customers
(d) Track record of the management and promoter in meeting liabilities of other
agencies.
Quantitative Parameters
(a) Earning capacity of the customer
(b) Net worth of the customer
(c) Customers’ stage of business
One of the traditional methods of organizing this information is by
characterizing the applicant along five dimensions. These dimensions are called the
Five Cs of the credit-Capital, Character, Collateral, Capacity and Conditions of the
customer.
Dimensions Source and inference
Capital It refers to analysis of financial position of the customers. The source of
information is the financial statement. Various ratios such as debt equity,
current ratio, return on capital employed etc can be calculated to ascertain
repayment capacity of the customer.
Character It basically determines the customer’s willingness to pay debt. The
information pertaining to this aspect can be sourced from financial statements,
various financial institutions and agencies from where the customer has
already borrowed funds or availed credit facilities.
Collateral It is defined as the security offered by the customer to avail credit facility. In
the even of non-payment by the customer, the firm can liquidate the security
kept against payment by the customer and can recover its dues. The ability to
offer security by a firm can be assessed from the financial statement of the
firm.
Capacity It denotes the ability of the customer to manage business. The information
pertaining to this aspect can be sourced from the past history of the
management, it also reflects plants capacity i.e whether the technology of the
firm can adapt itself to the rapid changes occurring in the external
environment.
Conditions It basically refers to the changes in economic conditions which may have
bearing on the payment capacity of the customer. The information can be
gathered by studying relationship between the business of the applicants and
effect of economic conditions and changes on the same in the past.
4.1.7 Credit Terms

Once it has been decided that credit is to be extended to a particular customer, another
important issue is the terms and conditions on the basis of which the credit shall he
extended to the customer. The credit terms determine the farms and conditions on which
trade credit will be made available. The credit terms have basically three important
components
(a) Credit Period
(b) Cash discount
(c) Cash discount period
The credit period is the period elapsing between the date when the goods are sold to
the customer and the date within which the customer is required to make the payment. For
example, if a company is extending a credit period of 30 days, it means if the company has
sold goods on, say Jan 1, then it must receive its payment by Jan 31 (i.e within 30 days of the
date of selling). Sometimes a company tries to motivate the customer, who have purchased
goods on credit basis, to same the early payment instead of at the end of the credit period. For
example, in the above case, the company may offer discount to the customer who would pay
within first ten days of date of sale i.e by Jan 11. this discount is referred as cash discount
and the period for which this discount is available is known as cash discount period. To
illustrate, if the goods worth Rs. 1000 are sold on the terms, 3/15 net 60, it signifies the
following information.
(j) Here 3 represents rate of cash discount which will be available to the customer if
they pay the due amount within 115 days of the purchase. In case they would pay
within 15 days of the purchase date, they will be required to make payment of (Rs.
1,000-0.03 X 1,000) =Rs. 970 only. In case the customer would pay after 15 days of
the puchase, it would be required to pay the full amount due i.e Rs. 1,000.
(ii) 60 represent credit period within which the customer must pay to the company.
Cash discount has direct impact on the sales, profitability of the company, average
collection period and bad debt expense. The increase in cash discount directly leads to
increase in sales but it has negative impact on the profit per unit sold by the company. Since,
customer would be prompted to make early payments, it will reduce bad debt expenses as
well as average collection period.
Example 3. X Ltd. has current annual sales of Rs. 200,000 and average collection period of
45 days. The product being manufactured has sale price of Rs. 20 per unit and variable cost
of Rs. 7 per unit. Fixed expenses of the firm are Rs. 50000. the firm is contemplating to offer
2 percent discount for payment within 10 days of credit purchase. It is expected that 70% of
the total credit sales would be collected with 10 days. Consequent to this offer, the sales
turnover is likely to increase by 30% and average collection period would decline to 25 days.
Should the firm implement the proposal if the firm’s required rate of return is 20%? (Assume
there are no changes in bad debts)
Solution: The decision regarding implementation of the proposed offer of cash discount
would depend upon comparison of following costs and benefits.
Cost associated with cash discount.
1. Discount given to customers for making payment within cash discount period of 10
days.
Amount of Discount + credit sales X rate of discount X % age of expected
recovery
= 2,60,000 X 2 X 70 =3640
100 100
Benefits associated with cash discount.

1. Increase in profit due to increased sales:
Present Proposed
Sales 200000 260000
Less variable cost 70000 91000
Less Fixed cost 50000 50000
profit 80000 119000
. ‘ . Incremental Profit =119000 – 80000 = 39000
2. Decrease in Investment in A/c receivable
Present Proposed
Total Cost of sales (variable cost + fixed cost) 120000 141000
Average collection period 45 25
Total in A/c receivables (360 /avg. collection period) 8 14.4
Average Investment in A/c receivable 15000 9791.66
Decrease in Investment in A/c receivable =15000 – 9791.66 = 5208.34
Cost of funds saved = 20 X 5208.34 = 1041.66

100
Total Benefits = Increase in Profits + Savings due to decrease in investment in A/c

receivable
= 39000 +1041.66 = 400041.66
Net Benefit = Total Profit – Total cost
= 400041.66 – 3640 = 36401.66
4.1.8 Dimensions of receivables Management:
Receivables management involves the careful consideration of the following aspects:
1. Forming of credit policy.
2. Executing the credit policy
3. Formulating and executing collection policy.
1. Forming of Credit Policy:
For efficient management of receivables, a concern must adopt a credit policy.
A credit policy is related to decisions such as credit standards, length of credit period,
cash discount and discount period, etc
(a) Quality of Trade Accounts of Credit Standards: The volume of sales will be
influenced by the credit policy of a concern. But liberalizing credit policy the volume
of sales can be increased resulting into increased profits. The increased volume of
sales is associated with certain risks too. It will result in enhanced costs and risks of
bad debts and delayed receipts. The increase in number of customers will increase the
clerical work of maintaining the additional accounts and collecting of information
about the credit worthiness of customers. There may be more bad debt losses due to
extension of credit to less worthy customers. These customers may also take more
time than normally allowed in making the payments resulting into tying up of
additional capital in deceivable. On the other hand, extending credit to only credit
worthy customers will save costs like bad debt losses, collection costs, investigation
costs, etc. the restriction of credit to such customers only will certainly reduce sales
volume, thus resulting in reduced profits.
A finance manager has to match the increased revenue with additional costs.
The credit should be liberalized only to the level where incremental revenue matches
the additional costs. The quality of trade accounts should be decided so that credit
facilities are extended only upto that level. The optimum level of investment in
receivables should be where there is a trade off between the costs and profitability.
The increased investment in receivables also adversely affects the liquidity of a firm.
On the other hand, a tight credit policy increases the liquidity of the firm. Thus,
optimum level of investment in receivables is achieved at point where there is a trade
off between cost, profitability and liquidity as depicted below:
Profitability
Costs and
Profitability
Liquidity
Stringent Liberal
Credit Policy (Optimum Level)

(c) Length of Credit Period: Credit terms or length of credit period means the period
allowed to the customers for making the payment. The customers paying well in time
may also be allowed certain cash discount. There is no binding on fixing the terms of
credit. A concern fixes its own terms of credit depending upon its customers and the
volume of sales. The customs of industry act as constraints on credit terms of
individual concerns. The competitive pressure . in other firms compels to follow
similar credit terms, otherwise customers may feel inclined to purchase from a firm
which allows more days for paying credit purchases. Sometimes more credit time is
allowed to increase sales to existing customers and also to attract new customers. The
length of credit period and quantum of discount allowed determine the magnitude of
investment in receivables.
A firm may allow liberal credit terms to increase the volume of sales. The
lengthening of this period will mean blocking of more money in receivables which
could have been invested somewhere else to earn income. There may be an increase
in debt collection costs and bad debt losses too. If the earning from additional sales by
lengthening credit period are more than the additional costs then the credit terms
should be liberalized. A finance manager should determine the period where
additional revenue equates the additional costs and should not extend credit beyond
this period as the increase in cost will be more than the increase in revenue.
(C) Cash Discount : Cash discount is allowed to expedite the collection of
receivables. The funds tied up in receivables are released. The concern will be able to
use the additional funds received from expedited collections due to cash discount.
The discount allowed involves cost. The financial manager should compare the
earnings resulting from released funds and the cost of discount. The discount should
be allowed only if its cost is less than the earnings from additional funds. It the funds
cannot be profitably employed then discount should not be allowed.
(d) Discount period: The collection of receivables is influenced by the period
allowed for availing the discount. The additional period allowed for this facility may
prompt some more customers to avail discount and make payments. This will mean
additional funds released from receivables which may be alternatively used. At the
same time the extending of discount period will result in late collection of funds
because those who were getting discount and making payments as per earlier
schedule will also delay their payments. For example, if the firm allowing cash
discount for payments within seven days now extends it to payments within fifteen
days. There may be more customers availing discount and paying early but there will
be these also who were paying earlier within seven days will now pay in fifteen days.
It will increase the collection period of the concern. Hence, this decision involves
matching of the effect on collection period with the increased cost associated with
additional customers availing the discount.
2. Executing Credit Policy:
After formulating the credit policy, its proper execution is very important. The
evaluation of credit applications and finding out the credit worthiness of customers
should be undertaken.
(a) Collecting Credit Information: The first step in implementing credit policy
will be to gather credit information about the customers. This inflammation should be
adequate enough so that proper analysis about the financial position of the customers
is possible. This type of investigation can be undertaken only upto a certain limit
because it will involve cost. The credit information will certainly help in improving
the quality of receivables but the cost of collecting, information should not increase
the reduction of bad debts losses.
The sources from which credit information will be available should be
ascertained. The information may be available from financial statements, credit rating
agencies, reports from banks, firm’s records etc. financial reports of the customer for
a number of years will be helpful in determining the financial position and
profitability position. The balance sheets will help in finding out the short term and
long-term position of the concern. The income statements will show the profitability
position of the concern. The income figures will help in finding out whether it is
sufficient to enable the payment of receivable or other business liabilities or not. The
liquidity position and current assets movement will help in finding out the current
financial position. A proper analysis of financial statements will be helpful in
determining the creditworthiness of customers. There are credit rating agencies which
can supply information about various concerns. These agencies regularly collect
information about business units from various sources and keep this information upto
date. The interpreted information can be had from the agencies. These agencies
supply this information to their subscribers on a regular basis through circulars,
periodicals etc. the information is kept in confidence and may be used when required.
Such agencies are not available in India at present but countries like America have so
many agencies in this field.
Credit information may be available with banks too. The banks have their credit
departments to analyse the financial position of a customer. The bank in which one
has its accounts can be helpful in supplying this information. If the customer is at a
different place then the bank can collect this information through its branch at that
place and bank may even request the other banks for information about customers
having accounts with them. The credit limits allowed, frequency of amounts
deposited, etc. may be helpful to know about the customers.
In case of old customers, business’s own records may help to know their credit
worthiness. The frequency of payments, cash discounts availed interest paid on over
due payments, etc. may help to form an opinion about the quality of credit. The
salesmen of the business may also be asked to collect information about the
customers.
(b) redit analysis: After gathering the required information, the finance manger
should analyse it to find out the credit worthiness of potential customers and also to
see whether they satisfy the standards of the concern or not. The credit analysis will
determine the degree of risk associated with the account, the capacity of the customer
to borrow and his ability and willingness to pay.
(c) Credit Decision: After analyzing the creditworthiness of the customer, the
finance manager has to take a decision whether the credit is to be extended and if yes
then upto what level. He will match the creditworthiness of the customer with the
credit standards of the company. If customer’s creditworthiness is above the credit
standard then there is no problem in taking a decision. It is only in the marginal cases
that such decisions are difficult to be made. In such cases the benefit of extending the
credit should be compared to the likely bad debt losses and then a decision should be
taken. In case the customer’s are below the company’s credit standards then they
should not be out rightly refused. Rather they should be offered some alternative
facilities. A customer may be offered to pay on delivery of goods, invoices may be
sent through bank and released after collecting dues or some third party guarantee
may be insisted. Such a course may help in retaining the customers at present and
their dealings may help in reviewing their requests at a later date.
4.1.9 Evaluation of Credit Policies
Sometimes a firm may have number of available options of credit policy. As we know,
longer the credit policy, higher is likely to be sales and hence profit but the firm shall not
choose credit policy simply on the bases of increase in sales or profit it offers but the cost
aspect shall also be taken into consideration. Thus, the process of evaluating number of
credit policies shall be conducted using the following steps:
Step-1 Calculate profit associated with each given proposal
Step-2 Calculate incremental profit by comparing the present and each of the
proposed policy separately
Step-3 Calculate total cost associated with each policy.
Step-4 Calculate incremental cost associated with each proposal by compassing the
present and the proposed policy.
Step-5 Compare incremental profit (calculated in step 2) with the incremental cost
(calculate in step 4) to find net benefit. The proposal which gives highest value of net
benefit shall be accepted.
Example 4. The management of Vishwas Info Ltd. is considering to change its present
credit policy.
The details of the options are given below:
Credit Policy Present A B C D
Sales 80 81 82 83 84
VC (55% Sales) 44 44055 45.1 45.65 46.2
Fixed cost 20 20 20 20 20
Avg. collection period 20 30 40 50 65
Firm’s rate of investment 20%
Find which is the best option
Solution
Credit Policy Present A B C D
Sales 80 81 82 83 84
Less VC 44 44.55 45.1 45.6 46.2
Fixed cost 20 20 20 20 20
Profit 16 16.45 16.9 17.3 17.8
Inc. in profit (A) 0.45 0.9 1.35 1.8
Investment in account Receivable
Total Cost 64 64.55 65.1 65.6 66.2
Avg. collection period 20 30 40 50 65
Debtors’ Turnover 18 12 9 7.2 5.5
Investment in A/c Rec2 3.55 5.37 7.23 9.11 12.03
Increase in Investment 1.82 3.67 5.56 8.39
Cost of additional investment 0.36 0.73 1.11 1.6
(Inc. in invst. X20%) [B]
Incremental profit [A-B] 0.09 0.17 0.23 0.13
1. Debtors’ turnover =(360 /Avg. collection period)

2. Investment in account receivable = (Total cost of sales) / (Debtors turnover).
(e) Financing investments in Receivables and Factoring; accounts receivable block a
part of working capital. Efforts should be made that funds are not tid up in receivables
for longer periods. The finance manager should make efforts to get receivables
financed so that working capital needs are met in time.
The banks allow raising of loans against security of receivables. Generally,

banks supply between 60 to 80 per cent of the amount of receivables as loans against
their security. The quality of receivables will determine the amount of loan. The
banks will accept receivables of dependable parties only. Another method of getting
funds against receivables is their outright sale to the bank. The bank will credit the
amount to the party after deducting discount and will collect the money from the
customers later. Here too, the bank will insist on quality receivables only. Besides
banks, there may be other agencies which can buy receivable and pay cash for them.
This facility is known as factoring. The factor will purchase only the accounts
acceptable to him and may refuse purchase in certain cases. The factoring may be
with or without recourse. It is without recourse then any bad debt loss is taken up by
the factor but if it is with recourse then bad debts losses will be recovered from the
seller. The factor may suggest the customers for whom he will extend this facility.
The factoring service varies from bill discounting facilities offered by commercial
banks to a total take over of administration of the sales ledger and credit control
functions.
3. Formulating and Executing Collection Policy:
The collection of amounts due to the customers is very important. The concern
should devise procedures to be followed when accounts become due after the expiry
of credit period. The collection policy be termed as strict and lenient. A strict policy
of collection will involve more efforts on collection. Such a policy has both plus and
negative effects. This policy will enable early collection of dues and will reduce bad
debt losses. The money collected will be used for other purposes and the profits of the
concern will go up. On the other hand a rigorous collection policy will involve
increased collection costs. It may also reduce the volume of sales. Some customers
may not appreciate the efforts of the concern and may shift to another concern thus
causing reduced sales and profits. A lenient policy may increase the debt collection
period and more had debt losses. A customer not clearing the dues for long may not
repeat his order because he will have to pay earlier dues first, thus causing loss of
customers. The collection policy should weigh various aspects association with it, the
gains and losses of such policy and its effect on the finance of the concern.
The collection policy should also devise the steps to be followed in collecting
ovr due amounts. The objective is to collect the dues and not to annoy the customer.
The steps should be like (i)sending a reminder for payments (ii) Personal request
through telephone etc. (iii) Personal visits to the customers (iv) taking help of
collecting agencies and lastly (v) taking legal action. The last step should be taken
only after exhausting all other means because it will have a bad impact on relations
with customers. The genuine problems of customers should never be ignored while
making collections. The aim should be to make collections and kept amiable relations
with customers.
The collection of book debts can be monitored with the use of average
collection period and aging schedule. The actual average collection period may be
compared with the stated collection period to evaluate the efficiency of collection so
that necessary corrective action can be taken if the need be. The again schedule
further highlights the debtors according to the age or length of time of the outstanding
debtors. The following table presents the aging schedule of a firm.
Aging Schedule
Outstanding period Outstanding Amount of Debtors (Rs.) Percentage of Debtors
0-30 days 5,00,000 50%
31-40 days 1,00,000 10%
41-60 days 2,00,000 20%
Over 60 days 2,00,000 20%
10,00,000
Monitoring Accounts Receivables:
Just evaluation of individual accounts does not help in efficient accounts receivables
management without continuous monitoring and control of receivables. In other words
success of collection effort depends on mp /monitoring and controlling receivables. Then
how to monitor and control receivables? There are traditional techniques available for
monitoring accounts receivables. They are (a) Receivables turnover, (b) Average Collection
period (c) Aging Schedule and (d) Collection matrix.
(a) Receivables Turnover: Receivables turnover provides relationship between credit
sales and debtors (receivables) of a firm. It indicates how quickly receivables or debtors
are converted into cash. Ramamurthy observes “collection of debtors is the concluding
stage for process of sales transaction”, “The liquidity of receivables is therefore, is
measured through the receivables (debtors) turnover rate.
Debtors or Receivables Turnover Rate =Credit Sales + Average Debtors or

receivables Debtors turnover rate is expressed in terms of times. Analyst may not be
able to access credit sales information, average debtors and bills receivables to avoid of
non-availability of the above information and to evaluate receivables turnover there is
another method available for analyst.
(b) Average Collation period (ACP): Turnover rate converted into average collection
period is a significant measure of the collection activities of debtors. Average
collection period is a measure of how long it takes from the time sales is made to the
time to cash is collect form the customers.
ACP = 365 + Debtors or Receivables turnover.
Illustration 6:
A company’s credit sales are Rs. 20 lakhs in a year. The opening debts are Rs. 2 lakhs and
closing debtors are Rs. 2,10,000. Determine Debtors turnover and ACP.
Solution:
Debtors Turnover Ration = Rs. 20,00,000 + (Rs. 2,00,000+ Rs. 2,10,000) / 2=9,75 times
ACP = 365 +9.75 = 37,43 day
(c) Aging Schedule : As we have seen in the above average collection period measures
quality of receivables in an aggregate manner, which is the limitation of ACP. The
can be overcome by preparing aging schedule. Aging schedule is a statement that
shows age wise grouping of debtors. In other words, it breaks down debtors according
to the length of time for which they have been outstanding. A hypothetical aging
schedule is as follows:
Age Group Amount Percentage of Debtors to
(in days) Outstanding (Rs.) total Debtors
Less than 30 40,00,000 40
31-45 20,00,000 20
46-60 30,00,000 30
Above 60 10,00,000 10
Aging schedule is helpful for identifying slow paying debtors, with which firm may have
to encounter a stringent collection policy. The actual aging schedule of the firm is
compared with industry standard aging schedule or with bench mark aging schedule for
deciding whether the debtors are in control or not.
(d) Collection Matrix: Traditional methods (debtors turnover rate, average collection
period) of receivables management are very popular, but they have limitation, that they
are on aggregate data and fail to relate the outstanding accounts receivables of a period
with credit sales of the same period. The problem of aggregating data can be eliminated
by preparing and analyzing collection matrix. Collection matrix is a method (statement)
showing percentage of receivables collect during the month of sales and subsequent
months. It helps in studying the efficiency of collections whether they are improving or
deteriorating. Following table shows hypothetical collection matrix.
Percentage of Receivables collected During the April May June July August
Sales (Rs. Lakhs) 350 340 320 300 250
Month of sales 10 12 14 11 08
First Month following 30 38 40 30 34
Second Month following 25 24 22 20 21
Third Month following 20 26 22 19 18
Fourth Month following 15 10 02 15 20
Fifth month following - - - 05 09
For the above table, it may be read for April sales are Rs. 350 lakhs. The pattern of
collections are 10 per cent in the same month (April) 30 per cent of sales in May, 25 per cent
of sales in June, 20 per cent of sales in July and the remaining 15 per cent in the august.
Practical Problems:
Problem 1. Aakanksha Transformers Lted. Is considering tightening of its present credit
policy. The company has current annual sales of Rs. 32,00,000 and it is expected that
implementation of the proposed credit policy would reduce the annual sales to Rs. 28,00,000.
the average age of account receivable would decrease from 72 days to 45 days. The sale price
of a transformer is Rs. 40 and the variable cost involved in manufacturing of a transformer is
Rs. 25. on the volume of 80,000 units, the average cost is Rs. 32 Assume a year comprise of
360 days. Advice whether the proposed credit policy shall be implemental if firm’s required
rate of return is 20%.
Solution: First of all find the average investment in account receivable
Total number of units currently being manufactured = 32,00,000 = 80
40
Fixed cost = (Avg. cost per unit – Var. cost per unit) X Total no. of units
Fixed cost = Rs (32-25) X 80,000 = Rs. 5,60,000

Present Proposed
Total no. of units 80,000 70,000
Fixed cost 5,60,000 5,60,000
Variable cost 20,00,000 1750,000
Total cost of sales 25,60,000 23,10,000
Debtor’s turnover 5 8
Average investment in A/c Receivable 3,12,000 2,88,750
Reduction of investment in A/c receivable 2,23,250
Formula:
(Average Investment in A/c Receivable = Total Cost of sales / Debtor’s turnover
Savings = Firm’s required rate of return + Reduction of investment in A/c receivavle
Saving = 20% X 2,23,250 = 44,650
Reduction in Profits
No. of units 80,000 70,000
SP / Unit 40 40
Sales 32,00,000 28,00,000
Total cost 25,60,000 23,10,000
Profit 6,40,000 4,50m000
Reduction in Profits 1,50,000
Since reduction in profits is more than savings, the firm shall not accept the proposal.
Problem 2. Nomras watches Ltd. is considering rereading of its present credit policy. The
company has current annual sales of Rs. 25,00,000 and it is expected that implementation of
the proposed credit policy would increase the annual sales to Rs. 30,00,000. the average age
of actual receivable would increase from 30 days to 45 days. The sale price of a watch is Rs.
25 and the variable cost involved in manufacturing of a watch is Rs. 12. on the volume of
1,00,000 units, the average cost is Rs. 18. Assume a year comprises of 360 days. Advice
whether the proposed credit policy shall be implemented if firm’s required rate of return is
20%.
Solution. First of all find the average investment in account receivable
Total number of units currently being manufactured = 25,00,000/25 = 1,00,000
Fixed cost = (Avg. cost per unit – Var. cost per unit) X Total no. of units
Fixed cost = (18-12) X 1,00,000
Present Proposed
Tatal no. of units 1,00,000 1,20,000
Fixed cost 6,00,000 6,00,000
Variable cost 12,00,000 14,40,000
Debtor’s turnover 12 8
Avg. Investment in A/c receivable 1,50,000 2,55,000
Increase of investment in A/c receivable 1,05,000
Formula:
[Average investment in A/c Receivable = Total Cost of Sales/Debtor’s turnover]
Investment = Firm’s required rate of return X Reduction of investment in A/c receivable
Investment = 20% X (1,05,000)
Investment – 21,000
Increase in Profits:
Present Proposed
No. of units 1,00,000 1210,000
SP / Unit 25 25
Sales 25,00,000 30,00,000
Total cost 18,00,000 20,40,000
Profit 7,00,000 9,60,000
Increase in profits 2,60,000
Since, the increase in profit is more than the investment in account receivable, the proposal
shall be accepted.
Problem 3. Gassettes Ltd. is contemplating to relax its credit policy as a result of which the
annual sales of the company would increase from Rs. 10,00,000 to Rs. 12,00,000. the fixed
cost would remain Rs. 50,000 whereas the bad debt would increase from 1% to 2%. The
account receivable turnover ratio would decrease from 10 to 6. the PV ratio currently is 30%.
Advise whether the proposal shall be accepted if the firm’s required rte of return is 20%
Solution. Cost of Investment in account receivable:

Present Proposed
Total cost of sales 750,000 890,000
Turnover in A/c receivable 10 6
Investment in A/c receivable 75,000 148333.33
Cost of Investment 15,000 29,666,667
[Cost of Investment in account receivable = Investment in A/c receivable X firm’s required

rate of return]
Since P/V ratio = 30%
. ‘ . VC = 70% of sales
Present Proposed Change in income
Sales 10,00,000 12,00,000 2,00,000
Less VC 7,00,000 8,40,000 1,40,000
Less Fixed cost 50,000 50,000 0
Less Cost of Investment 15,000 29,666,667 14,667
Less Bad debts 10,000 24,000 14,000
Income / (deficiency) 2,25,000 2,56,333 31,333
The firm should relax its credit term as it will increase its income.
Problem 4. Mohit stationary Ltd. Is considering tightening of its credit policy. The details of
the present and proposed policies are given below:
Present Proposed
Sales 1,20,000 1,50,000
P/V ratio 30% 30%
Therefore VC = 70% of Sales 84,000 1,05,000
Fixed cost 20,000 20,000
Bad debts 1% 3%
A/c receivable turnover Ratio 8 5
Advice whether the proposal shall be accepted if firm’s required rate of return is 20%
Solution. Cost of Investment in account receivable
Present Proposed
Investment in A/c receivable 13,000 25,000
Cost of investment 2,600 5,000
Investment in A/c receivable = (Total cost of sales / Turnover in A/c receivable)

[Cost of investment in accounts receivable = Investment in A/c receivable X firm’s
required rate of returns]
Receivable Management
Present Proposed Change in income
Sales 1,20,000 1,50,000 30,000
Less VC 84,000 1,05,000 21,000
Less Fixed cost 20,000 20,000 0
Less cost of Investment 2,600 5,000 2,400
Less Bad debts 1,200 4,500 3,300
Income /(deficiency) 12,200 15,500 3,300
The firm should relax its credit term as it will increase its income.
Problem 5. The management of AKS Ltd. is considering to change its present credit policy.
The details of the options are given below:
Credit policy Present A B C D
Sales (s) 50 56 60 62 63
VC ((80%s) 40 44.8 48 49.6 50.4
Fixed cost 6 6 6 6 6
Average collection period 30 45 60 75 90
Firm’s rate of investment 20%

Advise which of the option is best.
Solution
Present A B C D
Sales 50 56 60 62 63
Less :Variable cost 40 44.8 48 49.6 50.4
Fixed cost 6 6 6 6 6
Profit 4 5.2 6 6.4 6.6
Increase in profit 1.2 2 2.4 2.6
Investment in account receivable

Total cost (Variable + Fixed) 46 50.8 54 55.6 56.4
Avg. collection prd. 30 45 60 75 90
Debtors Turnover* 12 8 6 4.8 4
Investment in A/c receivable 3.83 6.35 9 11.58 14.1
Increase in Investment 2.51 5.16 7.75 10.26
Cost of additional Invest. @ 20% 0.50 1.03 1.55 2.05
Incremental profit 0.70 0.97 0.85 0.55
 Debtor Turnover = 360 / average collection period

Option B is best.
4.1.10 Summary:
 The term receivable is defined as debt owed to the firm by customers arising fro
sale of goods of services in the ordinary course of business. The accounts
receivables arising out of credit sales has the characteristics Risk Involvement.
Based on Economic Value, and implies Futurity.
 Accounts Receivable management involves maintenance of receivables of optimum
level, the degree of credit sales to be made, and the debtors collection.
 The objectives of accounts receivables management are: maximizing the value of
the firm, Optimum Investment in Sundry Debtors, Control and Dr. Bhatt the Cost of
Trade Credit.
 The management of accounts receivables is not cost free. It involves cost and its
association with accounts receivables results in: Opportunity Cost/Capital Cost,
Collection Cost and bad Debts.
 The economic value of goods or services sold on credit, will be paid by adoption of
different modes-(1) Cash Mode, (2) Open Account, (3) Letter of Credit and (4)
Consignment.
 The level of investment in receivables is affected by the factors:Volume of Credit

sales, credit Policy of the firm, Trade Terms, Seasonality of Business, Collection
Policy, Bill discounting and Endorsement.
 Receivables management involves the decisions areas: credit standards, credit
period, cash discounts and collection procedures.
 Liberal credit policy is that policy where the seller sells goods on very liberal credit
terms and standards, which increase in sales, higher profits. But it involves bad debt
loss, and liquidity problem.
 Stringent credit policy seller sells goods on credit on a highly selective basis only,
which reduces bad losses, sound liquidity position. These benefits are accompanied
by less sales less profits.
 Firms should follow optimum credit policy that lies between lenient and stringent
credit policy. Optimum credit policy involves a balance between costs and benefits.
The optimum credit policy occurs at point where there is a trade off between
liquidity and profitability.
 The major controllable variables of credit policy are: (a) Credit Standards, (b) credit
Terms, and (c) Collection Policy and Procedures.
 Credit Standards refer to the minimum criteria for the extension of credit to a
customer. The firm’s decision, to accept or reject a customer to extend credit
depends on credit standards. Practical ones lies between these two points, liberal
credit standards and rigid credit standards.
 Credit Terms: The second decision criterion in receivables management is the credit
terms. Credit terms means the stipulations under which goods or services are sold
on credit. Credit terms have three components such as : (1) credit period and (ii)
cash discount and (iii) cash discount period.
 The collection policy of a firm is the procedures passed to collect amount
receivables, when they become due. Collection policies may be divided into two
categories. First strict / rigorous, and second lenient / lax collection policy.
 The credit evaluation (individual’s accounts) procedure involves three related steps:
viz (i) obtaining credit information, (ii) analyzing the information and (iii) making
the credit decision (iv) credit information can be obtained from one or more of the
following sources of information. The information may be divided into two sources,
such s (a) internal source and (b) external source. Internal sources is that source that
is available with in the organization and it provides information at free cost.
External sources of information (information agencies, banks, fellow business
undertakings and associates, competitors.
4.1.11 Review Exercises:
1. What are the objectives of receivable management of the firm?
2. Discuss various type of costs associated with the receivable management
3. What are credit terms? State the significance of the term “3/10 net 45”?
4. Discuss the role of financial manager in framing credit policy of the firm.
5. What are the costs and benefits associated with the change in credit policy?
6. Explain the method of credit appraisal
7. Distinguish between credit period and cash discount period
8. Write short notes on the following:
(a) Credit standards
(b) Credit Terms
(c) Collection procedures relating to receivable management
Practical Problems
1. Extending credit to all customers results in decrease in sales, investment in
debtors, and bad-debt losses (True or false)
2. a trader whose current sales are Rs.15 lakhs per annum and average collection
period is 30 days wants to pursue a more liberal credit policy to improve sales. A
study made by a consultant firm reveals the following information:
Credit Policy Period Increase in Collection Period Increase in Sales
A 15 days 60,000
B 30 days 90,000
C 45 days 1,50,000
D 60 days 1,80,000
E 90 days 2,00,000
The selling price per unit is Rs. 5 average cost per unit is Rs. 4 and variable cost per
unit is Rs. 2.75. The required rate of return on additional investment is 20 percent.
Assume a 360 days year and also assume that there are no bad losses. Which of the
above policies would you recommend for adoption?
3. H. Ltd. has a present annual sales of level of 10,000 units at Rs. 300 per unit. The
variable cost per unit is Rs. 200 per unit and the fixed cost amount to Rs. 3,00,000 per
annum. The present credit allowed by the company is one month. The company is
considering a proposal to increase the credit period to two months and three months
and has made the following estimates:
Credit policy Existing Proposed
1 month 2 Months 3 Months
Increase in Sales - 15 percent 30 percent
Percentage of bad Debts 1 percent 3 percent 5 percent
There will be increase in fixed cost by Rs. 50,000 on account of increase in sales beyond
15 percent of present level. The company plans on a pre tax return of 20 percent on
investment in receivables. You are required to compute the most paying credit policy for
the company.
4. A company is currently engaged in the business of manufacturing computer
component. The computer component is currently sold for Rs. 1,000 and its variable
cost is Rs. 8000. for the year ended 31/12/98 the company sold on an average 500
components per month.
Presently the company grants one month credit to its customers. The company is
thinking of extending the credit to two months on account of which the following is
expected:
Increase in Sales 25%
Increase in Stock Rs. 2,0,000
Increase in Creditors Rs. 1,00,000
You are required to advise the company on whether or not to extend the credit term if
(a) all customers avail the credit period of two months and
(b) the new credit policy is given to only new customers.
Assume that the entire increase in sales is attributable to the new customers. The
company expects a minimum return of 40% on investment
4. Explain briefly Credit Policies
5. discuss the consequences of lengthening and shortening of the credit period by a
firm
6. what are the costs and benefits associated with a change in credit policy?
CASE FOR CLASS DISCUSSION-1

YAHOO. PRODUCTS LIMITED
Yahoo. Products limited manufactures a special variety of industrial which are used
by other manufacturing units to produce shoes and chapppals. The market for the
company’s product comprises a few target public limited companies and a number of
small units run as proprietary or partnership concerns. The sales had in the past proved to
be seasonal, with sales being recorded in the period January to July (year)
Rs. / MT
Raw materials (V) 2,500
Direct labour and supervision (f) 800
Indirect Materials file etc (f) 500
Depreciation, Insurance etc (f) 2,700
Factory Cost of production 6,500
Administration, selling and interest Changes (f) 500
Selling Price per MT 7,000
(exclusive of all discounts allowance for freight etc)
Dr. Batt the Director was not satisfied by the under utilization of installed
capacity and its effect on the profitability of the company. He called his senior managers
to discuss the situation and means of improving the profitability of the concern. The sales
Manager, on whom the pressure was tried to described the limitation of sales to be the
stringent credit policy pursued by the company. He argued that under the strict norms for
grant of credit followed by the company and the smaller customers were put on the cash
and carry list. This, he maintained led to an overdependence on the larger customers and
an almost complete neglection of a section of the market consisting of the small
manufactures, who were cultivated by the competition by offering them attractive
discounts. In fact, the smaller manufacturers came to his company, only if the market was
starved of the product. The sales manager pleaded for a more liberal credit policy which
would also help increase the sales volume. He ruled out the possibility of procuring
additional volume of business from the big customers who had already evolved a scheme
sharing out their business among the different suppliers. Any attempt to obtain more
business by offering discounts to the bigger firms, the sales manager argued will only
lead to a retaliatory action by competitors and ultimately escalate into a price war which
will only prove disastrous for the company. On the other hand, granting credit to the
smaller customer will bring the company’s policy in line with competitors and will
actually stimulate growth in the consuming industry with beneficial effects to the
company.
Dr. Bhatt obviously undecided abut the wisdom of extending credit to the smaller
customers to boost sales volume, called for a detailed note from both the sales manager
and the Credit Manager. He however, pointed out that any such change of credit policy
even if approved would bring in results only in long run while there was an immediate
need to boost sales. The sales Manager at this point, conveyed to Dr. Bhatt, an offer he
had just received from the Shoe manager. An offer he had just received from the shoe
Plast Limited one of the larger public limited company. The controller referred to the
substantial investment in receivables that this transaction would entail and reckoning
interest at 18 percent per annum which was the rate the company was paying to lits
bankers, he argued that this transaction would involve an interest burden of Rs. 1,64,250
whereas the profits from the transaction would only be Rs. 90,000. as such the offer was
wholly unattractive. Shoe Plast Limited would pay for these additional supplies to be
effected in the next three months in the seventh month from date. It was however,
unwilling to pay an interest on the extended credit term. The sales Manager pointed out
that Shoe Plast Limited ranked high in the ratings by the Credit Department and
therefore, there should be no hesitation in accepting this offer for additional business.
The customer company wads carrying out an expansion scheme at that time using
partly is current resources to finance the same and was therefore, finding itself in a
difficult liouid situation. It however expected this to be only temporary and anticipated
that the position would improve considerably after six months. Shoe Plast Limited had
made an offer to take 100 MT additional each month in the next three months over and
above the regular off-take. If Plastic products Limited agreed to give special credit terms.
The Credit Manager intervening at this stage, pointed to the high rate of mortality among
the smaller firms. He read out a long list of the smaller firms in the industry which had
closed their creditor5s in the last few years. He points out with pride the excellent record
of the company in the matter of credit management and to the fact that the company has
had no incidence of bad debts in the last smaller manufacturers. He further argued that
the company would be taking grave risk if it chose to adopt such a policy as it would lead
to bad debts. About 6 per cent each year which he was quick to point out was about the
profit margin company appears to have from its products.
Questions
1. What consideration he should take into account, while revising the credit policy
of a company?
2. Advice Dr. Bhatt how he should deal with the circumstances?
CLASS DISCUSSION CASE-2
CREDIT LIMIT DECISION:
BAJAJ ELECTRONICS COMPANY
Perluence international is large manufacturer of petroleum and rubber based products
used in a variety of commercial applications in the fields of transportation, electronics and
heavy manufacturing in the northwestern united states, many of the Purulence products are
marketed by a wholly owned subsidiary, Bajaj Electronics Company. Operating from a
headquarters and warehouse facility in ----------------- strand electronics has 950 employees
and handles a volume of ------ sales annually . about $6 million of the sales represents items
manufactured by perluence.
Gupta is the credit manager at Bajaj clectronics. He supervises five employees who
handle credit application and collections on 4,600 accounts. The accounts rqnge in size from
$ 120 to $85.000. the firm sells on varied terms, with 2/10 net 30 mostly. Sales fluctuate
seasonally and the average collection period tends to run 40 days. Bad debt losses are less
than 0.6 per cent of sales.
Gupta is evaluating a credit application from Booth Plastics, Inc. a wholesale supply
dealer serving the oil industry. The company was founded in 1977 by Neck A. booth and has
grown steadily since that time. Bajaj Electronics is not selling any products to Booth Plastics
and had no previous contact with Neck Booth.
Bajaj Electronics purchased goods from Perluence International unser the same terms
and conditions as Perluence used when it sold to independent customers. Although Bajaj
Electronics generally followed Perluence in setting its prices, the subsidiary operated
independently and could adjust price levels to meet its own marketing strategies. The
Perluence’s cot-accounting department estimated a 24 per cent markup as the average for
items sold to Pucca Electronics. Bajaj Electronics, in turn, resold the items to yield a 17 per
cent markup it appeared that these percentages would hold on my sales to booth Plastics.
Bajaj Electronics incurred out of pocker expenses that were not considered in calculating the
17 per cent markup on its items. For example, the contact with Booth Plastics had been
made by lames, the salesman who handled the Galveston area. Lames would receive a 3 per
cent commission on all sales made Booth Plastics, a commission that wold be paid whether
or not the receivable, was collected jams would of course be willing to assist in collecting
any accounts that he had sold. In addition to the sales commission the company would incur
variable costs as a result of handing the merchandise for the new account. As a general
guideline, warehousing and other administrative variable cost would run 3 per cent sales.
Gupta Holmstead approached all credit decision in basically the same manner . first
of all he considered the potential profit from the account James had estimated first year sales
to Booth Plastics. Of $65,000. assuming that Neck Booth took the 3 per cent discount. Bajaj
Electronics would realize a 17 per cent markup on these sales since the average markup was
calculated on the basis of the customer taking the discount. If Neck Booth did not take the
discount the markup would be slightly higher, as would be slightly higher, as would the cost
of financing the receivable for the additional period of time, in additio9n to the potential bad
debts at any time and therefore required a vigorous collection effort wherever their accounts
were overdue. His department probability spent three times as much money and effort
managing a marginal account as compared to a strong account. He also figured that overdue
and uncollected funds had to be financed by Bajaj Electronics at a rate of 18 per cent. With
these consideration in mind. Gupta began to review the credit application for Booth Plastics.
Assignment
How would you judge the potential profit of Bajaj Electronics on the first year of sales to
Booth Plastics and give your suggestion regarding Credit limit. Should it be approved or not,
what should be the amount of credit limit that electronics give to Booth Plastics.
CASE STUDY FOR CLASS DISCUSSION-3
CREDIT DECISION
AGARWAL CASE
OM August 30,2006.Agarwal Cast Company Inc. applied for a $200,000 loan from
the main office of the National bank of New York. The application was forwarded to the
bank’s commercial loan department.
Gupta, the president and Principal Stockholder of Agarwal cast, applied the loan in
person. He told the loan office that he had been in business since February 1976., but that he
had considerable prior experience in flooring and carpets since he had worked as an
individual contractor for the past 20 year. Most of this time, he had worked in Franker and
Michigan. He finally decided to work for himself and the formed the company with Berry
Hook, a former co-worker. This information seemed to be consistent with the Dun and
Bradstreet report obtained by the bank.
According to Gupta, the purpose of the loan was to assist him in carrying his
receivables until they could be collected. He explained that the flooring business required
him to spend considerable cash to purchase materials but his customers would not pay until
the job was done. Since he was relatively new in the business, he did not feel that he could
compete if he had to require a sizeable deposit or payment in advance, instead, he could
quote for higher profits, if he were willing to wait until completion of the job for payment.
To show that his operation was sound, be included a list of customers and projects with his
loan application. He also included a list of current receivables.
Gupta told the loan officer that he had reportored his firm’s financial status closely
and that he had financial reports prepared every six months. He said that the would send a
copy to the bank in addition he was willing to file a personal finaicial statement with the
bank.
Assignment
Prepare your recommendation on Agrwal cast Company.
UNIT-IV
LESSION -2 INVENTORY MANAGEMENT
Objectives: The objectives of this lesion is to understand meaning techniques,
controlling, valuation and financing of inventories as a feasible
component of the working capital.
Structure:
Introduction
Meaning and Definition of inventory
Components of inventory
Inventory Management Motives
Inventory Management Objectives
Need for Balanced investment in inventory
Costs of Holding inventory
Benefits of holding inventory
Tools and Techniques of inventory Management
Vluation of inventories
Role of Financial manager in inventory management
Summary
Practical problem & solutions
Case study
Review Exercises
INVENTORY MANAGEMENT
4.2.1 Introduction
Inventory Management constitutes important segment of working capital
management. A financial manager often deals with the decision of inventory management.
The decisions with are normally taken while managing inventories are
(a) how much of the inventories shall be ordered
(b) when the order for purchasing inventories shall be placed
(c) how the inventories shall be maintained
4.2.2 Meaning and Definition of Inventory
The term ‘Inventory’ is originated from the French word ‘Inventaire’ and the Latin
‘Inventariom’ which implies a list of things found. The term inventory has been defined by a
the American Institute of Accountants as the aggregate of those items of tangible personal
property which (a) are held for sale in the ordinary course of business (b) are in the process
of production for such sales, or (c) are to be currently consumed in the production of goods
or services to be available for sale. The term inventory refers to the stockpile of the products
a firm is offering for sales and the components that make up the product. Inventories are the
stocks of the product of a company manufacturing for sale and the components that make up
the product. The various forms in which inventories exist in a manufacturing company are
(i) raw materials, (ii) work-in process, (iii) finished goods, and (iv) stores and spares.
However, in commercial parlance, inventory usually includes stores, raw materials work-
in=process and finished goods. The term inventory includes materials-raw materials in
process, finished packaging spares and others stocked in order to meet an unexpected
demand or distribution in the future.
4.2.3 Components of Inventory
From the above definitions, we can draw the components of inventory. The various
forms in which inventories exist in a manufacturing firm are, raw materials, work-in-
process, finished goods, and stores & spares. The following figure-1 gives the
components:
(i) Raw materials: Raw materials are those inputs that are converted into
finished goods through a manufacturing or conversion process. These form a
major input for manufacturing a product. In other words, they are very much
needed for uninterrupted production.
(ii) Work-in-Process: Work-in-process is a stage of stocks between raw
materials and finished goods. Work-in-process inventories are semi-finished
products. They represent products that need to under go some other process to
become finished goods.
Components of Inventory
Raw Materials Work-in-process Finished Products Raw Materials
(iii) Finished Products: Finished products are those products, which are
completely manufactured and ready for sale. The stock of finished goods
provides a buffer between production and market.
(iv) Stores & Spares: Stores & spares inventory (include office and plant
cleaning materials like, soap, brooms, oil, fuel, light, bulbs etc) are purchased
and stored for the purpose of maintenance of machinery.
4.2.4 Inventory Management Motives
Managing inventories involves lack of funds and inventory holding costs.
Maintenance of inventory is expensive, then why should firms hold inventories?
There are three general motives for holding inventories’
(i) The Transaction Motive: Transaction motive includes production of goods and
sale of goods. Transaction motive facilitates uninterrupted production and
delivery of order at a given time (right time).
(ii) The precautionary Motive: This motive necessitates the holding of
inventories for unexpected changes in demand and supply factors.
(iii) The Speculative Motive: This compels to hold some inventories to take the
advantage of changes prices and getting quantity discounts.
4.2.5 Inventory Management-Objectives
The objectives of inventory management may be viewed in two ways and they are
operational and financial. The operational objective is to maintain sufficient inventory, to
meet demand for product by efficiently organizing the firm’s production and sales
operations, and financial view is to minimize inefficient inventory and reduce inventory-
carrying costs.
These two conflicting objectives of inventory management can also be expressed in
terms of costs and benefits associated with inventory. The firm should maintain investments
in inventory which implies that maintaining an inventory involves cost, such that smaller the
inventory the lower the carrying cost and vice versa. But inventory facilitates (benefits) the
smooth functioning of the production. An effective inventory management should.
 Ensure a continuous supply of raw materials and supplies to facilitate uninterrupted
production.
 Maintain sufficient stocks of raw materials in periods of short supply and anticipate
price changes.
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service.
 Minimize the carrying costs and time, and
 Control investment in inventories and keep it at an optimum level.
 Other apart from the above, the following are also objects of inventory management.
Control of materials costs, elimination of duplication in ordering by centralization of
purchasers, supply of right quality of goods of reasonable prices, provide data for
short term and ling-term for planning and control of inventories.
Therefore, management of inventory needs careful and accurate planning so as to avoid both
excess and inadequate inventory in relation to the operational requirement of a firm. To
achieve higher operational efficiency and profitability of a firm, it is very essential to reduce
the amount of capital locked up in inventories. This will not only help in achieving higher
return on investment by minimizing tied-up working capital, but will also improve the
liquidity position of the enterprise.
4.2.6 Need for Balanced Investment in inventory
Management of optimum level of inventory investment is the prime objective of
inventory management. Inadequate of excess investment in inventories is not healthy by for
any firm . In other words a firm should avoid inadequate (under) investment or excess (over)
investment in inventory. The investment in inventories should be sufficient. The optimum

level of investment in inventories lies between excess investment and inadequate investment.
(A) Dangers of Excessive (over) investment in Inventory
The following are the dangers of excessive investment in inventory:
 The excessive level of inventories consumes funds of the company, they cannot be used
for any purpose since they have locked in inventory and they involve an opportunity
costs.
 The excessive investment in inventory increases carrying cost, that include cost of
storage, capital cost (interest on capital in inventories, insurance, handling, recording,
inspection, obsolescence cost, and taxes. These cost will reduce the firms profits)
4.2.7 Costs of Holding Inventories
Minimizing cost is one of the operating objectives of inventory management. The
costs (excusing merchandise cost), there are three costs involved in the management of
inventories.
(i) Ordering costs: Ordering costs are those costs that are associated with the
acquisition of raw materials. In other words, the costs that are spend from placing
an order to raw materials to the receipt of raw materials. They include the
followings:
(a) Cost of requisitioning the items (raw materials)
(b) Cost of sending reminders to get the dispatch of the items expedited.
(c) Cost of sending reminders to get the dispatch of the items expedited.
(d) Cost of transportation of goods (items).
(e) Cost of receiving and verifying the goods.
(f) Cost of in unloading of the (items) of goods.
(g) Storage and stocking charges.
However, incase of items manufactured in house the ordering costs would comprise
the following costs:
(h) Requisitioning cost,
(i) Set-up cost,
(j) Cost of receiving and verifying the items,
(k) Cost of placing and arranging/stacking of the items in the store etc,
Ordering costs are fixed as per order placed, Irrespective of the amount of the order
but ordering costs increases in proportion to the number of orders placed. If the firm
maintains small inventory levels, them the number of orders with increase, there by ordering
cost will Increase and vice versa.
(ii) Inventory Carrying Costs: Inventory carrying costs are those costs, which are
associated in carrying or maintaining inventory. The following are the carrying
costs of inventory:
(a) Capital cost [interest on capital locked in the inventories]
(b) Storage cost [insurance, maintenance on building utilities serving costs]
(c) Insurance lon inventory against fire and the insurance]
(d) Obsolescence cost and deterioration
(e) Taxes
Carrying costs usually constitute to around 25 per cent of the value of inventories held.
(iii) Shortage: Costs [Costs of stock out]. Shortage costs are those costs that arise due
to stock out, either shortage of raw materials or finished goods.
(a) Shortage of inventories of raw materials affect the firm in one or more of the
following ways:
 The firm may have to pay some higher prices, connected with
immediate (cash) procurements.
 The firm may have to compulsorily resort to some different production
schedules, which may not be as efficient and economical.
(b) Stock of finished goods- may result in the dissatisfaction of the customers
and the resultant lad, to loss of rules.
Thus, with a viw to keep inventory costs of minimum level, we may have to arrive at
the optional level of inventory cost, its total order’s cost plus carrying costs are minimum.
In other words we have to determine Economic Order Quantity (EOQ) at that level in
which the total inventory [ordering plus carrying less] cost is minimum.
4.2.8 Risks of Holding Inventory:
Holding of inventories involves above said cost, they also exposes the firm to take
some risks. Risk in inventory management refers to the chance that inventories cannot be
turned over into ash 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 way
also cause prices to decrease. This is also a long- run management problem, because,
decrease in demand may be due to change in in consumer buying habits, tastes and
incomes.
(ii) Product Deterioration: Holding of finished goods for a long period or storage
under improper conditions of light, heat, humidity and pressure lead to product
deterioration. For example: Cadbury’s chocolate, Recently, there were some live
worms in the 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 s;tyle merchandise, changes in
requirements. 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 investment.
Thus, inventories are risk assets to manage in an effective way by minimizing risks.
4.2.9 Benefits of Holding Inventory:
Optimum level of inventory is that level where the total costs of inventory is less. The major
benefits of inventory are the basic function of inventory. Proper management of inventory
will result in the following benefits to a firm:
 Inventory management ensures an adequate supply of materials and stores, minimizes
tock outs and storages and avoids costly interruptions in operations
 It keeps down investment in inventories, inventory carrying costs, and obsolescence
losses to the minimum.
 It facilitates purchasing economies through the measurement of requirements on the
basis of recorded experience.
 It eliminates duplication in ordering stocks by centralizing the source from which
purchase requisitions emanate.
 It permits better utilization of available stock by facilitating inter-department transfers
within a firm.
 In 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
4.2.10 Tools and Techniques of Inventory Management:

Effective Inventory management requires an effective control system for inventories.
A proper inventory control not only helps in solving the acute problem of liquidity but also
increases profits and causes substantial reduction in the working capital of the concern. The
following are the important tools and techniques of inventory management and control:
1. Determination of Stock Levels.
2. Determination of Safety Stocks.
3. Selecting a proper System of Ordering for Inventory.
4. Determination of Economic Order Quantity.
5. A.B.C. Analysis
6. V.E.D Analysis
7. Inventory Turnover Ratios
8. Aging Schedule of Inventories
9. Classification and Codification of Inventories
10. Preparation of Inventory Reports.
1_Determination of Stock Levels:
Carrying of too much and too little of inventories is detrimental to the firm. If the
inventory level is too little, the firm will face frequent stock-outs involving heavy
ordering cost and if the inventory level is too high it will be unnecessary tie-up of capital.
Therefore, an efficient inventory management requires that a firm should maintain an
optimum level of inventory when inventory costs are the minimum and at the same time
there is no stock-out which may result in loss of sale or stoppage of production. Various
stock levels are discussed as such.
(a) Minimum Level. The represents the quantity which must be maintained in
hand at all times. If stocks are less than the minimum level then the work will
stop due to shortage of materials. Following fators are taken into account
while fixing minimum stock level.
Lead Time: A purchasing firm requires some time to process the order and
time is also required by the supplying firm to execute the order. The time
taken in processing the order and then executing it is known as lead time. It is
essential to maintain some inventory during this period.
Rate of Consumption: It is the average consumption of materials in the

factory. The rate of consumption will be decided on the basis of past
experience and production plans.
Nature of Material; The nature of material also affects the minimum level. If
a material is required only against special orders of the customer then
minimum stock will not be required for such materials. Minimum stock level
can be calculated with the help of following formula:
Re- ordering Level=Maximum Consumption x Maximum Re – order
period.
(b) Re-ordering Level. When the quantity of materials reaches at a certain figure
then fresh order is sent to get materials again. The order is sent before the
materials reach minimum stock level. Re-ordering level or ordering level is
fixed between minimum level and maximum level. The rate of consumption,
number of days required to replenish the stocks, and maximum quantity of
materials required on any day are taken into account while fixing re-ordering
level. Re-ordering level is fixed with the following formula:
(c) Maximum Level: It is the quantity of materials beyond which a firm should
not exceed its stocks. If the quantity exceeds maximum level limit then it will
be overstocking. A firm should avoid overstocking because it will result in
high material costs. Overstocking will mean blocking of more working
capital. More space for storing the materials more wastage of materials and
more chances of losses from obsolescence. Maximum stock level will depend
upon the following factors.
(1) The availability of capital for the purchase of materials
(2) The maximum requirements of materials at any point of time
(3) The availability of space for storing the materials
(4) The rate of consumption of materials during lead time
(5) The cost of maintaining the stores
(6) The possibility of fluctuations in prices.
(7) The nature of materials. If the materials are perishable inb nture, then
they cannot be stored for long.
(8) Availability of materials. If the materials are available only during
seasons then they will have to be stored for the rest of the period.
(9) Restrictions imposed by the Government. Sometimes, government fixes

the maximum quantity of materials which a concern can store. The limit
fixed by the government will become the limiting factor and maximum
level cannot be fixed more than this limit.
(10) The possibility of change in fashions will also affect the maximum level.
The following formula my a be fused for calculating maximum stock
level:
Maximum Stock Level=Re – ordering Level + Re-ordering Quantity
– (Minimum Consumption x Minimum Re-ordering period).
(d) Danger Level. It is the level beyond which materials should not fall in anyu
case. If danger level arises then immediate steps should be taken to replenish
the stocks even if more cost is incurred in arranging the materials. If materials
are not arranged immediately there is a possibility of stoppage of work.
Danger level is determined with the following formula:
Danger Level=Average Consumption x Maximum re-order period for
emergency purchases.
(e) Average Stock Level. The average stock level is calculated as such:
Average Stock Level = Minimum Stock Level + ½ of re-order quantity
2_Determination of safety Stocks:
Safety stock is a buffer to met some unanticipated increase in usage. The
usage of inventory cannot be perfectly forecasted. It fluctuates over a period of
time. The demand for materials may fluctuate and delivery of inventory was also be
delayed and in such a situation the firm can face a problem of stock-out. The stock
out can prove easily by affecting the smooth working of the concern. In order to
protect against the stock out arising out of usage fluctuations firms usually maintain
some margin of safety or safety stocks. The basic problem is to determine the level
of quality of safety stocks. Two costs are involved in the determination of this stock
i.e. opportunity cost of stock-outs and the carrying costs. The stock-outs of raw
materials cause production disruption resulting into higher cost of production.
Similarly, the stock-outs of finished goods result into the failure of the firm in
competition as the firm cannot provide proper customer service. It an firm
maintains low level of safety frequent stock-out will occur resulting into the larger
opportunity costs. On the other hand, the larger quantity of safety stocks involve
higher carrying costs.
3_Ordering Systems of Inventory
The basic problem of inventory is to decide the re-order point. This point
indicates when an order should be placed. The re-order point is determined with the
help of these things; (a) average consumption rate, (b) duration of lead time, (c)
economic order quantity, when the inventory is depleted to lead time consumption,
the order should be placed. There are three prevalent systems of ordering and a
concern can choose any one of these:
(f) Fixed order quantity system generally known as economic order quantity
(EOQ) system;
(g) Fixed period order system or periodic re-ordering system or periodic
review system
(h) Single order and scheduled part delivery system.
4_Economic Order Quantity (EOQ)
A decision about how much to order has great significance in inventory
management. The quantity to be purchased should neither be small nor big because
costs of buying and carrying materials are very high. Economic order quantity is the
size of the lot to be purchased which is economically viable. This is the quantity of
materials which can be purchased at minimum costs generally economic order
quantity is the point at which inventory carrying costs are equal to only costs. In
determining economic order quantity it is assumed that cost of managing inventory
is made up soley of two parts i.e. ordering costs and carrying costs.
(A) Ordering Costs. These are the costs which are associated with the
purchasing or ordering of materials. These costs include:
1. Costs of staff posted for ordering of goods. A purchase order is processed and
then placed with suppliers. The labour spent on this process is included in
ordering costs.
2. Expenses incurred on transportation of goods purchased
3. Inspection costs of incoming materials
4. Cost of stationery, typing, postage, telephone charges, etc.
These costs are as known as buying costs and will arise only when some
purchases are made
When materials are manufactured in the concern then these costs will be known
as set-up costs. These costs will include costs of setting up machinery for
manufacturing materials, time taken up it setting cost of tools, etc.
The ordering costs are totaled up for the year and then divided by the number of
orders placed each year. The planning commission of India has estimated these costs
between Rs. 10 to 20 per order.
(B) Carrying Costs; these are the costs for holding the inventories. These costs
will not be incurred if inventories are not carried. These costs include:
(1) The cost of capital invested in inventories. An interest will be paid on
the amount of capital asked up in inventories.
(2) Cost of storage which could have been used for other purposes.
(3) The loss of materials due to deterioration and obsolescence. The
materials may deteriorate with passage of time. The loss of
obsolescence arises which the materials in stock are not usable because
of change in process or product.
(4) Insurance cost
(5) Cost of spoilage in handling of materials.
The Planning Commission of India had estimated these costs between 15 per cent to
20 per cent of total costs. The longer the materials kept in stocks, the costlier it becomes by
20 per cent every year. The ordering and carrying costs have a reverse relationship. The
ordering cost goes up with the increase in number of orders placed. On the other hand,
carrying costs go down per unit with the increase in number of units, purchased and stored. It
can be shown in the diagram given on the next page.
Ordering Cost
Total Cost
Cost
in
Rupees
Inventory Carrying Cost
No. of Orders
The ordering and carrying costs of materials being high, an effort should be made to
minimize these costs. The quantity to be ordered should be large so that economy may be
made transport costs and discounts may also be earned. One the other hand storing facilities,
capital to be lucked up insurance costs should be taken into account-
Assumptions of EOQ. While calculating EOQ the following assumptions are made
(1) The supply of goods is satisfactory. The goods can be purchased whenever these
are needed
(2) The quantity to be purchased by the concern is certain
(3) The prices of goods are stable. It results to stabilize carrying costs.
When above-mentioned conditions are satisfied, economic order quantity can be
calculate with the help of the following formula:
2AS
EOQ =
1
Where A=Annual consumption in rupees.

S=Cost of placing an order.
I=Inventory carrying costs of one unit.
5_A-B-C Analysis
The materials are divided into a number of categories for adoption selective or material
control. It is generally seen that in manufacturing concern, a small percentage of items
contrite a large percentage of value of consumption and a large percentage of items of
materials contribute a small percentage of value. In between these two limits there are some
items which have almost equal percentage of value of materials. Under A-B-C analysis, the
materials are divided into three categories viz. A, B and C. Past experience has shown that
almost 10 per cent of the items contribute to 70 pr cent of value of consumption and this
category is called “A” Category. About 20 per cent of the items contribute about 20 per cent
of value of consumption and this is known as category “B” materials. Category “C” covers
about 70 per cents of items of materials which contribute only 10 per cent of value of
consumption. There may be some variation in different organizations and an adjustment can
be made in these percentages.
The information is shown in the following diagram:
Class No. of Items Value of Items
% %
A 10 70
B 20 20
C 70 10
100
90
80
VALUE 70
OF 60
TIMES 50
(%) 40
30
20
10
10 20 30 40 50 60 70 80 90 100
No of Items (%)
A-B-C analysis helps to concentrate more efforts on efforts on category. A since
greatest monetary advantage will come by controlling these items. An attention should be
paid in estimating requirements, purchasing, maintaining safety stocks and properly storing
of “A” category matrials. These items are kept under a constant review so that a substantial
material cost may be controlled. The control of “C” items may be infixed and these stocks
may be purchased for the year. A little more attention should be given towards “B” category
items and their purchase should be undertaken at quarterly or half-yearly intervals.
The following example will explain the advantages of A-B-C analysis:
Suppose three items P,Q,R have been used and their consumption is Rs. 2,40,000, Rs.
24,000 and Rs. 2,400 respectively. Let us presume that A-B-C classification is not done and
annual orders are 12 in number. Each item will be ordered 4 times and average inventory will
be:
Item Annual No. of orders Average
consumption working inventory
(Rs.)
P 2,40,000 4 60,000
Q 24,000 4 6,000
R 2,400 4 666
2,66,400 12 66,600
Suppose A-B-C analysis is followed and the number of orders will be according to the
importance of the items. If the number of orders are 8,3 and 1, for items P,Q and R
respectively then the average inventory
Item Annual No. of orders Average
consumption working inventory
(Rs.)
P 2,40,000 8 30,000
Q 24,000 3 8,000
R 2,400 1 2,400666
2,66,400 12 40,400
When A-B-C analysis was not followed the average inventory was Rs. 66,600 and after
following items in the earlier situation, than as compared to the second situation.
6_VED Analysis
The VED analysis is used generally for spare parts. The requirements and urgency of
spare parts is different from that of materials. A-B-C analysis may not be properly used for
spare parts. The demand for spares depends upon the performance of the plant and
machinery. Spare parts are classified as Vital (V), Essential (E) and Desirable (D). The vital
spares are a must for running the concern smoothly and these must be stored adequately. The
non-availability of vital spares will cause havoc in the concern. The E type of spares are also
necessary but their stocks may be kept at low figures. The stocking of D type of spares may
be avoided at times. If the lead time of these spares is less, then stocking of these spares can
be avoided.
The classification of spares under three categories is an important decision. A wrong
classification of any spare will create difficulties for production department. The
classification of spares should be left to the technical staff because they know the need
agency and use of these spares.
7_Inventory Turnover Ratios
Inventory turnover ratios are calculated to indicate whether inventories have been used
efficiently or not. The purpose is to ensure the blacking of only required minimum funds in
inventory. The inventory turnover Ratio also known as stock velocity is normally calculated
as sales/average inventory or cost of goods sold/average inventory cost. Inventory conversion
period may also be calculated to find the average time taken for clearing the stocks.
Symbolically
Cost of Goods Sold

Inventory Turnover Ration =
Average Inventory at Cost
Net Sales
or =
(Average) Inventory
Days in a year
and, Inventory Conversion Period =
Inventory Turnover Ration
We have already discussed these rations at length in the chapter of Ratio Analysis.
8. Aging Schedule of Inventories
Classification of inventories according to the period (age) of their holding also helps in
identifying slow moving inventories thereby helping in effective control and management of
inventories. The following table shows aging of inventories of a firm.
Item Age Date of Amount (Rs.) % age to total
Name/Code Classification Acquisition
001 0-15 days June 25,2000 30,000 15
002 16-30 days June 10,2000 69,000 30
003 31-45 days May 20,2000 50,000 25
004 46-60 days May 5,2000 40,000 20
005 61 and above April 12,2000 20,000 10
2,00,000 100
9. Classification and Codification of Inventories

The inventories of a manufacturing concern may consist of raw materials, work in
process, finished goods, spares, consumable stocks, etc. All these categories may have their
sub-divisions. The raw materials used may be of 3-4 types, finished goods may also be of
more than one type, spares may be of a number of types and so on. For a proper recording
and control of inventory, a proper classification of various types of items is essential. The
inventories should first be classified and then code numbers should be assigned for their
identification. The identification of short names are useful for inventory management not
only for large concerns but also for small concerns. Lack of proper classification may also
lead to reduction in production.
The inventories may be classified either according to their nature or according to their
use. Generally, materials are classified according to their nature such as construction
materials, consumable stocks, spares, lubricants, etc. after classification; the materials are
given code numbers. The class of materials is assigned two digits and then two or three digits
are assigned to the category of materials in that class. The third distinction is needed for the
quality of goods and decimals are used to note this factor. For example, a concern has two
categories of items divided into 15 groups. Two numbers will be used for main category and
two in the sub-groups (because the number is 15 i.e more than 9) and then decimals will be
used to the quality etc. If mobile oil is to b coded, two digits will be used in the category, i.e.
lubricant oils say 12, two digits will be used for mobile oil, say 56 and one digit may be used
for the quality of mobile oil, say 1. The code of mobile oil will be 1256.1.
The classification and coding of inventories enables the introduction of mechanized
accounting. It also helps in maintaining secrecy of description. It also helps the prompt issue
of stores.
10. Inventory Reports
From effective inventory control, the management should be kept informed with the
latest stock position of different items. This is usually done by preparing periodical inventory
reports. These reports should contain all information necessary for managerial action. On the
basis of these reports management takes corrective action wherever necessary. The more
frequently these reports are prepared the less will be the chances of lapse in the
administration of inventories.
Illustration 1. From the following information calculate minimum stock level maximum
stock level and re-ordering level:
(i) Maximum Consumption = 200 units per day
(ii) Minimum Consumption = 150 units per day
(iii) Normal Consumption = 160 units per day
(iv) Re-order period = 10-15 days
(v) Re-order quantity = 1,600 units
(vi) Normal re-order period = 12 days
Solution:
Re- ordering level =Maximum consumption X Maximum Re-order Period=200 units X
15=3,000 units
Minimum Stock Level =Re-ordering level-(normal Consumption X Normal Re-ordering Period)
=3,000- (160 X 12)
=3000-1,920 =1,080 units
Maximum Stock Level =Re-ordering Level+Re-order Quantity-(Minimum consumption X

Minimum Re-order Period)
=3,000+1,600-(150X10)
=3,000+1,600-1500
=3,100 units
Illustration 2. From the following information, find out economic order quantity.
Annual usage, 10,000 units
Cost of placing and receiving one order Rs. 50
Cost of materials per unit Rs. 25
Annual carrying cost of one unit: 10% of inventory value.
Solution :
2AS
EOQ=
1
Where, a=annual consumption in units
S=Cost of placing an order
I=Inventory carrying cost of one unit
2 X 10,000 X 50 25 X 10
EOQ= as 1= = 2.5
2.5 100
= 4,00,000 = 632 units
Illustration 3: The cost of goods sold of E.S.P. Limited is Rs. 5,00,000. The opening
inventory is Rs. 40,000 and the closing inventory cost is Rs. 60,000. find out inventory
turnover ratio.
Cost of Goods Sold

Inventory Turnover Ration =
Average Inventory at Cost
5,00,000
=
40,000 + 60,000
5,00,000
= =10 units
50,000
Illustration 4: Following information is given about materials.

Annual usage = Rs. 2,00,000
Cost of placing and receiving one order : Rs. 80
Annual carrying cost : 10% of inventory value
Find out the economic order quantity.
Solution :
2AS
EOQ =
1
A=Annual usage is Rs. 2,00,000

S=Cost of placing an order is Rs. 80
I=Annual carrying cost is 10% of material value
2 X 2,00,000 X 80
EOQ =
10%
2 X 2,00,000 X 80 X 100
=
10
= 3,20,000 = 14,833 units
Illustration 5: Economic Enterprises require 90,000 units of a certain item annually. The
cost per unit is Rs. 3, the cost per purchase order Rs. 300 and the inventory carrying cost Rs.
6 per unit per year.
(i) What is the Economic Order Quantity?
(ii) What should the firm do if the supplier offers discount as below:
Order Quantity Discount

4500-5999 2%
6000 and above 3%
Solution :
(i) 2AS
EOQ =
1
Where, A=Annual usage in units = 90,000

S=Cost of placing an order is Rs. 300
I=Annual carrying cost of one unit = Rs. 6
2 X 90,000 X 300
EOQ =
6
= 3,20,000 = 14,833 units = 3,000 units
(ii) As the supplier offers discount on order quantity, we shall calculate the total cost
of 3000 units, 4500 units and 6000 units as below:
Order Average Annual No. of Price per Cost of Carrying Cost at Total cost
inventory requirements orders unit purchase cost at Rs. 300 (6+7+8+)
(units) (3/1) ((3) X (5) Rs. 6 per per order
unit (Rs.) (Rs.)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
3,000 1,500 90,000 30 3.00 2,70,000 9,000 9,000 2,88,000
4,500 2,250 90,000 20 2,94 2,64,600 13,500 6,000 2,84,100
6,000 3,000 90,000 15 2,91 2,61,900 18,000 4,500 2,84,400
Since the total cost at order size of 4500 unit is the lowest, the firm should place order for
4500 units and obtain 2% discount
4.2.11 VALUATION OF INVENTORIES:

The value of materials has a direct bearing on the income of a concern, so it is
necessary that a method of pricing materials should be such that it given a realistic value of
stocks. This traditional method of valuing materials cost price or market price whichever is
less’ is no longer the only method. Different methods of pricing materials give different
values of closing materials and it leaves a scope for window dressing. If management is
interested to show more profits then it can choose such a method which will show more stock
or vice-versa. To safeguard public interest the Government of India has instituted statutory
controls to prevent frequent change of material valuation methods. A concern will have to
use aa particular valuation method for at least three years and any changes there from must
be approved by the Board.
The following methods for pricing material issues are generally used:
(1) First in First out method (known as FIFO method)
(2) Last in First out method (known as LIFO method)
(3) Average price method.
(i) simple average price method
(ii) weighted average price method.
(4) Base Stock method
(5) Standard Price method
(6) Market Price method
(1) First in first out (FIFO) method: In first in first out method the materials
received first are issued first. The materials are issued in chronological order. The recently
received materials remain in stock. Whenever a requisition for material issue is presented to
the store-keeper he will use the price of the first lot and then of the second and third lot, etc
when the quantity of the first, second lot is exhausted. When prices are fluctuating then the
cost of different batches of production will be different because issues prices are falling
because material issues will be period at earlier (bigger) figures while costs of replacement
will be low. On the other hand, when prices are rising then materials will be issued at lower
prices (earlier prices) and replacement costs will be higher. This method is useful for
materials which are subject to obsolescence or deterioration. The following example will
explain this method.
Illustration 6: The following are the figures of receipts and issues of materials.
2003
Jan. 1 Opening balance 500 units @Rs. 5.00 per unit
Jan. 6 Purchase of material 400 units @Rs. 5.25 per unit
Jan. 8 Issue of material 600 units

Write up the store ledger account by pricing for issues at FIFO method.
Solution:
FIFO Method
Stores Ledger Account
Date Particulars Quantity Receipts Issues Balance
2003 (units)
Total cost Cost Quantity Total Cost Cost Per Quantit Amount
Rs. Per unit (units) Rs. unit y Rs.
Rs. Rs. (units)
Jan 1 Balance b/d 500 2,500.00
Jan 6 Purchase:
Order No 400 2,100.00 5.25 900 4,600.00
Jan 8 Issues; 3,025.00
Requisition 500@ 5.00 5.00
Slip No 600 100@ 5.25 5.25 300 1,575.00
Jan 10 Purchase:
Order No 550 2,997.00 5.45 850 4,572.50
Jan 15 Purchase:
Order No 350 1,960.00 5.60 1,200 6,532.50
Jan 16 Issues; 2,392.50
Requisition 300@ 5.25 5.25 750 4,140.00
Slip No 450 150@ 5.45 5.45
Jan 22 Purchase: 5.75 1,230 6,900.00
Order No 480 2,760.00
Jan 28 Issues; 3,300.00
Slip No 600 200@5.60 5.60 630 3,600.00
Jan 30 Issues; 1,702.00
Slip No 300 150@5.75 5.75 330 1,897.00
Note: Closing balance of 330 units consists of materials purchased on January, 22 @
Rs. 5.75 per unit.
(2) Last in First Out (LIFO). In lat in first out method the lat received materials are
issued first and ending inventory consists of earlier acquired materials. The method is also
known as replacement cost method because the latest purchased goods will correspond to the
current market prices except that goods were not purchased much earlier. The inventories
will be valued at oldest lots on hand and these values will be quite different from current
invoice prices.
Last in first out method is suitable during rising prices because goods will be issued
from the latest received lots at prices which are closely related to current market prices. The
current costs will also be matched to current income. This method is able to show lower
profits because of increased charge to production and closing stock figures will also be low
as they will be valued at earlier prices. The taxable liability will also be low thus enabling the
concern to retain more money in the business.
A comparison between two jobs will not be possible if these jobs were started at the
same time but materials to the second job were issued from a different lot, the earlier lot
having been exhausted. The materials may be priced at two or more prices even in the same
invoice.
Illustration 7 From the following information about materials, prepare a material ledger
account using last in first out method.
2003
Jan. 1 Opening balance 800 units @Rs. 2.50
Jan. 8 Purchase of material 900 units @Rs. 2.60
Jan. 20 Purchase of material 650 units
Jan. 25 Issue of material 800 units @Rs. 2.85
Solution
FIFO Method
2003 (units)
Total cost Cost Quantity Total Cost Cost Per Quantit Amount
Rs. Per unit (units) Rs. unit y Rs.
Rs. Rs. (units)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Jan 1 Opening 800 2,000
Balance
Jan 8 Purchase:
Order No 900 2,340 2.60 1,700 4,340
Jan 12 Issues;
Requisition
Slip No 700 1,820 2.60 1,000 2,250
Jan 15 Purchase:
Order No 600 1,620 2.70 1,750 1,600 4,140
Jan 20 Issues;
Slip No 650 50@ 2.60 2.60 950 2,390
Jan 25 Purchase:
Order No 800 2,280 2.85 1,750 4,670
Jan 27 Purchase:
Order No 500 1,450 2.90 2,250 6,120
Jan 29 Issues; 1,735
Slip No 600 100@2.85 2.85 1,650 4,385
Jan 31 Issues;
Requisition
Slip No 300 855 2.85 1,350 3,530
(3) Average cost method. In average cost method of pricing all materials in stock
are so mixed that a price based on all lots is formed. Average cost may be of two types: (a)
simple average cost and (b) weighted average cost.
(a) Simple average cost. In this method the prices of all lots in stock are averaged
and the materials are issued on that average price, for example, three lots of
materials are in stock and the prices per unit of these lots are Rs. 2, Rs. 3 and Rs.
4 of first, second and third lots respectively; then the average price will be
(2+3+4)
=Rs. 3. Though this is a simple method of pricing materials but
3
particularly this method dos not give good results. The total cost of materials is
not observed in this method. The following example will explain this point:
10,000 units were purchased @ Rs. 2 per unit
15,000 units were purchased @ Rs. 3 per unit
20,000 units were purchased @ Rs. 4 pr unit
The total cost of materials will be:
10,000 X 2 = 20,000
15,000 X 3 = 45,000
20,000 X 4 = 80,000
Rs. 1,45,000
(2+3+4
The simple average price issue in this case is Rs. 3 and total amount will come to
3
Rs.1,35,000 (45,000) the under absorbed amount this case will be Rs. 10,000. Because of this
defect
wighted average method is preferred.
(c) Weighted average method. In this method the total cost of all the materials is
divided by the total number of items in stock. The price calculated in this
way will be used for issue of materials upon the time a fresh purchase has
not been made. After a fresh purchase, the quantity will be added to the
earlier balance quantity and material cost will be added to the earlier cost. A
fresh price is calculated by dividing the changed total cost by the number of
units in stock after the purchase. A new price is calculated where even a
fresh purchase is made. Taking the earlier example the weighted average
price will be:
10,000 X 2+15,000 X 3+ 20,000 X 4 1,45,000
= = Rs. 3,22
10,000 + 15,000 + 20,000 45,000
The weighted average price method recovers the whole cost of materials.
This method is suitable when price fluctuations are frequent because it
smoothes out fluctuations by taking into account total cost and total quantity
of materials.
Illustration 20. The following figures are taken from the materials record of
a concern.
2003 Material received Price per unit Material Issue
(units) (Rs.) (units)
Jan 1 400 2.00
Jan 4 300 2.25
Jan 10 250
Jan 18 500 2.25
Jan 22 450
Jan 25 600 3.00
Jan 30 500
Record these transactions in the materials ledger by pricing issues at

weighted average price method.
Weighted Average price Method
Date Particulars Receipts Issues Balance
2003
Quantity Total Cost Per Quantity Total Cost Cost Quantit Amount Price
(units) cost unit (units) Rs. Per y Rs. per unit
Rs. Rs. unit (units) Rs.
Rs.
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
Jan 1 Purchase:
Order No 400 800 2.00 400 800.00 2.00
Jan 4 Purchase:
Order No 300 675 2.25 700 1,475.00 2,107
Jan 10 Issues;
Requisition
Slip No 250 526.75 2.107 450 948.25
Jan 18 Purchase:
Order No 500 1,250 2.50 950 2,198.00 2.314
Jan 22 Issues;
Requisition
Slip No 450 1,041.30 2.314 500 1,156.70
Jan 25 Purchase:
Order No 600 1.800 3.00 1,100 2,956.70 2,688
Jan 30 Issues;
Requisition
Slip No 500 1,344.00 2,688 600 1,612.70
4 Base stock mentions in size method some quantity of materials is assumed to be

necessary for keeping the concern going. The quantity is not issued unless other wise
there is an emergency. This material which is not issued as is kept in stock is known as
a base stock. The earlier materials received are kept as a base and are valued at the
price on which they were acquired.
This method is not an independent method. It is used along with some other
methods such as FIFO, LIFO. Average Price Method, etc. After maintaining the base
quantity in stock, the issues are priced at one or the methods mentioned above. The
purpose of this method is to issue materials at current prices. This aim will be achieved
only when LIFO method of pricing the materials is used.
5 Standard price method. The issue price of materials is predetermined or
estimated in this method. The standard price is based on market conditions, usages rate,
handling facilities, storage facilities, etc. the materials are priced at standard price
irrespective of price paid for various purchases. For example, the standard price of the
raw materials is fixed at Rs. 5 per unit. Two lots of materials of 10,000 units and 12,000
units were purchased at Rs. 4.90 and Rs. 5.25 per unit. Every issue of materials will be
priced at Rs. 5 per unit, without taking into consideration the prices at which these were
purchased. There will be a difference between the cost of materials and price charged to
production. The difference between these two prices will be transferred to ‘Purchase
Price Variance Account’. The profit or loss incurred from issue of materials will
depend upon whether actual pri9ce paid is less or more than the standard price charged.
Illustration 8. the following information is given about material A for the month of
March 2003.
2003
March 1 Opening Balance 1,000 units @ Rs. 2.50
March 7 Purchase of material 1,500 units @ Rs. 2.70
March 10 Issue of material 1,000 units
Prepare stores ledger account using:

(i) FIFO method
(ii) LIFO method
(iii) Base stock is 1,500 units.
Solution: (i)
Stores Ledger
Base Stock Method with FIFO Method
Base Stock: 1,500 units
(units)
2003 Total Cost Quantity Total Cost Quantity Amount
Cost Rs. Per unit (unit) cost Rs. Per unit (units) Rs.
Rs. Rs.
March 1 Opening Balance 1,000 2,500
March 7 Purchase : Order No. 1,500 4,050 2.70 2,500 6,550
March 10 Issue: Requisition Slip No. 1,000 2,700 2.70 1,500 3,850
500 @3.00
500 @3.10
Closing Stock consists of the following:
March 1 1,000 unit @2.50 2,500
March 7 500 units @ 2.70 1,350
March 14 1,100 units @ 3.10 3,410
March 25 2,500 units @ 3.20 8,000
5,100 units 15,260

(ii) Stores Ledger

Base Stock Method with FIFO Method
Base Stock: 1,500 units
Date Particulars Receipts Issues Balance
2003 Quantity Total Cost Quantity Total Cost Quantity Amount
(units) Cost Rs. Per unit (unit) cost Rs. Per unit (units) Rs.
Rs. Rs.
March 1 Opening Balance 1,000 2,500
500 @3.00
500 @3.10
March 31 Issue: Requisition Slip No. 2,400 7,440 1,500 5,100 14,960
@3.20
900 @
3.10
Role of Financial Manager in Inventory Management

In the preceding section, the costs and benefits associated with inventories have been
discussed. The financial manager shall be aware of advantages and disadvantages associated
with high level and low level of inventories. The financial manager can arrive at optimum
quantity of inventories to be ordered by using EOQ model. The model helps in determining
the optimum size of the order but another issue relating to time for placing the order is sorted
out by evaluating reorder level. The financial manager on the basis of his past experience can
estimate the time usually taken by suppliers to deliver the inventories after placement of an
order i.e. lead time. Thus, using lead time and safety stock, reorder level can be ascertained.
Besides the evaluation of order size of inventories and timing for placing order for
inventories, the financial manager shall take care of maintaining inventories for which ABC
system / analysis criteria may be used. In addition to these techniques, the financial manager
shall use inventory turnover ratio and ageing schedule of inventory which are briefly
discussed below
(a) Inventory Turnover Ratio. It is given by the formula
Cost of goods consumed / sold during the period

=
Average inventory held during the period
The ratio helps in determining the amount of investment to be made in various kinds
of inventories being maintained by the firm. On the basis of ratio, inventories are classified
into four types:
(i) Slow moving inventories
(ii) Fast moving inventories
(iii) Dormant inventories
(iv) Obsolete inventories.
(b) Ageing Schedule of Inventory. The financial manager shall determine the
time lag be tween the date of purchase of inventories and the date of their usage for
production purpose. This will help in identifying the rate at which various inventories
are consumed. Using this information, the inventory manager will be able to take
adequate steps while purchasing inventories so that inventories do not get deteriorated
before they are consumed for production process.
4.2.12 SUMMARY
 Inventory management occupies the most significant position in the structure of
working capital. Management of inventory may be defined as the sum of total of
those activities necessary for the acquisition, storage, disposal or use of materials.
 Efficient management of inventory reduces the cost of production and consequently
increases the profitability of the enterprise by minimizing the different types of
costs associated with holding inventory.
 The components of inventory are: (1) raw materials, (2) work-in process, (3)
finished goods, and (4) stores and spares.
 There are three general motives for holding inventories are : (1) maintain
investments in inventory and (2) to facilitate (benefits) the smooth functioning of
the production, which in turn meet the demand.
 An effective inventory management should: Ensure a continuous supply of raw
materials and supplies to facilitate uninterrupted production; maintain sufficient
finished goods inventory for smooth sales operation, and efficient customer service;
minimize the carrying costs and time; and control investment in inventories and
keep it an optimum level.
 The areas of inventory management covers: determining the size of inventory to be

carried, establishing timing schedules, procedures and lot sizes for new orders,
ascertaining minimum safety levels, co-coordinating sales, arranging the receipt,
disbursement and procurement of materials, developing the forms of recording
these transactions, assigning responsibilities for carrying out the inventory control
functions, and providing the reports necessary for supervising this overall activity.
 Management of optimum level of inventory investment is the prime objective of
inventory management. Inadequate or excess investment in inventories is not
healthy by for any firms. The optimum level if investment in inventories lies
between excess investment and inadequate investment.
 The dangers of excessive investment in inventory are: unnecessary tie-up of funds,
excessive carrying costs, impairing liquidity, physical deterioration of inventories,
and chance of theft, waste and mishandling of inventories.
 Under investment in inventory is also not healthy one. It has some negative points,
they are: stoppage of production, and loss of customers.
 Minimizing cost is one of the operating objectives of inventory management. The
costs (excluding merchandise cost), there are three costs involved in the
management of inventories. They are: (i) Ordering Costs, and (ii) Inventory
Carrying Costs.
 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: (1) price Decline, (2) product Deterioration, and (3) product
Obsolescence.
Proper management of inventory will result in the benefits to a firm: ensures an
adequate supply of materials and stores, minimizes sock outs and shortages, and
avoids costly interruptions in operations, keeps down investment in inventories,
inventory carrying costs, and obsolescence losses to the minimum, facilitates
purchasing economies, eliminates duplication in ordering stocks, permits better
utilization of available stocks, provides a check against the loss of materials through
careless or pilferage. Perpetual inventory value provides a consistent and reliable
basis for preparing financial statements a better utilization.
 Inventory management problems can be handled by sophisticated / refined
mathematical techniques. The major problem areas are (a) classification problem to
determine the type of control required (b) the order quantity problem (c) the order
point problem and (d) determination of safety stocks.
 The most widely used inventory, control technique is ABC analysis [classification
problem]. According to this technique, the task of inventory management is proper
classification of all inventory items in to three categories namely A, B & C
category. ‘A’ item, because greater benefit. The control of ‘C’ items may be
released due to less benefits (some times control cost may exceed benefit of control)
and reasonable attention should be paid on category ‘B’ items.
 Economic Order Quantity (EOQ) [Order Quantity Problem] refers to that level of
inventory at which the total cost of inventory is minimum. The total inventory cost
comprising ordering and carrying costs, EOQ also known as Economic Lot Size
(ELS) EOQ can be obtained by adopting two methods (a) Trial and Error approach
and (b) short cut or Simple mathematical formula. Here, for calculation of EOQ we
have adopted simple short cut method. The formula is.
2AO
EOQ=
CC
 Order Point Problem relates to the determination of the different stock levels are (a)
Minimum level (b) Reorder level (c) Maximum level, (d) Average stock level and
(e) Dangers level (a) Minimum Level is that level that must be maintained always
production will be disturbed if it is less than the minimum level, symbolically,
Minimum stock level = Re-order level – [Normal Usage x Average delivery time]
(b )Reordering Level is that level of inventory in weeks, which an order should be
placed for replenishing, the current stock of inventory. Generally the reorder level lies
between minimum stock level and maximum stock level, Symbolically,
Re-order point = Lead time (in days) x Average Daily usage
Safety stock is that minimum additional inventory to serve as a safety margin or
better or buffer or cushion to meet an unanticipated and increase in usage resulting
from an unusually high demand and or an uncontrollable late receipt of incoming
inventory. To avoid stock out, firm may require to maintain safety stock. Formula
(under uncertainty of usage and lead time).
Re-order point = Lead time (in days) X Average usage = Safety stock
(c) Maximum Level of stock, is that level of stock beyond which a firm should
not maintain the stock. Symbolically.
Maximum Stock Level = Re-order Level + Re-order Quantity – (Minimum Usage x

Minimum Delivery Time).
(d) Average Stock Level average Stock Level = Minimum level + [Reorder Quantity
/21
(e) Danger Stock Level is that level of materials beyond which materials should not
fall in any situation. Symbolically.
Danger Level = Average Usage x Minimum Deliver Time [for emergency purchase]
 Strategies that help to succeed in inventory management are : (1) Rationality,
complete understanding is the most prominent prerequisite for the success of any
monitoring and control system of inventory by all affected parties (2) Flexibility is
the strategy that is required for successful monitoring and control of inventory
management system. (3) Punctuality, right action in right time is as essence in
inventory management.
4.2.13 PRACTICE YOURSELF SOLVED PROBLEMS
1. From the following information of VST Company, compute re-order level,
minimum level, maximum level, and average stock level. The company uses two
components X and Y for manufacturing a product.
Normal usage – 100 units per week; Minimum usage – 50 units per week
Maximum usage – 150 per week
Re-order period – Component x 4 to 10 weeks; Component Y: 2 to 8 weeks
Re-order quantity – Component x 600 units: Component Y: 900 units
Solution
Re-order Level = Maximum usage x Maximum delivery time
Component X = 150 units x 10 weeks = 1,500 units
Component Y = 150 units x 8 weeks = 1,200 units
Minimum Level = Re-order level – (Normal usage x Average delivery time)
Component X = 1,500 units – (100 units x 7 weeks) = 800 units
Component Y= 1,200 units – (100 units x 5 weeks) = 700 units
Maximum Level = Re-order level + re-order quantity – (minimum usage x minimum
delivery time)
Component X = 1,500 units + 600 units – (50 units x 4 weeks) = 1,900 units
Component Y = 1,200 units + 900 units – (50 units x 2 weeks) = 2,000 units
Average Stock Level = Minimum level + (re-order quantity /2)
Component X = 800 units + (600 units /2) = 1,100 units

Component Y = 700 units + (900 units /2) = 1,150 units
2. Determine re-order level, minimum level, maximum level, and average stock level.
Normal usage – 100 units per week; Lead-time-4 to 6 weeks
Minimum usage-50 units per week; Maximum usage-150 per week Re-order quantity-
600 units.
Solution:
Recorder Level = Maximum usage x Maximum delivery time
= 150 units x 6 weeks = 900 units
Minimum Level = Re-order level – (Normal usage x Average delivery time)
= 900 units – (100 units x 5 weeks) = 400 units.
2. The following relating to inventory costs have been established for XYZ ltd.,
 Orders must be place for the year in multiples of 1,000 units
 Requirements for the year are 3,00,000 units.
 The purchase price per unit is Rs. 3.00
 Carrying cost is 25 per cent of the purchase price of goods.
 Cost per order placed is Rs. 20
Solution:
= (2 x 3,00,000 x 20) / (3 x 0.25) = 4,000 units
TEST YOUR KNOWLEDGE

1 Fill in the blanks with appropriate word(s)
(a) Inventory is one of components of ______________ assets
(b) The term inventory is originated from the ____________ “Inventoried” and the
Latin __________
(c) Raw materials, work-in-process, finished goods and stores and spares are the
components of ______________.
(d) ____________ motive necessitates the holiday of inventories for unexpected

changes in demand and supply factors.
(e) The time required to process and execute an order is called ____________ time.
(f) __________ costs are those costs that are associated with the acquisition of raw
materials.
(g) __________ refers to the level of inventory at which the total inventory cost is
minimum.
(h) _________ also known as ZIPS.
(i) _________ is that level of inventory at which an order should be placed for
replenishing the current stock of inventory.
(j) Minimum stock level plus half of the re-order quantity is equal to________.
(Answer : (a) Current (b) French, Inventariom (e) Inventory (d) Precautionary (e) Lead (f) Ordering (g) EOQ
(h) JIT (i) re-order, level (j) Average stock level)
2 State whether each of the following statement is true of false:
(a) Holding of inventories to take the advantages of changes in prices and
getting quantity discounts are known as speculative motive.
(b) Inventory carrying costs are those costs that are associated with the
carrying of goods from supplies to the firm.
(c) Price decline, product deterioration, and product obsolescence are the risks
of holding inventory.
(d) Classification of inventor, order quantity and order point are the three
problems of inventory management.
(e) ABC Analysis is also known at PAV
(f) In EOQ Formula 2AO / CC, ‘A’ stands for annual usage.
(g) VED classification is applied to spare parts.
(h) Just in time system was developed in Japan by Taichi Okno.
(i) Capital cost is one of the components of inventory carrying cost.
(j) Cost of carrying goods from supplies to firm factory premises is included
in ordering cost.
(Answer: (a) True (b) False (c) True (d) true (e) False (f) True (g) true (h) True (i) True and (j)
True)
3 Answer the Following Question
1. What is EOQ?
2. What is inventory management?
3. name the three main components of inventory

4. Name various motives for holding inventories.
5. List out the risks associated with holding inventory
6. Give three problems of inventory management
7. What is ordering cost?
8. What is inventory-carrying cost?
9. State any two objectives of inventory management
10. Define VED analysis
11. What do you understand by ABC analysis
12. How do you compute EOQ
13. State the assumption of EOQ
14. What do you understand by shortage costs?
15. What is Lead Time?
16. What do you understand by JIT system?
17. Write note on FSN system of inventory control.
18. What do you understand by HML, system of inventory control.
19. What is inventory management? Discuss in detail the objectives of inventory
management.
20. Write a brief note on ABC analysis
21. “There are two dangerous situations that management should usually avoid in
controlling inventories”. Explain.
22. What is safety stock?
23. What is order cycling system?
DO IT YOURSELF PROBLEMS
1. The Management of Shesha Sai textiles has predicted sales of 1,00,000 units of a
product in the next 12 months. The product cost is Rs. 18 per unit. Its estimated
carrying cost is 25 per cent of inventory value and ordering cost is Rs. 10 per
order. What is the EOQ? [Answer: 730.29 units]
Bharath Engineering Factory consumes 3,00,000 units of a component per
year. The ordering receiving and handling costs are Rs. 60 per order and the firm is
estimating its carrying cost at 20 per cent. Component cost per unit is Rs. 20.
Calculate EOQ. [Answer: 2,683.28 units]
2. finance Department of RRR Cement Company gathered the following

information. You are required to compute EOQ number of orders in a year, the
time gap between the two orders and the total cost of ordering and carrying.
Monthly usage 150 untis, ordering cost Rs. 20 cost of purchase of the component
Rs. 5 and carrying cost are 16 per cent.
[Answer: EOQ-300 units; Orders-6, Time Gap
between orders- 1 month; Total ordering cost-120]
3. a manufacturing company has an expected usage of 1,00,000 units of certain
product during the next year. The cost of an order is Rs. 40 and carrying cost is
Rs. 0.5 per unit for one year. Lead-time on an order is five days and company will
keep a reserve supply of two days usage. You are required to calculate (a) EOQ
and (b) the Re-order point (assuming 250-day year)
[Answer: EOQ-4,000, Re-order point-3,600 units]
4 A company received an order for 15,000 units at the rate of 1,000 units per
order. The production cost per unit is Rs. 24 per unit-Rs. 10 for raw materials and Rs.
14 as overhead cost. It costs Rs. 1,500 to set up for one run of 1,000 units and
inventory-carrying cost is 20 per cent of the production cost. Since the customer may
buy at least 15,000 this year the company would the to avoid making five different
production runs. Determine most economic production run.
[Answer: 3,062 units]
5 from the following information of ABC Co. Ltd., calculate minimum
maximum and re-order stock levels.
Minimum consumption- 300 units per day
Maximum consumption-400 units per day
Normal consumption- 320 units per day
Re-order period-10-20 days
Re-order quantity- 1,500 units
Normal re-order period-14 days.
[Answers: Re-order level-8000 units, Mini
level-3200 units, Maxi. Level-3500 units]
CASE STUDY
ANITA MILLS LIMITED
The Finance Minister of Anita Mills Limited, a medium size mill manufacturing
coarse cloth was assessing the cash requirements for the operating year 1992 which had just
started. The company had plans to increase its sales by 331/2 per cent during 1992. In 1991
the company sold cloth valued at Rs. 708.48 lakh. The physical facilities presently at the
command of the company were considered adequate to sustain twice the 1991 level of
production. In fact in early January 1992 when this cash budgeting exercise was being done,
revised production plans to suit the changed sales plan had just been finalized.
Due to the seasonal demand of textile products, the sales during the quarters ending
September and December were twice as much as those in the first two quarters of the year.
Within each of these half years, however, there was near uniformity in the off-take. Efforts
that Anita Mills management were capable of could not alter the seasonal pattern of sales.
The company however follows and would wish to continue to follow a consistent level
production throughout the year because of several reasons.
Sales are made on 30 days credit, and the company’s experience in collection were
satisfactory. At the end of 1991 the clients owed Rs. 79.95 lakh of which Rs. 65.19 lakh
pertained the December 1991 sales. The remaining sum of Rs. 14.76 lakh was being carried
over from year to year, and there was no distinct possibility of its realization even during
1992-93.
Major items of inputs required for the manufacture of cloth are cotton, dyes and
chemicals, fuel and power, and labour. The Finance manager knew that, for every rupee of
sales, cost of cotton was 44 paise, dyes and chemicals 6 paise, fuel 4 paise and on packaging
etc. 1 paisa. The company purchased cotton dyes and chemicals and general maintenance
stores on 60 days credit. Although it had not been strictly possible to pay the creditors in time
in the past, the Finance manager strongly wished to set things right at least during 1992. at
the end of 1991, the company owed Rs. 132.84 lakh to its suppliers.
The minimum stock of cotton the company would like to hold at any poi8nt of time is
a fixed 1.5 months’ requirements. Further, it is the company’s policy to buy the requirements
of cotton for any one months in the preceding month itself. At the end of 1991, cotton worth
Rs. 55.35 lakh was held in inventory. Dyes and chemicals, available with insignificant lead
time, were usually bought a month in advance of need. There was no stock of this item at end
of 1991, stores valued at Rs. 20.91 lakh of which a sum of Rs. 14.76 lakh represented
obsolete stock. The company expects its annual consumption of stores and spares during
1992 to remain at the 1991 level of Rs. 49.20 lakh for the whole year.
The mill had unsold funished goods worth Rs. 61.50 lakh (valued at market price) at
the end of 1991. the semi-processed material on the spindles and looms worth Rs. 6.15 lakh
in 1991 is expected to remain the same during 1992. there was no clear defined policy with
regard to stocking finished goods. The company would receive requisitions from buyers, well
in advance, indicating the quantities they would like to lift in specified months. The company
however made it a point to ensure that as far as possible the deliveries proposed in a
particular month were ready by the end of the preceding one. The aggregate cash and bank
balance was around Rs. 12.30 lakhs which, according to the Finance Manager, was the
minimum he should hold at any tme in 1992 also.
Period based costs, as they were incurred in the year 1991, are given below:
Expense under 1, 2 and 4 are paid every month. Insurance is paid half yearly in March and
September; interest on term loan, which is expected to remain the same for 1992, is also paid
half yearly but in the months of June and December.
(Rupees in lakh)
1. Wages and salaries 221.40
2. rent 6.15
3. insurance and repairs 4.92
4. miscellaneous 18.45
5. interest on term loan 9.84
The management expects a five per cent increase in wages and salaries during 1992 on
account of revision in rates. The increased production plan for the year would increase the
wage bill further by 5 per cent.
Other obligations which the company has to meet during 1992 are as follows:
(Rupees in lakh)
1. Tax dues for the year 1990 (to be paid in January) 3.69
2. Unclaimed dividends (may be payable in January) 2.23
3. Dividend for the year 1992 (two equal instalments in 12.30
June and December)
The company estimates that its liability on the operational results for the year 1992 could be
of the order of Rs. 49.20 lakh which, according to the tax laws, would have to be paid up in
four equal quarterly instalments, which commenced from June 1992.

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WORKING CAPITAL MANAGEMENT

3.2.1 MEANING OF WORKING CAPITAL

CONSTITUENTS OF CURRENT ASSETS

Balance Sheet of Pearl India Ltd. as on 31.03.2003

Equity Shares 2,00,000 Goodwill 20,000

(i) Gross Working Capital = Total of Current Assets

KINDS OF WORKING CAPITAL

ON THE BASIS OF CONCEPT ON THE BASIS OF TIME

REGULAR RESERVE SEASONAL SPECIAL

1. Permanent or Fixed Working Capital : Permanent or fixed working capital is the

1. Solvency of the business: Adequate working capital helps in maintaining solvency

2. Goodwill: sufficient working capital enables a business concern to make prompt

5. Regular supply of raw materials: Sufficient working capital ensures regular

6. Regular payments of salaries, wages and other day-to-day commitments:

7. Exploitation of favourable market conditions: Only concerns with adequate

10. High morale: Adequacy of working capital creates an environment of security,

3.2.5 EXCESS OR INADEQUATE WORKING CAPITAL

Disadvantages of Excessive Working Capital

4. It may result into overall inefficiency in the organization.

7. The redundant working capital gives rise to speculative transactions.

Disadvantages of Dangers of Inadequate Working Capital

5. It becomes impossible to utilize efficiently the fixed assets due to non-availability

3.2.6 THE NEED OR OBJECTS OF WORKING CAPITAL

1. For the purchase of raw materials, components and spares.

2. To pay wages and salaries.

4. to meet the selling costs as packing, advertising etc.

5. To provide credit facilities to the customers.

6. To maintain the inventories of raw material, work-in-progress, stores and

3.2.7 FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS

The working capital requirements of a concern depend upon a large number of

1. Nature or Character of Business: The working capital requirements of a firm

2. Size of Business/Scale of Operations: The working capital requirements of a

3. Production Policy: In certain industries, the demand is subject to wide

4. Manufacturing Process/Length of Production Cycle: In manufacturing

5. Seasonal Variation: In certain industries raw material is not available

2. Principle of Cost of Capital: The various sources of raising working capital

4. Principle of Maturity of Payment: This principle is concerned with planning

To sum up, working capital management should be considered as an integral

1. Estimating the working capital requirements.

2. Financing of working capital needs.

3. Analysis and control of working capital.

3.2.8 FORECAST/ESTIMATE OF WORKING CAPITAL REQUIREMENTS

“Working capital is the life-blood and controlling nerve centre of a business.” No

Factors Requiring Consideration While Estimating Working Capital

1. Total costs incurred on material, wages and overheads.

5. The average period of credit allowed to customers.

6. The amount of cash required to pay day-to-day expenses of the business

7 The average amount of cash required to make advance payments, if any.

8. The average credit period expected to be allowed by suppliers.

9. Time-lag in the payment of wages and other expenses.

In order to provide for contingencies, some extra amount generally calculated as a

1. For a Trading Concern: Proforma

Statement of working capital Requirements Amount (Rs.)

(ii) Debtors or Receivables (For….. month’s sales) _

(iii) Stocks (for….. month’s sales)

(iv) Advance payments, if any

(ii) Lag in payment of expenses

(Outstanding expenses, if any)

Working Capital (C.A. – C.L.)

Add: Provision/Margin for Contingencies

Net working capital required

2. For a Manufacturing Concern